CHAPTERONE

1. PRICEANDOUTPUTDETERMINATIONUNDERMONOPOLISTICCOMPETITION
Monopolistic competition is the market structure whose characteristics lie between
perfectcompetitionandmonopoly.Inmany industries,theproductsthatfirmsproducearedifferentiated. For
one reason or another, consumers vieweach firm's products as different from those of otherfirms.
Product differentiation is the major characteristic of monopolistically competitive market structure. A
monopolistically competitive market combines the characteristics of competitive and monopoly
markets.

1.1. BASIC ASSUMPTIONS OF MONOPOLISTIC COMPETITION

(CHAMBERLAIN’S HEROIC ASSUMPTIONS)
The assumptions of the monopolistic competition are the same as those of perfect competition, withan

exception of homogeneity of products. That is, monopolistic competition is a market structure in

which a large number of sellers sell differentiated products, which are close, but not perfect,

substitutes for one another.

One of the assumptions of a perfectly competitive market structure is firms in the industry produce

homogenous products while firms in a monopolistically competitive market produce a differentiated

products otherwise market structures, perfectly competitive and monopolistic competition, have the

same assumptions. Specifically, the following are some of the basic assumptions of a monopolistic

competition market:

i. Thereisrelativelyalargenumberofsellersandbuyersinmarket

ii. The products of the sellers are differentiated, but they are close substitute. In other word, many

firms sell slightly differentiated (heterogeneous) products and hence the cross elasticity of DD is

large but not infinitive. The effect of product differentiation is that any firm in a monopolistic

competitionmarkethassomedegreeoffreedominthedeterminationofpriceforitsproduct. That is to say,

the firm is not price taker for it has some degree of monopoly power over its product, which it can

exploit.
iii. Entry to and exit from the market relatively to monopoly is easy. This is because, firms canenter
in to the market by having patent rights for their products, copy rights on their brand names and
trademarks, enhancing the difficulty and cost of being successfully imitating their products
(innovation). This in turn gives them the right to become price maker depending on the quality of
their products. The best examples for monopolistic competition are the market for toothpastes,
automobiles, TV sets, PCs, soaps, tyres, breweries etc.
iv. Due to product differentiation, in addition to price competition, there is also non-price
competition. That is, competition for potential consumers through advertising and salespromotion
(by/through arranging exhibitions, trade fair, acquiringcertificate for qualityassurance, sponsorship
etc.)
v. The goal of each firm in monopolistic competition is profit maximisation both in the short run
and long run. A firm is assumed to know its DD and cost functions.
vi. Thepricesoffactorsofproduction(labor,capital,etc.)andtechnologyaregiven

1.2. PRODUCTDIFFERENTIATIONANDTHEDEMANDCURVE
Product differentiation in the monopolistically competitive market may be based up on certain

characteristics of the product itself. Therefore, demand of a product in this market is determined not

only by the price policy of the firm, but also by the style of the product, the servicesassociated withit,

and the selling activities of the firms.Thus, the demand curve will shift if:

 Thestyle,orthesellingstrategy ofthefirmchanges

 Competitorschangetheirprice,output,servicesorsellingpolicies

 Tastes,incomes,pricesorsellingpolicesofproductsfromotherindustrieschange

TheDemandCurve

The demand for a product, once preference for a product is created, it gives rise to a negativelysloping

demand curve for the product of the individual firm. That means, since each firm produces a

differentiated product, it holds the monopoly power over its own products and the firm has some

power to influence the market price of its products. As a result, the demand curve for a product of a

firm is downward (or negatively) sloping, as presented below.

 Price

X(quantityofoutputsold)
Fig.1:monopolisticdemandcurve

Thedemand(dd)curveofafirmforitsproductsinmonopolistic competitiveisnegatively sloped and highly

elastic (or greater than the monopoly) because of the assumption of a large number of sellers in the

market. In other words, products are close substitutes one to the other so that a slight change in the

price of a firm's product brings about a larger change in its output quantity demanded. Since

consumers have a large number of alternatives, if a firm increases its product price (p), customers will

shift to the other producers and hence the demand for a firm's product (x) decreasesand vice versa.

