1.

Monopolistic Competition

• Monopolistic competition is market structure in which there are many firms selling
differentiated products.
• It is a market structure that has some features of competition and some features of monopoly.
• A monopolistically competitive market departs from the perfect competition because each of
the sellers offers a somewhat different product.
• Product differentiation leaves under monopolistic competition some monopoly power.
• Firms may not lose its entire demand even if it raises prices. For example due to brand
loyalty
• Firms may attract some but not all buyers by reducing price.

The theory of monopolistic competition was independently developed by Chamberlin and

Robinson. The theory of monopolistic competition developed by Chamberlin works under many
of the assumption of pure competition.

Assumptions

• Large number of buyers and sellers

• The products of the sellers are not homogeneous. The products slightly differ one from the
other but serve the same purpose.
• There is free entry and exit
• The objective of the firm is profit maximization.
• There is easy mobility of factors of production.
• Though the products are differentiated, all firms have identical cost and demand curves.

1.1 Product Differentiation and the Demand Curve

Product differentiation is any feature of a product or seller that make buyers to prefer one
product or seller to another. The objective of product differentiation is to make the product
unique in the mind of consumers.

The product differentiation can be real or perceived:

Real product differentiation: this is when the inherent characteristics of the products are
different. Example:
• Difference is quality. Example: durability
• Difference is transportation facility (location of the firm).
• Difference in factor inputs.

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Perceived (fancied) product differentiation: in this consumers are persuaded that one product
is different from the other while they are basically the same. This may be due to advertisement,
packaging and brand loyalty.

Product differentiation leaves firms under monopolistic competition some monopoly power.
They may not lose its entire demand even if it raises prices. Example: brand loyalty. Firms may
attract some but not all buyers by reducing price.

A firm in monopolistic competition market is not a price taker and has a certain degree of control
over price or some degree of monopoly power. The power is limited because the firm faces in its
surrounding other close substitute goods. There is a certain degree of monopoly and a certain
degree of competition. This is why it is called monopolistic competition.

The product differentiation in this market gives rise to downward sloping demand curve due to
monopoly power but highly elastic because of availability of substitutes. Therefore, the demand
curve will be downward sloping which is somewhat flatter.

P A monopolistic competitive firm face high

own price and cross price elasticity of
demand.

1.2 Cost of the Firm

A firm in monopolistic competitive market has the same cost structure as perfect competition and
monopoly. The AVC, ATC and MC curves have U-shape. But the difference is that costs in
monopolistic competition include selling costs (cost associated with advertising and other selling
activities).Therefore, total cost is the sum of production cost and selling cost.

The selling costs curves are also taken to be U-shaped because of economies and diseconomies
of scale in selling activities like advertising. Therefore, the U- shaped selling costs and the U-
shaped production costs give U – shaped ATC curve.

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1.3 The Concept of Industry and Products Group

Industry is a group of firms producing homogeneous products but firms in monopolistic

competition produce differentiated products. Hence, firms under monopolistic competition do
not constitute an industry. Instead Chamberlin uses ‘Product Group’ which describes a large
number of products, close substitutes, which satisfy similar needs of the consumer with high
elasticity of demand. The extent of the elasticity of demand is not determined by Chamberlin.

1.4 Equilibrium of the Firm

Short run Equilibrium

• There is assumption by Chamberlin that demands (preference of the consumers) are evenly
distributed among the different products and the firms have identical costs.
• The demand curve of a firm under monopolistic competition is downward sloping which can
be considered as sales planning curve. Because an individual firm expects to operate
assuming that the other firms will not react to its price adjustments.
• The short run equilibrium of monopolistic competitive firm is determined by the equality of
MR and MC (like equilibrium of a monopoly) assuming that demand and cost curves remain
stable.

P
C MC
ATC

Pe C

ATCe B
e

0 Qe Q

MR

Long run Equilibrium

According to Chamberlin there are three ways through which adjustment towards long run
equilibrium takes place
(i) Equilibrium with new firm entering the group
(ii) Equilibrium with price competition
(iii) Equilibrium with both price competition and entry of firms.

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Case 1. Equilibrium with new firms entering the group

Let us start from short run equilibrium in which firms earn excess profit. A firm with a demand
curve of ‘d’ will be in short run equilibrium at output level Qm and price level Pm.

