Monopolistic competition

MONOPOLISTIC COMPETITION
(BASED ON BA ECONOMICS SYLLABUS OF UNIVERSITY OF CALICUT)
MuhammedSuhaib m
Head of the Department,
Department of Economics,
KR’s Sree Narayana College, Thozhuvanoor

Monopolistic Competition
 Monopolistic competition is a market structure characterized by a
large number of firms producing differentiated products.
 Monopolistic competition combines elements of both monopoly and
competition. Since each firm sell a differentiated product, it has some
control over the price at which it sells its output.
 The monopolistically competitive firm has an absolute monopoly in
terms of the differentiated product it markets.

Monopolistic Competition
 There is competition from the firms selling products that are close
substitutes which severely limits the monopolistic power of firms.
 The theory of monopolistic competition was originated by the
American economist Edward Chamberlin.
 Chamberlin’s book “the theory of monopolistic competition” was
published in 1933
 The same theory was developed independently by the British
economist Joan Robinson in her book “The Economics of
Imperfect Competition” published in 1933.

Features of Monopolistic Competition
 1. Products are Differentiated: Firms compete by selling differentiates products
that are highly substitutable for one another but not perfect substitutes. Each firm has
some monopoly power in that it has the sole right to produce and market its
particular variety of the product. There are a number of close substitutes such that-
the cross-price elasticity between brands will generally be positive.
 3. Number of Sellers and Buyers: There are many firms in a monopolistically
competitive industry, but generally fewer than in perfectly competitive industry. One
result of having a large number of firms is that no individual firm have much
discretion aver price. But prices may not be the same for all firms.
 3. Free Entry and Exit: It is relatively easy for new firms enter the market with
their own brands and for existing firms to leave if their production become
unprofitable. Normally there are very few restrictions imposed by governments.

Features of Monopolistic Competition
 4. Profit Maximization: the goal of the firm is profit maximisation, both in short
run and in long run.
 5. Absence of Collusion: Firms are assumed to function independently of one
another. Thus, there is no collusion among the sellers.
 6. Imperfect Knowledge: Monopolistic competition is characterized by imperfect
knowledge on the part of the buyers and sellers.
 7. Selling Costs: Advertising is necessary because buyers have imperfect
knowledge about the products sold by firms. To overcome the ignorance of buyers
and to increase the demand for their products, firms advertise.
 8. Each firm knows its demand and cost curves with certainty.

PRODUCT DIFFERENTIATION
The practice of distinguishing the goods or services of one seller from those of
another on the basis of factors other than price is called product differentiation.
The objective of product differentiation is to distinguish the product of one
producer from that of the other producers in the industry.
 Real product differentiation exists when there are differences in terms of
chemical composition, specification of the products, factor inputs, services
offered by the seller and location of the firm. Thus, in real product
differentiation is the inherent characteristics of the products are different.
 Fancied product differentiation exists when the consumers are persuaded to
believe that the products are different even though they are basically the same.
Thus, fancied product differentiation is based on perceived differences by
consumers. Fancied product differentiation established by advertising,
difference in packaging, difference in design or by brand names.

SHORT RUN EQUILBRIUM
 The objective of the firm in monopolistic
competition is maximization of profits.
Monopolistic competition characterized by product
differentiation.
 Product differentiation means that each firm is a
little monopolist having downward sloping demand
curve for its product.
 Because there are many firms, each firm can set its
price without considering the reactions of its
competitors. The firm is in short run equilibrium
where MC = MR.

 The determination of the equilibrium price and output level for a
monopolistically competitive firm in the short run is illustrated in the
following figure. The firm’s demand curve is highly elastic because of
the existence of a large number of firms producing differentiated
products. An increase in the price of the product will shift customers to
other brands.
 Profit maximizing level of output is given by the point where its short
run MC curve intersects its MR curve from below
 Thus, the profit maximizing output is Q and the corresponding price is
OP. Because the price P exceeds average cost, the firm earns
supernormal profit. Supernormal profits of the firm shown by the
rectangle PABC. In the short run, supernormal profits are possible
since the number of firms is constant. Thus, the equilibrium of the firm
in the short run is very similar to that of monopoly.

LONG RUN EQUILIBRIUM
 The existence of supernormal profit will
induce entry by other firms. The condition of
free entry ensures that new firms will enter
the industry and compete away the super
normal profits.
 The entry of new firms means that the
demand for the product must be shared
among more and more brands. Thus, the
demand curve for each existing firm shifts to
the left.
 Entry will continue until all firms earn only
normal profits. It is in this sense that
monopolistic competition resembles perfect
competition.

