Monopolistic competition

Notes on monopolistic competition.
Based on syllabus of university of calicut.

1. MONOPOLISTIC COMPETITION (BASED ON BA ECONOMICS SYLLABUS OF UNIVERSITY OF CALICUT) Muhammed Suhaib m Head of the Department, Department of Economics, KR’s Sree Narayana College, Thozhuvanoor

2. Monopolistic Competition Monopolistic competition is a market structure characterized by a large number of firms producing differentiated products. Monopolistic competition combines elements of both monopoly and competition. Since each firm sell a differentiated product, it has some control over the price at which it sells its output. The monopolistically competitive firm has an absolute monopoly in terms of the differentiated product it markets.

3. Monopolistic Competition There is competition from the firms selling products that are close substitutes which severely limits the monopolistic power of firms. The theory of monopolistic competition was originated by the American economist Edward Chamberlin. Chamberlin’s book “ the theory of monopolistic competition ” was published in 1933 The same theory was developed independently by the British economist Joan Robinson in her book “The Economics of Imperfect Competition” published in 1933.

4. Features of Monopolistic Competition 1. Products are Differentiated: Firms compete by selling differentiates products that are highly substitutable for one another but not perfect substitutes. Each firm has some monopoly power in that it has the sole right to produce and market its particular variety of the product. There are a number of close substitutes such that-the cross-price elasticity between brands will generally be positive. 3. Number of Sellers and Buyers: There are many firms in a monopolistically competitive industry, but generally fewer than in perfectly competitive industry. One result of having a large number of firms is that no individual firm have much discretion aver price. But prices may not be the same for all firms. 3. Free Entry and Exit: It is relatively easy for new firms enter the market with their own brands and for existing firms to leave if their production become unprofitable. Normally there are very few restrictions imposed by governments.

5. Features of Monopolistic Competition 4. Profit Maximization : the goal of the firm is profit maximisation, both in short run and in long run. 5. Absence of Collusion: Firms are assumed to function independently of one another. Thus, there is no collusion among the sellers. 6. Imperfect Knowledge: Monopolistic competition is characterized by imperfect knowledge on the part of the buyers and sellers. 7. Selling Costs : Advertising is necessary because buyers have imperfect knowledge about the products sold by firms. To overcome the ignorance of buyers and to increase the demand for their products, firms advertise. 8. Each firm knows its demand and cost curves with certainty.

6. PRODUCT DIFFERENTIATION The practice of distinguishing the goods or services of one seller from those of another on the basis of factors other than price is called product differentiation. The objective of product differentiation is to distinguish the product of one producer from that of the other producers in the industry. Real product differentiation exists when there are differences in terms of chemical composition, specification of the products, factor inputs, services offered by the seller and location of the firm. Thus, in real product differentiation is the inherent characteristics of the products are different. Fancied product differentiation exists when the consumers are persuaded to believe that the products are different even though they are basically the same. Thus, fancied product differentiation is based on perceived differences by consumers. Fancied product differentiation established by advertising, difference in packaging, difference in design or by brand names.

7. SHORT RUN EQUILBRIUM The objective of the firm in monopolistic competition is maximization of profits. Monopolistic competition characterized by product differentiation. Product differentiation means that each firm is a little monopolist having downward sloping demand curve for its product. Because there are many firms, each firm can set its price without considering the reactions of its competitors. The firm is in short run equilibrium where MC = MR.

8. The determination of the equilibrium price and output level for a monopolistically competitive firm in the short run is illustrated in the following figure. The firm’s demand curve is highly elastic because of the existence of a large number of firms producing differentiated products. An increase in the price of the product will shift customers to other brands. Profit maximizing level of output is given by the point where its short run MC curve intersects its MR curve from below Thus, the profit maximizing output is Q and the corresponding price is OP. Because the price P exceeds average cost, the firm earns supernormal profit. Supernormal profits of the firm shown by the rectangle PABC. In the short run, supernormal profits are possible since the number of firms is constant. Thus, the equilibrium of the firm in the short run is very similar to that of monopoly.

9. LONG RUN EQUILIBRIUM The existence of supernormal profit will induce entry by other firms. The condition of free entry ensures that new firms will enter the industry and compete away the super normal profits. The entry of new firms means that the demand for the product must be shared among more and more brands. Thus, the demand curve for each existing firm shifts to the left. Entry will continue until all firms earn only normal profits. It is in this sense that monopolistic competition resembles perfect competition.