Thedemandisdeterminednotonlybythepricepolicyofthefirmbutalsobythestyleofthe product and other

services. Two important policy variables in the theory of the firm are the product itself and selling

activities. Thus the dd curve will shift if all other things (other than the firm's priceof its product) are

changed. Variables other than firm's price can be style, quality, design, advertising, etc. They are

called product and selling activities.

If a firm introduces good quality or design or extensively advertises its product, the dd curve shifts to

the right, implying at that level of price the quantity demanded (x) increases. However, the change

only in price (other things being constant) leadsa movement along the samedd curve, because p andx

are inversely related.

A typical characteristic of monopolistic competition market is product differentiation. As a
result, individual firms face a DD curve that is highly elastic (slightly negatively sloped), but not
perfectly elastic. This implies that:

1. Afirminmonopolisticallycompetitivemarkethasfewrivalsunlikeperfectcompetitivefirm, which has

significant rivals, and a monopoly firm, which has no rival.

P
P P

d curve d curve

DDcurve

Fig.2b:DDcurveforamonopoly
Fig.2a:DDcurveforafirm Fig.2c:DDcurveforafirmin
firmandtheindustry
monopolistic comp mkt

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. For example, in the case of toothpastes we have brands such as Collegate, Aqua fresh,
Choice, and President etc. The patent right given to the manufacturers of the above-mentioned
brands restricts two or more manufacturers from producing identical toothpaste. However, all
brands of toothpastes are similar or close substitute to one another. Hence, a firm that producesany
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 of freedom in the determination of price for its product.

Ingeneral,theimportanceofproductdifferentiationare:
It gives some advantage in the determination of price for its product to a firm in monopolistic
competition market. However, each firm faces keen (stiff, bottleneck) competition from other firms
that produce close substitutes. Therefore, the freedom a firm to alter the price of its product is
constrained(limited)tosomeextent.Thisisbecauseifafirmincreasesitspriceitwilllosesome but not all of
its customers (consumers of its product). On the contrary, if a firm decreases its price it will increase
its sales by attracting some but not all consumers of other firms’ products.
Consumers do have specialpreferencesfor theproductsof a specific seller and within limitswill pay a
higher price to satisfy those preferences. The reason why not a firm looses or attract all consumers
when price increases or decreases, respectively and consumers are willing to pay a higher price for a
product of a specific firm is due to brand loyalty. This means that whatever the
changeinthepriceofotherfirms’productspeoplemaynotswitchtheirconsumptiontoother brands. The best
example for this is the survey conducted regarding the DD for Sharp brand products in Manchester
(England) 1990’s. In 1990’s a Japanese company that produce Sharp brand was the official sponsor of
Manchester United Football Club.

During that decade, there was a decline in the prices of other brands of TV sets and refrigerators. In
spite of this, the survey conducted on Manchester United Football Club funs confirmed that no
significant reduction in the sales of the company which was registered in the city. This was because
the funs keep on consuming the product of the firm (Sharp brand) that sponsor and made the club
financially strong and the best club in the world after losing all of its players in an airplane accident
occurred in 1980’s. This example therefore best explains how brand loyalty due to non-price
competition is stronger than price reduction under monopolistic competition.

1.2.1. TRADITIONALCOSTSANDSELLINGCOSTS
All cost curves:- short- run average variable cost (AVC), average cost (AC),marginal cost (MC) and

long- run total average cost (LAC) of a firmare U- shaped, implying that there is only a single

levelofoutputwhichcanbeoptimally producedandeconomiesanddiseconomiesofscales.Sothe

shapesofcostsarethesameinallperfectlycompetitive,monopoly,andmonopolistically competitive

markets.

But here, in the monopolistic competitive, a new cost is introduced, i.e.,selling costs. Selling costsare

costs incurred on advertisement, improving the quality and style, etc. of the product. Selling costs

help to alter the position or the shape of the dd curve for a product.

Accordingly, selling costs curve is U- shaped, i.e., there are economies and diseconomies of selling

costs. For instance, if we take advertisement, initially the increment in selling quantity is greater

thantheadvertisementcostandafteracertainpointthesalesrateremainsmoreorlessconstant
 but the advertisement cost continues to rise.This leads to a fall in the average selling cost

initiallyanditrisesupasadvertisementcontinues.HencethesellingcostisU-shaped.TheU-Shaped selling

cost added to the U- shaped production cost (APTC), yields a U-shaped ATC curves.