 The long run equilibrium of the firm in monopolistic competition is
shown in the following figure.
 The firm is in equilibrium when its long run AC is tangent to the
long run AR curve. This means that unit cost is equal to unit revenue
or price and there are no abnormal profits.
 The profit maximizing output is Q and the corresponding price is P.
With normal profits for all the firms in the industry, there will be no
incentive for new firms to enter the industry in the long run.

THE CONCEPT OF EXCESS CAPACITY
 Excess capacity is the difference between ideal output and the actual
output in the long run equilibrium.
 Excess capacity = Ideal Output -Actual Output
 Ideal output is that level of output associated with the minimum long
run AC. It is the level of output at which the short run AC and the
long run AC are at their minimum.
 Thus, when the short run AC is tangent to the long run AC at its
minimum point, the firm is having the most efficient size or ideal
plant size.

 In the following diagram, ideal output is Q. In monopolistic competition, the
long run equilibrium output is determined by the tangency of the demand
curve-and the LAC.
 Thus, the profit maximizing output is QM. Since the actual output is less than
ideal output, there is excess capacity in monopolistic competition.
 Excess capacity is the difference between the minimum LAC output and the
actual long run equilibrium output. In the following figure excess capacity is
equal to Qm Q.

Excess capacity is inevitable in monopolistic competition due to the
following factors.
 1. Too Many Small Firms: Monopolistic competition is characterized by
the existence of too many small firms than would be desirable. These firms
are unable to produce at the lowest LAC which results in excess capacity.
 2. Under Utilization of the Plant: A second reason for the existence of
excess capacity is the under-utilization of the plant built.
 3. Product Differentiation: The greater the degree of product
differentiation, the greater the amount of excess capacity. As the degree of
product differentiation rise, the degree of product substitutability declines
which is shown by a steeper individual demand curve. The demand curve
will be tangent to the LAC at a higher point which will result in a reduction
in the actual output. The firm will be able to charge a higher price.

NON-PRICE COMPETITION
 Non-price competition refers to all those efforts on the part of firms to increase
sales or make the demand curves less elastic based on variables other than price.
 Non-price competition is an important feature of monopolistic competition.
There are mainly. live forms of non-price competition.
They are
 1) Advertising
 2) Product variation
 3) Design differences
 4) Locational effects and
 5) Provision of supplemental services.

 1. Advertising: Advertising is an important form of nonprice competition.
Firms incur advertising costs because they believe that 'by using
advertising, revenues will increase more than costs, so profits will be
higher.
 2. Product Variation: Another form of nonprice competition involves
variations in the quality of the product offered for sale by various firms.
 3. Design Differences: Differences in product design may provide a more
profitable form of competition than attempting to offer a lower price.
 4. Locational Effects: The decision of where one locates the sale of a
product is another way of competing on a nonprice basis. Some firms
compete by taking their line of products to the consumer’s home for sale.
 5. Supplemental Services: The provision of supplemental services may
also be used as nonprice competition.

Selling costs
 The costs of changing consumers’ wants are selling costs. Selling
costs include all expenses incurred in order to increase the demand
for the good or service. Examples of selling costs are advertising in
its many forms, free samples and salaries and allowances given to
salesmen. The purpose of selling costs is to shift the demand curve
to the right, to increase the demand for the product.
 Chamberlin introduced the concept of selling costs. According to
him selling cost curve is U-shaped. A firm will continue adding to
its selling costs as long as addition to costs (MC) is less than
addition to revenue (MR). Firms pay for increased costs due to
advertising by charging consumers a higher price. Thus, price
increases when a firm is incurring selling costs. The consumer is
worse off as a result of the increased selling costs.

Selling costs
Significance:
 Monopolistic competition is characterized by the existence of a large
number of firms producing differentiated products. There is difference
in quality and variety of the product. The people should be made
known of the commodity produced by the firm. Thus advertising is an
integral part of monopolistic competition.
 Selling costs are incurred to promote sales or to shift the demand
curve rightward and upward. The preferences of the consumers are
sometimes influenced by advertisement and publicity. Thus, selling
costs are incurred to persuade the consumers. If the firms are not
cautious, advertisement war may lead to a reduction in the profits of
those firms engaging in it.

Production Costs and Selling Costs
 Production costs are those costs which are incurred by a firm in the
production and transport of a good or service to the buyer. The costs
incurred by a firm on raw materials, wages to the workers, fuel, packing,
transportation etc are examples of production cost.
 The costs of changing consumers’ wants are selling costs. Selling costs
include all expenses incurred in order to increase the demand for the good
or service. Examples of selling costs are advertising in its many forms,
free samples and salaries and allowances given to salesmen. The purpose
of selling costs is to shift the demand curve to the right, to increase the
demand for the product.
 Production costs are independent of selling costs. Total costs are the sum
of production costs and selling costs. The distinction between production
costs and selling costs was made by Chamberlin.

