Hill – Mankiw 9th Edn Chapter 16 – Monopolistic Competition
Mankiw, N. G. (2021) Principles of microeconomics (9th ed.)
Principles of economics (9th ed.)
Mason, OH: South-Western Cengage Learning.
Rod Hill
University of New Brunswick, Saint John campus
Saint John, New Brunswick, Canada
email: rhill@unb.ca
Chapter 16 – Monopolistic Competition
Here are some things to consider when reading this chapter.
- Is the model of monopolistic competition useful?
In Chapter 4, Mankiw used the market for ice cream cones as an example of a market that could be analysed using the supply and demand/perfectly competitive model. In describing the market, he wrote: “The sellers of ice cream are in different locations and offer somewhat different products… Each seller posts a price for an ice-cream cone, and each buyer decides how many cones to buy at each store.” (p. 61). Yet this market resembles a classic model of monopolistic competition because location and the physical characteristics of the products give sellers some leeway to set their own prices. If the goods are perfect substitutes, there is no ‘market price’.
In the concluding section of Chapter 15 on monopoly, Mankiw argues that such market power can be disregarded when choosing a model to apply to such a market:
Most firms have some control over the prices they charge. They are not forced to charge the market price [sic] for their goods because their goods are not exactly the same as those offered by other firms… Each of these goods has a downward-sloping demand curve, which gives each producer some degree of monopoly power… It is also true that their monopoly power is usually limited. In such situations, we will not go far wrong assuming that firms operate in competitive markets, even if that is not precisely the case. (pp. 311-312).
If so, why bother with the monopolistically competitive model? Indeed, Mankiw’s statement quoted here echoes the view of the Chicago School, expressed in a 1949 essay by George Stigler. Stigler suggested that a judicious application of either the perfectly competitive model or the monopoly model would be sufficient to analyse a market, the choice of model depending on the question being asked. In his view, the predictions of the monopolistically competitive model “differ only in unimportant respects from those of the theory of competition because the underlying conditions will usually be accompanied by very high demand elasticities for the individual firms” (Stigler 1972, p. 144).
In this chapter, Mankiw seems to contradict the statement from Chapter 15, just cited, by writing: “When analyzing actual markets, economists have to keep in mind the lessons learned from studying all types of market structure and then apply each lesson as they deem appropriate” (p. 320, my emphasis).
Mankiw gives the example of whether a firm would like to attract more customers at existing prices. That seems to be the case for the typical firm in the real world and the monopolistically competitive model is consistent with this (as are other models of imperfect competition). When the firm’s price is greater than marginal cost, new customers add to profits as long as marginal costs remain less than the current price.
In contrast, as seen in Figure 4 (p. 323), the U -shaped average cost curve limits the perfectly competitive firm’s willingness to produce and to sell additional product. A marginal customer adds nothing to profits because price equals marginal (and average) cost. Rising average and marginal costs prevent the firm from wanting to sell more at the current price.
Commenting on this in a famous 1926 critique of the supply and demand framework, the Italian economist Piero Sraffa rejected the empirical relevance of the U-shaped average cost curve. He wrote that “[b]usiness men … would consider absurd” the perfectly competitive model’s claim that rising costs limit their ability to sell more (1926, p. 543). Instead, their problem was that to attract additional customers, they would need to reduce their price or try to increase demand by spending more on marketing.
Yet, in Sraffa’s view, these commonly-found firms and markets could neither be adequately described as monopolies nor as oligopolies. As Sraffa was writing his paper, he was unaware that a model of monopolistic competition was being developed by American economist Edward Chamberlin (Archibald 2008, p. 1).
One example where the monopolistically competitive model has proven useful is in the theory of international trade. The theory Mankiw presents in Chapter 9 is based on comparative advantage and results in countries specializing and trading products that are in different industries. For example, one country could specialize in producing textiles and export them to another country in exchange for steel, the pattern of production and trade depending on comparative advantage. This is termed inter-industry trade.
However, much international trade takes place between high-income countries with little comparative advantage with respect to each other. Their trade largely consists of intra-industry trade, where products are defined in categories. For example, Germany and France export wine to each other; in turn, ‘wine’ could be subdivided into finer categories (e.g. red, white, sparkling). As Paul Krugman explains: “It quickly became apparent that one could use monopolistic competition models to offer a picture of international trade that completely bypassed conventional arguments based on comparative advantage. In this picture, countries that were identical in resources and technology would nonetheless specialize in producing different products, giving rise to trade as consumers sought variety” (2008, p. 338).
