Monopolistic Competition

This model was developed by

Edward Chamberlin
in the 1930’s.
The general model of monopoly is useful in the analysis of firm behaviour in other
types of markets in which firms have some degree of market power but are not
pure monopolies.

Monopolistic competition exists when individual producers have moderate

influence over product prices, where each product enjoys a degree of uniqueness
in the perception of the customers.

Firms in such markets, facing downward slopping demands, attempts to

maximise profit in the same way as the monopoly does: setting MR=MC.

These markets lie between monopoly (the most market power) and perfect
competition (with least market power.

In these markets, certain complications arise for profit maximising decisions

 Monopolistically competitive markets are characterised by

 A large number of relatively small firms. Each firm produces a small portion of
industry output and each customer buys only a small part of the total.

 Product heterogeneity: The output of each firm is perceived to be essentially

different from, though comparable with, the output of the other firms in the
industry. So products are similar to, but somewhat different from, one another.

 Unrestricted entry and exit of firms into and out of the market.

 Perfect dissemination of information: Cost, price, and product quality

information is known by all buyers and all sellers

 Opportunity for normal profits in the long-run equilibrium.

The only difference between monopolistic competition and perfect
competition is that under monopolistic competition firms produce a
differentiated products.

The major difference between monopolistic competition and monopoly

is that under monopolistic competition firms can easily enter into and
exit out of the market.

Thus, as the name implies, monopolistic competition has characteristics

of both monopoly and perfect competition.
Product differentiation under this market structure prevents a firm’s demand
from becoming horizontal.

Real and perceived difference between goods, though slight, will make them less
than perfect substitute.

For example: petrol pumps in a particular city are good, but not perfect substitutes
for one another. One’s car will run on petrol from any petrol pump, but pumps differ
in locations, and people’s tastes differ.

Vigorous monopolistic competition is evident in the banking, container and

packaging, discount and fashion retail, electronics, food manufacturing, office
equipment, paper and forest products, and most personal and professional service
industries.

The most important point is that although the products are similar, they are
differentiated, causing each firm to have a small amount of market power.
Because each firm in the market sells a highly differentiated products, it
faces a downward slopping demand curve., which is relatively elastic but
not horizontal.

Any firm could raise its price slightly without loosing all its sales, or it
could lower its price slightly without gaining the total market.

Under the original assumptions employed by Chamberlin, each firm’s

output is so small relative to the total sales in the market that the firm
believes that its price and output decisions will go unnoticed by other
firms in the market.

It therefore acts independently.

The theory of monopolistic competition is essentially a long-run theory.

In the short-run, there is virtually no difference between monopolistic

competition and monopoly.

In the long-run, because of unrestricted entry into the market, the theory
of monopolistic competition closely resembles the theory of perfect
competition.
Short-run Equilibrium
With the given demand, marginal revenue, and cost curves, a
monopolistic competitor maximises profit or minimises loss by equating
marginal revenue and marginal cost.

The figure in the next slide illustrates the short-run profit maximising
equilibrium for a firm in a monopolistically market.

The profit is maximised by producing an output of Q and

selling at price P.
The firm will earn an economic profit, shown as the area PABC.

However, as the case for perfect competition and monopoly, in the short-run the
firm could operate with a loss, if the demand curve lies below ATC but above AVC.
If the demand curve falls below AVC, the firm would shut down.

This figure is
identical to one
illustrating short-
run equilibrium
for monopoly.
In its original form, there appears to be little competition in monopolistic
competition as far as Short-run is concerned.

In the long-run a monopoly cannot be maintained if there are

unrestricted entry in the market.

If firms are earning economic profit in the SR, other firms will enter and
produce the product, and they will continue to enter until all economic
profits are eliminated.
Long-run Equilibrium
The long-run equilibrium is more closely related to the equilibrium
position under perfect competition.

Because of the unrestricted entry, all economic profit will be eliminated

in the LR, which occurs at an output at which price equals LR average
cost.

The only difference between this equilibrium and that for perfect
competition is that, for a firm in a monopolistically competitive market,
tangency cannot occur at minimum average cost.

Sine the demand curve facing the firm is downward slopping under
monopolistic competition, the point of tangency must be on the
downward slopping range of LR average cost.

Thus long-run equilibrium output under monopolistic competition is less

than that forthcoming under perfect competition in the LR.
 Suppose the original demand curve is given by Dm.
In this case the firm would be making substantial economic profit because demand
lies above LAC over a wide range of output, and if this firm is making profits,
potential new entrants would expect that other firms in the market are also
earning economic profit.
These profits would then attract new
firms into the market.

While new firms would not sell

exactly the same product as existing
firms, their products would be very
similar.

So as new firms enter, the number of

substitutes would increase and the
demand facing the typical firm would
shift backward and probably becomes
more elastic.

The entry will continue as long as

there is no economic profit being
earned.
Thus entry causes each firm’s
demand curve to shift backward until
a demand curve (D) is tangent to LAC
at a price P and output Q.
If too many firms enter the market, each firm’s demand curve would be pushed so far
back that demand falls below LAC.

Firm would be suffering losses and exit would take place.

As it happens, the demand curve would be pushed back up to tangency with LAC.

Free entry and exit under monopolistic competition must lead to a situation where the
demand curve is tangent to LAC-where price equals average cost and no economic
profit is earned, but firms do earn normal profit.

The equilibrium must also be charaterised by the intersection of LMC and MR. Only at
output Q can the firm avoid a loss, so that output must be optimal.

But the optimal output requires that MC=MR.

Thus at Q, it must be the case that MR=LMC.

Here firms act independently. But in reality firms may not act independently when
faced with competition from closely related firms, possibly because of proximity, they
may exhibit a great deal of interdependence and intense personal rivalry.

Here profits are competed away in the LR. But we do not mean to imply that there is no
opportunity for astute managers to postpone this situation to the future by innovative
decision making.

Firms can advertise and change product quality in an effort to lengthen the time period
over which they earn economic profit.

Those managers whom are successful in their marketing strategy can sometimes earn
profits for a long time. Sometimes can reduce their costs.

However successful strategies can be limited by competitors selling a product that is

rather similar.

Therefore, there is always a strong tendency for economic profit to be eliminated in the
LR, no matter what strategies managers undertake.
 Critique of Chamberlin’s Model

 The assumption of product differentiation and of independent action by the

competitors are inconsistent. It is a fact that firms are continuously aware of the
actions of competitors whose products are close substitutes of their own product.

 It is hard to accept the myopic behaviour of businessmen implied by the model.

Surely some firms will learn from past mistakes, and those that did not would be
competed out of existence by firms which do not take past experience into account
in decision making.

 The assumption of product differentiation is also incompatible with the assumption

of free entry, especially if the entrants are completely new firms as in Chamberlin’s
model. A new firm must advertise substantially and adopt intensive selling
campaign in order to make its product known and attract customers from already
established firms. Product differentiation and brand loyalty of buyers create a
barrier to entry for new firms.
 The concept of industry is destroyed by the recognition of product differentiation.
Each firm is an industry in its own right since its product is unique. Heterogeneous
products cannot be added to give the industry demand and supply curve. Such
summation would be meaningful if the price were unique for the close substitutes
constituting the industry.