PRICE AND OUTPUT DETERMINATION UNDER PERFECT COMPETITION
AND MONOPOLISTIC COMPETITION: A COMPARISON
 A perfectly competitive firm is in long run equilibrium when it
produces an output at which price is equal to the marginal cost of
production. At equilibrium, the firm will be producing at the
minimum point of the LAC curve.
 The long run profit maximizing level of output in monopolistic
competition must lie to the left of the minimum point on the LAC
curve.
 This occurs because the firm’s demand curve is negatively sloped
due to product differentiation and must be tangent to the LAC curve
only to the left of the minimum point on the LAC curve.

 The difference between the equilibrium price and quantity of the
good produced in perfect and monopolistic competition is shown in
the following figure.

 The competitive industry is in equilibrium at point C where LAC is
at its minimum.
 The equilibrium price is OPc and output is OQc. The long run
equilibrium output in perfect competition is known as the ideal
output.
 Monopolistic competition is in equilibrium at point E, where the
demand curve is tangent to the LAC curve.
 A comparison of the two equilibrium points shows that price is
higher and output is smaller under monopolistic competition than
under perfect competition. That is Pm > Pc and QM < Qc.

PERFECT COMPETITION AND MONOPOLISTIC COMPETITION: A
COMPARISON
Similarities
 1. Goals of the Firm: In both the markets profit maximization is the
objective of the firm.
 2.Number of Sellers: Both markets are characterized by the existence of a
large number of sellers.
 3. Free Entry and Exit: There are no barriers to entry to both markets.
There is freedom for new firms to enter the market or existing firms to
leave the industry
 4. Absence of Collusion: Firms in both markets function independently of
one another. Thus, there is no collusion among the sellers.
 5. Cost Conditions: In both the markets the cost conditions give rise to U
shaped cost curves
 6. Normal Profit: The firm earns only normal profits in both markets.

PERFECT COMPETITION AND MONOPOLISTIC COMPETITION: A
COMPARISON
Differences
 1. Nature of the Product: In pure competition, the product is homogeneous. Firms in
monopolistic competition sell heterogeneous products that are differentiated from one
another.
 2. Shape of Demand Curve: The demand curve of a firm in perfect competition is
horizontal. In monopolistic competition the demand curve is negatively sloped.
 3. Degree of Knowledge: Perfect competition is characterized by perfect knowledge.
Monopolistic competition is characterized by imperfect knowledge on the part of the
buyers and sellers.
 4. Equilibrium Condition: The long run equilibrium condition of perfect competition is
MC = MR == AC = P. The long run equilibrium condition of monopolistic competition is
MC = MR and AC _= P but P > MC.
 5. Price: Price in monopolistic competition is higher than the competitive price.
 6. Output: Output in monopolistic competition is lower than the output in perfect
competition.

PERFECT COMPETITION AND MONOPOLISTIC COMPETITION: A COMPARISON
Differences
 7. Excess Capacity: Monopolistic competition is characterized by the existence of excess capacity in the
long run equilibrium. In perfect competition there is no excess capacity
 8. Efficiency :Competitive firm in the long run equilibrium produces the efficient output where price equals
long run marginal cost. In monopolistic competition, the industry produces an inefficient level of output,
where price is greater than marginal cost.
 9. Selling Costs: In monopolistic competition firms incur selling costs which are not present in pure
competition.
 10. Market Power: Perfect competition is characterized by the absence of market power. Firms enjoy
market power in monopolistic competition because each seller differentiates his product from that of the
others.
 11. Main Decisions: The only decision of the firm in pure competition is the determination of its output.
The firm in monopolistic competition can determine both his price and output.
 12. Equilibrium Price In perfect competition there is an equilibrium price determined by the forces of
market demand and market supply. In monopolistic competition, there is no unique equilibrium price, but
an equilibrium cluster of prices. This is because product differentiation allows each firm to charge a
different price.

Product group
 The concept of product group was introduced b Chamberlin A product group
is composed of firms that produce products that are close substitutes for one
another. Thus, product group includes firms producing very related
commodities. According to Chamberlin the products should be close
technological and economic substitutes.
 Technological substitutes are products which can technically satisfy the same
want. For example, all motor cycles are technological substitutes in the sense
that they provide transport.
 Economic substitutes are products which cover the same want and have
similar prices. For example, a Hero Honda Splendor and Yamaha Libero can
be considered as economic substitutes. Products forming the group have high
price and cross elasticities. It means that the demand of a product shifts
appreciably when the price of other products in the group changes.

