Microeconomics II lecture notes on Monopolistically Competitive Market Structure

1. CHAPTER ONE MONOPOLISTIC
COMPETITION
Instructor: Aschalew SH.

2. Monopolistic Competition Defined
• As the name implies, monopolistic competition is a blend of
competition and monopoly.
– It possesses some elements or characteristics of perfect
competition and draws some elements from pure monopoly.
• The competitive element arises because there are many
sellers, each of which is too small to significantly affect the
other sellers.
• In addition, firms can enter and leave a monopolistically
competitive industry. Thus, the major elements of perfect
competition found in monopolistic competition are:
– the existence of many small firms which are unable to
significantly affect each other (when seen individually),
and
– the possibility of entry and exit.

3. Cont’d
• The monopolistic element arises from product differentiation.
– since the product of each seller is similar but not identical, each seller
has a monopoly power over the specific product it sells.
• This monopoly power, however, is severely limited by the
existence of close substitutes.
– Examples of monopolistic competition include the markets of the
numerous brands of soap (B-29, Wabel, 777 …), toothpaste (Aquafresh,
Colgate, Close-Up …), stationeries (SinarLine, MAMCO …), cigarettes
(Rothmans, Marlboro, Nyala, Dunhill …), etc.
• Edward Chamberlin (1933) and Joan Robinson (1933)
contributed the pioneering works on monopolistic competition.

4. Product Differentiation, the Demand Curves &
Costs of the Firm
• Product Differentiation:
• Product differentiation is generally intended to distinguish the
product of one producer from that of the others in the
‘industry.’ This product differentiation might be attributed to:
– The subjective judgment of the consumer,
– The quality (for instance, the durability) of the product,
– The characteristics of the product such as taste, color ,
– Sales promotion, packaging, trademarks, etc.
• Product differentiation can be real or fancied.

5. Cont’d
• Real product differentiation: exists when there are d/ces in
the specification of the products (chemical composition/
ingredients), or d/ces in the factor inputs, or the services
offered by the producer during times of sale.
• As long as there is a d/ce in what the consumer or the buyer
actually gets, whether it is a d/ce of chemical composition or a
d/ce of the accompanying service, the product differentiation
is real.

6. Cont’d
• Fancied (spurious/imaginary) product differentiation: exists
when the products are basically the same but the consumer is
persuaded, via advertising or other selling activities, that the
products are different. It is established by advertising,
difference in packaging, difference in design, or simply by
brand name.
• Whatever the case, the aim of product differentiation is to
make the product unique in the mind of the consumer.

7. Demand Curve
• One major implication of product differentiation is that
the producer has some power in the determination of its
product’s price.
– The firm is not a price-taker but a price-maker even though
it faces the keen competition of close substitutes offered
by other firms.
• Hence, product differentiation gives rise to a negatively
sloping demand curve.
• This demand curve is less elastic than perfectly competitive
firm’s demand curve, but more elastic than the demand
curve a pure monopolist faces because of the availability of
close substitutes in monopolistic competition.
– Unlike a wheat-farmer who cannot individually affect the
market price of wheat (nearest example of perfect
competitor), the producer of a cigarette brand (say,
Marlboro) can set the price for its product.

8. Cont’d
• We distinguish between two types of demand curves in the
theory of monopolistic competition – the planned sales curve
and the actual sales curve.
– The planned sales curve – this is a demand curve that shows
how much the firm will sell if it varies its price from the
ongoing level under the assumption that other firms
maintain their existing prices.
– If the firm reduces its price and other firms maintain their
prices, the firm can expect a considerable increase in sales
since it will be able to attract buyers away from other firms in
the group (‘industry’) and increase sales to existing
customers.
– If the firm increases its price and other firms maintain their
prices, the firm can expect a considerable decrease in sales
since it will lose business to other firms in the group.

9. Cont’d

10. Cont’d
• Thus, assuming that each firm expects its actions to go unfelt
by the others, each believes its demand curve to be quite
elastic.
– This demand curve (the planned sales curve) is shown as dd in Figure
1.1.
• If the firm under consideration charges P2 per unit, it would sell
Q4 units of its output; similarly, Q* and Q3 units would be sold
at prices P* and P1, respectively.
• Under the assumption we made regarding what this firm thinks
about its competitors, the decision of this firm to change prices
implies a movement along the dd curve.

11. Cont’d
• The actual sales curve – this is the demand curve based on the
assumption that all firms raise or lower their prices by the same
amount as the firm under consideration.
– This demand curve, also known as the share-of-the-market curve, is shown as
DD in Figure 1.1.
• If this firm reduces its price from P* to P1 (on the expectation of
raising sales to Q3) and all other firms reduce their prices to P1 as
well, this firm will sell only Q1 units of output.

