LECTURE TWO

MONOPOLISTIC COMPETITION

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 INTRODUCTION: DEFINITION
 Monopolistic competition is a market structure in which
product differentiation exists and in which there are
elements of both monopoly and perfect competition.
Under the monopolistic competition there are large number
of firms producing and selling goods that are close
substitutes but are not completely homogenous from one
seller to another.
• Monopolistically competitive firms act independently.
– Many sellers characteristic gives monopolistic
competition its competitive aspect while
– Product differentiation gives monopolistic competition
its monopolistic aspect.
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 Monopolistic Competition
 Market structure in which there are
 Large number of buyers and sellers; and the
sellers sell products that are heterogeneous or
differentiated in which the products are close, but
not perfect substitutes for one another.
 In contrast to perfect competition, the firms
produce heterogeneous or differentiated
products that render a sort of monopoly power
over their own product.

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 Cont.………
 Differentiation exists so long as advertising
convinces buyers that it exists.
 Firms will continue to advertise as long as the
marginal benefits of advertising exceed its marginal
costs.
 In monopolistic competition, focus on product
design, special features, safety, and functionality.
 That is., mainly emphasis the number of the firms in
the market and the type of the product.

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 Assumptions
1. Large number of buyers and sellers in the group.
2. Products of the sellers are differentiated yet they are
close substitutes of one another.
3. Free entry and exit of firms in the group.
4. Goal of the firm is profit maximization, both in the
short run and long run.
5. Prices of factors and technology are given.
6. Long run consists of a number of identical in short run
periods,
– which are assumed to be independent of one another in
the sense that decisions in one period don’t affect future
periods and are not affected by past actions. 5
 Cont.…….
 Differentiated product is the product produced and
supplied by many sellers in the market is similar but not
identical.
 Product differentiation may be: real or spurious
differentiation.
Real differentiation : occur when the intrinsic
characteristics of the products are different, or
• It occurs when differences in:
specification of the product or
Inputs or location of the firm and other.
 For instance, Sports wear shoes produced by several
firms, some sports shoes are made of synthetic and some
are leather made. 6
 Cont.…….
Spurious or fancied differentiation
• It occurs when the products are basically the same
but the consumer is convinced through advertising
and other selling activities.
• Is established by advertising, difference in
packaging, design, simple brand name and the like.
 For example, Dashen Beer and St. George beer in
which both having equal alcoholic content and
are produced by almost the same input. You can
take also the foods you eat in different restaurants
(e.g. Roasted meat).
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 PRODUCT DIFFERENTIATION AND DD CURVE
• A typical characteristic of monopolistic competition market is
product differentiation.
• Individual firms face a DD curve that is highly elastic (slightly
negatively sloped), but not perfectly elastic.
1. A firm in monopolistically competitive market has few rivals unlike
perfect competitive firm, which has significant rivals, and a
monopoly firm, which has no rival.

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 Cont.…….
• Chamberlain introduced two additional policy variables in
the theory of the firm;
– i.e., the product itself and selling activities.
• DD is determined not only by the price policy of the firm,
but also by the style of the product, the services associated
with it, and the selling activities of the firm.
• The demand curve will shift if:
– The style, services, or the selling strategy of the firm
changes.
– Competitors change their price, output, services or
selling policies.
– Tastes, incomes, prices or selling policies of products
from other industries change. 9
 Cont.…….
2. The products of sellers are slightly differentiated. This
means that the product of any firm is similar (close), but
not identical (perfect) substitute to the products of any
other firm in the industry.
 The patent right given to the manufacturers of the above-
mentioned brands restricts two or more manufacturers from
producing identical toothpaste.
 All brands of toothpastes are similar or close substitute
to one another.
 A firm that produces any toothpaste faces a slightly
negatively sloped DD curve for its product-implying that
any manufacturer has monopoly power over its product,
limited share in the market and therefore has some degree
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of freedom in the determination of price for its product.
 Reading Assignment

Importance of Product
Differentiation!

