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Monopolistic Competition ( Imperfect competition) Learning Outcomes: Assumptions and features Price Determination Equilibrium in the Firm Group Equilibrium in the Long Period Non-Price competition ( Factor: Quality) Product Equilibrium Selling Cost and Monopolistic Competition Price and output equilibrium under selling cost Defects and Wastes of Monopolistic competition

Assumption and features of Monopolistic Competition The model of monopolistic competition describes a common market structure in which firms have many competitors, but each one sells a slightly different product. Features: Existence of Large number of Firms- Large number of firms mean that each individual firm contribution to industry is small and there are no possibilities of collusion. Each firm makes independent decisions about price and output, based on its product, its market, and its costs of production.

A central feature of monopolistic competition is that products are differentiated. There are four main types of differentiation: Physical product differentiation, where firms use size, design, colour, shape, performance, and features to make their products different. For example, consumer electronics can easily be physically differentiated. For example Toothpaste has many substitutes, but no one can come with the brand name with Colgate other than the producer of Colgate. Marketing differentiation, where firms try to differentiate their product by distinctive packaging and other promotional techniques. For example, breakfast cereals can easily be differentiated through packaging.

Human capital differentiation, where the firm creates differences through the skill of its employees, the level of training received, distinctive uniforms, and so on. Differentiation through distribution, including distribution via mail order or through internet shopping, such as, which differentiates itself from traditional bookstores by selling online.

Selling Costs; A producer under monopolistic competition has to incur expenses to popularize his brand. The expenditure involved in selling the product is called Selling Cost. Most important form is Advertisement cost.

Firms are price makers and are faced with a downward sloping demand curve. Because each firm makes a unique product, it can charge a higher or lower price than its rivals. The firm can set its own price and does not have to take' it from the industry as a whole, though the industry price may be a guideline, or becomes a constraint. This also means that the demand curve will slope downwards. Freedom of entry and exits: There are no barriers as in the case of Monopoly Monopolistic competition presupposes that customers have definite preferences for particular varieties or brand of products. Hence pricing is not the problem but product differentiation is the problem and competition is not on prices but on products. Price Determination The Price and output determination under monopolistic competition is governed by the cost and the revenue curves of the firm The cost curves are governed by the laws of production. The revenue curves will not be elastic, like in Perfect competition where it is parallel to x axis and not like monopoly where it is steepingly falling down. It will be a sloping down curve, neither too steep nor too flat. The product is not homogenous, but slightly different. The firm cannot sell unlimited quantities at the established price as products of other firms are close substitutes, if not perfect substitutes. The curve will not be too steep, since any price change, the demand is more sensitive due to close substitutes being available and the AR curve is sloping down curve and MR is also sloping down, below the AR curve.

Equilibrium under monopolistic competition

In the short run supernormal profits are possible, but in the long run new firms are attracted into the industry, because of low barriers to entry, good knowledge and an opportunity to differentiate. Monopolistic competition in the short run At profit maximisation, MC = MR, and output is Q and price P. Given that price (AR) is above ATC at Q, supernormal profits are possible (area PABC). As new firms enter the market, demand for the existing firms products becomes more elastic and the demand curve (AR curves) shifts to the left, driving down price. Eventually, all supernormal profits are eroded away. Monopolistic competition in the long run ( Group Equilibrium) Super-normal profits attract in new entrants, which shifts the demand curve for existing firm to the left. New entrants continue until only normal profit is available. At this point, firms have reached their long run equilibrium. In the long run, with all inputs variable, a monopolistically competitive industry reaches equilibrium at an output that generates economies of scale or increasing returns to scale. At this level of output, the negatively-sloped demand curve is tangent to the negatively-sloped segment of the long run-average cost curve. This is achieved through a two-fold adjustment process. The first of the folds is entry and exit of firms into and out of the industry. This ensures that firms earn zero economic profit and that price is equal to average cost The second of the folds is the pursuit of profit maximization by each firm in the industry. This ensures that firms produce the quantity of output that equates marginal revenue with short-run and long-run marginal cost. Because a monopolistically competitive firm has some market control and faces a negatively-sloped demand curve, the end result of this long-run adjustment is two equilibrium conditions: MR = MC = LRMC P = AR = ATC = LRAC

With marginal revenue equal to marginal cost, each firm is maximizing profit and has no reason to adjust the quantity of output or factory size. With price equal to average cost, each firm in the industry is earning only a normal profit. Economic profit is zero and there are no economic losses, meaning no firm is inclined to enter or exit the industry. These conditions are satisfied separately. However, because price is not equal to marginal revenue, the two equations are not equal (unlike perfect competition). This further means that monopolistic competition does NOT achieve long-run equilibrium at the minimum efficient scale of production.

Clearly, the firm benefits most when it is in its short run and will try to stay in the short run by innovating, and further product differentiation. Examples of monopolistic competition Examples of monopolistic competition can be found in every high street. Monopolistically competitive firms are most common in industries where differentiation is possible, such as: The restaurant business Hotels and pubs General specialist retailing Consumer services, such as hairdressing The survival of small firms The existence of monopolistic competition partly explains the survival of small firms in modern economies. The majority of small firms in the real world operate in markets that could be said to be monopolistically competitive.



Selling Cost and Monopolistic Competition

Defects and Wastes of Monopolistic competition Evaluation The advantages of monopolistic competition Monopolistic competition can bring the following advantages: There are no significant barriers to entry; therefore markets are relatively contestable. Differentiation creates diversity, choice and utility. For example, a typical high street in any town will have a number of different restaurants from which to choose. The market is more efficient than monopoly but less efficient than perfect competition - less allocatively and less productively efficient. However, they may be dynamically efficient, innovative in terms of new production processes or new products. For example, retailers often constantly have to develop new ways to attract and retain local custom. The disadvantages of monopolistic competition There are several potential disadvantages associated with monopolistic competition, including:

Some differentiation does not create utility but generates unnecessary waste, such as excess packaging. Advertising may also be considered wasteful, though most is informative rather than persuasive. As the diagram illustrates, assuming profit maximisation, there is allocative inefficiency in both the long and short run. This is because price is above marginal cost in both cases. In the long run the firm is less allocatively inefficient, but it is still inefficient. Inefficiency The firm is allocatively and productively inefficient in both the long and short run. There is a tendency for excess capacity because firms can never fully exploit their fixed factors because mass production is difficult. This means they are productively inefficient in both the long and short run. However, this is may be outweighed by the advantages of diversity and choice. As an economic model of competition, monopolistic competition is more realistic than perfect competition many familiar and commonplace markets have many of the characteristics of this model.

Unemployment- Productive capacity may not be used fulyl and this will result in unemployment of resources in the economy. Monopolistic competition may increase national income but will reduce the propensity to consume, without creating a comparable increase in the desire to invest.

Excess Capacity:

This excess capacity is considered to be wasteful under monopolistic competition as it arises because of irrational consumer preferences. If the buyers preferences are rational, this excess capacity will be reduced by concentrating in fewer varieties. Cross Transport: The existence of cross transport is another factor for waste in monopolistic competition. For example cloth produced at Bangalore will be sold at Ahmadabad and clothe produced at Ahmadabad will be sold at Bangalore. Hence cost of cloth will be increased necessarily due to cost of transport. Failure of specialisation: The advantage of arising out of specialisation is lost. The cost advantage can be had only if sales can be expanded. Advertising: There is lot of waste in competitive advertisement. This lead to high cost to consumers.