- Mankiw’s example of a monopolistically competitive market
The chapter begins with a description of the publishing industry which seems to have the characteristics of a monopolistically competitive market: many similar, but different, products, sellers having some choice about product prices, and ease of entry (of writers) into the industry (pp. 317-18). Mankiw writes that “anyone can enter the industry by writing and publishing a book”. As a result, “the book business is not very profitable. For every highly paid novelist, there are hundreds of struggling ones” (p. 317).
However, like his casual descriptions of other industries earlier in the book, this ignores the way that books make their way from the writer to the reader. Mankiw’s account could be read as if writers are their own publishers who choose the retail prices of their books.
Typically, the publishing industry consists of at least three separate markets. In the first market, authors sell rights to publish their work to book publishers in return for royalty payments based on the sales of the book. In the second market, publishers set or negotiate prices with wholesalers and/or retailers. In the retail market, retailers usually set the retail price. (The case where publishers set the retail price is examined in Chapter 17.)
Publishers typically specialize. Different firms are found in textbook publishing, scientific publishing (such as academic journals and monographs), and books for the general public (so-called trade publishing).
Consider trade publishing in the United States. The biggest publishers are now so big that a merger between two of them can trigger antitrust scrutiny and possible action. An April 2022 article on the Publishers Weekly website described the state of the industry:
As 2022 began, the U.S. trade publishing business was dominated by what has been called the Big Five – Simon & Schuster [S&S], Penguin Random House, HarperCollins, Hachette Book Group, and Macmillan. Before the Penguin–Random House [PRH] merger in 2013, that group was referred to by PW [Publishers Weekly] as the Big Six; if a court battle between PRH and the Department of Justice allows PRH to acquire S&S, a deal that the government blocked in November 2021, it could shrink to the Big Four in late 2022.
The proposed merger was blocked in October 2022 by a judge who agreed with the Justice Department’s argument that the merger could (as one report put it) “stifle competition for best-selling books and lead to lower advances for authors”. Concerns about this kind of market power are more consistent with oligopsony (as described below in section 3), not monopolistic competition.
The extent of concentration of ownership in trade publishing is not obvious because each publisher has numerous ‘imprints’. Penguin Random House alone has nearly 275 “editorially and creatively independent imprints”. For example, you could buy a book published by Pantheon Books, once an independent publisher, without realizing that it is now an imprint of Knopf Doubleday Publishing Group, which, in turn (as a result of past mergers and acquisitions), is owned by Penguin Random House.
The academic publishing industry is also significantly concentrated with its own ‘big five’ who reportedly control more than 50 percent of the market for academic journals and are extremely profitable. Their profitability is greatly assisted by government funding of the research behind the articles, which are written and refereed for free by academics. Public and private universities and institutions then pay high prices for access to the resulting academic journals.
Textbook publishing is similarly highly concentrated, with Mankiw’s publisher, Cengage, being the fourth largest educational publisher with 22 percent of the market. In contrast with Mankiw’s claim that “anyone can enter the industry by writing and publishing a book”, high upfront fixed costs in producing a textbook and support materials for instructors and students create economies of scale that act as a barrier for new firms, who would also have to invest in setting up a network of salespeople.
In short, Mankiw’s inaccurate characterization of the publishing industry is not helpful in determining an appropriate way to model the markets involved in bringing writing from writers to readers.
- Market structure and concentration ratios
Mankiw describes the use of four-firm concentration ratios to describe the extent to which a market is (or isn’t) dominated by a small number of firms (p. 318). While four-firm and eight-firm concentration ratios have their uses, it’s worth keeping in mind their limitations.
Concentration ratios are calculated for the share of domestic production accounted for by domestic producers. Imports are not considered. If imports constitute a significant share of the domestic market, the concentration ratio is misleading (Shepherd 1987).
Another potential issue is the way ‘the market’ is defined. Concentration ratios are calculated at the national level, but this is misleading if the relevant market is a local one. For example, there could be a low national concentration ratio for newspapers, while most cities have a monopoly newspaper.
