Unit III- Monopolistic Competition

Introduction-
Pure monopoly and perfect competition are two extreme cases of market
structure. In reality, there are markets having large number of producers
competing with each other in order to sell their product in the market. Thus,
there is monopoly on one hand and perfect competition on other hand. Such a
mixture of monopoly and perfect competition is called as monopolistic
competition, it refers to a market situation in which there are large numbers of
firms which sell closely related but differentiated products. Markets of products
like soap, toothpaste AC, etc. are examples of monopolistic competition.

The following are the features or characteristics of monopolistic

competition:-
1) Large Number of Sellers-
There are large numbers of sellers producing differentiated products. So,
competition among them is very keen. Since number of sellers is large, each
seller produces a very small part of market supply. Every firm is limited in its
size. In other words, there are large numbers of firms selling closely related, but
not homogeneous products. Each firm acts independently and has a limited
share of the market. So, an individual firm has limited control over the market
price. Large number of firms leads to competition in the market.

2) Product Differentiation-
It is one of the most important features of monopolistic competition. In
perfect competition, products are homogeneous in nature. On the contrary, here,
every producer tries to keep his product dissimilar than his rival’s product in
order to maintain his separate identity. This boosts up the competition in market
and at the same time every firm acquires some monopoly power. Hence, each
firm is in a position to exercise some degree of monopoly (in spite of large
number of sellers) through product differentiation. Product differentiation refers
to differentiating the products on the basis of brand, size, colour, shape, etc. The
product of a firm is close, but not perfect substitute for products of other firms.
Implication of ‘Product differentiation’ is that buyers of a product differentiate
between the same products produced by different firms.

3) Freedom of Entry and Exit-

 This feature leads to stiff competition in market. Free entry into the
market enables new firms to come with close substitutes. Free entry or exit
maintains normal profit in the market for a longer span of time.

4) Selling Cost-
It is a unique feature of monopolistic competition. In such type of
market, due to product differentiation, every firm has to incur some additional
expenditure in the form of selling cost. This cost includes sales promotion
expenses, advertisement expenses, salaries of marketing staff, etc. But on
account of homogeneous product in perfect competition and zero competition in
monopoly, selling cost does not exist there.

5) Absence of Interdependence-
Large numbers of firms are different in their size. Each firm has its own
production and marketing policy. So no firm is influenced by other firm. All are
independent.

6) Two Dimensional Competition-

Monopolistic competition has two types or aspects of competition
aspects viz. Price competition i.e. firms compete with each other on the basis of
price. Non price competition i.e. firms compete on the basis of brand, product
quality advertisement.

7) Concept of Group-
In place of Marshallian concept of industry, Chamberlin introduced the
concept of Group under monopolistic competition. An industry means a number
of firms producing identical product. A group means a number of firms
producing differentiated products which are closely related.

8) Falling Demand Curve-

In monopolistic competition, a firm is facing downward sloping demand
curve. It means one can sell more at lower price and vice versa.

9) Lack of Perfect Knowledge-

Buyers and sellers do not have perfect knowledge about the market
conditions. Selling costs create artificial superiority in the minds of the
consumers and it becomes very difficult for a consumer to evaluate different
products available in the market. As a result, a particular product (although
highly priced) is preferred by the consumers even if other less priced products
are of same quality.

Equilibrium of firm-
The two types of demand curves of a firm under monopolistic competition are due
to the following reasons:
 When a firm revises the price of its product, the rival firms don’t always
increase the prices of their products too. Therefore, the demand curve has a
smaller slope and the demand for the product is more elastic.

 If the rival firms follow the price revision by the first firm, then the demand
for its product becomes less elastic. In such cases, the firm needs to slash its
prices further to achieve an increase in demand. In this case, the demand
curve has a steeper slope.

A Firm’s Short-Run Equilibrium under Monopolistic Competition

 Under Monopolistic Competition, the revenue curves are downward
sloping (like under Monopoly). This is because, in order to sell more, the
firm has to decrease the price.

 A firm under Monopolistic Competition can either earn normal profits,

super-normal profits, or incur losses. Also, like under Monopoly, a firm
earns super-normal profits if the demand for its product is very high.