10. The long run equilibrium of the firm in monopolistic competition is shown in the following figure. The firm is in equilibrium when its long run AC is tangent to the long run AR curve. This means that unit cost is equal to unit revenue or price and there are no abnormal profits. The profit maximizing output is Q and the corresponding price is P. With normal profits for all the firms in the industry, there will be no incentive for new firms to enter the industry in the long run.

11. THE CONCEPT OF EXCESS CAPACITY Excess capacity is the difference between ideal output and the actual output in the long run equilibrium. Excess capacity = Ideal Output -Actual Output Ideal output is that level of output associated with the minimum long run AC. It is the level of output at which the short run AC and the long run AC are at their minimum. Thus, when the short run AC is tangent to the long run AC at its minimum point, the firm is having the most efficient size or ideal plant size.

12. In the following diagram, ideal output is Q. In monopolistic competition, the long run equilibrium output is determined by the tangency of the demand curve-and the LAC. Thus, the profit maximizing output is QM. Since the actual output is less than ideal output, there is excess capacity in monopolistic competition. Excess capacity is the difference between the minimum LAC output and the actual long run equilibrium output. In the following figure excess capacity is equal to Qm Q.

13. Excess capacity is inevitable in monopolistic competition due to the following factors. 1. Too Many Small Firms: Monopolistic competition is characterized by the existence of too many small firms than would be desirable. These firms are unable to produce at the lowest LAC which results in excess capacity. 2. Under Utilization of the Plant: A second reason for the existence of excess capacity is the under-utilization of the plant built. 3. Product Differentiation: The greater the degree of product differentiation, the greater the amount of excess capacity. As the degree of product differentiation rise, the degree of product substitutability declines which is shown by a steeper individual demand curve. The demand curve will be tangent to the LAC at a higher point which will result in a reduction in the actual output. The firm will be able to charge a higher price.

14. NON-PRICE COMPETITION Non-price competition refers to all those efforts on the part of firms to increase sales or make the demand curves less elastic based on variables other than price. Non-price competition is an important feature of monopolistic competition. There are mainly. live forms of non-price competition. They are 1) Advertising 2) Product variation 3) Design differences 4) Locational effects and 5) Provision of supplemental services.

15. 1. Advertising : Advertising is an important form of nonprice competition. Firms incur advertising costs because they believe that 'by using advertising, revenues will increase more than costs, so profits will be higher. 2. Product Variation: Another form of nonprice competition involves variations in the quality of the product offered for sale by various firms. 3. Design Differences: Differences in product design may provide a more profitable form of competition than attempting to offer a lower price. 4. Locational Effects: The decision of where one locates the sale of a product is another way of competing on a nonprice basis. Some firms compete by taking their line of products to the consumer’s home for sale. 5. Supplemental Services: The provision of supplemental services may also be used as nonprice competition.

16. Selling costs The costs of changing consumers’ wants are selling costs. Selling costs include all expenses incurred in order to increase the demand for the good or service. Examples of selling costs are advertising in its many forms, free samples and salaries and allowances given to salesmen. The purpose of selling costs is to shift the demand curve to the right, to increase the demand for the product. Chamberlin introduced the concept of selling costs. According to him selling cost curve is U-shaped. A firm will continue adding to its selling costs as long as addition to costs (MC) is less than addition to revenue (MR). Firms pay for increased costs due to advertising by charging consumers a higher price. Thus, price increases when a firm is incurring selling costs. The consumer is worse off as a result of the increased selling costs.

17. Selling costs Significance: Monopolistic competition is characterized by the existence of a large number of firms producing differentiated products. There is difference in quality and variety of the product. The people should be made known of the commodity produced by the firm. Thus advertising is an integral part of monopolistic competition. Selling costs are incurred to promote sales or to shift the demand curve rightward and upward. The preferences of the consumers are sometimes influenced by advertisement and publicity. Thus, selling costs are incurred to persuade the consumers. If the firms are not cautious, advertisement war may lead to a reduction in the profits of those firms engaging in it.

18. Production Costs and Selling Costs Production costs are those costs which are incurred by a firm in the production and transport of a good or service to the buyer. The costs incurred by a firm on raw materials, wages to the workers, fuel, packing, transportation etc are examples of production cost. The costs of changing consumers’ wants are selling costs. Selling costs include all expenses incurred in order to increase the demand for the good or service. Examples of selling costs are advertising in its many forms, free samples and salaries and allowances given to salesmen. The purpose of selling costs is to shift the demand curve to the right, to increase the demand for the product. Production costs are independent of selling costs. Total costs are the sum of production costs and selling costs. The distinction between production costs and selling costs was made by Chamberlin.