Another potential problem is the breadth or narrowness by which the market is measured. For example, Mankiw gives no source (or time period) for the data he cites so it’s impossible to know what the four firm concentration ratio for “batteries” means. After all, batteries range from those powering watches, tablets, cell phones all the way to electric vehicle batteries. To be meaningful, the market should be defined so that the products included in it are close substitutes for each other.
- Missing market structures
Mankiw’s text is typical of most principles texts in identifying only four types of market structures: monopoly, oligopoly, monopolistic competition and perfect competition. All focus on differing degrees of sellers’ market power. Nothing is said about the power of buyers in markets. It’s assumed that there are many buyers in all of these markets, all small relative to the size of the market, so that none have significant market power.
Students studying practical business strategy invariably encounter ideas about buyer power. For example, Michael Porter’s well-known five forces model warns of the danger to a firm’s profits of powerful buyers who “can capture more value by forcing down prices, demanding better quality or more service (thereby driving up costs), and generally playing industry participants off against one another” (Porter 2008, p. 30).
The terms for market structures in which buyers have some market power are: monopsony (a single buyer in a market), oligopsony (a market dominated by a few large buyers), and monopsonistic competition (many buyers, each small relative to the size of the market, but still retaining some market power).
Different models of market structures can be used when considering the various stages in the production and distribution of goods. Mankiw’s examples of markets typically ignore these stages, as described in the Commentaries for Chapter 4 (wheat) and Chapter 14 (milk), and here when considering the publishing industry.
Consider the example of Walmart which buys goods from producers and sells them to consumers. Because of its enormous size, Walmart exerts considerable monopsony power over some suppliers of goods and (depending on local conditions) of labour. (The Commentary for Chapter 18 will discuss the power of employers over wages, a particularly important instance of buyer power.) At the same time, Walmart may have monopoly power as a seller in some localities, particularly for groceries.
- Advertising
Up to this point, advertising has received only two passing mentions (pp. 26 and 68). A sustained discussion of advertising issues appears only in this chapter; it’s not mentioned in Chapter 21 on consumer choice.
Perhaps this is because buyers in the standard textbook models are implicitly assumed to have perfect information about everything relevant to their decisions. Advertising that provides information would be redundant. Advertising that attempts to persuade or to manipulate lies outside this simple model; it assumes that people have preferences at any given time, without being interested in where those came from.
So, a discussion of advertising broadens the standard model by acknowledging imperfect information and buyers’ and sellers’ response to it. Sellers incur costs to provide it; buyers incur costs to inform themselves. The possibility of persuasive advertising opens the door to incorporating into the economic model some aspects of preference formation and change. After all, decisions by sellers to use advertising and other marketing strategies to influence buyers’ choices are just part of the profit maximizing decisions they make.
(i) Mankiw’s account of the ‘debate over advertising’
Mankiw summarizes the arguments of those he describes as critics of advertising and the arguments of those who defend advertising (pp. 326-7). But the issue is not whether there should be unregulated advertising or no advertising at all. There is widespread agreement that buyers can make better decisions if advertising accurately informs people about prices, product characteristics and sellers’ locations. This could also spur price competition among sellers (as well as nonprice competition, e.g. store hours, customer service). The results of the case studies that Mankiw describes (allowing advertising of the prices of eyeglasses, eye examinations, and liquor) are unsurprising. Advertising prices reduces consumers’ costs of acquiring that information and could be expected to reduce average prices for these products which are perceived as close or identical substitutes for each other.
According to Mankiw, one point on which critics and defenders of advertising disagree is whether or not advertising impedes competition. Does it affect people’s perceptions of a product, helping to create brand loyalty and to act as a barrier to entry of new firms? Or can new firms enter the market more easily because they can advertise and attract customers from existing firms? This is an empirical question and the answer needn’t be the same for every market.
A new café in a university town may enter the market with modest advertising costs, in line with the assumption of low entry barriers in a monopolistically competitive industry. On the other hand, a company entering a market dominated by well-established oligopolists with a long history of high advertising expenditures will have a much more difficult time. In that context, Michael Porter, in his classic article on business strategy, wrote that “[b]rand identification creates a barrier by forcing entrants to spend heavily to overcome customer loyalty” (1979, p. 138). The “need to invest large financial resources in order to compete can deter new entrants… The barrier is particularly great if the capital is required for unrecoverable and therefore harder-to-finance expenditures, such as up-front advertising…” (Porter 2008, p. 27). (The Commentary on the next chapter gives an example of breakfast cereals, an oligopolistic industry.)
