What is Tangency solution of

Chamberlin in Monopolistic
Competition?
What is Excess Capacity? Is it
always harmful. What are the
issues of Excess capacity by
Chamberlin?
Submitted By :
Bipasha -5136
Arti- 5132
Anjali- 5131
Meaning And Definition :
Mixture of Monopoly and Perfect Competition gives
birth to the new form of market which is known as
‘Monopolistic Competition’.
According to Chamberlin, “ Monopolistic Competition
refers to the competition among a large number of
sellers of similar but differentiated products, which are
close substitutes but not perfect substitutes of one
another”.
As such is a market situation in which both
monopolistic element and competitive element are
foreseen.
Assumptions :
• The basic assumptions of Chamberlin's large-group model are
the same as those of pure competition with the exception of the
homogeneous product. We may summarizes them as follows:
1. There is a large number of sellers and buyers in the 'group’.
2. The products of the sellers are differentiated, yet they are close
substitutes of one another.
3. There is free entry and exit of firms in the group.
4. The goal of the firm is profit maximization, both in the short
run and in the long run.
5. The prices of factors and technology are given.
6. The firm is assumed to behave as if it knew its demand and cost
curves with certainty.
7) The long run consists of a number of identical short-run periods, which are assumed
to be independent of one another in the sense that decisions in one period do not
affect future periods and are not affected by past actions. The optimum decision
for any one period is the optimum decision for any other period. Thus, by
assumption, maximization of short-run profits implies maximization of long-run
profits.
8) Chamberlin makes the 'heroic' assumption that :
-Both demand and cost curves for all 'products' are uniform throughout the group.
This requires that consumers' preferences be evenly distributed among the
different sellers, and that differences between the products be such as not to give
rise to differences in costs.
-Symmetry Assumption: An individual firm’s adjustments regarding price and
quantity will have no or a negligible effect upon its competitors that is, they will
not think of retaliation.
Chamberlin makes these assumptions in order to be able to show the equilibrium of
the firm and the 'group' .
The above 'heroic' assumptions lead to a model which is very restrictive, since it
precludes the inclusion in the 'group' of similar products which have different
costs of production. Chamberlin himself recognizes that the 'heroic' assumptions
are unrealistic and he relaxes them at a later stage.
Product Differentiation and Firm’s Perceived
Demand curve
Product differentiation is the basis of competition among the
monopolistically competitive firms. Chamberlin has defined product
differentiation in the following words:
 “A general class of product is differentiated in any significant basis exists
for distinguishing the goods of one seller from those of others. Such a basis
may be real of fancied, as long as it is of any importance to buyers, and
leads to a preference for one variety of product over another.
Differentiation may be based upon certain characteristics of the product,
such as exclusive patented features, trade-marks, trade-names,
peculiarities of the package if any. It may also exist with respect to the
conditions surrounding its sales.”
The basic purpose of product differentiation is to make customers
distinguish the product of a firm from those of others in the industry and to
develop a preference or brand loyalty. Once it is developed, it alters the
course of the demand curve for the product.
 In the ultimate conclusion, Product differentiation aims at changing the slope and
position of the demand curve for the product and converting it from a horizontal
demand line to a downward sloping demand curve which gives the firm power to
use its discretion in fixing the price of its product.
 The Perceived Demand Curve:
 Under monopolistic competition with product differentiation, each firm perceives
that the demand curve for its product is more elastic than that of the rival firms.
As per Chamberlin, the basis of the perceived demand curve is the firm’s belief
that if it changes the price of their product , it will go unnoticed by the rival firms
and they will not react to change the price of their products.
 The perceived demand curve shows the increase in quantity demanded of a
product of a firm when a firm cuts down its price provided others keep their
prices at the present level. On the other hand, proportional curve facing an
individual shows the demand or sales of the product of a firm when the prices of
all firms in a product-group or industry change, all of them simultaneously in the
same direction and by the same amount so that they charge same or uniform
price.
 The greater the number of firms in a product-group (or the industry), the smaller
the share of an individual firm at a given price. Therefore, the proportional
demand curve facing an individual firm shifts to the left as more firms enter into
the product-group or industry.
 Proportional demand curve as DD ′ curve and, the perceived demand curve as
dd ′curve.
 The two demand curves have been shown to be intersecting at point A
corresponding to price OP and quantity demanded OQ.