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 Cost Structure of the Firm
 The AVC, MC and ATC curves are all U-shaped implying
that there is only a single level of output which can be
optimally produced.
 The particular shape of costs is not important in
Chamberlin’s model so long as the slope of the MC curve is
greater than the slope of the MR curve.
 The recognition of product differentiation provides the
rational for the selling expenses incurred by the firms with
advertising and other selling activities the firm seeks to
accentuate the difference between its product and the
product of other firms in the group.
 Advertising in general will shift upward the DD and will make it
less elastic by strengthening the preferences of the consumers for
the advertised product. 12
 Selling Cost Curves
• Selling cost curves cost of advertising, salesman’s salary,
expense of sales department
– This implies there are economies and diseconomies of
advertising as output changes.
• Initially expansion of output will not require an equi-
proportional increase in selling costs, and this leads to a
fall in the average selling expenditure.
• Beyond a certain level of output the firm will have to spend
more per unit in order to attract customers from other
firms.
– As output expands the firm has to attract customers which are
well used to the product of other firms.
• The U-shaped selling cost, plus the U-shaped production
cost, yields a U-shaped ATC curve 13
 PRODUCT GROUP
 It refers to a group of sellers in an industry, supplying different
brand of commodities or services, but are very much (closely)
related and hence consumers are unable to differentiate them
based on some state of quality, such as shape, test, colour etc.
 Product group is that the demand of each single product be
highly elastic and that it shifts appreciably when the price of
other products in the group change.
 In other words, products forming the group or the industry
should have high price and cross elasticity.
 For instance, within automobile industry cars with brand
name Fiat and Lada, Corolla DX and Toyota DX are alike in
their shape many people cannot differentiate them precisely
simply by looking them distant without getting close and
search for some clues, such as looking at their brand names.
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 Cont.……….
 Similarly, though it typically represents an example
of oligopoly market, in the;
– Soft drink industry are supplied Mirinda and Fanta,
Pepsi
– Moha soft drink P.L.C industry are supplied Coca-
Cola, 7 UP
– East Africa bottling P.L.S.C (Private Limited Share
Company), respectively are so close that a consume
provided two glasses of these bundles without looking
when poured can hardly tell precisely which glass
contains which bundle simply by testing or looking the
colours of the products in the two glasses. 15
 Home Doing Exercise!
 Selling costs make the demand curve inelastic than
“before” under the condition of monopolistic
competitions. Do you agree by this statement?
Deeply justify your response.

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 INDUSTRY
 The concept industry refers to broader classification and
hence consists of several product groups.
 All firms in a monopolistic competition market produce
very close products as the brewery industry or supply very
close service as the banking and insurance industry in
Ethiopia all the firms in can be regarded as product group
and industry.
 If all firms in an industry produce highly differentiated
products, we say there is no product group. Thus, product
group is a sub set of industry.
 Demand curve analysis under monopolistic competition
• DD curve is downward sloping and each firm confronts
two demand curves drawn based on different assumptions.
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 The DD curves is very elastic, which is sketched on the
assumption that when the firm changes its price, other
firms in the product group do not change theirs.
– This DD curve is referred as Perceived or Anticipated
DD curve.
• In this case each firm believes that other firms will not
follow its price changes.
The other DD curve is less elastic. This DD curve is
portrayed on the assumption that each firm has an identical
demand and cost condition in the product group.
• Each firm acts in the same manner in raising or lowering
price for they have the same incentive to change price and
ultimately each firm retains a constant share of the market.
– This DD curve is termed as Proportional DD curve.
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 READING ASSIGNMENT!

