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TABLE OF CONTENTS
1. Learning Outcomes
2. Introduction
3.Features of Monopolistic Competition
3.1 Product Differentiation
3.2 The Concept of the Industry and Product Group
3.3Free Entry and Exit
3.4 Number of Buyers and Sellers
3.5 Non-Price Competition
3.6 Independent Behaviour
4. Equilibrium of Monopolistic Competition
4.1 Assumption in Analyzing Firm Behaviour
4.2 Individual Equilibrium
4.3 Group Equilibrium
4.4 Equilibrium of Monopolistic Competition with Chamberlin’s Approach
4.5 Excess Capacity under Monopolistic Competition
5. Summary
1. Learning Outcomes
This module will help you to understand
market structure of monopolistic competition;
price and output determination under monopolistic competition;
equilibrium of its market structure; and
excess capacity creation under monopolistic competition.
2. Introduction
Perfect Competition and Monopoly are the two extreme cases of market structure. In practice, one
hardly observesany suchsituation,which fit into such kinds of market structure. The assumptions
in perfect competition and monopoly are not exactly happening in the real world. There are
always some deviations from the assumptions. For example, the assumption of homogenous
products in perfect competition does not resemblethe products available in real word. Economists
like Chamberlin and Joan Robinson contributed a lot to the economic literature by trying to
reconcile the two extremes so that they can fit into the real word. Their individual contributions to
the economic literaturebrought a new market structure which is known as “Monopolistic
Competition”. Therefore, monopolistic competition is a blending of both monopoly and perfect
competition, which we can observe from the industries with similar market structures viz. shoes,
restaurants, soft drinks, and clothing industries. In all these industries, products are homogenous
but they are slightly differentiated. They are close but not perfect substitute for the buyers. For
example, the soft drinks like Pepsi and Coke are homogenous but slightly differentiated products
with respect to brand name, packing design etc.
Thus, monopolistic competition is a form of market structure in which a large number of firms
are supplying homogenous but slightly differentiated product. The products of the competing
firms are close but not perfect substitutes because for buyers they are not identical as they are
slightly differentiated. This is a kind of market structure, where there iscompetition among a large
number of “monopolists” and therefore is known to economists as monopolistic competition.
The products produced by different firms are not homogenous, they are heterogeneous. However,
the products of the same firm are close substitutes to each other. In order to make the product
unique, producers make their products different from others consciously. Firms adoptdifferent
ways todifferentiate the products. For example soft drinks like Pepsi, Coke, and ThumpsUp etc.
In these cases the firms simply change the chemical composition, appearance, brand
name,advertising, packing material etc. to make new and differentiated products in order to attract
the buyers. Thus in monopolistic completion firms produce homogenous but slightly
differentiated products. This differentiation among competing products can be attributed to real or
imaginary differences in quality. Sometimes advertisement has the impact of drawing the
attention of the buyers to imagine or believe that the advertisedproduct has better qualities.
We assume that the demand curves of all firms are symmetrical, which implies that market share
of every firm isthe same and equal to a constant proportion of total market demand.
Fig. 4.1 Individual Equilibrium Under Monopolistic Competition with Super Normal Profit
The individual equilibrium under monopolistic competition in short run is graphically shown in
Fig.4.1. DD is the demand curve for the product of an individual firm, the nature and prices of all
substitutes being given. This demand curve DD is also the average revenue curve of the firm. AC
represents the average cost curve of the firm, while MC is the marginal cost curve corresponding
to it. Given these demand and cost conditions, a firm will adjust its price and output at the level
which gives it maximum total profits. A firm in order to maximize profits will equate marginal
cost with marginal revenue. In Fig. 4.1 at the equilibrium point E, price is determined as
MQ=OPand quantity of output produced is OM. Thus, the area RSQP indicates the amount of
supernormal profits made by the firm.
In the short run, the firm, in equilibrium, may make losses too if the demand conditions for its
product are not so favourable relative to cost conditions. Fig.4.2 depicts the case of a firm the
firm making losses equal to the area GTKH.
various firms differ in respect of shape and position. As a result of these heterogeneous conditions
surrounding each firm, there will be differences in prices, in outputs and profits of the various
firms in the group. Chamberlin in monopolistic competition make that under the heroic
assumption both demand and cost curves for all the ‘products’ are uniform throughout the group.
Further, to facilitate exposition of this theory, Chamberlin introduces a further assumption which
has been called ‘symmetry assumption’ by Prof. Stigler. It is that the number of firms being large
under monopolistic competition, an individual’s actions regarding prices and output adjustment
will have a negligible effect upon his numerous competitors so that they will not think of
retaliation for readjusting their prices and outputs.