 Since it is assumed that all firms charge the same price, all firms in the industry
will be producing and selling OQ quantity and each charging OP price.
Therefore, point A lies on the proportional demand curve.
 We construct the perceived demand curve dd ′ passing through
point A as being more elastic than the proportional demand
curve DD ′.
 However, it may be pointed out that since each firm in the
product group will think independently that its price reduction
will have a negligible effect upon each of his rivals and
therefore assumes that others would keep their prices constant,
the actual movement would not be along the perceived demand
curve dd ′ but along the proportional demand curve DD ′ which
shows actual sales by each firm when the prices of all change
equally and are identical.
THE CONCEPT OF THE 'INDUSTRY' AND
'PRODUCT GROUP'
Product differentiation creates difficulties in the analytical
treatment of the industry. Heterogeneous products cannot be
added to form the market demand and supply schedules as in
the case of homogeneous products.
Chamberlin uses the concept of 'product group', which
includes products which are 'closely related'. The products
should be close technological and economic substitutes.
Technological substitutes are products which can technically
cover the same want. For example, all motor cars are
technological substitutes in the sense that they provide
transport. Economic substitutes are products which cover the
same want and have similar prices. For example, a Hillman
Avenger, and a Morris 1300 can be considered as economic
substitutes while a Rolls-Royce and a Mini clearly are not.
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 other products in the
group changes. In other words, products forming 'the
group' or 'industry' should have high price and cross-
elasticity's.
Product differentiation allows each firm to charge a
different price. There will be no unique equilibrium price,
but an equilibrium cluster of prices, reflecting the
preferences of consumers for 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. This
more realistic market situation emerges from Chamberlin's
analysis after the relaxation of his 'heroic assumptions'.
Models:
Model-1 equilibrium with new firms entering the
industry:
 In this model it is assumed that each firm is in short-run
equilibrium, maximizing its profits at abnormally high levels.
 The firm, having the cost structure depicted by the LAC and
the LMC curves and faced with the demand curve dd', will set
the price PM which corresponds to the intersection of the MR
and the MC curves. This price yields maximum profits (equal
to the area ABCPm).
The firm, being in equilibrium (at C), does not have any incentive to
change its price. The abnormal profits will, however, attract new
competitors into the market.
The result of new entry is a downward shift of the demand curve dd',
since the market is shared by a larger number of sellers.
Assuming that the cost curves will not shift as entry occurs, each shift
to the left of the dd' curve will be followed by a price adjustment as
the firm reaches a new equilibrium position, equating the new
marginal revenue (on the shifted MR curve) to its marginal cost.
The process will continue until the demand is tangent to the average-
cost curve, and the excess profits are wiped out.
In the final equilibrium of the firm the price will be PE and the ultimate
demand curve dEd1E. This is an equilibrium position, since price is
equal to the average cost.
There will be no further entry into the industry, since profits are just
normal. The equilibrium is stable, because any firm will lose by either
raising or lowering the price PE.
Model-2 : equilibrium with price
competition
 In this model it is assumed that the number of firms in the
industry is that which is compatible with long-run
equilibrium, so that neither entry nor exit will take place.
But the ruling price in the short run is assumed to be higher
than the equilibrium one.
 The analysis of this case is done by the introduction of a
second demand curve, labeled DD' in figure which shows
the actual sales of the firm at
each price after accounting for the
adjustments of the prices of other
firms in the group.
 DD' is sometimes called actual-sales curve or share-of-the-market curve,
since it incorporates the effects of actions of competitors to the price
changes by the firm. The DD' curve shows the full effect upon the sales of
the firm which results from any change in the price that it charges.
 DD' is thus the locus of points of shifting dd' curves as competitors, acting
simultaneously, change their price. It should be clear that the change in the
price does not take place as a deliberate reaction to other firms'
reductions, but as an independent action aiming at the profit maximization
of each firm acting independently of the others.
 The DD' curve shows a constant share of the market, and, as such, it has
the same elasticity as the market demand at any one price.
 Clearly the DD' curve is steeper than dd', because the actual sales from a
reduction in P are smaller than expected on the basis of dd' as all firms
reduce their price and expand their own sales simultaneously.
 A shift in the DD' is caused by entry of new firms or exit of existing firms
from the 'industry' and shows a decline or an increase in the share of the
firm.
