CHAPTER ONE

Monopolistic Competition

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 Chapter contents

 Introduction/Assumptions
 Product Differentiation, demand curve and cost of the firm
 The Concept of Industry and product ‘group’
 Short-run and long-run equilibrium of the firm
 Excess capacity and welfare loss

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 1.1Introduction

• As you know prefect 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.
• In case of monopoly, however only single firm producing a
product for which there is no close substitute dominates the
industry.
• As a result, the monopolistic firm has power to set price and
output level, which maximizes its profit.

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 Cont’d…

• Until 1920s, these two extreme forms of market model are the
only model that used to explain the behavior of firms.

• However, by 1930s some economists began to question the

capacity of these models to explain the modern market
economics. They cannot explain several empirical facts.

• The assumption of homogenous product of prefect competitive

market did not fit to the real world.

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 Cont’d….
• Advertising and other selling activities, which are widely
practiced by businesspersons, could not explained by both
market models.

• Moreover, under the existence of legal monopoly on its

trademarks and brand names for a firm, it is possible for other
firms to produce similar product, which is not exactly the
same.
• Such product viewed as a substitute by a consumer to some
degree unlike non-existence of close substitute assumption of
monopoly market model.

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 Cont’d…
• From the viewpoint of a single firm therefore, production
decision of its competitor will be a very important
consideration in deciding how much it can produce and what
price it can charge.
• This implies perfect competition and monopoly market models
are useful tools for shedding light on how market works but
they rarely represent the real market situation.

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 Cont’d…
• Edward Chamberlin (1933) from Harvard University in his
theory of monopolistic competition and Joan Robinson from
Cambridge University in her economics of imperfect
competition working independently, comes up with a new
model, which falls between the two extreme models.
• This model, which is the subject of this chapter, is termed as
monopolistic competition market structure.

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 Cont’d…
• Relatively it is a market model that can better explain the
existing market situations.
• For example, the way retail trade, fast food and cosmetics
market works better explained by monopolistically
competitive market model than monopolistic or perfect
competitive market model.
• If we take retail traders, they sell goods in many different
stores by competing with one other through differentiating
their product based on location, availability and expertise of
sales peoples and the provision of credit terms.

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 Cont’d…
• In addition, entry is relatively easy. Therefore, if the business
is profitable new store will be established to supply slightly
differentiated products.
• Such feature of retail trade better fits to monopolistic
competition than to perfectly competitive and monopoly
market.
• Thus, monopolistic competition said to exists when there are
many firms, as in perfect competition and each firm produce a
product that is slightly different from that of the other.

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 Cont’d…
• Perfect competition and pure monopoly are two extreme
market situations which are not found in real life.

• The actual market situations are somewhere between these

two.
• It is a market situation with some elements of competition and
some elements of monopoly, and thus termed as monopolistic
competition (or imperfect competition).

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 Cont’d…
 The competitive element arises from the existence of large
number of firms and no barrier to entry or exit.

 The monopoly element results from differentiated products, i.e.

similar but not identical products.

 A seller of a differentiated product has limited monopoly power

over customers who prefer his product to others.

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 Cont’d…

• Developed by two Economists, E.H Chamberlain (America)

and Joan Robinson (England). But we more focus on
Chamberlin model of monopolist competition.
Basic Assumption of Chamberlin large group model
1. Large number of sellers in product group
 fairly large but not as large that of PCM
It has the following implications
1. small market share there is certain monopoly power
2. No collusion between firms
3. Independent action

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 Cont’d…

2. Product differentiation
 seller found in the product group produces differentiated
product. But still the products are close substitute one another
3. Easy entry and exit
 because of financial barrier to develop differentiated product
• Entry is not free as that of PC . But easy as compered to pure
monopoly
4. Firms objective is to maximizing profit.

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 Cont’d…

5. Heroic/Uniformity Assumption
 Both the demand and cost curve for all product is uniform
throughout the product group
6. Myopic assumption
 Firms learn not from their past experience

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 Cont’d…

Generally monopolistic competition is market in which:

• Large number of independent firms compete
• Each firms produces differentiated product
• Firms compete with product quality, price and Market activity
• Reasonable entry and exit is free
Example: Soap; Cold remedies; Soft Drinks, shoes, dresses...