The demand and cost curves of each of the firms in the group are DD and AC as depicted in
Fig.4.1. Each firm will set price OP at which marginal cost is equal to marginal revenue and
hence profits are maximum. Although all firms are making supernormal profits, there is no reason
for anyone to cut down price below OP.These supernormal profits will however attract new firms
in the field. New entrants are free to produce closely related products which are very similar to
the products of existing firms. Thus, under monopolistic competition there can be freedom of
entry only in the sense of freedom to produce close substitutes. When the new firms attracted by
the supernormal profits enjoyed by the existing firms enter into the field, the market would be
shared between more firms and as a result the demand curve for the product of each firm will
shift downward i.e., to the left. This process of entry of new firms and the resultant shift in the
demand curve to the left will continue until the average revenue curve becomes tangent to the
average cost curve and the abnormal profits are completely wiped out. This is shown in Fig.4.3
where average revenue curve is tangent to average cost curve at point T.
Marginal cost and marginal revenue curves will intersect each other, exactly vertically below T.
Therefore, the firm is in long-run equilibrium but setting price LT or OK and producing OL
quantity of his product. 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 curves of all will be tangent to their average cost curves and all firms will therefore be
earning only normal profits.
Chamberlin’s alternative approach makes use of two types of demand curves- perceived demand
curve and proportional demand curve. The demand curve facing an individual firm, as perceived
by it describes the demand for the product of one firm on the assumption that all other firms in
the industry or group keep the prices of their products constant. The number of firms being large
in a product group under monopolistic competition, it is assumed that each firm is so small
relative to the whole group that it thinks that the price change by it will have a negligible impact
upon its competitive firms, with the result that they would not think of reacting to the change in
price by it in retaliation.
On the other hand,the proportional demand curve facing an individual firm shows the demand of
the product when the prices of all firms of the product group change simultaneously in the same
direction and by the same amount so that they charge same or uniform price. So, the proportional
demand curve of a firm will be less elastic than its perceived demand curve, since equal change in
price by all firms of the industry simultaneously will prevent the movement of customers from
one seller to another. The proportional demand curve of each firm slopes downward and is a
fractional part of the total market demand curve. The greater the number of firms in a product
group, the smaller the share of an individual firm at a given price. Therefore, the proportional
demand curve facing an individual firm shifts to the left as more and more firms enter to the
product group or industry. The proportional demand curve DD́ and the perceived demand curve
dd́ are shown graphically in Fig.32.4.
An individual firm perceives that its demand is elastic and it can increase it profits by cutting
down its price. Therefore, we construct the perceived demand curve dd́ passing through point A
as being more elastic than the proportional demand curve DD́. However, since each firm in the
product group will think independently that its price reduction will have a negligible effect upon
each of his rivals and therefore assumes that others would keep their prices constant, the actual
movement would not be along the perceived demand curve dd́ but along the proportional demand
curve DD́.Therefore, DD́ shows the actual sales by each firm when the prices of all change
equally and identically.
The firm is initially at point A on the proportional demand curve DD́ in Fig.4.5. Firm’s perceived
demand curve d0d́0 has been drawn through point A. Each firm’s share of demand for its product
is equal to OM0 and all of them are charging uniform price OP0. With Firm’s initial position at A
on the proportionate demand curve DD́, it perceives that it can increase its profits by cutting
down price below OP0 thinking that other firms would not react. It is observed from the Fig. 4.5
that if the firm cuts down price to OP1, it can maximize its profits by producing OM1 output
which is demanded at price OP1 provided others do not react to it. The perceived marginal
revenue curve MR0 corresponding to the perceived demand curve d0d́0intersects the marginal cost
curve, MC at the OM1 level of output. Thus, given the perceived demand curve d0d́0 passing
through point A on the proportional demand curve, the profit maximizing-output is equal to OM1,
which implies that the firm will have advantage to lower its price from OP0 to OP1 so as to raise
quantity demanded of its product to OM1 Level. Each firm in monopolistically competitive
industry will perceive independently that if they lower their price below the prevailing one, they
can attract customers from others thinking that others would not react.
But as a matter of fact since all firms would try to cut down their prices thinking others would not
react, each firm will not be in equilibrium at point Á. Instead, the firm will find themselves at
point B on the proportional demand curve, getting a proportionate share of the increase in market
demand at the lower price OP1. Thus each firm will be working at point B on the proportional
demand curve and producing OM2output. Thus, as a result of price cutting the perceived demand
curve of each firm will slide down the proportional demand curve to point B.With point B on the
new perceived demand curve d1d́1, the firm thinks that it can increase its profit if it lowers its
price below OP1 provided that others will not react. Because the new perceived marginal revenue
curve MR1 corresponding to the new perceived demand curve d1d́1lies above the marginal cost
curve MC in the relevant region. Though its earlier attempt to increase profits by lowering price
was retaliated by others, each firm again believes that if it lowers the price and thereby bringing
about increase in quantity demanded of its product, it can increase its profits.