P
LMC • At this short run equilibrium,
LAC
MR=MC, there is excess profit
C which attract new firms to the
Pm
market.
Pe E B • Profit equals area ABCPm
A • The firm at ‘E’ does not have any
incentive to change price
D’ D
0 Qm Q

MR’ MR

• As new firms enter into the market, the market share of each firm declines. Then, the demand
curve shifts inward as the market demand will also be shared by the new entrants.
• The shift in demand curve will change the equilibrium of the firm with price adjustment
(because of new MR). This shift of demand continues until the new demand curve is tangent
to the average cost curve in which the firm will be earning zero (normal) profit.
• The final demand curve in the long run will be tangent to the AC curve.
• The MR curve will also shift to MR’.
• At the new equilibrium, we found P= AC. Therefore the profit level is normal. Hence, there
will not be any further entry of new firms into the market.

Case2. Equilibrium with Price Competition

Now it is assumed that the number of firms in the market is compatible with the long run
equilibrium in the sense that there is no entry and exit of firms. In this analysis we introduce a
second demand curve, D, which shows the actual sales of the firm at each price following the
price adjustment. It is called actual sales curve or share of the market curve. It includes the
effects of actions of competitors to the price changes by the firm. D shows the full effects. D is
thus the locus of points of shifting demand (d) curves as competitors, acting simultaneously and
independently of others, change their price. A movement along D shows changes in actual sales
of existing firms as all of them adjust simultaneously with their share remaining constant.

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¾ The price level of short run equilibrium is assumed to be higher than the long run
equilibrium.

P
D
C
LMC
P0
LAC

P1

P2
Pe d

d’’ d’

Q0 Q1 Q2 Qe Q’0 Q

Initially the equilibrium of the firms was at P0. In order to increase its profit the firm will reduce
its price level to increase quantity sold to Q’0.
¾ New price level is P1
This action of the firm is independent of the action of the other firms. But the other firms also
think the same way, i.e., to increase profit by reducing price. So for this firm with the new price
P1, quantity demand will not increase to Q’0 as expected. Because the demand curve shifts
inward as all firms reduce their price level simultaneously and independently.
¾ d’ is new demand curve and Q1 is the actual quantity demanded.
¾ Firms are myopic who do not learn from past experience. So the firm will again reduce price
to P2 in order to increase demand to Q’0. But the other firms will do the same resulting shift
of demand to d”.
¾ The new quantity level is Q2.
This continues until the demand curve is tangent to the LAC curve. Beyond this tangency point
the firm will not reduce the price level because AC will be greater than the price.
¾ Long run equilibrium is determined by the tangency of demand and the LAC curve.
¾ The demand curve D is called the actual sales curve or share of the market curve.
¾ D curve shows the full effect of price reduction by all firms. It takes into account the action
of other firms.
¾ ‘D’ is steeper than ‘d’ because the actual sales from a reduction in price are smaller than
expected on the basis of ‘d’ as all firms reduce their price and expand their own sales
simultaneously.

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Therefore, movement along the demand curve D shows changes in the actual sales of existing
firms as all of them adjust simultaneously and independently with their share remaining constant.
¾ When ‘D’ shifts, it implies entry or exit of firms

Case 3. Equilibrium with both price competition and entry of new firms

Here there are two forces that lead to long run equilibrium: price adjustment and entry/exit of
firms.
¾ price adjustment is shown by movement along demand curve ’d’
¾ entry /exit of firms is shown by the shift of the demand curve ’D’

The firm will be in the long run equilibrium when

• the ‘d’ demand curve is tangent to the average cost curve (P=AC), and
• when the expected sales are equal to the actual sales
This will occur when demand curve ‘D’ cross demand curve‘d’ at the point of tangency with
average cost curve, point E.

Let‘d’ be expected sales curve (sales planning curve) and ‘D’ be market share curve.

AC D” D
D’
P
LMC
e1
P
LAC
P1
e0
P2
Pe E
d
d’’ d’
d’’’

Q Q1 Q2 Qe Q

¾ Let e0 be a point where actual sales is equal to expected sale.

¾ At e0, price is greater than AC ( i.e. P >AC)
¾ Firms will be earning excess profile at e0.

