Chapter Two: Monopolistic Competition

Definition: Monopolistic competition is a market structure which combines elements of

monopoly and competitive markets. Essentially a monopolistic competitive market is one with
freedom of entry and exit, but firms can differentiate their products. Therefore, they have an
inelastic demand curve and so they can set prices. However, because there is freedom of entry,
supernormal profits will encourage more firms to enter the market leading to normal profits in
the long term.

Chamberlain(the pioneer of the market), defined monopolistic competition as a market

structure in which a large number of sellers sell differentiated products which are close but not
perfect substitute for one another. It has elements from both competitive and monopoly market
structures it is similar to competitive market structure in all aspects except its differentiated
products. These heterogeneous products create some power for the firms like firms in monopoly
market structure.
2.1. Assumptions of Monopolistic Competitive Market

A monopolistically competitive market has features that represent a cross between a perfectly
competitive market and a monopolistic market (as the name suggests). The following are some
of the main assumptions of the model:

1. Many, many firms produce in a monopolistically competitive industry. This

assumption is similar to that found in a model of perfect competition.
2. Each firm produces a product that is differentiated (i.e., different in character) from
all other products produced by the other firms in the industry. Thus one firm might
produce a red toothpaste with a spearmint taste, and another might produce a white
toothpaste with a wintergreen taste. This assumption is similar to a monopoly market that
produces a unique (or highly differentiated) product.
3. The differentiated products are imperfectly substitutable in consumption. This
means that if the price of one good were to rise, some consumers would switch their
purchases to another product within the industry. From the perspective of a firm in the
industry, it would face a downward-sloping demand curve for its product, but the position
of the demand curve would depend on the characteristics and prices of the other
substitutable products produced by other firms. This assumption is intermediate between
the perfectly competitive assumption in which goods are perfectly substitutable and the
assumption in a monopoly market in which no substitution is possible.

Consumer demand for differentiated products is sometimes described using two distinct
approaches: the love-of-variety approach and the ideal variety approach. The love-of-
variety approach assumes that each consumer has a demand for multiple varieties of a
product over time. A good example of this would be restaurant meals. Most consumers

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 who eat out frequently will also switch between restaurants, one day eating at Mr. X’s
restaurant, another day at Y’s restaurant, and so on. If all consumers share the same love
of variety, then the aggregate market will sustain demand for many varieties of goods
simultaneously. If a utility function is specified that incorporates a love of variety, then
the well-being of any consumer is greater the larger the number of varieties of goods
available. Thus the consumers would prefer to have twenty varieties to choose from
rather than ten.

The ideal variety approach assumes that each product consists of a collection of
different characteristics. For example, each automobile has a different color, interior and
exterior design, engine features, and so on. Each consumer is assumed to have different
preferences over these characteristics. Since the final product consists of a composite of
these characteristics, the consumer chooses a product closest to his or her ideal variety
subject to the price of the good. In the aggregate, as long as consumers have different
ideal varieties, the market will sustain multiple firms selling similar products. Therefore,
depending on the type of consumer demand for the market, one can describe the
monopolistic competition model as having consumers with heterogeneous demand (ideal
variety) or homogeneous demand (love of variety).

4. There is free entry and exit of firms in response to profits in the industry. Thus firms
making positive economic profits act as a signal to others to open up similar firms
producing similar products. If firms are losing money (making negative economic
profits), then, one by one, firms will drop out of the industry. Entry or exit affects the
aggregate supply of the product in the market and forces economic profit to zero for each
firm in the industry in the long run. (Note that the long run is defined as the period of
time necessary to drive the economic profit to zero.) This assumption is identical to the
free entry and exit assumption in a perfectly competitive market.
5. There are economies of scale in production (internal to the firm). This is incorporated
as a downward-sloping average cost curve. If average costs fall when firm output
increases, it means that the per-unit cost falls with an increase in the scale of production.
Since monopoly markets can arise when there are large fixed costs in production and
since fixed costs result in declining average costs, the assumption of economies of scale
is similar to a monopoly market.

These main assumptions of the monopolistically competitive market show that the market is
intermediate between a purely competitive market and a purely monopolistic market. The
analysis of trade proceeds using a standard depiction of equilibrium in a monopoly market.
However, the results are reinterpreted in light of these assumptions. Also, it is worth mentioning
that this model is a partial equilibrium model since there is only one industry described and
there is nointeraction across markets based on an aggregate resource constraint.

