The purpose of persuasive advertising is to shift the utility functions of the customers, thus to shift their demand curves in favor of the good being advertised. Since we judge consumers' benefits in terms of given consumer utility functions, it is hard to say if consumers benefit or lose -- so persuasive advertising looks like spending money without making consumers any better off, and many economists regard that as a negative.

We expect that both forms of advertising will be especially common in oligopolies and whenever products are differentiated, as in monopolistic competition. Monopolies, too, may find it profitable to advertise.

Products are differentiated when the products of different companies are not perfect substitutes -- instead, "every company has a monopoly of its own product." Nevertheless, companies may compete by changing the characteristics of the product they sell. The idea is not necessarily to make a better product than the competitor, just different -- to appeal to a different "market niche."

Again, economists (on the whole) regard this form of competition as a mixed bag:

• It increases variety, but
• It divides up the market, leading to higher prices and costs

In some industries, there is a very hot competition to introduce a product that is superior to rival products. This form of competition has a good reputation but may be overrated -- it lends itself to "horse races," in which only the winner gets any profit at all, and recent research indicates that these "winner take all" competitions tend to lead to overinvestment and waste of resources. (The constant upgrading of computer software may be an example). On the other hand, quality improvement makes consumers better off in an obvious and probably pretty major way, so competition in quality is at worst a mixed bag.

While the various forms of nonprice competition each seems to be a mixed bag -- some good, some bad consequences -- many economists feel that, on the whole, more competition in all these categories tends to be better than less competition.

My experience of garbage pickup in Rose Valley, Delaware County, seems an illustration. Rose Valley was incorporated as a Borough mainly to keep city conveniences out, and has no garbage collection services, public or privatized. Three haulers serve the individual homes by contract. This oligopoly competes somewhat in price and quality of the service, and my impression is that Rose Valleyans really do get better garbage service than other communities where, public or private, there is no competition at all.

We have "monopolistic competition" when a group of firms sell closely related, but not homogenous products. Instead, the products are said to be "differentiated products." Thus, the characteristics of "monopolistic competition" are:

• Many buyers and sellers
• Differentiated products
• Sufficient knowledge
• Free entry

Some economists have avoided any reference to industries in dealing with monopolistic competition. Instead they talk about "product groups." A product group is a group of firms selling products that are "good," but not necessarily "perfect" substitutes.

The Short Run

When the product is differentiated, that means the firm has some monopoly power -- maybe not much, if the competing products are close substitutes, but some monopoly power, and that means we must use the monopoly analysis, as if Figure 1 below.

Figure 1: Monopolistic Competition

But this is just a short run situation. New firms will set up, and existing firms will change their products, so that there will be more, and closer, substitutes in the long run. That will shift the demand for this firm's profits downward, and perhaps cause the cost curves to shift upward as well, squeezing the profit margins.

The Long Run

A new "long run equilibrium" is reached when (economic) profits have been eliminated. This is shown in Figure 2:

Figure 2

Zero (economic) profit is also the condition for long run equilibrium in a p-competitive industry. But this equilibrium is not the ideal that the long run equilibrium in a p-competitive industry is. Many economists feel that the long run equilibrium in a monopolistic industry has some problems:

• Inefficiency
• Excess capacity
• Advertising and nonprice competition

Increasing Product Differentiation

One way thata monopolistically competitive firm might be able to improve its profit margins is by changing its product type so that the other products are less substitutable for it. Recall

• The more and the closer substitutes there are for a product, the more elastic the demand for that product is.
• A less elastic demand is correlated with a steeper demand curve.

So we can visualize a more differentiated product as having a steeper demand curve. That's the idea behind Figure 3:

Figure 3

Increasing Product Differentiation:
Long Run

Here is the way the firm's new long run equilibrium would look:

Figure 4

Now we see zero profits on the new demand curve, with sales of 610 units at a price of $99 per unit. Comparing the two long run equilibria, we see that in this case, nonprice competition has increased the price and cost from $76 per unit to $99 per unit, while production has been cut back from 935 units to 610 units. This doesn't look very good for monopolistic competition.

The Controversy on
Monopolistic Competition

It sometimes happens in the reasonable dialog of economics that issues are raised that cannot be fully resolved to everybody's satisfaction. During the 1980's and 1990's, monopolistic competition theory had made something of a comeback. Product differentiation and variety seemed to important to leave out of economic theory, and economists found ways to make this idea quite precise. It also seemed especially important in international trade: when both the United States and Germany import automobiles to one another, it must mean that automobiles are a differentiated product, and that the American cars are different from the German cars. The problem is that we still really do not know what that implies for efficiency. The theorists of the 1990's tend to put a great deal of stress on the tendency of nonprice competition to encourage innovation and the introduction of new products, rather than any tendency to raise prices. The discussion is still going on.

1. The oligopoly firms will conspire and collaborate to charge the monopoly price and get monopoly profits
2. The oligopoly firms will compete on price so that the price and profits will be the same as those of a P-competitive industry.
3. The oligopoly price and profits will be somewhere within the range, and the more "concentrated" the oligopoly is -- that is, the fewer and bigger the firms are, so that it more nearly resembles a monopoly -- the nearer monopoly profits and prices the industry will come.
4. Oligopoly prices and profits are "indeterminate." That is, they may be anything within the range, and are unpredictable.

Since the 1950's there have been many statistical studies to try to resolve this question. While there is room for some controversy, the weight of the evidence seems to favor commonsense hypothesis 3.

Modern study of strategy is called "game theory" because of the analogy to strategies in a game.

Like Neoclassical Economics, Game Theory assumes:

• People are rational
• People are self-interested

• The "rules of the game" are stable
• Everybody knows them
• Each "player's"payoff depends on the strategies chosen by others, as well as oneself

Dominant Strategies

DEFINITION Dominant Strategy: Let an individual player in a game evaluate separately each of the strategy combinations he may face, and, for each combination, choose from his own strategies the one that gives the best payoff. If the same strategy is chosen for each of the different combinations of strategies the player might face, that strategy is called a "dominant strategy" for that player in that game.

DEFINITION Dominant Strategy Equilibrium: If, in a game, each player has a dominant strategy, and each player plays the dominant strategy, then that combination of (dominant) strategies and the corresponding payoffs are said to constitute the dominant strategy equilibrium for that game.

Nash Equilibrium

1. In each case, there are two decision-makers.
2. The payoffs to each decision-maker depends on both decisions.
3. Both decision-makers seek their own interests.
4. Each chooses in isolation from the other, taking the other decision as given.
5. As a result, both have relatively bad outcomes -- long prison terms or zero profits.