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Subject: Managerial Economics

Paper: Managerial Economics

Module 21: Monopolistic Competition

Principal Investigator

Co-Principal Investigator

Paper Coordinator

Content Writer

Prof. S P Bansal Vice Chancellor

Maharaja Agrasen University, Baddi

Prof Yoginder Verma

Pro–Vice Chancellor

Central University of Himachal Pradesh. Kangra. H.P.

Prof. S.K. Garg

Former Dean and Director,

HPU, Shimla

Mr. Suraj K.Walia Assistant Professor, Department of Economics

R.K.S.D. (PG) College, Kaithal, Haryana

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Items Description of Module

Subject Name Managerial Economics

Paper Name Managerial Economics

Module Title Monopolistic Competition

Module Id

Pre- Requisites Basic knowledge of monopolistic competition

Objectives To understand Price & Output determination in Monopolistic

Competition

Keywords Monopolistic competition, Group, Firm, Product Differentiation

QUADRANT-I

Module 1: Monopolistic Competition

1. Learning Outcome

2. Introduction and Definition of Monopolistic Competition

3. Assumptions / Features of Monopolistic Competition

4. Demand and Cost Curves under monopolistic Competition

5. Price and Output Determination/ Equilibrium under it

6. Concept of Excess Capacity

7. Selling Cost and Equilibrium Under it

8. Equilibrium with Product Differentiation

9. Group Equilibrium

10. Summary

1. Learning Outcome:

After completing this module the students will be able to:

Understand the Monopolistic Competition and its features.

Understand the Demand and Cost curves under it.

Know the Equilibrium of firm/Price and Output determination under Monopolistic Competition.

Know the concept of Excess Capacity.

Understand the concept of Selling Cost and Equilibrium of firm with selling cost.

Know about Product Differentiation and Equilibrium with it.

Learn Group Equilibrium under Monopolistic Competition.

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MONOPOLISTIC COMPETITION

2. INTRODUCTION

The classical theory of price determination mainly includes pure competition and monopoly (i.e.

No competition) up to 1920. Latter it was found that pure competition was not realistic as it was

based on many unrealistic assumptions like homogeneous product. It was also not able to explain

the realistic fact like price determination under selling cost and product discrimination. E.H.

Chamberlin in his works ‘The Theory of Monopolistic Competition’ and Joan Robinson in his

work ‘The Economics of Imperfect Competition’ in 1933 independently explains the model of

monopolistic competition models. Though their works are different from each other but they arrive

at the same conclusion/solution of market and firm equilibrium.

Joan Robinson got the idea of falling demand curve from Sraffa’s article ‘The laws of Returns

under Competitive Condition’. In between pure competition and pure monopoly there is

imperfect competition. In pure competition an individual seller compete with perfect substitutes of

his own product while in pure monopoly a single seller doesn’t face any competition from any

substitute product. There are three important forms of imperfect competition.

MONOPOLISTIC COMPETITION

Monopolistic competition is a market structure in which there are large numbers of sellers of a

commodity selling heterogeneous or differentiated product which are close substitutes. We can see

many examples from real world like tooth paste, soaps, and cold drinks etc.

DEFINITION

According to Left witch, “Monopolistic competition is a market situation in which there are many

sellers of a particular product, but the product of each seller is in some way differentiated in the

minds of consumers from the product of every other seller”

Forms of Imperfect Competition

Monopolistic Competition

(Large Number of Sellers)

Duopoly

(Only two sellers)

Oligopoly

(Few Sellers)

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According to J.S. Bains “Monopolistic competition is market structure where there are a large

number of small sellers selling differentiated but close substitute products”

3. ASSUMPTIONS/FEATURES OF MONOPOLISTIC COMPETITION

Monopolistic competition is intermediate situation of pure competition and pure monopoly. Its

main assumptions are as follows:

i. A Large Number of Firms and Buyers: The first and important feature of monopolistic

competition is that in it there are large number of small firms or sellers and buyers also.

