D C M T (MBA) – 2021-22 ME ( UN - 03 )

Chapter : Market & Output Determination Topic : Monopolistic Competition

 Concepts
 Mean : A market with a blending of monopoly and competition (i.e. a large number of small
producers or suppliers having some degree of monopoly power because of their differential
products.
 Characteristics of Monopolistic Competition:-
1.Large number of sellers
2.Product differentiation
3.Free Entry
4.Selling Cost
5.Two-dimensional competition
6.The Group

Equilibrium under Monopolistic Competition: Determination of Price and Output in the Short-run:-

In the short-run, the firm can adopt independent price policy, with least consideration for the varieties
produced and prices charged by other producers. The firm being rational in determining the price for a
given product will seek to maximise total profits.
The short-run equilibrium of a monopolistic competitive firm is the same as that of an firm under monopoly. In the short
run, a firm under monopolistic competition attains its equilibrium where marginal revenue equals marginal cost and sets
its price according to its demand curve. This implies that in the short run, profits are maximized when MR=MC.

In the figure, AR is the average revenue curve, MR represents the marginal revenue curve, SAC curve denotes the short
run average cost curve, while SMC signifies the short-run marginal cost. It can be seen that, MR intersects SMC at output
OM where price is OP1 which is equal to MP.

It can be inferred from the figure that the firm is earning

supernormal profit. Supernormal profit per unit of output
is the difference between the average revenue and average
cost. In the figure, average revenue at equilibrium point is
MP and average cost is MT.

Therefore, PT is the supernormal profit per unit of output. The total supernormal profit would be
measured by the area of rectangle P1PTT1 (which is output multiplied by supernormal profit per unit
of output).

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On the other hand, when average cost is greater than average revenue, firm would incur losses, as shown in Figure.
Figure shows the condition of losses in the short run under monopolistic competition. Here, OP is smaller than MT,
which implies that average revenue is smaller than average cost. TP is representing the loss that has incurred per unit of
output. Therefore, total loss is depicted from rectangle T1TPP1.

Equilibrium under Monopolistic Competition: Determination of Price and Output in the Long-run:-

In the long run, there is a gradual decrease in the profits

of firm. This is because in the long run, several new firms
enter the market due to freedom of entry and exit under
monopolistic competition.

When these new firms start production the supply would

increase and the prices would fall. This would
automatically increase the level of competition in the
market. Consequently, supernormal profits are replaced with normal profits.

In the long run, the AR curve is more elastic than that of in the short run. This is because of an increase in the number of
substitute products in the long- run. The long-run equilibrium of monopolistically competitive firm is achieved when
average revenue is equal to average cost. In such a case, firm receive normal profits.
In the figure, P is the point at which AR curve touches the average cost curve (LAC) as a tangent. P is regarded as the
equilibrium point at which the price level is MP (which is also equal to OP1) and output is OM.
In the present case, average cost is equal to average revenue that is MP. Therefore, in long- run, the profit is normal. In
the short run, equilibrium is attained when marginal revenue is equal to marginal cost. However, in the long run, both
the conditions (MR=MC and AR=AC) must hold to attain equilibrium.

 Selling Cost Under Monopolistic Competition:

Selling costs refer to those expenses which are incurred for

popularizing the differentiated product and increasing the
demand for it. Selling cost is a special feature of
monopolistic competition. According to famous American
economist, Edward Chamberlin, Selling Costs are Costs
incurred in order to alter the position or shape of demand
curve for a product. Such selling costs may be incurred in
any form such as advertising, sales promotion, samples to

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potential customers etc.

Difference Between Production Cost and Selling Cost

Production cost is the cost of direct labour, direct materials, and direct expenses that are consumed to
create a product, whereas, Selling Cost is the expenses incurred in the marketing and distribution of
a product.

Individual Equilibrium with Selling Cost:-

In the figure, equilibrium price OP=EQ. At the equilibrium output, the firm's AverageSelling Cost (ASC) =ED.

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The total selling cost=ED×OQ. Since, OQ=SD, so the firm's total selling cost is ED×SD= SDEP. The
total revenue of the firm is OQ×OP= OPEQ. Since the firm's demand curve and overall average cost
curves are tangent to one another at point E, selling price= overall average cost i.e. APC+ASC. The
firm is therefore, making only normal profit.
Group Equilibrium with Selling Cost:-

Initially, none of the firm is incurring any selling cost. Under these
conditions, the firms are shown to be in equilibrium at the point E
where they all make normal profits.

Subsequently, if any of the firm is incurring selling cost, so that its

APC added with ASC rises to the position as represented by the
curve as APC+ ASC1 and its total sale increases to OQ4. At output
OQ4, the firm makes supernormal profits of P3PMP2. This profit is
only possible so long as other firms do not advertise their own products.

If other firms do advertise their products and incur the same amount of selling cost, then the initial
advantage to the firm advertising first, will disappear and its own output will fall to the position OQ 2
units. Then the firm will be in equilibrium at point A and produce OQ2 units and the selling cost will
increase and the APC+ASC curve shifts further upward.

This process continues until APC+ASC2 becomes tangent to the AR=MR line as represented by point
B. Beyond this point, advertising of no use to any firm. The equilibrium will be stable at point B
where each firm produces OQ3 units of output and makes only normal profit.

Concept of Excess Capacity under Monopolistic Competition:-

The concept is developed by Prof. Chamberlin and is defined as “the difference between ideal (optimum) output and the
output actually attained in the long-run.”
In the figure, the monopolistic competitive firm’s demand curve is d and MR1 is its corresponding
marginal revenue curve. LAC and LMC are the long-run average cost and marginal cost curves.
The firm is in equilibrium at E1 where the LMC curve cuts the MR1 curve from below and OQ1 output is set at
the price Q1 A1. OQ1 is the equilibrium output but not the ideal output because d is tangent to the LAC curve
at A1 to the left of the minimum point E. Any effort on the part of the firm to produce beyond OQ 1 will mean
losses as beyond the equilibrium point E1, LMC > MR1. Thus the firm has negative excess capacity measured
by OQ1 which it

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The monopolistic competition output OQ1 is less than the perfectly competitive output OQ, and the
monopolistic competitive price Q1A1 is higher than the competitive equilibrium price QE. This is
because of the existence of excess capacity under monopolistic competition.
The degree of excess capacity depends on : 1. the elasticity of demand for the product of the firm. 2. the intensity of
economies of scale which determines the rate of fall of the LAC. 3. the degree of differentiation of the product desired
by the consumers. 4. the presence of price competition.

END.

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