Monopolistic competition, short run and long run analysis, selling costs

1. MONOPOLISTIC COMPETITION
Prof. Prabha Panth,
Osmania University,
Hyderabad

2. Monopolistic Competition
• Capitalist markets are neither pure monopoly nor
perfect competition.
• Monopolist cannot fully stop competition,
because some rival firms will enter.
• And perfect competition does not really exist,
there will always be some monopoly factors in it.
• Therefore capitalist markets could have some
features of monopoly and some of perfect
competition.
• Joan Robinson and Edward Chamberlin called
such a market as “Monopolistic Competition.”
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3. Characteristics
Monopolistic competition refers to a market
organisation that has many sellers of a
differentiated product.
Characteristics:
1. Large number of buyers and sellers, but less than
in PC.
2. Sellers cannot influence each other in the market
3. Differentiated products: heterogeneous – so each
seller is a monopolist for his brand. Price maker.
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4. 4. D-curve for each firm is downward sloping, high price
elasticity as there are many substitutes.
5. U-shaped cost curves.
6. Free entry and exit.
7. High cross elasticity: Many substitutes, so if firm A’s
price increases, consumers shift to B.
8. No industry, but a group of firms producing similar but
differentiated products.
9. Advertisement costs are extra costs in this market.
10. Firms do not anticipate or retaliate to other firms’
market practices. Are independent of each other.
11. Non-price competition
Characteristics
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5. Product Differentiation
• Non homogeneous and differentiated
products.
• Real or perceived differences of products, but
same in actual purpose of use.
• Differences could be due to:
– External features, such as branding of commodity
or features such as packaging
– Internal features such as colour, perfume, shape,
size,
– Examples: soaps, tooth paste, cosmetics,
shampoos, ready made, textiles, confectionery
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6. Short Run Equilibrium of a MC firm
• The firm is rational – wants to maximise its
profits.
• Faces a downward sloping D-curve for its
product.
• Price maker.
• AC includes Selling Costs. Has to advertise to
attract consumers.
• Chamberlin’s two heroic assumptions:
1. Symmetry in Demand: all firms have the same
demand levels. All firms are of the same size.
2. Uniform costs: all firms have the same levels of cost
– U-shaped cost curves
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7. Short Run Equilibrium
RC
0
Q
D = AR
MR
SAC
SMC
F
Q1
E
P
C
C1
ABNORMAL
PROFITS
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Firms earn short
run profits by using
the conditions for
profit
maximisation: -
1) MC = MR
2) MC rising

8. Product Differentiation and
Advertisement
• Short term profits earned through successful
advertisements.
• Advertisement needed to show product
differentiation and attract consumers.
• But in the long run, other firms also advertise, or
bring in other innovations.
• Mono-comp firms tend to cluster together, to
attract customers from each other, called the
“spill over effect”:
– E.g. restaurants, medical shops, mechanics, gold and
jewellery shops
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9. Long Run Equilibrium
• In the long run the Mono-Comp firm faces three
situations:
 With free entry, the market size of each firm
decreases,
 Selling costs increase, and
 Economies of scale
• In the long run, the MC firm will earn only normal
profits.
• But at an output < PC, and with excess capacity.
• Inefficiency in production.
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10. Long Run Equilibrium
RC
0
Q
D = AR
MR
LAC
LMC
F
E
P = AC
Q1
Normal Profit
Efficient level of
Production
G
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11. Long run equilibrium
• Demand curve is less steep, and market share of firms
decrease due to entry of new firms.
• Demand curve of a firm will shift downwards due to
entry of new firms,
• Given the long run costs, equilibrium output, OQ1
gives zero profit, for at E, LAC = AR.
• But minimum LAC is at G, the level of efficient
production.
• The firm stops production at E, which is the falling part
of the LAC curve
• Hence the firm, though getting zero profit in the long
run, is not as efficient as a firm in perfect competition.
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12. PC Mon-Comp Monopoly
Number of firms Large nos Large nos < PC Single firm
Demand curve Horizontal straight
line
Downward sloping
(gentle)
Downward sloping
(steep)
Elasticity - Infinity Elastic (- e > 1) Inelastic (- e < 1)
Price Price taker Price maker Price maker
Product Homogeneous Differentiated No substitutes
Entry Easy Easy Blocked
Short run profits Possible yes yes
Long run profits Normal profits Normal profits Abnormal profits
Efficiency and size Optimum Efficient
(minimum LRAC)
Inefficient, >
optimum (LRAC)
Inefficient, >
optimum (LRAC)
Capacity use Full Capacity Excess capacity Excess capacity
Welfare to
consumers
P = MC P > MC P > MC
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13. Selling Costs
• Selling costs include
• Promotion expenses,
• Packaging, and
• Advertisement expenditure.
• Free gifts,
• Through this the firms want to influence
consumers’ demand.
• But it also leads to increase in their costs.
• These costs are extra in Mono-comp as compared
to other markets.
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14. Merits of Advertising
• Mono-comp firms show product
differentiation through advertising.
• Merits of Advertisement:
 Information on new products, and
improvements in old products,
 Consumers made aware of better deals and
offers.
 Reduces asymmetric information between seller
and the consumer.
 Intensifies competition, innovation and efficiency
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15. Demerits
• Manipulates consumer tastes, without
conveying any useful information. (e.g.
fashions, food and drink habits, new gadgets)
• Advertising may also try to create
differentiation within products that are
actually very similar.
• Advertising tries to make demand curves less
elastic, and impedes competition.
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16. Demerits of Advertisement
• Product differentiation encourages brand
loyalty, and makes consumers less price
sensitive
• This then leads to a high mark up over
marginal cost.
• Increases the ability of firms to charge more
than marginal cost. Market power.
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17. Demerits of Advertisement
• Heavy spending on advertising creates barrier
to entry, as new firms also have to spend on
advertising.
• Wasteful costs on advertisement.
• Affects size and quality of the product.
• Wrong and misleading information, harmful
effects not shown. (smoking, junk food, colas)
• Unethical and dangerous ads.
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18. Questions
Short Answers:
1. What is meant by differentiated products? Why
is this necessary in Monopolistic Competitive?
2. What are the extra costs of production borne by
a firm in monopolistic competition?
3. How does a monopolistic competitive firm
achieve short run equilibrium?
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19. Essay Questions:
1. Compare Monopolistic competition to a)
monopoly, and b) perfect competition?
2. Explain the long run equilibrium situation of a
monopolistic competitive firm. How does it differ
from other markets?
3. What are selling costs? What are the advantages
and disadvantages – to the firm and to the
consumers?
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