Subject ECONOMICS Paper No and Title 3: Fundamentals of

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ECONOMICS

Paper 3: Fundamentals of micro economic theory

Module 26: Monopolistic competition

Subject ECONOMICS

Paper No and Title 3: Fundamentals of micro economic theory

Module No and Title 26: Monopolistic competition

Module Tag ECO_P3_M26

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ECONOMICS



TABLE OF CONTENTS

1. Learning Outcomes

2. Introduction

3. Definition and characteristics of monopolistic competition

4. Comparison of monopolistic competition with perfect competition and

monopoly

5. Short run equilibrium of monopolistic competition firm

6. Long run equilibrium of monopolistic competition firm

7. Monopolistic competition and economic efficiency

8. The concept of excess capacity

9. Monopolistic competition versus perfect competition: a comparison

10. Criticism of Chamberlin theory of monopolistic competition

11. Summary

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1. Learning Outcomes

After studying this module, you shall be able to

Know the meaning of monopolistic competition and its characteristics

Learn how a monopolistic competitive firm determines its equilibrium in short

run and long run

Learn the concept of economic efficiency under monopolistic competition

Learn the concept of excess capacity

2. Introduction

Monopolistic competition is a market structure which lies in between perfect competition

and monopoly and thus it has the features / characteristics of the both.

The concept of monopolistic competition is more realistic than perfect competition and

monopoly and we can even relate this type of market structure with the one which is

prevailing in our current markets.

In this module we will thus study the model given by Professor E. H Chamberlin in his

book “The theory of monopolistic competition” in 1933.

3. Definition and Characteristics of Monopolistic competition

By definition, monopolistic competition refers to a market structure in which a large

number of sellers sell differentiated products, which are close substitutes for one another.

Here, a close substitute is one whose cross-elasticity is close to unity or greater.

Monopolistic competition combines the basic elements of both perfect competition and

monopoly.

The element of monopoly in monopolistic competition arises from the fact that each firm

has an absolute right to produce and sell a branded or patented product. Other firms are

prevented by laws from producing and selling a branded product of other firms. This

gives a firm monopoly power over production, pricing and sale of its own-branded

product. For example, consider toilet soap industry. There are a number of brand names

available in the market, e.g., Lux, Liril, Palmolive, Fairglow, Pears, Fa, Rexona,

Lifebuoy, Carmel, Godrej, Cinthol, Ponds, Dove, Dettol and so on. Each of these branded

toilet soaps is produced and sold by a company having monopoly power over the product.

Similarly, Maruti Udyog Limited has monopoly power for producing and selling cars

under the brand name Maruti. No other car manufacturing company can produce and sell

cars under this brand name. So is the case with all other car manufacturing companies.

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The element of competition comes from the fact that each branded product has several

close substitutes and firms selling branded products of the same generic category have to

compete for the market share. Considering again our example of toilet soaps,, all the

companies producing and selling these branded toilet soaps are in intensive competition

for capturing the largest possible market share. One index of the competition between

them is the amount that they spend advertising their product. These features of the toilet

soap industry make it monopolistically competitive. Toothpaste industry with a number

of branded product names (e.g. Binaca, Colgate, Close-up, Pepsodent, Forhans, Cibaca,

Neem, Meswak, Signal, Promise, Prestige and so on) is another example of monopolistic

competition. So is the case with major industrial products in India, e.g., electrical tubes

and bulbs, TV sets, refrigerators, air conditioners, personal computers, textile goods, tea,

coffee, cigarettes, soft drinks, cold creams, shampoos, detergents, shaving blades,

shaving cream, hair oils, hair dyes, shoes, wrist watches, steel, cement, mobile phones

and so on.

Let’s now have a look at the characteristics of monopolistic competition:

Large number of buyers and sellers: In monopolistic competitive market, there

exist large number of both the buyers and sellers of the product. This is the same

feature as of the perfect competition. However there is one difference that

competitive firms are very small relative to the size of the market whereas in

monopolistic competition, the firms are not so small in relation to the size of the

market.

Product differentiation: Since various firms under monopolistic competition

compete with each other, thus, they compete by selling differentiated products

that are either similar or close substitutes of each other. Hence the prices of the

products are not too much different from each other. Moreover the cross price

elasticity of demand for the products is large but not infinite.