1.2.2. THECONCEPTOFPRODUCTGROUPANDINDUSTRY

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. For instance, within
automobile industry cars with brand name Fiat and Lada,Corolla DX and Toyota DX are alike intheir
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. Similarly, though it typically
represents an example of oligopoly market, in the soft drink industry Mirinda and Fanta,
PepsiandCoca-Cola,7UPandSprite-suppliedbyMohasoftdrinkP.L.CandEastAfricabottling
P.L.S.C (Private Limited Share Company), respectively are so close that a consumer 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. Therefore,
the above bundles can be categorised as 3 different product groups.

Industry:Anindustryunderperfectlycompetitivemarketisdefinedasagroupoffirmsthat produce

homogenous products. However, this definition cannot be applied in the case

ofdifferentiatedproducts.Inthecaseofhomogeneity ofproducts,itispossibletoaddthem horizontally and

get the market demand and supply of the products. But here, in the case of monopolistic competition,

products cannot be added to get the market demand and supply. For this reason, it is very important to

redefine the industry for analytical purpose.

Theconceptindustryreferstobroaderclassificationandhenceconsistsofseveralproductgroups.If 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 can
beregardedasproductgroupandindustry.Ontheotherhand,ifallfirmsinanindustryproducehighly
differentiated products, we say there is no product group. Thus, product group is a sub set of
industry.

Productdifferentiationcreatesdifficultiesintheanalyticaltreatmentoftheindustryof monopolistically

competitive market structure. Heterogeneous products cannot be added to form the market demand and

supply schedules as in the case of homogeneous products. The monopolistically competitive industry is

a ' group' of firms producing a closely related' commodity, referred to as ' product group'.An

operational definition of ‘product group’ is that the demand of each singleproduct be highly elastic and

that it shifts appreciably when the price of other products in the group changes. In other words,

products, forming ‘the group’ or ‘industry ‘, should have high price andcross-elasticity.

Product differentiation allows each firm to charge different prices. There will be no uniqueequilibrium
price,butanequilibriumclusterofprices,reflecting thepreferencesofconsumersfor the products of the
various firms in the group. When the market demand shifts or cost conditions change in a way
affecting all firms, then the entire cluster of prices will rise or fall simultaneously.

1.3. THESHORTRUNANDLONGRUNEQUILIBRIUMOFFIRMS
Inordertobeabletoanalyze theequilibriumofthefirmandtheproductgroup(industry) Chamberlin made the
following' heroic assumption ‘that firms have identical demand and cost curves. This requires that
consumers’ preferences be evenly distributed among the sellers, and that differences between the
products be such as not to give rise to differences in costs. The rule of determining profit maximizing
level of output is the same in all market structures, i.e., producing the
outputatwhichmarginalrevenue(MR)isequaltomarginalcost(MC)andatthatpointMCmustbe
TR
rising.MRistheslopeoftotalrevenue( )orthefirstderivativeoftotalrevenuewithrespectto
Q
dTR TC
quantityproducedandsold( ),whereasMCistheslopeoftotalcost( )orthefirst
dQ Q
dTC
derivativeoftotalcostwithrespecttoquantityproducedandsold( ).
dQ
 1.3.1. SHORTRUNEQUILIBRIUMOFTHEFIRM

P P ATC
MC

MCATC
SRPe A C A

SRPe B

C B
E
SRD SRMR SRd ESRD
SRd
SRMR

SRQe SRQe
Fig.3a:Shortrunprofit fig.3b:shortrunloss

The shape of the proportional DD curve and cost conditions-MC and ATC-are the same as firmsunder
perfect competition. The difference between perfect and monopolistic competition lies in the
perceivedDDcurve(d).Afirminmonopolisticcompetitionmarketperceivesitsdemandcurveto
belessthanperfectly elastic(nothorizontal).Thereasonisthattheoutputofonefirmisclosebut 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 runMR (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.