(ii) Advertising as psychological manipulation or a signal of quality?
On the ‘defenders of advertising’ side, Mankiw offers the argument that firms will only find it profitable to invest in advertising if their product satisfies customers, thus generating repeat business (p. 328). This seems to presuppose that the advertising itself is unable to create and maintain the need for the product.
Consider the example of Listerine, the mouthwash found on the shelves of pharmacies everywhere. The product has its origins in a brilliant advertising campaign that began in the early 1920s. As author James Twitchell explained, it was “one of the first times that advertising really did create a ‘cure’. But, of course, to make the cure, they first had to create the disease. Listerine did not make mouthwash as much as it made halitosis [bad breath]. Or, in advertising terms, you don’t sell the product, you sell the need” (2000, p. 60). Later, other companies came up with bathroom products to cure problems that people had not previously realized that they had, such as body odour, smelly armpits, dandruff, ‘5 o’clock shadow’ beards, and hair with split ends.
Mankiw gives the standard argument that potential buyers should see expensive advertising that conveys little or no information about the product itself as a signal of quality. For example, advertising on US football’s Super Bowl game is notoriously expensive. But watching Sam Bankman-Fried’s FTX Super Bowl ad, or its many pricey ads featuring celebrities, and taking this as a reliable signal of quality would have been a serious mistake. Clearly, ‘let the buyer beware’ still applies.
This expense-signals-quality argument is potentially relevant for first time purchasers of ‘experience goods’, goods whose quality can’t be determined just by examination (‘inspection goods’) but by the buyer’s own past experience. It could also be relevant for ‘credence goods’, goods whose quality can’t be determined even after consumption. (For example, a product could be claimed to be good for your health, but even after consumption the claim would likely have to be taken on faith.) In any case, much expensive advertising deals with products with which buyers are already familiar.
Mankiw writes that critics of advertising say that it uses psychology to manipulate people’s tastes and behaviour. This Pepsi fact-free advertisement is a typical example. Indeed, providing information about the contents of the drink (carbonated water, glucose-fructose and/or sugar, caramel colour, phosphoric acid, caffeine, citric acid, ‘natural’ flavours) would only draw unwanted attention to its caloric content and lack of nutrients.
In his review essay on advertising, Richard Schmalensee writes: “In sharp contrast [to the advertising-as-signaling argument], information processing models of human behaviour, explored in the marketing literature, suggest that advertising may affect behaviour mainly by enhancing a brand’s chances of being on the short list… from which final choices are made” (2008, p.2). This way of thinking about decision-making is quite different from the simple consumer choice story that features perfect information and well-defined preferences (illustrated in detail in Chapter 21).
(iii) Advertising, changes in preferences, and consumer surplus
What if persuasive advertising can change those preferences and therefore the decisions that people make by creating needs or wants? Mankiw acknowledges this possibility, but does not examine the questions that arise.
In a brief essay on changes in tastes, Michael McPherson (1987) points out that it is not obvious whether the preferences before or after the change are the ones to use in judging the outcome. If persuasive advertising increases demand in the market, consumer surplus in the market could increase. Are buyers better off than they were before? After all, advertisers serve their own interests, not those of potential buyers. The standard stories Mankiw offers – that advertising offers information, directly or indirectly – does not acknowledge that people could be persuaded to do things that could leave them no better off or that they could later regret.
The textbooks implicitly assume that all that counts are the wants of the moment and the extent to which they are being satisfied. The simplest economic model takes preferences as ‘given’, determined outside the model. Including imperfect information and malleable preferences leaves firms with profit maximizing decisions about advertising to inform and persuade potential customers. This expanded model raises the question McPherson considers. It also raises questions about whether firms’ marketing activities lead to socially desirable outcomes or require regulation.
(iv) Regulation of advertising
Public policy in many countries takes a different view, where governments regulate and restrict advertising, particularly advertising directed towards children. Young children can’t distinguish between entertainment and advertising on television, which is one reason why some western European countries ban the use of children in TV advertising. Sweden, Norway, Brazil and the Canadian province of Québec all ban domestic TV advertising aimed at children under the age of 12. The United Kingdom bans the advertising of foods high in fat, sugar and sodium that is directed at children. No such regulation exists in the United States, where the advertising of junk food is the focus of most advertising directed towards children.