Freedom of entry and exit: It is relatively easy for the new firms to enter a

monopolistic competition market industry and for the existing firms to leave the

industry. If the industry is profitable, new firms will enter the industry and

similarly any firm can leave the industry if it incurs losses. This feature of free

entry and exit is based on the low start up costs and no exit cost.

Market power: Firms under monopolistic competition face downward sloping

demand curve (AR) and marginal revenue (MR) curve lies below it because the

firms sell differentiated products (which are and can be close substitutes), and any

reduction in the price by the seller would attract the customers of the other

product towards it. Therefore, fall in the price of one product will increase the

demand of that product; hence, firms under monopolistic competition have some

influence on the price. Moreover, the demand curve is comparatively more elastic

in this market structure but it is not perfect elastic.

Non price competition: Firms under monopolistic competition compete not only

in terms of prices but also on other non price variables which the firm spends on

advertising like marketing cost, sales promotion expenses etc.

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Absence of interdependence among firms: In monopolistic competition, each

firm acts more or less independent and have their own price policies regarding

price and output. Hence, the change in the pricing policy of one firm does not

have a significant effect on the price and output of the other firm.

Concept of industry under monopolistic competition: Industry is defined as the

number of firms selling homogeneous / identical products. However with product

differentiation, the definition of industry becomes ambiguous. Hence, Professor

Chamberlin has replaced the concept of industry with “group of firms” producing

differentiated products which are close substitutes of each other and have high

cross price elasticity of demand.

4. Comparison of monopolistic competition with perfect competition

and monopoly

Monopolistic competition Perfect

competition

Monopoly

1 Large number of firms

2 Monopoly power- face downward sloping demand and

MR curves

3 Free entry and exit

4 Firms can earn super normal profits in short run

5 Economic profits are zero, P=AC in the long run

6 Non pricing competition – advertising

7 Pricing – P>MC (MR=MC) (deadweight loss)

5. Short run Equilibrium of the monopolistic competitive firm

Chamberlin has made the following explicit and implicit assumptions to develop his

theory of monopolistic competition.

1. There are a large number of firms selling slightly differentiated products, which

are close substitutes for one another.

2. The number of firms in a product group is so large that their activities,

especially, maneuvering of price and output, go unnoticed by the rival firms.

3. Demand and cost curves for all the products and for all the firms of the group

are uniform, i.e., firms face identical demand (including perceived one) and

cost curves.

4. Consumer's preferences are evenly distributed among the different products and

product differentiations are not such that they make a difference in cost.

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Since monopolistically competitive firms have downward sloping demand curve, so

they have some market power and can influence the price as each firm sells

differentiated product which is not exactly similar to the product of the other firm but

yes somewhat substitute to the product of the other firms. Moreover there exist no

major barriers to entry or exit in monopolistic competition, thus, this feature puts a

limit on the profits of the firms.

Now because of the free entry, the new firms will keep entering a monopolistic

competition market until economic profits are driven to zero.

Fig 1: Short run equilibrium of monopolistically competitive firm

Here, AR is the demand curve of the monopolistic competitive firm which is downward

sloping because they sell differentiated products. MR is the corresponding marginal

revenue curve. MC is the marginal cost curve and AC is the Average cost curve of a

monopolistic competitive firm. A profit maximizing firm will produce where it’s MR =

MC. In this case, P>AC so firms earn super normal profits, as indicated by the rectangle

area in fig 1.

Here the second order condition is also satisfied at the equilibrium i.e. dMR/dQ <

dMC/dQ.

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6. Long run equilibrium of a monopolistically competitive firm

The long-run conditions differ from the short-run conditions because in the long run: (i)

new firms enter the industry, (ii) firms indulge in price competition, (iii) changes (i) and

(ii) take place simultaneously and (iv) firms advertise their product more vigorously.

When monopolistically competitive firms earn positive or supernormal profits in short

run, then this attract new firms to enter the market and hence new potential firms start

producing their own differentiated product in the market. This reduces the economic

profit of the market as the existing firms lose their market share and their demand curve

shifts down. This will go on till all the firms earn only normal profits and the economic

profits comes to zero.

