MONOPOLISTIC COMPETITION

Most markets have neither large number of sellers selling homogeneous product necessary to qualify as perfectly competitive market structure nor the single seller required to meet the definition of a monopoly. Where the number of sellers is large and the product differentiated, the model of monopolistic competition is a useful tool for analyzing price and output decisions. An important contribution is the model of monopolistic competition developed by Edward Chamberlin. Chamberline observed that even in markets with a large number of sellers, the products of individual firms are rarely homogeneous.


According to Joe S.Bain,” Monopolistic competition is found in the industry where there is a large number of small sellers selling differentiated but close substitute products.”

H.H.Leibhafsky writes,” Monopolistic competition has today come to mean a state of affairs in which there is large number of sellers selling non-homogeneous or slightly differentiated products and in which freedom of entry exists.

Monopolistic competition has elements of both monopoly and perfect competition. Like perfect competition there are large number of small sellers. Thus the actions of any single seller do not have a significant effect on other sellers in the market. Also, like perfect competition there are many buyers and that resources can easily be transferred into and out of the industry. However, monopolistic competition resembles the monopoly in that products of individual firms are differentiated and a close, but not a perfect substitute for that of other firms. The result is that each firm faces a demand curve with a slight downward slope, implying that the individual firm has some control over price. Increasing the price will cause the firm to loose sales; some consumers will be willing to buy at the higher price because the product is slightly differentiated from that of competitors. “ Products are not homogeneous, as in perfect competition, but neither are they remote substitutes, as in monopoly. What this really means is that in monopolistic competition there are various ‘monopolists’ competing each other. These competing monopolists do not produce identical goods. Neither do they produce goods that are completely different. Product differentiation means that products are different in some ways but not altogether so
Key Features
The important features of the market of monopolistic competition may be described as follows:

1. Larger number of sellers

            The number of sellers is sufficiently large that there is no feeling of mutual interdependence among them. Each firm acts independently without caring for any effect that its action may have upon those of its competitors.

2. Differentiated Product

            There is a large number of buyers who are offered differentiated products and consequently have preference for the products of particular sellers. Different sellers may use different methods for creating preference for their own products in the minds of buyers. Differentiation of the product may be real or imaginary. Real differentiation is made through differences in the materials used, design, color or workmanship. Spurious differentiation may be made through packaging, advertising, use of trademarks and brand names. Further, differentiation of a particular product may be linked with the conditions of sale, the location of the shop, the courteous and smiling disposition of its salesmen, or a reputation of fair dealing etc.

3. Free Entry

            There is no restriction on the entry into the industry. New firms are able to commence production of very close substitutes for the existing brands of the products even though they cannot make items which are exactly identical in the eyes of the purchasers to existing brands.

4. Selling Costs

            Every firm makes efforts to promote its own product among the consumers through different types of expenditures on advertisement. These advertisement expenditures may be done on different methods of appealing to the consumers to purchase its brand of the product. The effect of these advertisement expenditure or selling cost may be to attach particular consumers to particular brands. In this way firm with particular brands become monopolist of their own product for their consumers.

5. Price Policy of a firm

            A firm has a price policy under monopolistic competition. This is the feature that distinguishes monopolistic competition from perfect competition where a firm is only a price taker and has to adjust its output to given price.

6. Imperfect knowledge

            The buyers in the monopolistically competitive market have imperfect knowledge about the market.

7. Non- Price Competition

            Through non-price competition firms in the market try to win over customers. There are many methods of competing rivals other than price such as guarantee for repairs, distinctive after sales service, a gift coupon scheme with specific purchases, a undeclared discount or transport free of cost etc, All these methods are secret ways of attracting customers to particular brands.

Short Run Equilibrium in Monopolistic Competition

In its characteristics monopolistic competition is closer to perfect competition, its pricing and output decisions are similar to those under monopoly because a firm under monopolistic competition, similar to a monopolist, encounters a downward sloping demand curve. Such demand curve is the outcome of a strong preference of a section of consumers for the product, and the quasi-monopoly of the seller over the supply. The strong preference or brand loyalty of the consumers gives the seller an opportunity to raise the price and yet retain some customers. And, since each product is a substitute for the other, the firms can attract the consumers of other products by lowering their prices. Figure 1 depicts the short term pricing and output determination under monopolistic competition. 

SMC and SAC are the short run marginal cost curve and average cover curves of a monopolistic firm. Firm’s marginal cost curve cuts the marginal revenue curve at point S that satisfies the necessary condition of profit-maximization. Given the demand curve output OQ may be sold at price PQ. At this point the firm is in equilibrium position and earns a maximum economic profit PT per unit of output. The total profit earned by the firm is shown by rectangle P’PTP”.  The typical firm can earn supernormal profit in the short run because of no possibility of new firm entering the industry. But the rate of profit would not be the same for all the firms under monopolistic competition because of difference in the elasticity of demand for their product Some firms may earn only a normal profit if their costs are higher than those of others. For the same reason, some firms may make even losses in the short run to the extent of their average fixed cost.