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Examples of monopolistic competition

 Restaurants – restaurants compete on quality of food as much as price. Product

differentiation is a key element of the business. There are relatively low barriers to entry
in setting up a new restaurant.
 Hairdressers. A service which will give firms a reputation for the quality of their hair-
cutting.
 Clothing. Designer label clothes are about the brand and product differentiation
 TV programs – globalization has increased the diversity of TV programs from networks
around the world. Consumers can choose between domestic channels but also imports
from other countries and new services, such as Netflix.

2.2. Product Differentiation, the demand curve and cost of the firm

Definition: Product differentiation is a tactic that companies use in marketing campaigns to

distinguish their product from another similar products in the market. This strategy can focus on
real product differences or simply preserved differences in the consumers’ minds. This is a
marketing process that highlights the unique features of a company’s products as compared with
its revivals’. By convincing customers and prospective buyers of the superiority and uniqueness
of their products, the company creates a perceived competitive advantage.

Product differentiation is a marketing process that has the objective of making customers
perceive the product of a specific firm as unique or superior to any other product belonging to
the same group, and so creating a sense of value. Differentiation does not always imply changing
the product, sometimes it is enough just by simply creating a new advertising campaign or by
changing its packaging. This term was introduced in economics by Edward H. Chamberlinin his
book “Theory of Monopolistic Competition”, 1933.

A product can be differentiated based on the form of the product. The physical structure, size and
shape of the product can be used to differentiate it from others. Take an example of any
medicine. A medicine can be differentiated from that of its competition by the means of its
potency, its usability, the way it can be taken (intravenous or oral) so on and so forth. Thus the
way the product is made can be a type of product differentiation.

Because the monopolistically competitive firm's product is differentiated from other products,
the firm will face its own downward‐sloping “market” demand curve. This demand curve will be
considerably more elastic than the demand curve that a monopolist faces because the
monopolistically competitive firm has less control over the price that it can charge for its output.
The firm's control over its price will depend on the degree to which its product is differentiated
from competing firms' products. If the firm's product is not differentiated from other products,
the firm will face a relatively elastic demand curve and will have less control over the price it

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can charge. If the firm's product is differentiated compared to a competing firm's products, the
firm will face a relatively inelastic demand curve and will have more control over the price that
it can charge.

Chamberlin opined that demand for product is influenced not by price only but also the style of
the product and selling costs. It is so because the aim of product differentiation is to inspire the
consumer to demand a particular product. The producer is no longer entirely price taker; he/she
becomes partially a price maker. As a result demand curve assumes negative slope. It indicates
that when price falls demand will be more and vice-versa.

There are three ways in which a monopolistic competitive firm can differentiate its
product:
A) Style, Type or Design of the product

One way monopolistically competitive firms differentiate their productis by having special
designs on their products.
For example, it is easy to recognize an Apple laptop (Macbook) becauseof the design.Firms
design their products such that they will be appealing tocustomers.

B) Location
Many businesses attract customers because of their locations. Many people go to gas stations,
barber shops, car wash services… because of how conveniently they are located. A good location
provides a higher market power. An example is the price of goods sold in malls or downtown.

C) Quality of the Product

Firms also compete on the basis of quality. Fast food restaurants and actual restaurants charge
different prices and attract different kinds of hungry customers. The price a firm charges depends
on the quality of the product it makes.

2.3. The Concept of Industry and product ‘group’

An industry is defined as a group of firms producing homogenous products. But in this market
structure, there are firms producing different products. Each firm is an industry by itself. This
made the market demand curve inexistent to Chamberlain's model. To solve this problem, he
categorized the very close products under the same group. The group of products under the same
division is called product group. Products in the same group are expected to be technological and
economic substitutes. Technological substitutes are products which can technically cover the
same want. Example, all vehicles are technological substitutes in the sense that they provide
transport. Economic substitutes are products which cover the same want and have similar prices.
An operational definition of the “product group” is that the demand of each single product be
highly elastic and that it shifts appreciably when the price of the other products in the group

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changes. In other words products forming the group or industry should have high price and cross
elasticity. Therefore, for Chamberlain, an industry is defined as a group of firms producing
products in the same group or product group.

Group equilibrium relates to the equilibrium of the “industry” under a monopolistic competitive
market. The word “industry” refers to all the firms producing a homogeneous product. But under
monopolistic competition the product is differentiated.

Therefore, there is no “industry” but only a “group” of firms producing a similar product. Each
firm produces a distinct product and is itself an industry. Chamberlin lumps together firms
producing very closely related products and calls them product groups.

2.4. Short-run equilibrium of the firm

In the short run, monopolistically competitive firms behave like monopolies. Instead of
producing all units with marginal cost less than price (as in perfect competition), they produce
only those units with marginal cost less than marginal revenue (as a monopoly does). But in the
long run, monopolistic competition has free entry, much like perfect competition. Firms enter
the market when economic profits are available, and exit when they are faced with losses. In
long-run equilibrium, firms receive zero economic profits. Monopolistic competitors do not
interact strategically, because each firm cares only about the general price level, not about
the strategies of individual firms.