12. Cont’d
• Similarly, if this firm increases its price to P2 and all other firms
increase their prices to P2 as well, this firm will sell Q2 units of
output.
• Thus, if firms follow both price- rises and price-cuts of a firm,
no shift of customers is expected to result from a price
change. The only change that takes place is the change in the
quantity consumed of each firm’s product in a direction
opposite the direction of price change.

13. Costs:
• Chamberlin introduced the selling costs to the theory of the
firm for the first time. The recognition of product
differentiation provides the rationale for the selling expenses
incurred by a firm.
• He also argued that the selling-costs curve is U-shaped, i.e.,
there are economies and diseconomies of scale of advertising
as output changes. The cost of advertising per unit of output
initially declines and then eventually rises as output expands.
Thus, there is a level of output where the ATC of advertising is
minimized.
• The U-shaped selling costs, added to the U-shaped production
costs, yield U-shaped average, average variable, and marginal
cost curves.

14. The Concept of Industry and Product Group
• An industry under perfect competitive condition is defined as a
group of firms producing homogenous products. But this
concept of industry cannot be applied to the cases where
products are differentiated.
• Chamberlain defined the monopolistically competitive
industry as a group of firms producing a closely related
commodity called product group.
• The products in the same group can be technological and
economic close substitutes among themselves.

15. Cont’d
 The two products are technological substitutes for each other if
technically satisfy the same want.
 Example: Rothman Vs Nyala, Peacock soap Vs B-29, and all vehicles.
 The two products are considered as economic substitutes for
each other when they satisfy the same wants and have more or
less the same price.
 Example: Meta Vs Harar beers, Coca Vs Pepsi, etc.
 Operationally, products in a group are close substitutes in the
sense that the products are technologically as well as
economically substitutes.

16. Equilibrium of the Firm
• A perfectly competitive firm is a price-taker. It can choose the level
of output only. This means that quantity of output is the only choice
variable for a perfect competitor.
• On the other hand, a pure monopolist can choose either the price it
charges or the quantity of output it produces, but cannot
simultaneously choose both.
• What about a monopolistically competitive firm? The choice-
related variables for a monopolistically competitive firm are:
i. price (or quantity),
ii. product variation, and
iii. selling expenses.

17. Cont’d
• As for a firm under any type of
market structure, the best level of
output for a monopolistically
competitive firm is determined by
the equality of marginal revenue
and marginal cost, i.e., (MR = MC).
• Figure below depicts the three
possible short run equilibria of a firm
in a monopolistically competitive
market structure.

18. Cont’d

19. Cont’d
• In the long run, however, the monopolistically competitive
firm breaks even.
• While perfectly competitive firms reach the long run (zero
profit) equilibrium as result of free entry and exit,
monopolistically competitive firms reach the long run (zero
profit) equilibrium because of two forces:
– Free entry into and exit out of the product group, and
– Price competition of the existing firms.

20. Graphically

21. 21
Monopolistic versus perfect
competition: excess capacity
• There are two noteworthy differences between monopolistic
and perfect competition: excess capacity and mark-up.
• In perfect competition in the long run, firms produce at the
point where ATC is minimised (efficient scale). There is no
excess capacity.
• In monopolistic competition in the long run firms produce
output less than the efficient scale where ATC is minimised.
• In other words, monopolistic competition implies excess
capacity not only in the short run but also in the long run.

22. 22
Excess capacity
Quantity
Monopolistically Competitive Firm Perfectly Competitive Firm
Quantity
Price
P = MR
(demand
curve)
MC
ATC
Quantity
produced
Efficient
scale
Price
Demand
MC
ATC
Excess capacity
P = MC
Quantity
produced
= Efficient
scale

23. 23
Mark-up over marginal cost
• For a competitive firm, price equals marginal cost both in the short
and long run due to the horizontal demand curve (price taker)
P = AR = MR = MC
• For a monopolistically competitive firm, price exceeds marginal cost
both in the short and long run due to downward sloping demand
curve (price maker).
P = AR > MR = MC
• Mark-up means price exceeds marginal cost.
• Mark-up pricing implies that an extra unit sold at the posted price
earns more profit for the firm. Profit volume depends on sale volume

24. 24
Mark-up over marginal cost
Quantity
Monopolistically Competitive Firm Perfectly Competitive Firm
Quantity
Price
P = MC P = MR
(demand
curve)
MC
ATC
Quantity
produced
Price
Demand
Marginal
cost
MC
ATC
MR
Markup
Quantity
produced

25. 25
Monopolistic competition and the welfare of society
• Monopolistic competition is less desirable for society compared with
perfect competition
– First and foremost, it causes deadweight loss to the society due to the
markup of price over marginal cost
– Excess capacity in the long run implies unused scarce resources for the
society
• Regulation to achieve the equality of marginal cost and revenue is not
practical because it involves interfering with the pricing decisions of all
the firms with differentiated products
• Even an efficient and non-corrupt public administration may find this
task impossible

26. Cont’d

27. End of CH1!