 Assume that the firm is at the non-equilibrium position defined by price P0 and quantity
X0. The firm, in an attempt to maximize profits, lowers the price at P1 expecting to sell, on
the basis of its individual demand curve, quantity X0. This level of sales is not actually
realized, because all other firms, faced by the same demand and cost conditions, have the
incentive to act in the same way simultaneously.
 Each one attempts to maximize its own profit, ignoring the reactions of competitors, on
the assumption that the effect on the demand of other firms in the group is negligible.
Thus all firms, acting independently, reduce their price simultaneously to P 1. As a result
the dd' curve shifts downwards (d1d'1) and firm A, instead of selling the expected
quantity X0, sells actually a smaller quantity X1 on the shifted-demand curve d1d’1 and
along the share curve DD'.
 Equilibrium is determined by the tangency of dd' and the LAC curve. Any further reduction
in price will not be attempted since the average cost would not be covered.
 In summary, the individual demand curve dd' explains why each firm is led to reduce its
price. The DD' curve shows the firm's actual sales as the general downward cut in price
takes place. The dd' curve slides downwards along the DD' curve as prices are lowered,
and the adjustment process comes to a stop when the dd' is tangent to the LAC curve. At
the point of tangency the DD' curve cuts the dd' curve. Obviously it will pay no one firm to
cut the price beyond that point, because its costs of producing the larger output would
exceed the price at which this output could be sold in the market.
Model-3: Price competition and free entry
 Chamberlin suggests that in actual life equilibrium is
achieved both by price adjustments of the existing firms and
by new entry.
 Price adjustments are shown along the dd' curve while
entry (and exit) cause shifts in the DD' curve. Equilibrium is
stable if the dd' curve is tangent to
the AC curve and expected
sales are equal to actual sales,
that is, if the DD' curve cuts
the dd' curve at the point of its
tangency to the AC curve.
It is assumed that profits at point e1 are abnormal. New firms are
attracted until DD shifts to D'D'. One might think that e2 is a long-
run equilibrium (with price P and output X) since only normal profits
are earned. However, this is not the case, because each
entrepreneur thinks that dd is his demand curve, and consequently
he believes that if he reduced his price his sales would expand along
dd and profits would increase. But each firm has exactly the same
incentive and all firms reduce their price.
As price is reduced by all firms dd slides down D' D' and each firm
realizes a loss instead of positive abnormal profits. For example, at
position d'd' the firm has reduced its price to P' but, as all firms act
similarly, X1 is produced with a total loss equal to the shaded area
ABP'C. However, the firm acts on the 'myopia curve' d'd' and so long
as this lies above the LAC, it believes that it can obtain positive
profits by cutting its price. The loss increases still further as dd slides
further down along D'D'.
One might think that the process would stop when dd becomes
tangent to the LAC. This would be so if the firm could produce X*.
However, there are too many firms in the industry and the share of
the firm is only X 2 (on D'D').
The firm still on the 'myopia assumption' believes that it can reach X*
if it reduces price to P*. However, all firms do the same and d*d* falls
below the LAC with ever-increasing losses.
The financially weakest firms will eventually leave the industry first,
so that the surviving firms will have a larger share. D'D' moves to the
right together with dd. Exit will continue until dd becomes tangent to
the AC curve and DD cuts dd at the point of the tangency, E.
Equilibrium is then stable at point E with normal profits earned by all
firms and no entry or exit taking place. The equilibrium price P* is
unique and each firm has a share equal to OX*.
Conclusion: These are the tangency solutions in the monopolistic
competition by Chamberlin.
CRITIQUE OF CHAMBERLIN'S MODEL
Chamberlin’s theory has low predicting power: Critics claim that Chamberlin’s model of
monopolistic competition is not significantly different from traditional models of perfect
competition and pure monopoly. Where these models do not apply in predicting the price
and output, oligopoly models apply better than Chamberlin’s Model of Monopolistic
Competition.
Chamberlin’s model lacks empirical validity: Cohen and Cyert claim that it is difficult to
find any example in the real world to which Chamberlin’s model of monopolistic is relevant.
Chamberlin’s model makes unrealistic assumptions:
Assuming no independence is not reasonable.
Assuming identical cost and revenue curves are not justified.
Assuming that firms do not learn is not correct.
• Chamberlin's 'heroic model' is clearly not acceptable as an approximation to the real
world in which demands and costs are different among the various firms, giving rise to a
cluster of prices rather than a unique price.