19. PRICE AND OUTPUT DETERMINATION UNDER PERFECT COMPETITION AND MONOPOLISTIC COMPETITION: A COMPARISON A perfectly competitive firm is in long run equilibrium when it produces an output at which price is equal to the marginal cost of production. At equilibrium, the firm will be producing at the minimum point of the LAC curve. The long run profit maximizing level of output in monopolistic competition must lie to the left of the minimum point on the LAC curve. This occurs because the firm’s demand curve is negatively sloped due to product differentiation and must be tangent to the LAC curve only to the left of the minimum point on the LAC curve.

20. The difference between the equilibrium price and quantity of the good produced in perfect and monopolistic competition is shown in the following figure.

21. The competitive industry is in equilibrium at point C where LAC is at its minimum. The equilibrium price is OPc and output is OQc . The long run equilibrium output in perfect competition is known as the ideal output. Monopolistic competition is in equilibrium at point E, where the demand curve is tangent to the LAC curve. A comparison of the two equilibrium points shows that price is higher and output is smaller under monopolistic competition than under perfect competition. That is Pm > Pc and QM < Qc.

22. PERFECT COMPETITION AND MONOPOLISTIC COMPETITION: A COMPARISON Similarities 1. Goals of the Firm: In both the markets profit maximization is the objective of the firm. 2.Number of Sellers: Both markets are characterized by the existence of a large number of sellers. 3. Free Entry and Exit: There are no barriers to entry to both markets. There is freedom for new firms to enter the market or existing firms to leave the industry 4. Absence of Collusion: Firms in both markets function independently of one another. Thus, there is no collusion among the sellers. 5. Cost Conditions: In both the markets the cost conditions give rise to U shaped cost curves 6. Normal Profit: The firm earns only normal profits in both markets.

23. PERFECT COMPETITION AND MONOPOLISTIC COMPETITION: A COMPARISON Differences 1. Nature of the Product: In pure competition, the product is homogeneous. Firms in monopolistic competition sell heterogeneous products that are differentiated from one another. 2. Shape of Demand Curve: The demand curve of a firm in perfect competition is horizontal. In monopolistic competition the demand curve is negatively sloped. 3. Degree of Knowledge: Perfect competition is characterized by perfect knowledge. Monopolistic competition is characterized by imperfect knowledge on the part of the buyers and sellers. 4. Equilibrium Condition: The long run equilibrium condition of perfect competition is MC = MR == AC = P. The long run equilibrium condition of monopolistic competition is MC = MR and AC _= P but P > MC. 5. Price : Price in monopolistic competition is higher than the competitive price. 6. Output : Output in monopolistic competition is lower than the output in perfect competition.

24. PERFECT COMPETITION AND MONOPOLISTIC COMPETITION: A COMPARISON Differences 7. Excess Capacity : Monopolistic competition is characterized by the existence of excess capacity in the long run equilibrium. In perfect competition there is no excess capacity 8. Efficiency :Competitive firm in the long run equilibrium produces the efficient output where price equals long run marginal cost. In monopolistic competition, the industry produces an inefficient level of output, where price is greater than marginal cost. 9. Selling Costs: In monopolistic competition firms incur selling costs which are not present in pure competition. 10. Market Power: Perfect competition is characterized by the absence of market power. Firms enjoy market power in monopolistic competition because each seller differentiates his product from that of the others. 11. Main Decisions: The only decision of the firm in pure competition is the determination of its output. The firm in monopolistic competition can determine both his price and output. 12. Equilibrium Price In perfect competition there is an equilibrium price determined by the forces of market demand and market supply. In monopolistic competition, there is no unique equilibrium price, but an equilibrium cluster of prices. This is because product differentiation allows each firm to charge a different price.

25. Product group The concept of product group was introduced b Chamberlin A product group is composed of firms that produce products that are close substitutes for one another. Thus, product group includes firms producing very related commodities. According to Chamberlin the products should be close technological and economic substitutes. Technological substitutes are products which can technically satisfy the same want. For example, all motor cycles are technological substitutes in the sense that they provide transport. Economic substitutes are products which cover the same want and have similar prices. For example, a Hero Honda Splendor and Yamaha Libero can be considered as economic substitutes. Products forming the group have high price and cross elasticities. It means that the demand of a product shifts appreciably when the price of other products in the group changes.