 Also, in the short-run, new firms cannot enter the group and enhance the
supply of the product group. Therefore, they cannot compete away the
super-normal profits of the firm. Also, in the short-run, a firm faces certain
fixed costs. These can include production as well as selling costs.
 In the figure above, you can see that the AR and MR curves of the firm
have negative slopes. Further, the AVC curve includes the production costs as
well as the variable components of selling expenses. Furthermore.
The MC curve cuts the AVC curve at its lowest point. Also, the ATC curve
represents the average of the total cost of the firm including the fixed selling
expenses.
The MC curve intersects the MR curve from below at point I. Hence, the
firm decides to produce a quantity of OM and charge a price of EM per unit.
By doing so, the firm earns a profit of EK per unit and the entry of rival firms do
not compete it out. However, based on the relative location of the cost and
revenue curves, it is possible that the firm is in equilibrium with:

A Firm’s Long-Run Equilibrium under Monopolistic Competition

To discuss a firm’s long-run equilibrium under Monopolistic Competition,
it is important to remember the following points:
 There are no fixed costs in the long-run. The firm can vary its inputs as well
as its selling costs. Further, the firm can choose between various product
qualities.
 There is no compulsion on a firm to operate at a loss. It can leave the
industry whenever it wants. When a firm leaves the industry, the absolute
market shares of the remaining firms, increase. Further, their demand curve
shifts right and upwards. This continues until other firms can produce
without incurring a loss.
 On the other hand, if the demand is so strong that the existing firms make
super-normal profits, then new firms can enter the group.
 They produce close substitutes of the existing products and increase the total
product supply. Therefore, the demand shares of the existing firms reduce.
Hence, the demand curve of a firm cannot stay above its long-run average
cost curve.
 All firms operating under Monopolistic Competition can make a choice
between combinations of:
o Product quality
o Product Differentiation
o Selling costs
 A firm must consider the fact that any variation of price on its part can
attract a reaction from its rivals. Therefore, it faces a much steeper demand
curve.
 Therefore, under Monopolistic Competition, a firm is exposed to constant
interaction with the rest of the firms in the group. Its decisions are not independent
of the decisions of the other firms.
Further, the firm’s demand curve depends on its actions AS WELL AS on
the actions of its rivals. Therefore, it must consider different combinations of its
cost components pertaining to the product quality and its selling expenses, etc.
This helps the firm estimate the slope and position of the demand curve.
Let’s say that the LAC curve in Fig. I represent the product quality and
selling expenses that a firm selects. This has a corresponding long-term MC curve
(LMC) which intersects the MR curve from below at point I.
Therefore, the firm decides to produce a quantity of OM and sell it a per
unit price of EM. This gets a profit of EK per unit. However, soon new firms enter
the market and start offering close substitutes and bring the profit down.
Therefore, there is a reduction in the market shares of the existing firms.
The firm’s AR curve shifts left until it becomes tangent to the LAC curve at point
E as shown in Fig. ii. This ensures that the firm earns only normal profit. Once
this stage is reached, there is no incentive for new firms to enter the market.
This results in the firm’s long-term equilibrium under Monopolistic
Competition. The equilibrium is given by the point of tangency between the firm’s
AR curve and LAC curve, which is at point E in Fig. ii. Therefore, in the long-run,
under monopolistic competition, firms earn only normal profits.

Group Equilibrium
Group equilibrium is the simultaneous equilibrium of all the firms in the
group. We know that the cost and demand conditions of individual firms differ
from each other.
Further, they produce differentiated products making it impossible to derive
demand and supply curves for the group as a whole.
Chamberlin assumed that all firms in the group have identical demand and cost
conditions. Therefore, when in equilibrium, all firms produce the same quantities
of their respective products and sell them at the same prices.
This, however, is a little unrealistic assumption. For all practical purposes,
it is important to determine a firm’s equilibrium under Monopolistic Competition

Differences between Monopolistic Competitions and Perfect Competition

 In perfect competition, many small firms manufacture and supply the same
goods (or perfect substitutes) to the end-user. Small firms mean each firm is too
small to influence the product’s market price.
Monopolistic competition is whereby a handful of sellers offer a particular
product leading to minimal competition. However, each seller’s variants and
quality of products are slightly different.
 In the Perfect competition market, each firm sells a homogenous product (or
perfect substitute), whereas, in monopolistic competition, each firm will have a
slightly different output from the other.
 Since products are slightly different from each other in the monopolistic market,
non–price competition, like advertising and promotion, exists in the
monopolistic market to inform buyers about the quality of the product.
 Since the products are slightly different in the monopolistic market, pricing
power exists quickly until new players enter the market to exploit the pricing
power.
 In Perfect Competition, marginal revenue is equal to average revenue. Total
revenue is defined as a price per unit multiplied by units sold. Therefore, the
average revenue will be similar to that divided by units sold. Marginal revenue
is defined as the change in the total revenue by selling an additional unit. In
perfect competition, average revenue equals marginal revenue since all the
teams are sold equally.