• It is hard to accept the myopic behavior of businessmen implied by the model. Surely
some firms would learn from past mistakes, and those that did not would be competed out
of existence by firms which do take past experience into account in decision-making.
 Comparison with Pure competition
In monopolistic competition , the long-run equilibrium of the firm is defined by the
point of tangency of the demand curve to the LAC curve. At this point MC = MR
and AC = P, but P > MC, while in pure competition we have the long-run
equilibrium condition MC = MR = AC = P.
As a consequence of the different equilibrium conditions price will be higher and
output will be lower in monopolistic competition as compared with the perfectly
competitive model. Profits, however, will be just normal in the long run in both
models. In monopolistic competition there will be too many firms in the industry,
each producing an output less than optimal, that is, at a cost higher than the
minimum.
This is due to the fact that the tangency of AC and demand occurs necessarily at the
falling part of the LAC, that is, at a point where LAC has not reached its minimum
level. Consequently production costs will be higher than in pure competition.
Furthermore, in monopolistic competition firms incur selling costs which are not
present in pure competition, and this is another reason for the total cost (and price)
to be higher
What is Excess Capacity ? Is it always
harmful?
In the long-run equilibrium under monopolistic
competition the group is characterized by Excess
Capacity. “Excess Capacity is the difference between
optimum and actual output in the long-run equilibrium.
Optimum output of a firm have been regarded to be the
output where long-run average cost is minimum.
Monopolistic competition has been attacked on the
grounds that it leads to 'too many, too small' firms, each
working with 'excess capacity', as measured by the
difference between the 'ideal' output XF corresponding
to the minimum cost level on the LAC curve and the
output actually attained in long-run equilibrium XE.
The term 'excess capacity' is misleading in this case. One should really
talk of firms working at suboptimal scales having unexhausted
economies of scale. There is a 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 minimum average
cost.
 Chamberlin has argued that the criticism of excess capacity and
misallocation of resources is valid only if one assumes that the demand
curve of the individual firm is horizontal. Chamberlin argues that if the
demand is downward sloping and firms enter into active price
competition while entry is free in the industry, then, Chamberlin argues,
X F 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.
Consequently the difference between actual output XE
and minimum cost output XF is not a measure of excess
capacity but rather a measure of the 'social cost' of
producing and offering to the consumer greater variety.
The output XE, is a 'sort of ideal' for a market in which
product is differentiated.
According to Chamberlin excess capacity is the difference
between X and XE, the latter being the 'ideal' level of
output in a differentiated market.

From the point of view of social welfare monopolistic

competition suffers from the fact that price is higher than
the MC. But the socially desired P = MC cannot be achieved
without destroying the whole private enterprise system.
 What are the issues of Excess Capacity by
Chamberlin?
Chamberlin's argument is based on the assumptions of active price
competition and free entry. Under these circumstances Chamberlin (and
later Harrod) argues that the equilibrium output will be very close to the
minimum cost output, because firms will be competing along their individual
dd curves which are very elastic.
 However if firms avoid price competition and instead enter into non-price
competition, there will be excess capacity in each firm and insufficient
productive capacity in the industry, that is, unexhausted economies of scale
for the firm and the industry.
Chamberlin seems to argue that excess capacity and higher prices are the
result of non-price competition coupled with free entry.
In this event the firm ignores its dd curve (since no price adjustments are
made) and concern itself only with its market share. In other words, DD
becomes the relevant demand curve of the firm. In this event long-run
equilibrium is reached only after entry has shifted the DD curve to a position
of tangency with the LAC curve.
 Conclusion:
Despite some shortcomings, Chamberlin has made several important
contributions to the price theory. Even his critics including Stigler and
Kaldor have admitted the revolutionary character of his contributions.
As stated in the beginning, incorporation of product differentiation,
product variation and selling costs into the price theory by Chamberlin
and importance given to monopolistic elements and oligopolies in his
analysis of price formation in the real world are all his significant
contributions to the economic theory.
To quote Stigler, a server critic of Chamberlin’s theory, “The general
contribution of the theory of monopolistic competition, on the other
hand, seems to me indisputable; it has led to reorientation and
refinement of our thinking on monopoly. We are all now more careful
to pay attention to the logical niceties of definitions of industries and
commodities. We are now more careful to apply monopoly theory
where it is appropriate. Thus importance of trade marks and of
advertising and the need for study of product structure and evolution,
have become more generally recognized.
Thank you!!