CHAPTER TWO

MONOPOLISTIC COMPETITION
MARKET
 Dear students, in pervious course on microeconomics
2. INTRODUCTION

we have seen the basic features of

 monopoly and
 prefect competitive market.
 As you know perfect competitive market assumes
 free entry and
 large number of small firms producing
homogenous product.
 In such market environment, firms
 are worry only about the amount of output

produced and
 take market price as given.
Cont…
o In case of monopoly, however only single firm
producing a product for which there is no close
substitute dominates the industry.

o As a result, the monopolistic firm has power to set

price and output level, which maximizes its profit.
 Cont…
 The theory of monopolistic competition, as an intermediate
form of market structure between perfect competition and
monopoly, was originally developed by Chamberlain in 1933.

 Perfect competition and pure monopoly are useful tools of

analysis; but
 neither of the two depicts the common phenomena of the real
world.

 These real world phenomena are best analyzed using the

market structures that fall between the two extremes
 monopolistic competition and
 oligopoly.
 Cont…
Definition
 Monopolistic competition
 is a market structure in which product differentiation exists and
 as the name implies, it is a combination of in which there are
elements of both monopoly and perfect competition.

 Under the monopolistic competition

 there are many number of firms producing and selling goods
that are close substitutes but
 are not completely homogenous from one seller to another.

 The competitive element arises because there are many sellers,

each of which is too small to affect the other sellers.

 Firms can also enter and leave a monopolistically competitive

industry.
 Cont…
 The monopolistic element arises from product differentiation.

 That is, since

 the product of each seller is similar but not identical,

 each seller has a monopoly power over the specific product it

sells.

 This monopoly power, however, is severely limited by the

existence of close substitutes.
 2.1. Assumptions of the Chamberlin’s Model
The basic assumptions of Chamberlin’s many group model
are the same as those of pure competition with the exception
of the homogenous product.

Thus, are the main conditions for monopolistic competition

to exist.
Assumptions

1. There is many buyers and sellers in the industry

2. Each firm produces a slightly differentiated product.

3. There are minimal barriers to entry or exit.

 Cont…
4. The goal of the firm is profit maximization, both in the short
run and long run.
5. All firms have identical cost and demand functions.
6. Firms do not take into account competitors’ behavior in
determining price.
7. Prices of factors and technology are given.
8. Both demand and cost curves for all products are uniform
throughout the group.(5 & 8 are the same) This requires that
 consumers’ preferences be evenly distributed among the
different sellers, and
 differences between products be such as not to give rise to
differences in costs.
2.2. Product Differentiation, Demand Curve and Costs of the
Firm
 Chamberlain introduced two additional policy variables in the
theory of the firm, i.e.,
 the product itself and
 selling activities.
 Demand is determined
 not only by the price policy of the firm, but also by the
 style of the product,
 services associated with it, and
 selling activities of the firm.
 Cont…

 The demand curve will shifts and product differentiation may

be depend and attributed by:

 The style, services, or the selling strategy of the firm changes.

 Competitors change their price, output, services or selling policies.

 Tastes, incomes, prices or selling policies of products from other

industries change.
 Subjective judgment of the consumer and quality (durability) of

the product,
 Characteristics (taste, color, ---) of the product,

 Sales promotion, packaging, trademarks, etc.

 Cont…
Product differentiation is generally intended to
distinguish the product of one producer from that of the
others in the ‘industry’.
1. Real differentiation: exists when there are differences in:

 The specification of the products or the factor inputs,

 The location of the firm that determines the convenience
with which the product is accessible to the consumer,
 The services offered by the producer.
Cont…

2. Fancied (spurious / imaginary) differentiation:

 exists when the products are basically the same but
the consumer is persuaded via advertising or other
selling activities, that the products are different.
 It is established by
 advertising,
 difference in packaging,
 difference in design, or
 simply by brand name.
Cont…
 The aim of product differentiation is to make the product

unique in the mind of the consumer.

 The effect of product differentiation is that the producer has

some power in the determination of price.

 The firm is not a price-taker but faces the keen competition

of close substitutes offered by other firms.

 Hence, product differentiation gives rise to a negatively

sloping demand curve.

 This demand curve is less than perfectly elastic.
 2.3. COST OF MONOPOLOSTIC COMPETIOTION
 Chamberlain adopted the shape of costs of the traditional theory of

the firm.
 He introduced the selling costs in the theory of the firm for the first

time.
 The recognition of product differentiation provides the rationale

for the selling expenses incurred by the firm.

 He also argued that the per unit and marginal selling-cost’s curves

shape are U-shaped,

i.e.,
 there are economies and diseconomies of scale of advertising as

output changes.
Cont…

 Like perfect competition and monopolistic firm, traditional

production cost of monopolistically competitive firm’s AC and
MC are all U-shaped.
 Such shape indicates the operation of:
 Law of diminishing marginal return in the short run and
 Law of return to scale in the long run during production
process.
 All cost of monopolistically competitive firms of activities
requires firms to employ an additional resource that incurs
additional costs.
 This cost is known as selling cost or cost of product
differentiation.
 If we take advertisement, cost that comprises the major
proportion of selling cost shows economies and diseconomies
of scale.
Cont…
 Initially the amount of sells expansion through advertisement will

not result in equally increase in selling cost.

 It is characterized by falling of the average selling cost because of

increasing return to scale of advertisement (economies of scale).

 However, when large quantity of output sold, after a certain level,

firms have to spend more per unit in order to increase the amount of
output sold.
 That is diseconomies of advertisement start to operate and average

selling cost increase after its minimum point and average selling
cost give rise to U-shaped.
Cont…

Generally, the AVC, MC and ATC curves are all U-shaped

implying that there is only a single level of output which can be
optimally produced.