Though each firm perceives in the same way and cuts down its prices independently, itwould not
succeed in snatching away customers from its rival firms. As a result, each firm instead of
moving along to a point on the perceived demand curve for maximizing its profits will land itself
on the proportional demand curve getting the same proportionate share from the increase in
quantity demanded of the product at the lower price. In this way the process of price cutting
competition and sliding down of perceived demand curve on the proportional demand curve
would continue until a firm has reached a point where it cannot perceive to increase its profits by
reducing its price.The firm in this situation will be maximizing its profits and will have therefore
no advantage to lower the price of the product further.
As a result of price competition the perceived demand curve has slided down to the point H on
the proportional demand curve DD́ and accordingly price has fallen to OP2 and each firm is
producing and selling OM3 output as seen in Fig. 4.6.Each firm will be in equilibrium at this price
output combination and will have no incentive to change its price. Thus, according to
Chamberlin’s approach short-run equilibrium under monopolistic competition is reached and firm
will be maximizing its profits when the following two conditions are satisfied:
i) The price-output combination is such that perceived marginal revenue curve intersects
the marginal cost curve so that MR=MC.
ii) The price-output combination at which MR=MC is the point at which perceived demand
curve dd́ intersects the proportional demand curve DD́.
Thus in the short run,firm’s equilibrium occurs at the point on proportional demand curve and
perceived demand curve at which marginal revenue is equal to marginal cost.
4.4.1 Long –Run Equilibrium of the Firm and Group in Chamberlin’s Approach
Attracted by supernormal profits enjoyed by firms in short run,new firms will enter into the
industry. As a result of the entry of new firms, the market demand curve for the good would be
shared by more firms which would cause the proportionate demand curve to shift to left. Along
with the shift of the proportionate market demand curve, the perceived demand curve will also
shift to the left. The process of entry will continue until the perceived demand curve dd́ become
tangent to the long- run average cost curve LAC as seen in Fig.4.6. Further, it is observed that due
to the availability of more substitutes as a result of entry of more firms the perceived demand
curve has become more elastic. The tangency of the perceived demand curve dd́ with the long-run
BUSINESS PAPER No. : 1, MICROECONOMIC ANALYSIS
ECONOMICS MODULE No. : 23, MONOPOLISTIC COMPETITION
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average cost curve LAC shows that the firms are making only normal profits. Hence there will be
no tendency for new firms to enter into the group. Consequently, when perceived demand curve
dd́ becomes tangent to the average cost curve LAC, the product group as a whole will be in
equilibrium.
When sufficient numbers of new firms have entered the group and price cutting has been made,
the demand curve dd́ has fallen to the position of tangency with the long-run average cost curve
LAC in Fig.4.6. The proportional demand curve DD́ will intersect the dd́ and LAC at the point of
tangency. If too many firms have entered the group the perceived demand curve dd́ will fall to the
position below that of the tangency and the firms will be making losses. As a result some firms
will leave the group and DD́ along with dd́ curve will shift to the right.
In the Chamberlin’s approach, the two competitive forces- the entry of firms and the price
cuttingbehaviourare observed to be operating simultaneously and these force the dd́ curve to shift
and become tangent to the LAC curve. Then the DD́ curve cuts both of them at the point of
tangency which brings group equilibrium in Chamberlin’s approach.
which is an under-utilization of resources of the society. The optimum output is associated with
the minimum point of the LAC curve. The excess capacity is the difference between the
optimaloutput and the actual output attained by the firm in the long-run as shown in Fig.4.6.In
Fig. 4.6, ON is the optimal output as it corresponds to minimum point of LACcurve and OQ is
the long-run equilibrium output in a monopolistic competition. Thus the excess capacity equal
toON minus OQ, which is equal to QN.Therefore, according to Chamberlin, excess capacity is
equal to QN which has arisen due to the free entry of the firms but absence of price competition.
5. Summary
Both monopoly and perfect competition are extreme forms of market structure and are rarely seen
in real world. Chamberlin blends these two market structuresand develops the concept of
monopolistic competition.The conditions of short-run and long-run equilibrium under
monopolistic competition differconsiderably from those of monopoly and perfect competition. In
short-runthere is excess profit and in the long-run these disappear as new firms enterthe market.
Under monopolistic competition firms do notoperate at optimal plant size. They work with excess
capacity.