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 Product differentiation

• The process of making a product unique from other product is

called product differentiation.
• Chamberlin uses the concept of product differentiation to
develop the theory of monopolistic competition.
• Product differentiation is fundamental characteristic MC

• Monopolist produce slightly different product from it

competitor with regard to product attributes service customers,
location and accessibility.

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 Cont’d…

Product differentiation may take two forms :

i. If Product differentiation said to be Real: when product
found in the product group differs in terms of their inherent
characteristic: -types of input, location, storage capacity,
workmanship,

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 Cont’d…

II. Fancied /spurious /artificial differentiation

 A situation where the producer convinces its customer that
their product is different from other close substitutes .
 Product differentiation is said to be fancied when products are
basically the same yet the consumer persuaded by market
activities like:
- Advertisement
- Packing
- Brand names
- Design
- Trade marks

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 After all, why do MC firm differentiate it’s product in
both scenarios?
 The effect of product differentiation is that the producer has
same discretion in determination of its price
 Because of product differentiation MC firm is not price
taker. He has same degree of monopoly power.
 Product differentiation give rise to downward sloping demand
curve. Firms can increase price without losing all its
customers or has to reduce price to attract more customers
 The amount of monopoly power depends on the degree of
differentiation.
 To same extent MC firm is price maker!!

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 Cost in Monopolistic Competition

• We have seen that monopolistically competitive firm

undertake different activities and changes compositions of
goods to differentiate their product from their competitors.
• For example, firms use intensive advertisements to increases
demand and even to inform potential buyers about the
availability of the product.
• This causes strong attachment of consumer to the product so
that price elasticity of demand for the product becomes very
low.

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 Cont’d…
• In other words, firms often devote considerable resources to
differentiate their product from their competitors through such
devices as quality and style variations, warranties and
guarantees, special services features, and product
advertisement.
• All of these activities require firms to employ an additional
resource that incurs addition cost to them. This cost is known
as selling cost or cost of product differentiation.
• Therefore, firms have to consider this cost during pricing and
output decision in addition to traditional production costs.

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 Cont’d…
• Like perfect competition and monopolistic firm, traditional
production cost of monopolistically competitive firm’s average
costs and marginal costs 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.
• Moreover, Chamberlin tries to show the average and marginal
selling costs curve of monopolistically competitive firm have
U-shape.

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 Cont’d…
• If we take advertisement, cost that comprises the major
proportion of selling cost shows economies and diseconomies
of scale.
• However, the average and marginal cost of monopolistically
competitive firm is greater than average and marginal cost of
perfect competitive and monopolistic firm because of the
additional costs incurred to during product differentiation.

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 Figure 1.2 Average Cost in the Long Run
Average
Total
Cost
ATC in long run

Economies Constant
of returns to
Advertisement ads Diseconomies
of
Ads

0 Quantity of
Output sold
 Cost in Monopolistic Competition

Cost = production cost +selling

cost

Under production cost

Under selling
• -Cost manufacturing
• -Advertisement
• -Transportation
• Salary of
• Storage
salesman
• Delivery

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 Product group and Industry

 Industry is a collection of firms producing homogeneous

product
 The concept of an industry holds in a perfect competition
where in there is product homogeneity.
 The urge to redefine this concept led chamber line to use the
term product group
 According to chamberlain a product group is a collection of a
producer of fairly close substitutes.

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 Demand curve of MC firm

o Demand curve face by MC firm is highly elastic but not

perfectly elastic.
o The MC firm has more elastic demand curve than pure
monopoly.
 Because MC firm has many compotators producing close
substitute goods.
o MC firm demand is not perfectly elastic as PC firm
Because
fewer rival firm
 Product differentiation

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 Cont’d…
• In summary product differentiation, which is the basis of non-
price competition, give monopolistically competitive firm
certain monopoly power and then down ward sloping demand
curve.
• In other word in monopolistically competitive market
structure, firms have a certain capacity to change the demand
for their product through product differentiation.

