Chapter Two

Price and Output Determination Under Monopolistic Competition

Chapter Outline :
1. Introduction
2. Assumptions
3. Product Differentiation
4. Demand and Revenue functions
5. Cost of monopolistic competition
6. The concept of product group and industry
7. Equilibrium Under Monopolistic Competition
1. Short-run Equilibrium
2. Long Run Equilibrium
8. Comparison with perfect competition: the excess capacity
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2.1. Introduction
• Both monopoly and perfect competition are rare to find
• They don’t reflect the true behavior of the majority of the firms
• Very few commodities are entirely homogeneous (identical) to
make perfect competition assumption realistic.
• Monopolistic competition was developed by Edward
Chamberlin and Joan Robinson in early 1930s
• They were dissatisfied with the existing two markets
• This market structure lies between the two extreme market
structures of PC and Monopoly.

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Definition and Features
• Monopolistic competition is a market structure in
which many firms sell differentiated products.
– Examples: furniture, jewelry, leather goods,
barber shops, restaurants, books, magazines,
films and movies, bottled water, etc.
• Characteristics:
– Many sellers
– Product differentiation
– Free entry and exit

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2.2. Assumptions
a. There are large numbers of sellers (but not as large as PC)
in the product group
b. Differentiated product and yet close substitutes: firms
get certain monopoly power to set price of their product
* no identical or standardized product
c. Ease of entry and exit: long run normal profit
d. Objective of the firms is profit maximization
e. Firms are assumed to behave as if they knew their
demand and cost curves with certainty
f. Both demand and cost curves for all products are uniform
through the output group

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2.3. Product Differentiation
• Product differentiation:.
 process of making a product appear different from other
products
 It is accomplished by producing products that have distinct
positive identities in consumers’ minds
• The goal of PD is to achieve market power.
• It changes the demand curve from horizontal to
downward demand curve

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 Two types of product differentiations
• Real product differentiation: products differ in terms
of their inherent characteristics such as inputs used,
location, services etc.
E.g. Shampoo with and without conditioner
• Fancied (spurious) product differentiation: products
are the same but producers convince customers that
their product is different
E.g. Differences which are created due to advertisement,
in packing, design, brand name and other sales promotion
activities
E.g. Spring water( Yes Vs Abyssinia), Beer,
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2.4. Demand and Revenue functions
• A firm gains certain monopoly power through product
differentiation. This results in downward sloping demand curve.
• Marginal revenue is also downward sloping but is less than the
demand curve .
• The firm did not loss its entire customer through price rise even
though some of them may switch to its competitors product.
• Small rise in price results in large fall in quantity demanded
• The demand curve is highly elastic, but not perfectly elastic,
because of the existence of large number of firms producing
closely substitute products
• Flatter demand curve compared to pure monopolist and
steeper compared to perfect competitive firm.
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The actual sales and the perceived demand curve
• Chamberlin also introduced a new demand
curve
• The demand curve we know till now is
called perceived/ predicted/ demand curve
• It is drawn based on ceteris paribus assumption
• When other things do not remain the same,
the firm faces a new type of demand curve
called actual sales/market share/ demand
curve
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 Graphically,
P D
d

P0
P1
P2
d
D

Q 0 Q 1* Q1 Q

•There is difference between expected and actual sales

•The perceived demand curve is flat compared to the market share
demand curve
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2.5. Cost of monopolistic competition
• Firms often devote considerable resources to
differentiate their product from their competitors
through devices such as quality and style variations,
warranty, special services features, and product
advertisement.
• The firm faces a new type of cost called selling cost or
cost of product differentiation
• Average and marginal selling costs curve of monopolistically
competitive firm have U-shaped.
– Reason: economies and diseconomies of scale of selling activities.
• TC= Production Cost + Selling cost
• The average and marginal selling cost of monopolistically competitive firm is
generally greater than that of perfect competitive and monopolist firm
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 2.6. The concept of product group and industry
• Industry: is collection of firms with identical product
• Product group: formed by lumping together firms producing similar products (but
not identical) which are close substitutes.
– They are group of products with higher price and cross elasticity of demand.

• Close substitution can be two types:

– Technological substitute: products which satisfy the same demand.
e.g. all motor cars i.e. they provide transport, TV, Computers

– Economic substitute: products which have similar price and satisfy the
same demand.