Long- Run Equilibrium in Monopolistic Competition 

Figure 2 illustrates the price and output determination in the long run under monopolistic competition. Suppose that at some given time in the long run AR1 and MR1 are the average and marginal revenue curves and LAC and LMC are the long run average and marginal cost curves. The figure shows that the long run marginal cost curve intersects marginal revenue curve at point R. This point determines the equilibrium output OQ1 and price P1Q1. At this price the firm makes a supernormal profit of P1S per unit of output. This situation is similar to short run equilibrium. 

In the long run supernormal profit attracts new firms to the industry. Consequently, the firms within the industry lose a part of their market share to a new firm that shifts their demand curve downward to the left until AR is tangent to LAC. The increasing number of firms increases the price competition between the firms. Price competition also intensifies as losing firms try to regain their market share by cutting down the price of their product and new firms, in order to penetrate the market set comparatively low prices for their product. The demand curve shifts downward, since the market is shared by large number of sellers. As the cost curves will not shift as entry occurs, each shift to the left of the demand curve will be followed by a price adjustment as the firm reaches a new equilibrium position, making the new marginal revenue on the shifted MR curve equal to its marginal cost. The process will continue until the demand curve becomes tangent to the average-cost curve and the excess profits are wiped out. In the final equilibrium of the firm the price will be P2 and the ultimate demand curve AR2 This is an equilibrium position since, price is equal to the average cost. Since profits are just normal, there will be no further attraction for the new firm to enter into the industry. The equilibrium is stable, because any firm will lose by either raising or lowering the price P2.

Selling Cost and Equilibrium

Selling costs constitute the third important variable about which a firm has to take a decision. It is a feature that distinguishes monopolistic competition from pure competition. Firms do product variation along with variation in selling costs.

A firm to persuade buyers to purchase its product in preference to those of others incurs selling costs. According to Prof. Chamberlin selling costs are “costs incurred in order to alter the position or shape of the demand curve for a product.Chamberlin distinguishes selling cost from production costs. Production costs refer to the cost that must be incurred to make a product, to transport it, and to have it available to consumers. The costs of bringing a change in consumers’ wants are selling costs.
A distinction can also be drawn between advertising expenditure and selling costs. The advertising expenditures refer broadly to expenditures incurred to make a selling appeal to the customers directly. For example, advertisements in papers and journals, bill- boards, cinema slides and movies, and new- year gifts with purchases. Selling cost includes not only all advertisement expenditures but also all other expenditures on middlemen incurred with a view to promoting the sales of the product. Often however, in practice it is not possible to make a distinction.

Firms are tempted to incur selling costs on account of the fact that people have imperfect knowledge and that there is the possibility of altering people’s wants by advertising or selling appeal. The prevalence of imperfect knowledge among buyers helps a seller to advertise his product in the market, strengthening the preference of those who are already buying and winning over those consumers who are buying from others or not buying at present. Advertising in order to create product image in the minds of the consumers may be more important than providing any specific information about the product. Assume that advertising increases the demand for a product, other things (price, quality, buyers’ income) remaining constant. The selling cost curve represents the relationship between the advertising expenditure and the unit sales of its product.

Figure 3 depicts the curve of selling costs ASC that shows the average cost per unit of selling any given amount of the product. It costs an average of AA’ rupees each to sell OA’ units of product, and BB’ rupees each to sell OB’ units. The selling cost curve first declines because of initial economies of scale in advertising. Advertising expenses that are too small are considered to be wasteful. After reaching a minimum point, ultimately, the curve must eventually rise to indicate the increasing costliness of expanding sales and finally becomes vertical to saturate. The structure of the selling costs curve for a firm’s product in a given period of time reflects the play of the variables like the price of the product itself and the prices of its substitutes, the quality of the product as well as its substitutes, buyers’ income, and their resistance to having their tastes changed by the advertising.  A change in one or more of these variables will cause a change in the shape and position of the curve. With the increase in the price of the product, the costs of selling any quantity of the product will be higher. With the improvement in the quality of the product the curve goes down. If consumer tastes are going away from the producer and other similar products, the curve will curl up sooner or later.

 Remember that the main objective of the firm is to maximize its total profits. When a firm advertises, it seeks to increase its own sales. Figure 7.16 explains a simple model of advertising competition.

Suppose that the firms in a group are in equilibrium, none earning any net profits and none of them is involved in advertising. Suppose one of the firms, thinks that it can earn some profits by advertising and believes that it will be the only one perform so. All firms in the group are supposed to be the same. The figure shows that the cost of the product is PC and OP represents the price. The equilibrium output is OA where price equals average cost that results in no net profit. Then one of the firms indulges in advertising the curve SC1 shows. The curve shows that the firm can increase sales to OB if it alone advertises. OB is an optimum output where marginal cost equals marginal revenue. But the eager firm does not achieve the output OB and the net profits associated with it. Its rivals firms also advertise their products. The sales of each firm increase only a little, similarly they do as all firms reduce their prices. Currently, all firms are advertising their products. Then the curious but shortsighted firm attempts again. Now to increase advertising is more costly. The new selling cost curve is SC2 that exhibits the prospects of profits if the eager firm is the only one to increase advertising. Again the firm does not gain the destined objective. The stable equilibrium comes about only when all firms produce and sell the amount OC and have selling cost curve SC3. Here SC3 is tangent to price line No firm can now hope to earn profits by increased advertising, even if it were the only one to act. This advertising increases sale from OA to OC. Lastly, firms are no better off for starting their advertising war.