Fig 2: Long run equilibrium of a monopolistically competitive firm

In order to maximize profits, firms will produce where MR = MC. Here one point to note

is that the demand curve is tangent to the firms AC curve which implies P = AC and

economic profits = 0.

Hence we can write the following long run equilibrium conditions under monopolistic

competition:

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1. MR = MC

2. dMC/dQ < dMR/dQ

3. P = AC

7. Monopolistic competition and economic efficiency

Perfectly competitive firms are economically efficient because they maximize the sum of

producer and consumer surplus, whereas monopoly leads to a loss in the social welfare of

the society. Let’s see here if the monopolistically competitive firms are efficient or not

and how are they compared with the competitive firms.

There are basically two sources of inefficiencies in monopolistic competitive firms:

1. Under monopolistic competition, equilibrium price exceeds marginal cost,

whereas under perfect competition P=MC

Fig 3: Comparing perfect competition with monopolistic competition: deadweight loss

Since under monopolistic competition P>MC, this means that value to the consumers of

the additional units of output exceeds the cost of producing that output. The sum of

consumer and producer surplus can be maximized if the output was expanded up to the

point where P = MC by the MKL region in fig 3. Hence, MKL region is the deadweight

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loss under monopolistic competition that arises due to the existence of monopoly power

(downward sloping demand curve).

Hence social welfare is not maximized under monopolistic competition.

2. Because of the free entry and exit assumption under perfect competition and

monopolistic competition, long run equilibrium occurs where P = AC, i.e.,

economic profits = 0 in the long run. However, there is one important difference

in both types of market, i.e., in case of a competitive firm, zero profits occurs at

the minimum of the average cost curve, however, under monopolistic

competition, the zero profits occurs on the falling portion of the average cost

curve, and not at its minimum. This happens because firms face downward

sloping demand curve and therefore the zero point occurs to the left of the

minimum of the average cost curve. Hence, firms under monopolistic competition

operate with excess capacity.

8. The concept of excess capacity

Excess capacity is defined as the difference between the ideal output and the actual

output attained in the long run, where ideal output is the output which is produced by the

firms where the long run average cost is at its minimum. Under monopolistic

competition, the firms though earns zero economic profits but there always exists the

problem of excess capacity because the monopolistically competitive firms output does

not coincide with the output at the minimum of LAC curve.

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Fig 4: Excess capacity under monopolistic competition

As we can see in fig 4, a monopolistic firm produces M output which is less than the

ideal output N. This difference is termed as excess capacity because each firm is

producing its output at an average cost that is higher than it could achieve by producing

its capacity output. Excess capacity is a kind of inefficiency of the firms which reduces

social welfare and makes the consumers worse off.

Excess capacity under Chamberlin model

Prof. Chamberlin’s explanation of the theory of excess capacity is different from that of

ideal output under perfect competition. Under perfect competition, each firm produces at

the minimum on its LAC curve and its horizontal demand curve is tangent to it at that

point.

Its output is ideal and there is no excess capacity in the long-run. Since under

monopolistic competition the demand curve of the firm is downward sloping due to

product differentiation, the long-run equilibrium of the firm is to the left of the minimum

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point on the LAC curve. According to Chamberlin, so long as there is freedom of entry

and price competition in the product group under monopolistic competition, the tangency

point between the firm’s demand curve and the LAC curve would lead to the “ideal

output” and no excess capacity.

Fig 5- Excess capacity under Chamberlin model of monopolistic competition

When there is no price competition due to the prevalence of these factors, the curve dd is

of no significance and the firms are only concerned with the group DD curve. Suppose

the initial short-run equilibrium is at S where the firms are earning supernormal profits

because the price OP corresponding to point S is above the LAC curve.

With the entry of new firms in the group, super-normal profits will be competed away.

The new firms will divide the market among themselves and the DD curve will be pushed

to the left as d1d1 in Figure 5 where it becomes tangent to the LAC curve at point A1, This

point A1 is of stable equilibrium in the absence of price competition for all firms in the

group and they are earning only normal profits. Each firm is producing and selling OQ

output at QA (= OP) price.

