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Chapter Six

Monopolistic Competition Market Structure

Monopolistic competition characterizes many industries in the real world. Like the pure
monopolist, firms in these industries face downward- sloping demand curves. Like the pure
competition case, entry and exit are easy. It is a market structure with many buyers and sellers in
which product differentiation exists and there are elements of both monopoly and perfect
competition.

Characteristics of monopolistic competition

1) Relatively large number of sellers and buyers: - the number may range, say from 25 to 100,
but the hundreds or thousands needed for perfect competition. Because of the fairly large
number of firms such characteristics emerge:
i) Small market share: - each firm has a small percentage of the total market, so each
has limited control over market price.
ii) No collusion: - the relatively large number of firms ensures that collusion to restrict
output and raise prices is all but impossible
iii) Independent actions: - with numerous firms, there is no feeling of mutual
interdependence. Each firm determines its policies without considering possible
reactions of rival firms
2) Product differentiation: - as a fundamental feature of monopolistic competition, purely
competitive firms turn out a homogeneous product, and monopolistically competitive
firms produce variations of a particular product. The non-price competition takes such
forms
i) Product quality: - the basic product is the same but features of the product differ
somewhat, for example, different terms on a credit card.
ii) Services: - some may provide carry out service while another grocery store lets you
carry your own purchases.
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iii) Location: - some gas stations locate near interstate highways and sell at a higher price
than firms located in a city some distance from the highway. The location of some
firms may be convenient and they stay open the whole night.
iv) Advertising and packaging: - to differentiate their products many firms apply
perceived differences created through advertising or packaging. For example,
toothpaste in a pump container may be preferable to toothpaste in a tube for some
consumers
3) Easy entry: - entry in a monopolistically competitive industry is relatively easy. Economies
of scale and capital requirements are few.
Product Differentiation and the Demand Curve

Product differentiation is any feature of a product of sellers that makes buyers to prefer one
product or sellers to that of another. It leads to different consumer’s preference. It is also the
basis for establishing a downward sloping demand curve. Chamberlin suggested that the demand
for a product is not only determined by the price – but also by the style of the product, the
services associated with it and the selling activities of the firm. Thus, Chamberlin introduced
two additional policy variables in the theory of the firm: the product itself and selling costs.
Hence, the demand curve shifts if:

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

2. Competitors change their price, output, services or selling policies of a product;

3. Tastes, incomes, prices or selling policies of products from other industries change.

Product differentiation is intended to distinguish the product of one producer from that of the
other producer in the ‘industry’ (in the group). It can be real differentiation or fancied (artificial)
differentiation. Real differentiation: exists when the inherent characteristics of the products have
slight differences (slight difference in quality, durability), in the specification of products (terms
of credit, transportation, guarantee, location of the firm), which determine the convenience with
which a product is accessible to the consumer. Example: chemical differences existing in
shampoos or conditioners. On the other hand, fancied differentiation is established by
advertising or differences in packaging or differences in design (color or shape) or simply by
brand name.
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In any case, the aim of product differentiation is to make the product unique in the mind of the
consumers. And the effect of product differentiation leaves firms under monopolistic
competition with some degree of monopoly power. Because of this the firm is not a price –
taker.

Monopolistic competition has less power than pure monopoly and more power than perfectly
competitive market structure over the price of its product. The power of the firm over price is
limited because of the existence of other competitors. Product differentiation creates brand
loyalty and gives rise to a negatively sloped demand curve.

Demand function

The monopolistically competitive firm faces a demand curve that is downward sloping, but much

more elastic that the demand curve facing a pure monopolist. The latter faces a fairly inelastic or

steeper demand curve, and hence marginal revenue curve. But a monopolistically competitive firm,

which sells a product that has many close substitutes, faces a more elastic or flatter demand curve, of

which slope is much closer to zero, and marginal revenue curve.

Costs
All cost curves short- run average variable cost (AVC), average cost (AC),marginal cost (MC) and

long- run total average cost (LAC) of a firm are U- shaped, implying that there is only a single level

of output which can be optimally produced and economies and diseconomies of scales. So the

shapes of costs are the same in all perfectly competitive, monopoly, and monopolistically

competitive markets.

But here, in the monopolistic competitive, a new cost is introduced, i.e., selling costs. Selling costs

are costs incurred on advertisement, improving the quality and style, etc. of the product. Selling

costs help to alter the position or the shape of the dd curve for a product.