Each firm covers a small portion of market demand. As these firms sell differentiated

products which are close substitutes so competition is very tough.

ii. Heterogeneous Products: As there are large numbers of small firms which are producing

not same but similar products. These products are close substitutes of each other. Due to this

reason there prices cannot be very much different from each other.

iii. Partial control over Price: Under monopolistic competition a firm faces the downward

demand curve which implies if a firm increases price, some customers will leave it or if it

reduces the price some new customers will buy the product. So a firm has partial control

over price under this competition.

iv. Freedom of Entry and Exit: Chamberlin has used the term ‘Group’ instead of industry for

firms producing close substitutes goods. Under monopolistic competition competitive firms

are free to join or leave the group at any time. There is no restriction on these firms.

v. Non Price Competition: Non price competition is that competition in which firms take

measure to increase their supply other than reducing the price. Firm spend lot of amount on

advertisement, promotion offers, provide free service etc. to increase the sale of the product.

vi. Selling Cost: this is the cost which a firm incurred to increase the sale of the product. It is

wider that advertisement cost. It also increases the cost of sales man in it. In monopolistic

competition each firm spent a lot of amount on sale as there are close substitutes available in

the market.

vii. Imperfect Knowledge: as there are differentiated product in the market which are close

substitutes, sellers as well as buyers don’t have full knowledge about the price and quality of

the all the products available in the market.

4. DEMAND AND COST CURVES UNDER MONOPOLISTIC COMPETITION

To know the price and output determination under monopolistic competition we must have an idea

about the demand and cost curves under it.

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a) Demand Curve: As stated earlier that under monopolistic competition a firm has partial control

over prices of its product. By reducing its price it can increase the demand and by increasing the

price it can reduce the demand.

It is clear that demand curve is downward slopping under monopolistic competition as shown in

figure 1. At OP price quantity demanded is OQ as price rises to OP1 quantity demanded reduces to

OQ1. As price falls to OP2, quantity demanded rises to OQ2. Demand curve facing a firm will be

its AR curve. It also will negatively sloping and corresponding to it MR will be below to it.

b) Cost Curves: Under monopolistic competition cost curves are as traditional theory of cost. AC,

MC, AVC, LAC, LMC are all U shaped.

5. PRICE & OUTPUT DETERMINATION IN MONOPOLISTIC COMPETITION/

EQUILIBIRIUM UNDER MONOPOLISTIC COMPETITION

Equilibrium under monopolistic competition involves equilibrium of firm and equilibrium of group.

Equilibrium of an individual firm under monopolistic competition involves equilibrium in three

respects:

A. Equilibrium regarding Price and output

B. Equilibrium under Product Differentiation

C. Equilibrium with Selling Cost.

(A) EQUILIBRIUM REGARDING PRICE AND OUTPUT

Under monopolistic competition AR is downward sloping indicating a firm can sell more by

reducing output and MR is below it.

A firm will be in equilibrium position when following two conditions are satisfied:

i. Marginal revenue is equal to marginal cost (MR=MC)

ii. Marginal cost curve cut marginal revenue from below (MC Cut MR from below)

Figure 1: Demand Curve under Monopolistic Competition

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Figure 2 shows the conditions of equilibrium. Both conditions are fulfilled at point E, so a profit

maximising firm under monopolistic competition will produce OQ quantity of output and charge

AQ price.

We can discuss the equilibrium of a firm in short-run as well as in long-run.

SHORT RUN EQUILIBRIUM OF FIRM

Short run is the time period in which there are fixed as well as variable factors of production.

Monopolistic firm can increase its output by increasing variable factor only up to existing

production capacity. short-run time period is too short that no new firm can enter and no existing

firm can leave the market so a firm can face three situations in short-run:

(a) Super Normal Profit: A firm may get super normal profit in short period of a time. Super normal

profit is a situation when average revenue (AR) is greater than average cost (AC) at the equilibrium

output.

Figure 3 shows the super normal profit. Equilibrium is at point e. Firm will produce OQ level of

output and OP price will be charged. Here average cost is BQ and average revenue is AQ. Per unit

super normal profit is AB. Total super normal profit are PABP1.

Three Situations in Short Run Under Monopolistic Competition

Super Normal Profit

AR > AC

Normal Profit

AR=AC

Minimum Losses

AC > AR; AVC > AR

Figure 2: Equilibrium of Firm

Figure 3: Super Normal Profit

AR > AC

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(b) Normal Profit: A firm may earn normal profit under monopolistic competition. It is the

situation when average revenue (AR) is equal to average cost (AC) at the equilibrium level of

output.

Figure 4 shows the normal profit. Firm’s equilibrium is at point E. Firm is producing OQ level of

output and charging OP level of price. Here average revenue and average costs are equal i.e. AQ.

So form is getting normal profit.

(c) Minimum Losses: A firm may incur minimum losses in short-run. It is a situation when average

cost (AC) is greater than average revenue (AR) but a firm covers its average variable cost.