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 ¾ In the long run, new firms will enter into market. With this, the market will be shared by
large number of firms.
¾ The market share curve (D) will shift to the left until it is tangent to LAC at e1. At e1,
P=AC. It is a breakeven point so there will not be any further entry of new firms. But e1
is not a stable equilibrium. Because its expected sales curve (sales planning curve) is d1,
not D’. Then a firm taking ‘d’ as its demand curve (sales planning curve), the firm will
think that it can expand sales and earn excess profit by reducing price to P1. But all firms
will be doing the same. This causes the sales planning curve of the firm shift to the left to
d’.
¾ Sales will not increase as expected and the firm will supply only Q1 of amount at P1.
¾ The firm will incur loss which is equal to the shaded area because P1<AC.
¾ Firms are myopic; since d’ is still above the LAC curve it believes that it can get excess
profit by further reducing price. So the firm reduce price to P2, in order to get out of loss
and earn excess profit along d’. Other firms will also do the same shifting d’ to d’’ to the
left side. Hence the firm will supply only Q2 amount and increasing the loss .The firm
will think that it can avoid the loss by further decreasing price to Pe. Again other firms
will do the same and d’’ shift to d’’’ below the LAC.
¾ The loss amount increases very much.
¾ Financially weak firms will leave the market first so that the surviving firms have larger
share.
¾ The market share curve (D) along with the expected sales curve shift to the right exit will
continue until d (sales planning curve) is tangent to the AC curve and market share curve
(D) intersects (d) sales planning curve at the point of tangency at E.
¾ Point ‘E’ is a stable equilibrium
¾ P=AC it is a break event point (no entry of firms) and firms will not reduce price below
Pe because they will incur loss. With normal profits earned by all firms and no entry and
exit taken place, at point E, actual sales is equal to expected sales.
¾ Qe amount is supplied at Pe price level.
¾ Each firm has a share equal to OQe.

1.5 Excess Capacity and Welfare Loss

The long run equilibrium of a firm under monopolistic competition market occurs at the falling
part of the LAC. At this equilibrium, economies of scale is not fully exhausted. That is, the plant
size is at sub-optimal where the per unit cost is not minimized to the possible point.

The firms under monopolistic competition operate with excess capacity which is said to be
measured by the difference between the minimum cost output and output level that monopolistic
competitive firms produce.

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• For pure competitive market, long run equilibrium is when P=MC= MR= min AC where as
in monopolistic competition equilibrium is when P=AC and MR=MC but P >MC. In
addition in monopolistic competition firms incur selling costs which are not present in pure
competition and this is another factor for total cost (and price) to be higher.

• If P>MC, it tells us that the value of additional units of output for the society is greater than
what it costs to produce them.

P D
C
LMC

LAC
e0
E

d
d’’’

Qm Qc Q
• Excess capacity is measured by the difference between Qm and Qc.
• It implies that there is unexhausted economies of scale.
• Some people say that there is misallocation of resource in the long run because firms under
this market do not employ enough of the economy’s resource to reach minimum average
cost. However, Chamberlin disagrees with this argument.

Chamberlin argues that the higher price that consumer are willing to pay is for the
availability of differentiated (variety of products) products. For Chamberlin Qc cannot be
considered as the socially optimal level of product. Consumers desire variety of products.
Product differentiation reflects the desires of consumers who are willing to pay higher price
to have choice among differentiated products. Therefore, for Chamberlin, the higher cost of
production (at the falling part of AC) is socially acceptable. Consequently, the difference
between Qm and Qc is not excess capacity but rather it is a social cost of producing and
making available a variety of products.

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• Chamberlin argues that the output level under monopolistic market is close to the minimum
cost output. This is the result of price competition. If there is no price competition, firms will
have excess capacity and there will be unexploited economies of scale.
• If there is no price competition (adjustment) the firm will consider ‘D’ as the demand curve
instead of ‘d’. In this case, the long run equilibrium of the firm is when ‘D’ is tangent to the
AC curve (i.e. after entry of new firms cause to shift the demand curve until it is tangent to
LAC curve).

P D
D’

e2

LAC

e1
d
d’

Q Qm Qc Q
Excess
Capacity

In absence of price competition ‘e2’ is the long run equilibrium but with entry and exit of firms.
If there is both price competition and entry/exit of firms, point ‘e1’ is the long run equilibrium.
According to Chamberlin ‘Qm’ is the socially (ideal) optimal output with differentiated products
(markets). Therefore, Chamberlin’s measure of excess capacity is the difference between Qm
and Q.

From point of view of social welfare, output must be increased until price is equal to MC. But
under monopolistic competitive market it is impossible to have P = MC as firms will be in loss in
the long run.

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 P D
C D’
LMC

LAC

Pe b

a
P=MC d

Qe Qf Q
MR

The LMC intersects D curve below the LAC (at point a) so that any policy aiming at the
equalization of P and MC would imply a loss of ab per unit of output in the long run. Thus if
firms were forced to produce at which P = MC, the firm would close down in the long run.

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