Monopolistic competition and economic profit

Narrator: What I want to do in this video is think about why it's so hard for a monopolistic competitor to make money in the long run. Just as a reminder, a monopolistic competitor is much closer to perfect competition then it is to a monopoly. What it means is that you have a monopoly in your differentiated product, but eventually other people are going to make substitute products. They can't make exactly your product, it can't be identical and it might eat into your demand. To understand that, let us draw the demand curve for a market in which monopolistic competition is going on. I will draw it nice and big. In this axis right over here I'm going to plot dollars per unit and so price is revenue per unit and we'll have cost per unit and things like that. And in this axis I'm going to have quantity produced in an given period of time. We're going to speak in fairly general terms over here. Now, let's assume that our monopolistic competitor right over here is Apple and it's iPad's. (writing) Apple, iPad's. I want to emphasize, I'm not making any accusations that Apple is a monopolist here. They just have a differentiated product and so they are monopolistic competitors here, they have a monopoly in iPad's. They don't have a monopoly in Tablet computers or computers in general, but only they can sell iPad's. So, let's draw the demand curve in the short run for iPad's and I'll make it linear to make things simple. Let me draw a little bit better than that. Let's say the demand curve looks something like that. That is our demand curve and we know that if that's the demand curve and remember we're talking about the market for iPad's, not the market for Tablet computers, Apple is the monopolist in the market for iPad's, so it's marginal revenue will have twice the slope of this demand curve. So, it will look something like that. That is Apple's marginal revenue curve and then think about its short run economic profit in a given period of time, whatever this quantity per period of time is. Let's draw its cost, so first I'll draw ... Let me draw its marginal cost, so its marginal cost might look something like this. That is their marginal cost and then to do average total cost, up here when you have very low quantity, most of your costs are fixed cost, but you're dividing it by a very small quantity so you're going to have a very high average total cost. It's going to get lower and lower and lower as long as the cost on each incremental unit is lower than the average and the cost on each incremental unit is a marginal cost curve. As long as an average total cost is higher than the marginal cost curve, that's going to be downward sloping, and at some point they're going to be equal to each other. Now, each incremental unit that you add on is going to increase the average because each incremental unit's cost is more than the average, so it's going to cause everything to average up. This actually right over here should be the minimum point on our average total cost curve. Given the way I've drawn things, what is Apple's short run economic profit? We just have to think of its optimal quantity to produce. It's definitely going to produce one, so the marginal revenue much higher than the marginal cost is going to make economic profit on that unit, it's going to keep producing because that continues to be true all the way until this point right over here. It doesn't want to produce more than that because the opportunity cost on each incremental unit is higher than the revenue on that, so you're going to take an economic loss. So, you're going to produce right over there and at that quantity, I'll call that Q* right over there. At that quantity this is the price that they can charge in the market going in to the demand curve. I just went straight up to the demand curve over there. This is the price that they can charge in the market and there average or you could view that as their average revenue per unit. Then we have our average cost per unit right over here, an average total cost. This is their average economic profit per unit. If we multiply that times the total number of units. If we multiply times the total number of units the area of this rectangle right over here is going to give total economic profit. (writing) total, total, economic, economic, economic profit. Now, in all things, if the rest of the world sees economic profit they're just like, wow that's a good ... people are doing better in that market than their opportunity cost. So other competitors say well I can't produce iPad's but I can start making competitive products, so you'll see players like Samsung and we are seeing this, sitting here in 2012 and this is a work in progress for these competitors right over here. Samsung htc, HP, all the tablet manufacturers, all the computer manufacturers and they're pairing up, they're pairing up with the operating system manufacturers like Microsoft and Google's Android and they're making competitive products. And on top of it they are marketing it, they are marketing it heavily. (writing)they are marketing. They are trying to market the products as aggressively as possible. So, as their products become more and more comparable to an iPad, or maybe even better in certain dimensions, either cost or features and they market heavily. In the long run what's going to happen to Apple's demand curve? Well, at any given price less will be demanded and so the demand curve will shift. The demand curve will shift to the left and so we could end up with a new demand curve. I'll do it in a different shade of blue, that looks something ... that looks something like, (writing) That looks something like that. This is our new demand curve, or we should say, maybe our long run demand curve after these people have made their products better and have marketed heavily. If that's the new long run demand curve then our long run marginal revenue curve was going to have twice the slope of that, so it's going to look something like this. If it's twice the slope it's going to hit right about ... it's going to look ... I can do a better job than that. Our new marginal revenue ... let me do it in a slightly different color, I'll do it in pink. Our new marginal revenue curve will look something like that. This is long run marginal revenue. (writing) long run marginal revenue curve. Now what is the optimal quantity for Apple to produce? Now it's going to make economic profit, economic profit, economic profit, all the way until this point right over here. Now we have this new, I'll call it long run, long run quantity. Maybe I'll call it ... let me do it in a different color. I'm using that pink too much. Long run quantity right over there and to figure out the revenue per unit or the price at that quantity we just go up to the demand curve, our new demand curve. Remember our long run demand curve, it's right over there. It looks like, at least the way I've drawn it, that the price hasn't changed much. We've got the same price, but now what is our average economic profit per unit? The way I've drawn it, the average total cost right over there are right about what that price is. So, our average economic profit per unit goes down to zero. Over here we had this nice green height and now we have no height anymore. Even though we're selling a good number of units our average economic profit per unit is zero. Instead of an area over there, we're going to have the area of a line, which is essentially zero. Now we have zero economic, (writing) zero economic, economic, zero economic profit. The important thing to realize for a monopolistic competitor and this wont happen over night ... some would argue that sitting here in 2012, early 2012, Apple is still generating economic profit and it's always important to realize economic profit is different than accounting profit. Accounting profit can be positive, economic profit can be zero when accounting profit is positive. You can even have an economic loss and still have accounting profit. Some people would argue that right now Apple is still making profits above and beyond even their opportunity cost and this is actually a work in progress right now in 2012, that the demand curve is shifting to the left, but eventually all of the economic profit will be eaten up and there will be less incentive for all of these players to be as aggressive. The important thing to realize with a monopolistic competitor is sure, they're curves look like a monopolist, but the competition doesn't happen in terms of supply of iPad's. None of these players can supply iPad's the competitive part happens with all of these people producing substitutes and being aggressive about it and eating in to the monopolistic competitor's demand.