Thethreecharacteristicsofshortrunequilibriumundermonopolisticcompetition
1. Eachfirmdeterminesoutputandpriceby equatingMRandMC(pointE).
2. Dintersectsdattheoutputchosenbythefirm.
3. AfirmwillobtainexcessprofitifPe>ATCandlossifPe<ATC.
Exercise2.1
Assumeafirmengaginginsellingitsproductandpromotionalactivitiesinmonopolisticcompetitionface
shortrundemandandcostfunctionsasQd=20-0.5PandTC=4Q2-8Q+15,respectively.Havingthis information
A. Determinetheoptimallevelofoutputandpriceintheshortrun.
B. Calculatetheeconomicprofit(loss)thefirmwillobtain(incur).
 Solution:Q=20-0.5P B.∏=TR-TCorQ(P-ATC)
Q-20=-0.5P =(40Q-2Q2)–(4Q2-8Q+15)or4(32-11.75)
*P=40-2Q =(40(4)-2(4)2)-(4(4)2-8(4)+15)or4(20.25)
*TR=PQ =(160-64)–(64-32+15)or81
=(40-2Q)Q =128-47 or81
2
=40Q-2Q =81=81

*MR=∂TR=40-4Q
∂Q
*TC=4Q2-8Q+15
*MC=∂TC=8Q-8
∂Q
*MR=MC40-
4Q=8Q-8
48=12Q
Q=4
*P=40-2Q
P=40-2(4) P=40-8=32

Activity2.1
Given P=30-5Q and ATC=20/Q+4Q-6, answer the above questions A to C
Q=2,P=20, and profit 16

1.4. LONGRUNEQUILIBRIUMOFTHEFIRM
Here we will compare the equilibrium conditions of both monopolistically competitive and perfectly
competitive firms. In the long run, the tendency of a firm in monopolistic competition is to earn
normalprofit(BreakEvenpoint,P=LAC-notP= minLAC). Thisisbecause we expectthe 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. Thisin turn
shifts the perceived demand curve faced by the typical firm to the right; push price down, and the
disappearance of economic profit (∏ will be equal to zero). However, although profits are zero,the
situation is not Pareto efficient. 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.
Thelongrunequilibriumofafirminmonopolisticcompetitionisdefinedbythreeconditions.
1. dmccurvemustbetangentatthefallingpartofLAC(notattheminimumofLAC)
2. Theproportionaldemandcurve(D)mustintersectbothdandLACatthetangency
3. NoexcessprofitisobtainedbecauseP=LAC.Therefore,thelongrunequilibriumis obtained at a
point F where D=d=P=LAC.
LAC
P
LMC

Pmc F Ec dPC

Ppc

dmc
Emc

Excess DDmc
Capacity MRmc
LRQmc LRQpc Q

Fig.4: Equilibrium Conditions in Monopolistically Competitive Market – compared to perfect

competition

1.5. EXCESSCAPACITYANDWELFARELOSS:COMPARISONWITHPURE
COMPETITION
Now let us compare the long- run equilibrium situations of the perfectly and monopolistically
competitivemarketsandseehowthemonopolisticallycompetitivemarketstructureresultsin welfare loss.

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 afirmundermonopolisticcompetition.That is,firmswilltypically operatetotheleftof output where
LAC is minimised. This implies that there is misallocation of resources for P is greater than the
minimum of LAC.
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.

Welfare Loss: Another limitation of long run equilibrium of a firm in monopolistic competition isthat
P >LMC implying welfare loss. To maximize social welfare, output should be increased until
P=LMC. However, 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. In other words, 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 thatP>MC,the welfare lossofunder monopolistic competitionshouldnotbe 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.

Summary:
In the long run, firms both in perfectly and monopolistically competitive markets make zero profit.
However, the equilibrium price is higher and output is lower in monopolistic competitive as
compared to the equilibrium price and outputs of the perfectly competitive.The equilibrium point
in the monopolistic competitive is at the falling part of LAC while in the perfectly competitiveat the
lowest point on LAC (see fig.4 above). That means costs are higher in the monopolistic
competitivethanintheperfectlycompetitive.Asaresultmonopolisticcompetitionhasbeen attacked on the
ground that firms are working with ' excess capacity', as measured by the difference between ideal
out-put , LRQpcand the output actually attained in long -run equilibrium LRQmc.