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 Cont’d…
• Even though firms in monopolistically competitive
market faces downward sloping demand curve, their
demand curve is highly elastic because of the existence of
large number of firms producing closely substitute
products.

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 Chamberlin demand curve

Perceived demand curve is a demand curve for a firm’s

product drawn on the assumption that other firms in the product
group will keep their prices constant when a single firm changes
the price of its product.
-Associated with price competition
Proportionate demand curve/ Market share curve, is a
demand curve for a firm’s product which shows the actual sales
by each firm when the prices of all the firms changer equally and
in the same direction.
- Shift in Proportionate demand curve caused by entry and exit.

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Proportionate demand curve

Perceived demand
curve

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 Cont’d…

• Two extremes
• Perfect competition: many firms, identical products
• Monopoly: one firm

• Imperfect competition – in between the extremes:

– Monopolistic competition: many firms sell similar but not

identical products.

– Oligopoly: only a few sellers offer similar or identical

products.

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 Monopolistic Competition
• Characteristics:
– Many sellers
– Product differentiation
• Not price takers; downward sloping D curve
– Free entry and exit
• Zero economic profit in the long run
• Examples of monopolistic competition:
– Apartments, books, bottled water, clothing, fast food, night
clubs

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Characteristic Monopolistic Competition

Number of Fairly large number of firms, each with a relatively small amount of market
Firms share

Price making
Firms are small relative to the industry, meaning changes in one firms output
abilities of
have only a slight impact on market price. While they are price-makers,
individual demand will be relatively elastic compared to a pure monopolist
firms

Products are slightly differentiated. Firms will advertise to try and further
Type of
differentiate product. Branding and advertising are used to attempt to increase
product demand for the firm’s product over competitors.

Entry to and exit from the market is relatively easy. If profits exist, new firms
Entry barriers will enter, if losses are earned, it can be expected that some firms will exit.

Because of their price-making power, firms will produce at a price that is higher
Efficiency than their marginal cost and higher then their minimum ATC, meaning the
industry is not economically efficient.
Examples of Monopolistically Competitive Markets
Examples include:
• Restaurants in a major city: There are hundreds of restaurants in a city of any
reasonable size. They all sell a similar product (food), which is differentiated from one
seller to the other (Chinese, Mexican, French, Barbecue, etc…) Each restaurant can set
its own prices, but only to an extent (have you ever seen a $100 hamburger?)

• Apparel: The market for clothing is highly competitive, and like restaurants, the
hundreds (or thousands) of clothing manufactures are competing for our business by
differentiating their products from the competition. Again, firms have some price-making
power, but consumers can always switch brands if prices rise too much, so demand is
relatively elastic.

• Automobiles: Even the car market shows some characteristics of monopolistic

competition, although due to the relatively substantial economies of scale, it could be
considered oligopolistic in some markets. Each car is a close substitute for all other cars,
but is differentiated to try to make demand for it less elastic.
 Revenue Curves for the Monopolistic Competitor
Because each firm in in a monopolistically competitive market makes a product that is
differentiated from its competitors, it is able to control the price for its output, but only to a
certain extent.
Observations of the Monopolistic Competitor’s
Demand and MR curves:

• With many other firms making similar products, P Monopolistically

Competitive firm
each firm faces a relatively, but not perfectly,
elastic demand curve.

 A price increase will lead to a large loss of

buyers, but a price decrease will lead to a
large increase in buyers. P

• In order to sell additional units of its product, a

D=AR=P
firm must lower the price of all its output.
 For this reason, the firm’s marginal revenue
will fall faster than its price
MR

Q Q
 Short Run Equilibrium

• Profit maximization in the short-run for the

monopolistically competitive firm:
– Produce the quantity where MR = MC
– Price: on the demand curve
– If P > ATC: profit
– If P < ATC: loss
– Similar to monopoly

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A Monopolistically Competitive Firm Earning Profits in
the Short Run

The firm faces a Price

downward-sloping profit MC
D curve. P ATC

At each Q, MR < P. ATC

D
To maximize profit,
firm produces Q MR
where MR = MC.
Q Quantity
The firm uses the
D curve to set P.