• We do not have a single equilibrium price for differentiated product, but a

cluster of prices.

• Chamberlin assumed that every firm in the product group

faces the same demand curve with identical cost.
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2.7. Equilibrium Under Monopolistic Competition
2.7.1. Short-run Equilibrium
• At equilibrium, a firm should produce at a point where:
– MR = MC and
– Slope of MC is greater than that of MR
• The firm charges the corresponding price (P) based
on its demand curve.
• The nature of profit earned at equilibrium depends on
the relationship between P and AC. More specifically,
– When P > AC, the firm earns an economic profit. (AR>AC)
– When P < AC, the firm incurs a loss.(AR<AC)
– When P = AC, the firm earns normal profit (AR=AC) i.e.
profit=0
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 Case A: Monopolistically Competitive Firm with positive Profit

Fig. Above normal profit

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 A Monopolistically
Competitive Firm: Normal Profit

Fig. Normal profit

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 Case C: Monopolistically
Competitive Firm with Economic loss or -ve profit

Fig. Economic Loss

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 1.7.2 The Long Run: Only a Normal Profit
• Chamberlin made two heroic assumptions
a. Firms have identical cost
b. Consumer preferences are evenly distributed among
different product (firms have the same demand curve)
• The adjustments to equilibrium point takes place through
change in the position of demand curve resulted from:
– entry and exit of firms or
– price adjustment by the existing firm or a combination of the two.
• Chamberlin developed three distinct model of long run
equilibrium.

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Three distinct model of long run equilibrium.
A. Long run equilibrium with free entry of new
firms ( there is no price competition among
the existing firms)
B. Long run equilibrium with price competition
among the existing firms ( there is optimal
number of firms)
C. Long run equilibrium with price competition
among the existing firms and free entry of
new firms( the ultimate solution)

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 Long run equilibrium: graphical presentation

e
D
d

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 A equilibrium point
• MR=LMC
• LAC= P
• Demand curve becomes tangent to the LAC
curve
• DD=dd=LAC
• The market share demand curve passes through
the tangency point between perceived demand
curve and LAC.
• Profit =0
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2.8. Identifying Monopolistic Competition

• Two indexes:
– The four-firm concentration ratio (CR)
– The Herfindahl-Hirschman Index(HHI)

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 The Four-Firm Concentration Ratio
• The four-firm concentration ratio is the
percentage of the value of sales accounted for by
the four largest firms in the industry.
• The range of concentration ratio is from almost
zero for perfect competition to 100 percent for
monopoly.
• A ratio that exceeds 60 percent is an indication of
oligopoly.
• A ratio of less than 40 percent is an indication of a
competitive market—monopolistic competition.

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 The Herfindahl-Hirschman Index
• The Herfindahl-Hirschman Index (HHI) is the square
of the percentage market share of each firm
summed over the largest 50 firms in a market.
• Example, four firms with market shares as 50
percent, 25 percent, 15 percent, and 10 percent.
– HHI = 502 + 252 + 152 + 102 = 3,450
• A market with an HHI less than 1,000 is
regarded as competitive and between 1,000
and 1,800 is moderately competitive.

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 2.9. Monopolistic Competition and Efficiency
• In monopolistic competition, neither productive nor allocative efficiency
occurs in long-run equilibrium.
• Productive Efficiency: is achieved when the output is produced at minimum
average total cost (ATC).
 Condition: P=min ATC
• Allocative Efficiency: is achieved when the value consumers place on a good
or service (reflected in the price they are willing to pay) equals the cost of
the resources used up in production.
 Condition: P=MC
• Since the firm’s profit-maximizing price (and average total cost)
slightly exceed the lowest average total cost, productive efficiency is
not achieved.
• Since the profit-maximizing price exceeds marginal cost, monopolistic
competition causes an under allocation of resources.
• Monopolistic competition decision did not maximize social welfare
since equilibrium price is higher than MC and output is below social
desired level
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2.10. Excess Capacity and Comparison with PC and Monopoly

• Long run equilibrium of the firm under monopolistic

competition is attained at a point where the
perceived demand curve is tangent to LAC curve
• Compared to the LR equilibrium of perfectly
competitive firm, a monopolistically competitive
firm:
– Produces smaller units of output
– Charges higher price
– Price is above marginal cost of production
– Operates on the falling part of the LAC curve( it is at the
min point of the LAC curve of PC)

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Regarding similarity,
• For both economic profit in the long run is zero .