CHAMBERLIN'S GROUP EQUILIBRIUM
 Group equilibrium refers to the equilibrium of the product group. A product
group includes firms producing very closely related commodities. Different
firms in the product group adopt independent price output policies because of
their monopolistic position achieved through product differentiation. Each
firm will charge a different price. Price will be equal to full costs, which
include normal profits. New firms will enter the market only if there are
abnormal profits. In the long run, since all the firms in the group are getting
only normal profits, no outside firm wants to enter the group. Because full
costs include normal profits no firm in the group wants to leave. Hence the
group is in equilibrium. The condition for the attainment of group
equilibrium is that MC = MR and AR curve is tangent to the AC curve. This
is shown in the following figure

 The average revenue curve is tangent to the average cost curve at point
T Marginal cost and marginal revenue curves intersect each other
exactly vertically below T.
 Therefore, the firm is in long run equilibrium by setting price OP and
producing OQ quantity of output, because average revenue is equal to
average cost, the firm will be making only normal profits.
 Since all firms are alike in respect of demand and cost curves, the
average revenue of all firms will be tangent to their average cost curves
and they will be earn in g only normal profits.
 Because only normal profits are accruing to the firms, there will be no
tendency for the new competitors to enter the industry. The product
group as a whole will be in equilibrium.

MONOPOLY AND MONOPOLISTIC COMPETITION: DIFFERENCES
 1. Number of Sellers: Monopoly is a single seller market.
Monopolistic competition is characterized by the existence of a large
number of sellers.
 2. Barriers to Entry: Monopoly is characterized by the existence of
effective barriers to entry. There are no barriers to entry in monopolistic
competition.
 3. Nature of the Product: The product may or may not be
homogeneous in monopoly. Firms in monopolistic competition sell
heterogeneous products that are differentiated from one another.
 4. Degree of Knowledge: Monopoly is characterized by perfect
knowledge. Monopolistic competition is characterized by imperfect
knowledge.

MONOPOLY AND MONOPOLISTIC COMPETITION: DIFFERENCES
 5. Main Decisions: The monopolist can determine either his output or his
price but not both. The firm in monopolistic competition can determine
both his price and output.
 6. Selling Costs: In monopolistic competition firms incur selling costs
which are not present in pure monopoly.
 7. Market Power: A firm in monopoly enjoys very high market power.
This is because it is the sole producer of a commodity and substitutes are
not available. Firms in monopolistic competition have a small degree of,
monopoly power. This is because of the availability of close substitutes.
 8. Profit: In monopoly abnormal profits are usually earned both in the
short run and in the long run. In monopolistic competition the firm earns
abnormal profits in the short run and normal profits in the long run.

LONG RUN EFFICIENCY IMPLICATIONS OF MONOPOLISTIC COMPETITION
The long run. efficiency implications of monopolistic
competition can be analysed with respect to
Utilization of plant
Allocation of resources
 Advertising and
Product differentiation.

 Utilization of Plant
In monopolistic competition, the long run equilibrium output is
determined by the tangency of the demand curve and the LAC. Since
the demand curve is negatively sloped, the tangency point will always
occur to the left of the lowest point on the firm’s LAC curve. The firm
is not fully utilizing its plant to produce the optimum or ideal output.
Since the firm underutilizes its plant, actual output is less than ideal
output and there is excess capacity in monopolistic competition.

 Allocation of Resources
When the monopolistically competitive market IS in long run equilibrium, the price
charged by each firm exceeds the LMC of the last unit produced. Allocative
efficiency is achieved when price equals marginal cost for each product. Therefore,
resources are under-allocated to the firms and misallocated in the economy.
 Product Differentiation
 Product differentiation provides an opportunity to the consumers to choose from
a wide variety of competing products and brands that differ 1n various ways.
Even though it offers greater range of choices to the consumers, excessive
product differentiation is likely to confuse the consumer and adds to costs and
prices

 Advertising
There are two types of advertising-informative advertising and persuasive
advertising. Informative advertising contains information about new products, prices,
qualities, location, availability and so on. Persuasive advertising is that type of
advertising, which alters consumer’s preferences in favour of the advertised product.
Informative advertising makes markets function more efficiently because it helps
consumers to make better-informed choices. Persuasive advertising is sometimes
used to induce consumers to purchase products they don’t really want. Since the total
amount of advertising undertaken by the monopolistically competitive firms may be
excessive, it leads to higher prices.

Monopolistic competition

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