Critique of Chamberlin’s Model

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 SHORTRUN AND LONGRUN EQUILIBRIUM OF FIRMS
A. SHORT RUN EQUILIBRIUM
 The shape of the proportional DD curve and cost conditions-MC and
ATC-are the same as firms under perfect competition.
 The difference between perfect and monopolistic competition lies in
the perceived DD curve (d).
 A firm in monopolistic competition market perceives its demand curve
to be less than perfectly elastic (not horizontal).
 The reason is that the output of one firm is close but not perfect
substitute for the output of other firms that produce differentiated
products.
 This implies that the firm perceives it must reduce price to get more
consumers.
 Accordingly, it is the short run MR (derived from the perceived
demand curve) that will be equated with the MC curve in order to find
the optimal-profit maximization (loss minimization)-output and price.
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Cont.…….

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 Cont.…….
• The three characteristics of short run equilibrium under
monopolistic competition:
 Each firm determines output and price by equating
MR and MC (point E).
 D intersects d at the output chosen by the firm.
 A firm will obtain excess profit if Pe>ATC and loss if
Pe<ATC.

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 B. LONG RUN EQUILIBRIUM
 There are three worthwhile observations about monopolistically
competitive equilibrium in the long run.
• In the long run, the tendency of a firm in monopolistic
competition is to earn normal profit (BEP, P=LAC-not P =
min LAC).
– This is because we expect the short run economic profit of firms
to attract new rivals for entry is relatively easy than monopoly.
• As new firms enter in to the monopolistic competition
market, supply of output in the market increases.
• This in turn shifts the perceived demand curve faced by the
typical firm to the right; push price down, and the
disappearance of economic profit.
• However, although profits are zero, the situation is not
Pareto efficient.
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 Cont.…….
• The reason is that profits have nothing to do with
efficiency question: when P is greater than MC, there is
an efficiency argument for expanding output.
 The long run equilibrium of a firm in monopolistic
competition is defined by three conditions.
D must be tangent at the falling part of LAC
(not at the minimum of LAC)
The proportional demand curve (D) must
intersect both d and LAC at the tangency
No excess profit is obtained because P=LAC.
Therefore, the long run equilibrium is obtained
at a point F where D=d=P=LAC. 24
Cont.…….

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 Cont.…….
 Consumers who desire product differentiation are
willing to pay higher price.
 Nevertheless, economists argue that though there is
welfare loss under monopolistic competition on the
ground that P >MC, the welfare loss of under
monopolistic competition should not be
exaggerated (over emphasised) for it is much lower
than the DWL of monopoly and society have option
to choose (entertain their preferences) among
different brands.

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 EXCESS CAPACITY
 The long run equilibrium of monopolistic competition also
leads to excess capacity measured by the difference
between the ideal output (long run output of perfect
competition corresponding to the minimum LAC) and the
actual output produced in the long run by a firm under
monopolistic competition.
• That is, firms will typically operate to the left of output
where LAC is minimised.
• This implies that there is misallocation of resources for P is
greater than the minimum of LAC.
• If there were fewer firms, each could operate at a more
efficient scale of operation, which could be better for
consumers. 27
 Cont.…….
• If there were fewer firms there would also be less product
variety, and this would tend to make consumers worse off.
• Which of the two effects dominates is a difficult question to
answer.
• The extent of excess capacity depends on the condition of
entry and degree of price competition.
• If there is free entry and active price competition, the size
of excess capacity (restriction of output) will be small.

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 WELFARE LOSS
• Another limitation of long run equilibrium of a firm in
monopolistic competition is that P >LMC implying welfare
loss.
• To maximize social welfare, output should be increased
until P=LMC.
– This is not possible under monopolistic competition for the
perceived demand curve is downward sloping and P is greater than
the minimum of LAC.
• The higher cost resulting from product differentiation
would mean higher sales (advertising and promotion) cost
and price than perfect competition.
• Society however may accept the higher price in order to
have choice among the differentiated products. 29
 Cont.…….

•Welfare loss under monopoly is given by the triangle AEmEc

•Welfare loss under monopolistic competition is triangle FEmcEc.
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Therefore, AEmEc> FEmcEc.
 THE
END!!!
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