Accordingly, selling costs curve is U- shaped, i.e., there are economics and diseconomies of
selling costs. For instance, if we take advertisement, initially the increment in selling quantity is
greater than the advertisement cost and after a certain point the sales rate remains more or less
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constant but the advertisement cost continues to rise. This leads to a fall in the average selling
cost initially and it rises up as advertisement continues. Hence the selling cost is U- shaped. The
U- Shaped selling cost added to the U- shaped production cost (APTC), yields a U-shaped ATC
curves. Total cost = Production cost + Selling cost.

Like any other costs the average selling cost is U-shaped. That means there are economies and
diseconomies of selling cost as output increases.

Average Selling Cost

Average Selling Cost Curve

Q
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The Concept of Industry and Product "Group”

An industry under perfectly competitive market is defined as a group of firms that produce

homogenous products. However, this definition cannot be applied in the case of differentiated

products. In the case of homogeneity of products, it is possible to add them horizontally and get the

market demand and supply of the products. But here, in the case of monopolistic competition,

products cannot be added to get the market demand and supply. For this reason, it is very important

to redefine the industry for analytical purpose.

Product differentiation creates difficulties in the analytical treatment of the industry of

monopolistically competitive market structure. Heterogeneous products cannot be added to form the

market demand and supply schedules as in the case of homogeneous products. The monopolistically

competitive industry is a ' group' of firms producing a closely related' commodity, referred to as '

product group'. An operational definition of ‘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.
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Product differentiation allows each firm to change different prices. 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.

Short run equilibrium

In the short run the firm acts like a monopolist. The firm, given its demand and cost curves,
maximizes its profit by producing that which marginal cost is equal to marginal revenue
(MC=MR).

 A firm will obtain excess profit if Pe>ATC and loss if Pe<ATC.

Example

 Assume a firm engaging in selling its product and promotional activities in monopolistic
competition face short run demand and cost functions as Qd=20-0.5P and C= 4Q2-8Q+15,
respectively. Having this information
A. Determine the optimal level of output and price in the short run.
B. Calculate the economic profit (loss) the firm will obtain (incur).
 Solution
A. Q=20-0.5P B.∏=TR-TC or Q (P-ATC)
Q-20= -0.5P = PQ–(4Q2-8Q+15)

P=40-2Q =32(4) - (4(4) 2)-8(4) + (15)

R=PQ =128 - 47

= (40-2Q) Q =81

=40Q-2Q2

MR=∂R= 40-4Q P.
MC
∂Q

C=4Q2-8Q+15

MC=∂TC=8Q-8 ATC

∂Q

MR=MC Q=20-0.5P or P=40-2Q

MR=40-4Q
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40-4Q=8Q-8
32
48=12Q

Q=4

*P=40-2Q

P=40-2(4)

P=40-8=32

Exercise

 Given P=30-5Q and ATC=20/Q+4Q-6, answer the above questions A to B

Answer: Q=2, P=20, and profit 16

Long run equilibrium

In order to be able to analyze the equilibrium of the firm and of the industry on the same diagram
Chamberlin made two ‘heroic assumption’, namely that firms have identical costs, and
consumers’ preferences are evenly distributed among the different products. That is, although
the products are differentiated, all firms have identical demand and cost curves. Under these
assumptions the price in the market will be unique.
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Assumption: Each firm is in short run equilibrium with excess profit.

LMC

LAC

Pm dE

Pe

Pe E

A
Qe D|E D/Q
MR2 MR1
Q
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The firm in the short run is in equilibrium where MC = MR. At equilibrium point a given firm
attains abnormal profit. The excess profit attracts firms to come in to the market with competing
brands. 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. The process will continue until the dd curve is tangent to
the average cost curve at its equilibrium. i.e. until the abnormal profit is eliminated and excess
profit is wiped out. In the final equilibrium of the firm, the price will be P e and the ultimate
demand curve will be dd|E.

In the long run the equilibrium occurs at P=LAC, at this point there will be neither entry nor exit,
and the equilibrium is stable.

Generally

In Short run:

 the firm can make excess profits or lose money, as the demand and marginal revenue
curve shift
 The firm produces the level of output at which MR=MC and the price that corresponds
to this level of output is obtained using the demand curve.
 The vertical distance between the ATC and the demand curve provides the excess
profit per unit sold
 The excess profit attracts entry in the industry and the production of more close
substitutes, which leads to a downward shift in the demand curve that faces individual
firms
 Finally, as the demand curve continues to shift down until the excess profit is
exhausted and the individual firm loses money
In Long run

 If a firm loses money as a result then it goes out of business and the demand curve that
faces for the firms that still remain in the industry will shift upward
 Easy entry and exit of firms cause monopolistic competitors to earn only normal profit
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 The equilibrium output is such that price exceeds the minimum average total cost and
price exceeds marginal cost