A firm under monopolistic competition can influence its sales in two ways. It can change price or
the nature of its products and advertisement outlays. The first tool is used in the short-run while
others are possible only in the long –run.In the short-run, a firm in monopolistic competition acts
like a monopoly. It maximizes profit by equating marginal revenue to marginal cost.
Graphically, equilibrium in the short run is achieved when the marginal cost curve intersects the
marginal revenue from below. This point will give the equilibrium price when extended to the
demand curve and the equilibrium quantity when extended to the x-axis.

The profit-maximizing condition is MR = MC.

b. Above normal profit
• At this point, the corresponding profitmaximizing
output is Q1.

• Given the demand curve and Q1, the price of the

product is P1.

• The corresponding Average Total Cost given Q1 is A1.

• In this case, the price of the good is higher han the

Average Total Cost (i.e. P1 > A1), so the monopolist
makes an average profit equal to P1 – A1.

• The total profit made by the monopolist is the area of

the abcd rectangle in blue.

Short run profit =(P – ATC)x Q

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In the short run, a monopolist makes positive profit. Whether a firm in monopolistic competition
makes profit depends on how many firms there are in the industry. If there are “too few” firms in
the industry (relative to the long-run equilibrium number of firms), then a typical firm in
monopolistic competition will make a profit. But if there are “too many” firms in the industry
(relative to the long-run equilibrium number of firms), then a typical firm in monopolistic
competition will make a loss.

Short run economic profits encourage new firms to enter the market.
This:-
• Increases the number of products offered.
• Reduces demand faced by firms already in the market
• Incumbent firms’ demand curves shift to the left
• Demand for the incumbent firms’ products fall, and their profits decline

Short run economic losses encourage firms to exit the market

This:
• Decreases the number of products offered.
• Increases demand faced by the remaining firms.
• Shifts the remaining firms’ demand curves to the right.
• Increases the remaining firms’ profits.

Monopolistically competitive firm in the short-run: Economic loss

However, if the average total cost is above the market price, then the firm will incur losses, equal
to the average total cost minus the market price multiplied by the quantity produced. It will still
minimize losses by producing that quantity where marginal revenue equals marginal cost, but
eventually the firm will either have to reverse the losses, or it will have to exit the industry.

MR = MC

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Short-Run Loss = (ATC - Price) × Quantity

2.4. Long run equilibrium of the firm (Zero economic profit)

In the long run, a monopolist also makes positive profit. But in the long-run equilibrium in a
monopolistically competitive industry, all firms make zero profit. This is because in the long run,
in a monopolistically competitive industry, enough firms have entered or left the market to shift a
typical firm’s demand curve so that it is tangent to the firm’s average total cost curve at the
firm’s profit-maximizing quantity. The typical firm makes zero profit

Price and output determination in the long run

The super normal profit in the long run attracts new firms in to the industry brings loss of market
share-normal profit
–Increasing number of firm intensifies the price competition between them.
–Price competition increases existing firm cut down price to retain or regain market share new
firms lower to penetrate the market
–Demand curve more elastic.

Long run equilibrium

normal profit

Two Characteristics
a) As in a monopoly, price exceeds marginal cost.
• Profit maximization requires marginal revenue to equal marginal cost.
• The downward-sloping demand curve makes marginal revenue less than price.
b) As in a competitive market, price equals average total cost (P = ATC).
• Firms will enter and exit until P = ATC and the firms are making exactly zero economic profits
(no profit, no loss).

2.5. Excess capacity and welfare loss

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Excess capacity refers to a situation in which industry output is not produced at a minimum
average cost. The output actually produced is less than the output that would minimize average
total cost. The output that would be produced at the minimum level of average cost is termed as
ideal output. Whereas the output produced at the falling portion of average cost is referred to as
actual output

Ideal output of a firm is produced at a point where long-run average cost is minimum. The long-
run equilibrium for a firm in under perfect competition is at the point where long-run average
cost is minimum. At this point, P=LAC=MR=LMC=SMC=SMR. This implies that at
equilibrium P=MC. profit is normal (zero). The long-run equilibrium for a firm under
monopolistic competition is at a point where the individual firm’s demand curve is tangent to the
long run average cost curve. Since the demand curve is down ward sloping, the Long-run curve
has to be downward sloping at the point of tangency. This implies that unlike perfect
competition, the firm’s equilibrium will never be at the minimum point of LAC curve. Not only
this, at the point of tangency P=LAC but P>LMC. The output is lower and price is higher than
the output and price under perfect competition.