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 Cont’d…

• The graphical analysis of the monopolistically competitive

firm’s output, price, and profits/losses is very similar to that of
the monopoly firm.
• One subtle difference is that the demand curve (and MR curve)
facing the monopolistically competitive firm is likely to be
flatter than the demand curve facing the monopolist, as the
monopolistic competitor faces competition from other firms
selling similar products.

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Profit Maximization in the Short-run
As with firms competing in the other market structures, a monopolistic competitor will maximize
its total profits when it produces at the quantity of output at which:
MR=MC

Observe from the graph:

• The firm is producing at its profit maximizing
quantity (Qf) and charging the price
consumers are willing to pay for that quantity Monopolistically
(Pf) Competitive firm
P MC

• At this point, price is greater than ATC, so the ATC

Economic
firm is earning an economic profit. Profits

• Given the existence of profits in this market

(assuming this firm is a typical firm) new Pf
firms will be attracted to the industry.
ATC D=AR=P

• Since entry barriers are low, these short-run

economic profits are likely to be eliminated
in the long-run as new firms enter the market.
MR

Qf Q
 A Monopolistically Competitive Firm
With Losses in the Short Run

Price
For this firm, MC
P < ATC losses ATC
at the output where
ATC
MR = MC.
P
The best this firm can
do is to minimize its D
losses. MR
Q Quantity

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 Long Run Equilibrium
• If monopolistically competitive firms are making profit in
short run
– New firms: incentive to enter the market
• Increase number of products
– Reduces demand faced by each firm
• Demand curve shifts left; prices fall
– Each firm’s profit declines to zero

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 Cont’d…

• If losses in the short run:

– Some firms exit the market, remaining firms enjoy higher
demand and prices
• Short run: Under monopolistic competition, firm behavior is
very similar to monopoly.

• Long run: In monopolistic competition, entry and exit drive

economic profit to zero.

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Profit Maximization in the Long-run – Entry Eliminates Profits
One of the key characteristics of monopolistic competition is the low entry barriers.
Entrepreneurs will therefore be attracted to any economic profits that are earned .

P MC
P MC
Economic ATC
ATC
Profits

Pf

ATC P=ATC
D=AR=P
D=AR=P

MR MR

Qf Q Qf1 Q

Economic profits attract new firms to the More competition reduces demand for this firm’s
market, increasing the amount of competition product, and makes it more elastic (flatter).
and the number of substitutes for this firm’s Demand decreases until the firm is only breaking
product even
 Profit Maximization in the Long-run – Exit Eliminates Losses
Just as it is relatively easy to enter a monopolistically competitive market, it is also easy to leave.

P MC P MC
ATC ATC

Economic
Losses

ATC
P=ATC
Pf

D=AR=P D=AR=P

MR MR

Qf Q Qf1 Q

Due to weak demand, firms are earning losses, Less competition increases demand for this firm’s
leading some firms to exit the market. As they do product, and makes it less elastic (steeper).
so, demand for the remaining firms increases… Demand increases until the firm is breaking even
again
Monopolistic Competition in Long-run Equilibrium
Because of the low entry and exit barriers, firms in monopolistically competitive markets will
only break even in the long-run (just like in perfect competition).

Non-price competition: Because firms face so

much competition in order to break even (or earn
profits), a firm must compete through other, non-
price means, including:
Monopolistically Competitive MC
P firm in long-run equilibrium
• Branding: By developing a recognizable brand ATC
image, firms attempt to build consumer loyalty,
giving the firm more price-making power

• Product development: Continuously improving

its product through research and development P=ATC
will keep demand high.