26. CHAMBERLIN'S GROUP EQUILIBRIUM   Group equilibrium refers to the equilibrium of the product group. A product group includes firms producing very closely related commodities. Different firms in the product group adopt independent price output policies because of their monopolistic position achieved through product differentiation. Each firm will charge a different price. Price will be equal to full costs, which include normal profits. New firms will enter the market only if there are abnormal profits. In the long run, since all the firms in the group are getting only normal profits, no outside firm wants to enter the group. Because full costs include normal profits no firm in the group wants to leave. Hence the group is in equilibrium. The condition for the attainment of group equilibrium is that MC = MR and AR curve is tangent to the AC curve. This is shown in the following figure

27. The average revenue curve is tangent to the average cost curve at point T Marginal cost and marginal revenue curves intersect each other exactly vertically below T. Therefore, the firm is in long run equilibrium by setting price OP and producing OQ quantity of output, because average revenue is equal to average cost, the firm will be making only normal profits. Since all firms are alike in respect of demand and cost curves, the average revenue of all firms will be tangent to their average cost curves and they will be earn in g only normal profits . Because only normal profits are accruing to the firms, there will be no tendency for the new competitors to enter the industry. The product group as a whole will be in equilibrium.

28. MONOPOLY AND MONOPOLISTIC COMPETITION: DIFFERENCES 1. Number of Sellers: Monopoly is a single seller market. Monopolistic competition is characterized by the existence of a large number of sellers. 2. Barriers to Entry: Monopoly is characterized by the existence of effective barriers to entry. There are no barriers to entry in monopolistic competition. 3. Nature of the Product: The product may or may not be homogeneous in monopoly. Firms in monopolistic competition sell heterogeneous products that are differentiated from one another. 4. Degree of Knowledge: Monopoly is characterized by perfect knowledge. Monopolistic competition is characterized by imperfect knowledge.

29. MONOPOLY AND MONOPOLISTIC COMPETITION: DIFFERENCES 5. Main Decisions: The monopolist can determine either his output or his price but not both. The firm in monopolistic competition can determine both his price and output. 6. Selling Costs: In monopolistic competition firms incur selling costs which are not present in pure monopoly. 7. Market Power: A firm in monopoly enjoys very high market power. This is because it is the sole producer of a commodity and substitutes are not available. Firms in monopolistic competition have a small degree of, monopoly power. This is because of the availability of close substitutes. 8. Profit: In monopoly abnormal profits are usually earned both in the short run and in the long run. In monopolistic competition the firm earns abnormal profits in the short run and normal profits in the long run.

30. LONG RUN EFFICIENCY IMPLICATIONS OF MONOPOLISTIC COMPETITION The long run. efficiency implications of monopolistic competition can be analysed with respect to Utilization of plant Allocation of resources Advertising and Product differentiation.

31. LONG RUN EFFICIENCY IMPLICATIONS OF MONOPOLISTIC COMPETITION Utilization of Plant In monopolistic competition, the long run equilibrium output is determined by the tangency of the demand curve and the LAC. Since the demand curve is negatively sloped, the tangency point will always occur to the left of the lowest point on the firm’s LAC curve. The firm is not fully utilizing its plant to produce the optimum or ideal output. Since the firm underutilizes its plant, actual output is less than ideal output and there is excess capacity in monopolistic competition.

32. LONG RUN EFFICIENCY IMPLICATIONS OF MONOPOLISTIC COMPETITION Allocation of Resources When the monopolistically competitive market IS in long run equilibrium, the price charged by each firm exceeds the LMC of the last unit produced. Allocative efficiency is achieved when price equals marginal cost for each product. Therefore, resources are under-allocated to the firms and misallocated in the economy. Product Differentiation Product differentiation provides an opportunity to the consumers to choose from a wide variety of competing products and brands that differ 1n various ways. Even though it offers greater range of choices to the consumers, excessive product differentiation is likely to confuse the consumer and adds to costs and prices

33. LONG RUN EFFICIENCY IMPLICATIONS OF MONOPOLISTIC COMPETITION Advertising There are two types of advertising-informative advertising and persuasive advertising. Informative advertising contains information about new products, prices, qualities, location, availability and so on. Persuasive advertising is that type of advertising, which alters consumer’s preferences in favour of the advertised product. Informative advertising makes markets function more efficiently because it helps consumers to make better-informed choices. Persuasive advertising is sometimes used to induce consumers to purchase products they don’t really want. Since the total amount of advertising undertaken by the monopolistically competitive firms may be excessive, it leads to higher prices.