Hence, it is argued that the firm’s output under monopolistic competition is not the ideal output
because of excess capacity. There is misallocation of society’s resources. Production costs are
higher than necessary.

In the next figure, excess capacity is the difference between the ideal output Qc corresponding to
the minimum level on LAC curve and the output actually attained in the long-run equilibrium
Qm.
Price

Excess capacity is the gap

between ideal output(Qc)
LMC and the actual output (Qm)
LAC Pm= monopolistic price
Pm A
Pc = competitive price level
Pc B

D
MR
Qm Qc output (Q)

There is misallocation of resources in the long-run. Because the firm in a monopolistically

competitive market does not employ enough of the economy’s resources to reach the minimum
level of average cost. If the demand is down ward sloping and firms enter into active price

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competition while entry is free in the industry, Chamberlain argues that Qc cannot be considered
as the socially optimal level of output. Consumers desire variety of products. Product
differentiation reflects the desires of consumers who are willing to pay the higher price in order
to have choice among differentiated products. The higher cost, resulting from producing to the
left of the minimum average cost, is thus socially acceptable. According to Chamberlain, the
difference between ideal output (Qc) and actual output (Qm) is not a measure of excess capacity,
but rather a measure of the “social cost” of producing and offering to the consumer greater
variety of products.

Chamberlain's argument is based on the assumptions of active price competition and free entry.
But there is still a reaction from other groups that too many firms, too many brands, too much
selling expenses and too much spurious product differentiation are wastes under monopolistic
competition.

From the point of view of social welfare, monopolistic competition suffers from the fact that
price is higher than the marginal cost. Socially, output should be increased until price equals
marginal cost. However, this is impossible since all firms would have to produce at a loss in the
long-run. Since resources are not fully utilized under monopolistic competition, the optimum
level of output cannot be produced and there is loss in social welfare from the society’s point of
view.

Efficiency of firms in monopolistic competition

 Allocative inefficient. The above diagrams show a price set above marginal cost
 Productive inefficiency. The above diagram shows a firm not producing on the lowest
point of AC curve
 Dynamic efficiency. This is possible as firms have profit to invest in research and
development.
 X-efficiency. This is possible as the firm does face competitive pressures to cut cost and
provide better products.

Key difference with monopoly

In monopolistic competition there are no barriers to entry. Therefore in long run, the market will
be competitive, with firms making normal profit.

Are selling costs to be considered as items of waste?

We can prepare a case on both sides;

1. Selling Costs as wasteful

2. Not necessarily as wasteful.

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Selling costs may be considered as items of waste for following reasons:

 Retaliation: i.e. when one firm incurs selling cost to push up the sales of its product, the
other firms will also resort to advertisement to push up their sales. This almost leads to
advertisement warfare which would be considered as an item of waste.
 Rise in price: Selling costs are items of cost. When cost is incurred it will have to be
covered. This could be through rise in price.
 Misleading: Selling costs may mislead the consumers about the nature of quality of
product. This would be considered socially undesirable.
 Cross-transport: It may lead the consumers from one region to go to other region to
purchase the product of his choice being guided by its advertisement.
 Not effective: A firm may keep incurring selling cost without promoting sales. This is
wasteful.

 However, selling costs need not necessarily be considered as items of waste for
following reasons:

 Selling costs are of two type’s viz. Informative and Persuasive. Informative selling
costs make the consumers aware about the entry of new firm, new product or any change
in the product. This is educative role of selling cost and should not be considered as an
item of waste.
 Selling costs involve advertisement, publicity, salesmanship etc., all these have become
industry on their own. They create large scale employment and hence cannot be treated
as an item of waste.
 Selling costs create demand. To meet the demand the firm has to produce more. When
production expands, the average cost of production falls and hence prices need not be
raised because of selling cost. Thus selling costs need not be considered as items of
waste.

Limitations of the model of monopolistic competition

1. The assumption of product differentiation and independent action by the competitors are
inconsistent. It is fact that firms are continuously aware of the action of the competitors
whose products are close substitutes of their own.
2. It implicitly assumes that monopolistically competitive firms do not learn from their past
experience. Such an assumption can hardly be accepted.
3. The concept of product differentiation destroyed the recognition of and industry.
4. The model assumes a large number of sellers. But it did not define the actual number of
firms to distinguish it from oligopoly and pure competition.
5. The assumption of free entry is incompatible with product differentiation. Because
product differentiation and brand loyalty by themselves can create barrier.
6. It is impossible to assume identical demand and cost curves for differed products.

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