• Customer service: Offering good customer D=AR=P

service and support may increase demand
MR

Qf Q

• Location: Good access to large numbers of consumers allows a firm to charge higher prices
• Advertising: Making buyers aware of product features through advertising increases demand, giving the
firm a greater chance of earning economic profits in the long-run
 Note
 Efficiency: -it denotes the most effective use of a society’s
resources in satisfying people’s wants and needs.
We can look at two kinds of efficiency, namely
productive efficiency and allocative efficiency.
• Productive Efficiency: - this implies the production of any
particular mix of goods and services in the least costly way.
• Allocative Efficiency: -this is the production of that particular
mix (combination) of goods and services most wanted by the
society.
Efficiency in Monopolistically Competitive Markets
To determine whether monopolistically competitive firms are economically efficient, we must
determine whether:

• P = MC: This is an indicator of allocative efficiency, since price represents the marginal benefits of
consumers and MC the marginal cost to producers

• P = minimum ATC: This tells us whether firms are productively efficient, since if the price equals the
lowest ATC, then firms are forced to use their resources in the least-cost manner.

P MC
Efficiency is not achieved!
ATC
As we can see in the graph, a
monopolistic competitor in long-run
equilibrium will achieve neither
productive nor allocative efficiency.
P=ATC
P>MC
MC
P>min. ATC
D=AR=P

MR

Qf Qso (where P=MC) Q

 Why Monopolistic Competition Is
Less Efficient than Perfect Competition

• Monopolistic competition
– Excess capacity: quantity is not at minimum ATC
(it is on the downward-sloping portion of ATC)
– Markup over marginal cost: P > MC
• Perfect competition
– Quantity: at minimum ATC (efficient scale)
– P = MC

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 Welfare of Society

• Monopolistically competitive markets

– Do not have all the desirable welfare properties of perfectly
competitive markets
• Sources of inefficiency
– Markup of price over marginal cost
– Too much or too little entry (number of firms in the market)
• Product-variety externality
• Business-stealing externality

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 Welfare of Society
• Markup, P > MC
– Market quantity < socially efficient quantity
• Deadweight loss of monopoly pricing
• The product-variety externality:
– Consumers get extra surplus from the introduction
of new products
• The business-stealing externality:
– Losses incurred by existing firms when new firms
enter market

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 Cont’d…

• The product-variety externality is a positive one for

consumers; while the business-stealing externality is a
negative one on existing producers.

• It’s not clear which externality effect is bigger, and it may in

fact differ by industry.

• The inefficiencies of monopolistic competition are subtle and

hard to measure. No easy way for policymakers to improve
the market outcome

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 Monopolistic Competition compared to Perfect
Competition
 It may appear that, since they do not achieve economic
efficiency, monopolistically competitive markets are less
desirable than perfectly competitive markets.

 However, there are also several benefits of monopolistic

competition over perfect competition.

 Conclusion? Monopolistic Competition is more common in

the real world, and by most counts, more desirable to both
consumers and producers…

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Characteris
Perfect Competition Monopolistic Competition
tic

Price is low and quantity is high. Price is higher and quantity

Allocative and productive lower than in perfect
Price and
efficiency are achieved and competition, neither type of
Quantity
consumer surplus is maximized as efficiency is achieved and
a result. consumer surplus will be less.
Every firm differentiates its
Every firm sells an identical product, at least slightly, from
Product
product. There is no variety for every other seller, giving
Variety
consumers to choose from. consumers a wide variety to
choose from.
Firms will always break even in the
Firms have more ability to make
long-run, and due to the high level
profits through successful non-
of competition there is nothing an
price competition and product
Profits individual firm can due to earn
differentiation, which if done
profits, only an increase in market
well can earn a firm profits, even
demand can lead to short-run
over time.
profits
 Summary

• A monopolistically competitive market has many firms,

differentiated products, and free entry.

• Each firm in a monopolistically competitive market has

excess capacity—it produces less than the quantity that
minimizes ATC. Each firm charges a price above
marginal cost.

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 Summary
• Monopolistic competition does not have all of the desirable
welfare properties of perfect competition.
– There is a deadweight loss caused by the markup of price
over marginal cost.
– Also, the number of firms (and thus varieties) can be too
large or too small.
– There is no clear way for policymakers to improve the
market outcome.

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 Summary
• Product differentiation and markup pricing lead to the use of
advertising and brand names.
– Critics of advertising and brand names argue that firms use
them to reduce competition and take advantage of
consumer irrationality.
– Defenders argue that firms use them to inform consumers
and to compete more vigorously on price and product
quality.

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