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In Chamberlin’s analysis, O1 is the ‘ideal output’. But each firm in the group is producing

OQ output in the absence of price competition. Thus OQ1 represents excess capacity

under non-price monopolistic competition

9. Monopolistic competition versus perfect competition: A comparison

The monopolistic competition given by Chamberlin, is characteristically closer to perfect

competition. There are, however, significant differences between the two kinds of

markets in respect of (i) the number of firms, (ii) the nature of products, (iii) the nature of

competition, (iv) efficiency in production and (v) capacity utilization.

1. The Number of Firms: The number of firms in both monopolistic competition

and perfect competition is very large. But the number of firms under perfect

competition is much larger than that under monopolistic competition. The

number of firm in perfect competition is so large that an individual firm has

absolutely no control on the price of its product: price is determined by the

market forces and is given to the firm.

However under monopolistic competition, the number of firms is only so large

that an individual firm does have power to change price of its product

especially under the condition of product differentiation. A firm can increase

the price of its product and still retain some of its buyers (which are not

possible under perfect competition) and if a firm cuts down the price of its

product, it captures a part of the market of the rival firms. On the contrary, if a

firm in perfect competition cuts down the price, it goes out of the market itself.

Moreover, the competitive firms are very small relative to the size of the market

whereas in monopolistic competition, the firms are not so small in relation to the

size of the market.

2. The Nature of the Product: Under perfect competition, product is homogeneous

and, therefore, the product of each seller is treated as a perfect substitute for the

product of other firms. Under monopolistic competition, on the other hand,

there is product differentiation and the product of each firm is a close

substitute for that of the others.

3. The Nature of Competition: Under perfect competition with homogeneity of

products, there is practically no competition. Each firm faces a horizontal

demand curve and sells any quantity without affecting the market share of other

firms. On the other hand, under monopolistic competition, the firms face a

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downward sloping demand curve due to product differentiation. Competition

between the firms may take the form of price competition or non-price

competition where non-price competition takes the form of competitive

advertising of the product by the firms.

4. Efficiency in Production: Efficiency in production under monopolistic

competition and perfect competition is compared on the basis of their

equilibrium output. Though the rules for profit maximization are the same for

the firms in both the kinds of the markets (i.e., MR = MC with MC rising), but

still the equilibrium output under perfect competition is higher than that under

monopolistic competition. Moreover the production under perfect competition

is more efficient than under monopolistic competition.

5. Capacity Utilization: In continuation with the issue of efficiency in production,

it has been shown that capacity utilization under monopolistic competition is

lower than that under perfect competition. It means that under monopolistic

competition, there is underutilization of capacity i.e there is excess

capacity under monopolistic competition whereas there is none under perfect

competition.

10. Criticism of Chamberlin’s theory of monopolistic competition

1. Chamberlin's Theory has Low Predicting Power.

2. Chamberlin's Model is challenged on Theoretical Grounds.

3. Chamberlin's Model Makes Unrealistic Assumptions like assuming identical

cost and revenue curves are not justified, assuming no interdependence is not

reasonable, assuming that firms do not learn is not correct.

4. Chamberlin's Measure of Excess Capacity is logically inconsistent.

5. Chamberlin's Model Lacks Empirical Validity.

Despite these damaging criticisms, Chamberlin's theory of monopolistic competition is

regarded as a significant contribution to the theory of value and remains a subject matter

of microeconomics for analytical rigour and insight that it provides in analyzing a

monopolistically competitive market.

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11. Summary

This module has explained the characteristics of monopolistic competition which is a

combination of perfect competition and monopoly.

Moreover the short run equilibrium of a monopolistically competitive firm shows the

same effect as of monopoly but in the long run it ended up with excess capacity and with

zero economic profits. Monopolistic competitive market also has the same inefficiency of

deadweight loss as that of monopoly which arises due to the downward sloping demand

curve i.e. market power.

At the end we have compared the monopolistic competition market structure with perfect

competition in detail and have also pointed out the criticism of the Chamberlin’s

monopolistic competitive theory of pricing.

Documents

Subject ECONOMICS Paper No and Title 3: Fundamentals of