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Chapter 11
Monopolistic Competition
Lecture Plan
• Introduction
•
•
•
•
Features of Monopolistic Competition
Identification of industry
Demand and Marginal Revenue Curves of a Firm
Price and Output Decisions in Short Run
• Price and Output Decisions in Long Run
• Monopolistic Competition and Advertising
• Comparison between Monopolistic Competition,
Monopoly and Perfect Competition
Objectives
• To understand the nature of imperfect competition or
monopolistic competition.
• To analyze the pricing and output decisions of a
monopolistically competitive firm in the short run and
long run.
• To comprehend why a firm in monopolistic competition
operates with excess capacity.
• To understand the rationale behind advertising for the
“unique” product of a monopolistically competitive firm.
Introduction
• Introduced by Joan Robinson (The Economics of Imperfect
Competition, 1933) and Edward H. Chamberlin (The
Theory of Monopolistic Competition, 1933)
• It is a market situation in which a relatively large number of
producers offer similar but not identical products.
• A combination of perfect competition and monopoly.
• Imperfect competition because a large number of sellers
sell heterogeneous or differentiated products and buyers
have preferences for specific sellers.
• Monopolistic, because each of these sellers makes the
product unique by some differentiation and has control
over the small section of market, just like a monopolist.
Features of Monopolistic
Competition
Chamberlin:
“Monopolistic competition is a challenge to the traditional viewpoint of
economics that competition and monopoly are alternatives…By
contrast it is held that most economic situations are composites of
both competition and monopoly.”
Features:
• Large number of buyers and sellers:..
• Heterogeneous products.
– A differentiated product enjoys some degree of uniqueness in the
mindset of customers, be it real, or imaginary.
– Heterogeneous Products
•
•
•
•
Selling costs.
Independent decision making.
Imperfect knowledge.
Unrestricted entry and exit.
Demand and Marginal Revenue
Curves of a Firm
Price,
Revenu
e
O
M
R
A
R
Quanti
ty
•Normal downward sloping
demand curve (AR Curve) as
all the firms in the industry sell
close substitutes.
•Demand is highly elastic and
slope of demand curve is
flatter
•If a firm increases the price of its
product slightly, it will lose some,
but not all of its customers.
•if it lowers the price slightly, it
will gain some, but not all of the
customers of its rivals.
•MR curve lies below AR curve
Price and Output Decisions in
Short Run
• Joan Robinson: Each firm has a monopoly over its
product.
– When product is differentiated, firm has some monopoly power.
• Firms have limited discretion over price, due to the
existence of consumer loyalty for specific brands.
• Negative slope of the demand curve that is instrumental
for chances of monopoly profits in the short run.
• The reason for supernormal profit in short run, is supplying
a product which is differentiated, or at least perceived to
be different by the consumer.
Price & Output Decisions in Short Run
Firm maximizes profit where (i) MR=MC; (ii) MC cuts MR
when MC is rising.
Profit maximising output OQE and Price OPE
Price,
Revenu
e, Cost
M
C
PE
B
A
E
O
QE
M
R
Quanti
ty
A
C
A
R
Total revenue = OPEBQE
Total cost =OAEQE
Supernormal profit
=APEBE
since price OPE > OA
(AR>AC)
Price & Output Decisions in Short Run
Firm maximizes profit where (i) MR=MC; (ii) MC cuts MR
when MC is rising.
Profit maximising output OQE and Price OPE
Price,
Revenu
e, Cost
A
E
PE
B
O
QE
M
C
M
R
Quanti
ty
A
C
A
R
Total revenue = OPEBQE
Total cost =OAEQE
Loss =APEBE
since price OPE < OA
(AR<AC)
Price & Output Decisions in Long Run
Firm maximizes profit where (i) MR=MC; (ii) MC cuts MR
when MC is rising.
Profit maximising output OQE and Price OPE
Price,
Revenu
e, Cost
PE
O
M
C
B
QE
M
R
Quanti
ty
A
C
A
R
Total revenue = OPEBQE
Total cost =OAEQE
Normal profit = No loss
no gain
since AR=AC
Price & Output Decisions in Long Run
•Just like perfect competition, in monopolistic
competition too all the firms would earn normal
profits in the long run.
•In the long run supernormal profit would attract
new firms to the industry till all the firms earn
only normal profits.
•Losses, will force firms to exit the industry till
remaining firms in the market earn only normal
profits.
•If all the firms only normal profit there will be no
tendency to enter or exit the market.
Monopolistic Competition and
Advertising
Advantages
• Since there are a large number of sellers, offering a
unique brand, customers need to collect and process
information on such large number of brands.
• It is more profitable to attract customers through
advertising rather than by lowering price.
• Advertising induces customers to pay a premium for the
particular brand, termed “brand equity” in marketing.
• Advertising is to shift the demand curve of one particular
firm, at the expense of other firms that are offering similar
products.
Monopolistic Competition and
Advertising
Criticism:
• Advertising induces customers into spending more,
because of the brand, rather than rational factors.
• A wasteful expenditure that adds no value to the product
• Leads to brand confusion in the minds of the consumers.
• Advertisements of rival products may even cancel each
other, leading to increase in average costs of each firm,
without any corresponding increase of sales.
Optimal Level of Advertising
MR derived from advertising=MC of advertising
MRA=MCA
Comparison with Monopoly and
Perfect Competition
Firms are in equilibrium and
earning normal profit
AR=AC
Price,
Revenue,
Cost
PM
PMC
LAC
EM
EM
C
EC
DC
PC
DM
DMC
O
QM QMC QC
Excess Capacity
Quantity
Perfect competition: horizontal
demand curve (DC); output QC;
price PC
Monopolistic
competition:
downward sloping highly elastic
demand curve (DMC); output
QMC (< QC), at price PMC (> PC).
Monopoly: downward sloping
less elastic curve D M; output Q
M (< QC and QMC), at price PM (>
PC and PMC).
Monopoly and monopolistically
competitive firm operate at less
than optimum output and
charge a higher price.
Excess capacity due to market
imperfections= QC> Q MC >QM
Summary
• Most firms compete with each other and have some (if not full)
degree of market power. Thus they lie somewhere between the two
extremes of monopoly and perfect competition.
• Joan Robinson of Cambridge and Chamberlin of Harvard
independently came up with a new concept of market, which
Robinson referred to as “imperfect competition” and Chamberlin
termed as “monopolistic competition”.
• A monopolistically competitive has features like large number of
buyers and sellers, heterogeneous product, selling costs,
independent decision making, imperfect knowledge, unrestricted
entry and exit.
• It is difficult to define an industry in case of monopolistic competition
as firms sell differentiated products. Alternatively, we identify groups
of differentiated products in this type of market, by clubbing close
substitutes from the same industry and regard them as “product
groups”.
Summary
• Firms under monopolistic competition have a normal demand curve
with a negative slope because of substitution effect of
heterogeneous products, which are close substitutes of each other.
• They may generate supernormal profits or normal profits, or may
even incur losses in the short run.
• In the long run all firms earn normal profits due to the feature of
unrestricted entry and exit.
• It is profitable for to attract customers through advertising rather than
by lowering the price.
• A firm in perfect competition is able to efficiently allocate its
resources by maximizing producer and consumer surplus, though a
monopolist and a monopolistically competitive firm operate at less
than optimum output, and charge a higher price.