The U-shaped selling cost, added to the U-shaped production

costs, yields a U-shaped ATC curve.

Therefore, since both production and selling costs have U-

shaped, the total average and marginal costs of monopolistically
competitive firm is U-shaped similar to cost curves of monopoly
and perfect competitive firm.

However, the AC and MC of monopolistically competitive firm

is greater than AC and MC of perfect competitive and
monopolistic firm because of the additional costs incurred
during product differentiation.
Cont…
2.4. The Concept of 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.

 Further, we do not have a single equilibrium price for the

differentiated products, but a cluster of prices are existed.
 Cont…

 Under perfect competition, industry was defined as a

collection of firms producing identical (homogeneous)
products.

 But when products are differentiated one cannot define an

industry in this narrow sense.

 Each firm having a distinct product is, in a sense, an

industry in itself, exactly as a monopolist is.

 Nonetheless, we can usefully lump together firms producing

very closely related commodities and refer to them as a
‘product group’.
 2.5. Equilibrium of the Firm
 Product differentiation gives rise to a negatively sloping demand curve
for the product of individual firm.
 If the firm increases its price it will lose some but not all of its customers,
 while if it reduces its price it increases its sales by attracting some
customers from other firms.
 Although downward sloping the demand is highly elastic, because there
are many numbers of sellers in the group.
 If it reduces its price the increase in its sales
 will produce loss of sales distributed more or less equally overall the other
firms, so that
 each one of them will suffer a negligible loss in customers, not sufficient to
induce them to change their own price.

 Thus, the individual demand curve is a planned sales curve drawn on the
assumption that the competitors will not react to changes in the particular
firm price.
 Cont…

 The choice - related variables for a monopolistically competitive

firm are
 product variation,
 selling expenses and
 prices.

 In this section, we examine how a monopolistically competitive

firm determines its best level of
 output and
 price in the short run and long run on the assumption that
o the firm has already decided on the
• characteristics of the product to produce and
• on the selling expenses to incur.
 Cont…
 As for firms under any type of market structure, the best level
of output for a monopolistically competitive firm in the short
run is where MR = MC, provided that price exceeds the min.
AVC.
 To analyze equilibrium of the firm and the industry on the
same diagram two assumptions are necessary.

 The firms have identical costs and consumer preferences are

evenly distributed among the different products.
 Cont…
In the long run, however, the monopolistically competitive firm
breaks even.
In other words, production at positive profit or production at loss
is unrealistic and doesn’t exist because of free entry and exit
into and out of the product group.
This long run equilibrium is achieved through price adjustments
of the existing firms and by new firms entering the product
group.
In the short run the equilibrium of the firm in monopolistic
competition is very similar to that of the monopolist.
Profit is again maximized by producing the output where
MC = MR.
Supernormal profit can be made, depending on the position of the
AC curve, because the number of firms in the industry is fixed.
 Cont…
 The only real difference between the two situations is that in relating
to monopolistic competition, the demand curve (and hence the MR
curve) is flatter than monopoly.
 This is because of the greater availability of substitutes.
 Cont…
 In the long run, new firms will enter the industry, attracted by
the supernormal profit.

 This will have the effect of shifting the demand curve

downwards for existing firms.

 The downward shift will continue until the demand curve

becomes tangential to the AC curve (LAC in this case), at
which point all supernormal profit will have been competed
away.
 2.6. Excess Capacity and Welfare Loss
 Excess capacity is the difference between the

 ideal output corresponding to the minimum LAC and

 output actually attained in the long run equilibrium.
 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 MR = MC and LAC = P, but P > LMC.

 As a result

 price will be higher and

 output will be lower as compared with the perfectly
competitive model.
 Cont…
 In monopolistic competition market there are too many firms
in the industry, each producing
o an output less than optimal (at the falling part of the LAC), i.e.
o at a cost higher than the minimum LAC where tangency of LAC
and demand curves occurs at the falling part of LAC.

 The difference between the level of output indicated by the

lowest point on the LAC and the monopolistic competitor’s
output when in long run equilibrium measures excess capacity.

 As a result,
 P will be higher and
 output will be lower in monopolistic competition as compared to
pure competition but
 profit is normal.
 Cont…
Firms in this market incur selling costs.
In monopolistic competition market there are too many
firms each working with excess capacity.
Cont…
Chamberlain argues that the excess capacity and
misallocation of resources is valid only if one assumed that
the demand curve of each firm is horizontal.

If demand is downward sloping and firms enter into active

price competition while entry is free in the industry, then Xf
can’t be considered as the socially acceptable optimal level of
output.

Consumers desire a variety of products.

 Cont…
Product differentiation reflects the desire of consumers
who are willing to pay higher price in order to have a choice
among differentiated product.

The higher cost resulting from producing to the left of the

minimum LAC is thus socially acceptable.

Hence, the difference between Xe and Xf is

 not a measure of excess capacity but rather

 a measure of the social cost of producing and offering
variety of products.
 2.7.Measure of Excess Capacity
 According to Chamberlain, however, long run equilibrium
under monopolistic competition does not give rise to excess
capacity so long as the market is characterized by active
price competition.

 In his view, excess capacity arises when free entry is joined

with the absence of price competition.
 Cont…
Under the conditions of free entry and active price

competition, Chamberlain argues that,

the equilibrium output will be close to the minimum

cost output, because firms will be competing along their

individual demand curves that are very elastic.
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).
 Cont…
If firms avoid price competition and instead enter into non-
price competition, there will be excess capacity (restriction
of output) and higher prices in each firm and for the industry.

In this event the firm ignores its planned sales curve and
concern itself only with its market share (share - of – the-
market curve or actual - sales curve).
1. What are the choice - related variables for a monopolistically
competitive firm ? Briefly discuss about.
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