Lecture Two

MONOPOLISTIC COMPETITION

• After lecturing this lecture, you will be able to:

 define briefly monopolistic competition
 distinguish between monopolistic competitions
from others form of markets
 understand price differentiation in monopolistic
competition

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 Definition

 It is a market structure defined mainly by the number of the firms

in the market and the type of the product.
 Hence, monopolistic Competition is defined as a market structure
in which there are large number of buyers and sellers; and the
sellers sell products that are heterogeneous or differentiated in
which the products are close, but not perfect substitutes for one
another.
 Monopolistic competition resembles both perfect competition and
monopoly. As with perfect competition, entry and exit from the
industry is free that often results in large number of sellers.
 However, in contrast to perfect competition, the firms produce
heterogeneous or differentiated products that render a sort of
monopoly power over their own product.
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 This market is characterized by the existence of:
• Many buyers and sellers: there are many buyers
and sells of the product, but their number is not
as large as that of perfectly competitive market
• Differentiated product: the product produced
and supplied by many sellers in the market is
similar but not identical.
• Product differentiation may be:
• real or
• spurious (fancied) differentiation.

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• Real differentiation : occur when the
intrinsic characteristics of the products are
different, or
• It occurs when differences in:
specification of the product or
Inputs or
location of the firm and other.
 For instance, Sports wear shoes produced by
several firms, some sports shoes are made of
synthetic and some are leather made.

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• Spurious or fancied differentiation:
• It occurs when the products are basically the same
but the consumer is convinced through advertising
and other selling activities.
• is established by advertising, difference in
packaging, design, simple brand name and the
like.
 For example, Dashen Beer and St. George beer in which
both having equal alcoholic content and are produced
by almost the same input. You can take also the foods
you eat in different restaurants (e.g. Roasted meat).

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• Free entry and exist: like the perfectly competitive
market, there is no barrier on new firms to enter to the
market.
• No collusion among sellers or buyers: because of
many buyers and seller as well as product
differentiation, the is no collusion among firms.
• The existence of non- price competition: sellers
compete not only in price but also through
advertisement, brand name, etc.
• A firm spends money in advertisement to inform the
consumers about the relatively unique character brand
loyalty.
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 PRODUCT DIFFERENTIATION AND THE DD CURVE

• A typical characteristic of monopolistic

competition market is product differentiation.
• Hence, individual firms face a DD curve that
is highly elastic (slightly negatively sloped),
but not perfectly elastic. This implies that:
1. A firm in monopolistically competitive market
has few rivals unlike perfect competitive firm,
which has significant rivals, and a monopoly
firm, which has no rival.

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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.

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 However, all brands of toothpastes are
similar or close substitute to one another.
 Hence, a firm that produces any 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.

Compiled by: Tesfaye E.; WUSC; Economics

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department; tesfayeetensa@gmail.com
 In general, the importance (significant) of product
differentiation are:
1. 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) to some extent. This is
because if a firm increases its price it will loose some 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.

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2.Consumers do have special preferences for the products of a
specific seller and within limits will 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 change in the price of other
firms’ products people may not switch their consumption to
other 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.

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• 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 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.

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THE CONCEPT OF PRODUCT GROUP AND INDUSTRY

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 in
their 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.

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• Similarly, though it typically represents an example
of oligopoly market, in the soft drink industry
Mirinda and Fanta, Pepsi and Coca-Cola, 7 UP and
Sprite-supplied by Moha soft drink P.L.C and East
Africa bottling P.L.S.C (Private Limited Share
Company), respectively are so close that a consume
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.
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 INDUSTRY
 The concept industry refers to broader classification
and hence consists of several product groups.
 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 in can be
regarded as product group and industry.
 On the other hand, if all firms in an industry produce
highly differentiated products, we say there is no
product group. Thus, product group is a sub set of
industry.
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 Demand curve analysis under monopolistic
competition
• The demand curve is downward sloping.
• Each firm confronts two demand curves
drawn based on different assumptions.
One of the demand curves is very elastic,
which is sketched on the assumption that when
the firm changes its price, other firms in the
product group do not change theirs.

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• This demand curve is referred as Perceived or Anticipated
demand curve.
• In this case each firm believes that other firms will not follow
its price changes.
The other demand curve is less elastic. This demand curve is
portrayed on the assumption that each firm has an identical
demand and cost condition in the product group.
• Hence each firm acts in the same manner in raising or
lowering price for they have the same incentive to change
price and ultimately each firm retains a constant share of the
market.
• This demand curve is termed as Proportional demand curve.
These two types demand curves are presented in figure below.

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SHORTRUN AND LONGRUN EQUILIBRIUM OF FIRMS
A. SHORT RUN EQUILIBRIUM
 The shape of the proportional DD curve and cost conditions-MC and
ATC-are the same as firms under perfect competition.
 The difference between perfect and monopolistic competition lies in the
perceived DD curve (d). A firm in monopolistic competition market
perceives its demand curve to be less than perfectly elastic (not
horizontal).
 The reason is that the output of one firm is close but 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 run MR (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.

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• The three characteristics of short run
equilibrium under monopolistic competition:
 Each firm determines output and price by equating
MR and MC (point E).
 D intersects d at the output chosen by the firm.
 A firm will obtain excess profit if Pe>ATC and
loss if Pe<ATC.
•  Numerical Example: Look at your exercise
book

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 B. LONG RUN EQUILIBRIUM
• There are three worthwhile observations about
monopolistically competitive equilibrium in
the long run.
• In the long run, the tendency of a firm in
monopolistic competition is to earn normal
profit (BEP, P=LAC-not P = min LAC).
• This is because we expect the short run
economic profit of firms to attract new rivals
for entry is relatively easy than monopoly.

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• As new firms enter in to the monopolistic competition
market, supply of output in the market increases.
• This in 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.

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 The long run equilibrium of a firm in monopolistic
competition is defined by three conditions.
D must be tangent at the falling part of LAC
(not at the minimum of LAC)
The proportional demand curve (D) must
intersect both d and LAC at the tangency
No excess profit is obtained because
P=LAC. Therefore, the long run equilibrium
is obtained at a point F where D=d=P=LAC.

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 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 that P >MC, the
welfare loss of under monopolistic
competition should not be 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.
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 EXCESS CAPACITY AND 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 a firm under monopolistic competition.
• That is, firms will typically operate to the left of output
where LAC is minimised.
• This implies that there is misallocation of resources for
P is greater than the minimum of LAC.

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• If there were fewer firms, each could operate at a more
efficient scale of operation, which could be better for
consumers.
• However, if there were fewer firms there would also be
less product variety, and this would tend to make
consumers worse off.
• Which of the two effects dominates is a difficult question
to answer.
• However, 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.

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 WELFARE LOSS
• Another limitation of long run equilibrium of a firm in
monopolistic competition is that 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.
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•Welfare loss under monopoly is given by the triangle AEmEc
•Welfare loss under monopolistic competition is triangle FEmcEc.
Therefore, AEmEc> FEmcEc.

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Thank you for
your stay @ being
committed!!!
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