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 Monopolistic Competition vs. Monopoly

• It is possible for the monopolist to make economic

profit in the long run because of the existence of
barriers to entry
• No long-run economic profit is possible in
monopolistic competition because there are no
significant barriers to entry
• Flatter demand for monopolistically competitive firm,
while pure monopolist steeper demand

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 Excess capacity
• A firm has excess capacity if the quantity it produces
is less that the quantity at which average total cost is
a minimum.
• A firm’s efficient scale is the quantity of production
at which average total cost is a minimum.
• The gap between the minimum LAC output and the profit-
maximizing output of a monopolistically competitive firm
shows excess capacity that exists in the later market
• It is unused capacity that exists in this market structure
• Monopolistically competitive industries are overcrowded
with firms each operating below its optimal capacity.
• Higher cost due to Selling cost

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Graphically

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 Chamberlin’s excess capacity
• Chamberlin believes that as far as there is new entry
and price competition among existing firms, there is no
excess capacity in MC
• MC firms can not produce output indicated for
competitive firms owing to their downward sloping
demand curve
• The deviation in output is a measure of cost of product
differentiation according to him
• People like to consume varieties of a good and this has
a cost
• For Chamberlin, excess capacity exists only when firms
are not engaging in price competition.
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 Advertising and Monopolistic Competition
• Advertising is one of competition mechanism in MCM.
• Firms that sell highly differentiated consumer goods typically spend
between 10-20% of revenue on advertising.
• Overall, about 2 percent of total revenue, or over $200 billion a
year, is spent on advertising.
• Perfectly competitive firms have no incentive to advertise, but
monopolistic competitors do
• The increase in cost of a monopolistically competitive product is the
cost of “differentness”: Advertising increases ATC
• Differentiation exists so long as advertising convinces buyers that it
exists.
• Firms will continue to advertise as long as the marginal benefits of
advertising exceed its marginal costs.
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 Arguments for advertising
– Provide information to customers
• Customers - make better choices
• Enhances the ability of markets to allocate resources
efficiently
– Fosters competition
• Customers - take advantage of price differences
– Allows new firms to enter more easily

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 Arguments against Advertising
• The critique of advertising
– Firms advertise to manipulate people’s tastes
• Psychological rather than informational
• Creates a desire that otherwise might not exist
– Impedes competition
– Increase perception of product differentiation
• Foster brand loyalty
– Makes buyers less concerned with price
differences among similar goods

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 Summary of the relationships among the three
Market structure
Perfect Monopolistic
competition competition Monopoly
Features that all three market structures share
Goal of firms ………………………………………… Maximize Maximize profits Maximize profits
Rule for maximizing ……………………………… profits MR = MC MR = MC
Can earn economic profits in the short run? MR = MC Yes Yes
the products firms sell………………………………… Identical Differentiated Unique

Features that monop. competition shares with

monopoly
Price taker? …………………………………….. Yes No No
Price…………………………………………………. P = MC P > MC P > MC
Produces welfare-maximizing level of output? Yes No No
DD curve facing firm………………………….. Horizontal Downward sloping Downward sloping
Features that monopolistic competition shares
with competition
Number of firms …………………………………… Many Many One
Entry in long run? ………………………………….. Yes Yes No
Can earn economic profits in long run?..... No No Yes
Free entry/exit……………………………………… Yes Yes No

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 Critics of Chamberlin model

• Critics
– The assumptions of product differentiation and independent actions of
competitors are inconsistent: firms closely follow the actions of others.
– The absence of taking past experience into future decision is not valid.
– Product differentiation and “free entry”. Product differentiation and brand
loyalty create a significant barrier to entry for new firms
– ‘Large number of firms’….does not define the actual number

• Contribution of the model

– Introducing the concept of product differentiation and selling strategy as two
additional policy variables in optimal decision-making process of the firm.
– It introduces the concept of share of the market demand curve as a tool of
analysis.

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