Some products are so harmful that their advertising is banned – or at least is supposed to be. Here are a couple of examples.
The World Health Organization’s Framework Convention on Tobacco Control calls for a ban on all forms of tobacco advertising, promotion, and sponsorship including the retail display of tobacco products. Restrictions do exist in many countries, but serious problems remain. Tobacco companies have long directed advertising and marketing to children and youth, the smokers of the future. An international investigation in a sample of 22 developing countries a few years ago found that cigarettes were being sold and promoted within 300 metres (or closer) of schools in nearly all the countries (Boseley et al., 2018).
The World Health Organization’s International Code of Marketing Breast-Milk Substitutes, established in 1981, bans advertising and promotion of infant formula, sets strict labelling requirements, and requires that producers inform potential buyers that breast milk is best for babies. It’s up to individual governments to implement the Code in their own laws and to monitor compliance. (The United States, the only United Nations member to vote against the Code when it was established in 1981, has not implemented it.) In many developing countries, formula producers aggressively market their products regardless of the consequences (Hill and Myatt 2021, pp. 163-165).
(iv) The potential social consequences of advertising
Advertising is often claimed to play an important role in the creation of consumerism, a core feature of the consumer society. This is “a society in which a large part of people’s sense of identity and meaning is found to the purchase and use of consumer goods and services”, as a nonstandard introductory text puts it (Goodwin et al. 2023, p. 241). These concepts do not appear in Mankiw’s text, which ignores the possibility of the cumulative effects of the advertising of individual products on the culture.
In his essay on advertising, Richard Schmalensee writes that the claim that “advertising has fostered the long-run growth of materialism” has never been rigorously tested (2008, p. 2). However, there is evidence that increasing children’s exposure to advertising can make them more likely to agree with statements expressing materialistic views (Schor 2004, p. 86). It’s not surprising that some jurisdictions attempt to limit children’s exposure to it.
REFERENCES
Archibald, G. C. (2008) “Monopolistic Competition”, in Palgrave Macmillan (ed.), The New Palgrave Dictionary of Economics, DOI 10.1057/978-1-349-95121-5_1153-2
Boseley, Sarah, Dan Collyns, Kate Lamb and Amrit Dhillon (2018) “How children around the world are exposed to cigarette advertising”, The Guardian, 9 March.
Goodwin, Neva, Jonathan Harris, Julie Nelson, Pratistha Joshi Rajkarnikar, Brian Roach, and Mariano Torras (2023) Microeconomics in Context, Fifth Edition, Routledge.
Hill, Rod and Tony Myatt (2021) The Microeconomics Anti-Textbook: A Critical Thinker’s Guide, Bloomsbury.
Krugman, Paul (2008) “The increasing returns revolution in trade and geography”, Nobel Memorial Prize Lecture, available here.
McPherson, Michael S. (1987) “Changes in tastes”, in Palgrave Macmillan (eds.), New Palgrave Dictionary of Economics, Palgrave Macmillan. doi.org/10.1057/978-1-349-95121-5_305-1.
Porter, Michael E. (1979) “How competitive forces shape strategy”, Harvard Business Review, March-April, pp. 137-45.
Porter, Michael E. (2008) “The five competitive forces that shape strategy”, Harvard Business Review, January, pp. 24-41.
Schmalensee, Richard (2008) “Advertising”, in Palgrave Macmillan (ed.), The New Palgrave Dictionary of Economics, DOI 10.1057/978-1-349-95121-5_354-2.
Schor, Juliet (2004) Born to Buy: The Commercialized Child and the New Consumer Culture, Scribner.
Shepherd, William G. (1987) “Concentration Ratios”, in S. Durlauf and L.E. Blume (eds.), The New Palgrave Dictionary of Economics, DOI 10.1057/978-1-349-95121-5_520-1
Stigler, George (1972) “Monopolistic Competition in Retrospect”, pp. 131-144 in Charles K. Rowley, ed., Readings in Industrial Economics, Volume 1 Theoretical Foundations, Palgrave Macmillan.
Twitchell, James B. (2000) Twenty Ads That Shook the World: The Century’s Most Groundbreaking Advertising and How It Changed Us All, Three Rivers Press.
Related commentaries
Goodwin, Neva (2021) “Consumerism and the denial of values in economics”, real-world economics review, 96: 224-241. Available here.