Figure 5 shows the minimum losses. Equilibrium of firm is at point E. Firm is producing OQ level

of output and OP1 price will be charged. Here average cost is AQ and average revenue is BQ.

Average cost is greater than average revenue. Firm is incurring losses PP1BA. But here firm is

covering average variable cost i.e. BQ. So these losses are minimum losses.

LONG RUN EQUILIBRIUM OF FIRM

Long run is the time period when all the factors of production are variable. The firm can change the

size of the plant and machinery. New firms can enter into the market or existing can leave the

market. A firm will produce that level of output where long rum marginal cost is equal to marginal

revenue curve. A firm will earn normal profit in long run under monopolistic competition because

AR = AC

Figure 4: Normal Profit

AC > AR

AVC ≥ AR

Figure 5: Minimum Losses

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If there is super normal profit, new firms will enter into the group so it will increase the

supply into the market and price will fall. Again there will be normal profit.

In the long run to increase the demand a firm will reduce the price of the product following

it other firms will also reduce the price, resulting normal profit to all the firms in the group.

If there are losses to the firm in the short run it will try to recover it in long run but still it

incur losses in the long run it will exit the group.

So in monopolistic competition each firm earns normal profit in the long run.

Figure 6 is depicting long run equilibrium of firm. Here equilibrium is at point E. Firm is producing

OQ level of output and will charge OP price. Here firm is getting normal profit as average revenue

is equal to average cost i.e. AQ. If there is super normal profit, new firms will enter in the market or

if firms are incurring losses then they will leave the group. So in long run each firm will get normal

profit.

6. EXCESS CAPACITY

It is the situation when a firm is not producing at the socially optimum level of output. The Excess

capacity is possible only in long run. Chamberlin and Joan Robinson both have revealed that under

monopolistic competition a firm producing at the downward portion of long run average cost curve

not at the minimum point of it which is socially optimum level of output. There are mainly three

reasons of existence of excess capacity i.e.

i. A downward sloping demand curve is the main reason. As downward sloping average revenue

curve can be tangent to U shaped long run Average cost only at the falling portion

ii. Entry of a very large number of firms due to which these firms share market demand curve so

that each firm produces a smaller output that optimum capacity.

Excess capacity is beneficial in some respect because it increases consumer’s welfare by providing

variety in products.

AR = LAC

Figure 6: Normal Profit in Long Run

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Figure 7 shows the long run equilibrium and excess capacity of firm under monopolistic

competition. Here firm is in equilibrium at point E. Firm is producing OQ level of output and

charging OP level of price. Socially optimum point of production is pint E1 on long run average

cost curve, which is minimum point of average cost. A firm should produce upto this point but

under monopolistic competition it is producing less then this point which is known as excess

capacity. QQ1 is excess capacity which a firm not producing.

7. SELLING COST

To increase the sale of the product or to increase the profits a firm may indulge in two type of

competition (a) Price Competition: it involves reducing price to increase sale and (b) Non Price

Competition: It involves increase the sale by other than price cutting. It includes changing the

quality of the product, advertisement, providing free services with the product and free gift with

product.

Selling cost is one of the parts of non price competition. This is different from advertisement

expenditure. Advertisement expenditure includes cost incurred only on getting the product

advertised in newspaper and magazines etc. selling cost includes the salaries and wages of

salesman, allowance to retailers for displaying their product and other promotional activities.

a. Average Selling Cost Curve: It is believed that selling cost is subject to varying returns. In

beginning increasing returns to selling cost implying more return that expenditure incurred. After a

point diminishing returns, implying less return that selling cost incurred. So average selling cost

(ASC) is U shaped as shown in figure 8.

Figure8: Average Selling Cost

Figure7: Excess Capacity

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b. Effect of Selling Cost on Demand

The sole objective of selling cost is to increase demand. An equal increment in advertisement

expenditure brings first increasing returns, then diminishing returns. It means as selling cost is

incurred in equal amount initially the demand increases more and latter increases less. It is shown

in figure 9. Initially as selling cost in incurred demand increases DD to D1D1 then D2D2 with

increasing returns and then D3D3 which indicated diminishing returns.

c. Effect of Selling Cost on Cost

Due to selling cost, average production cost curve shifts upward which is shown in figure 10. It

shows if selling cost is incurred on proportional basis the average production cost curve CC

increases upward in same ratio i.e. C1C1.

Average Cost= Average Production Cost+ Average Selling Cost

d. Equilibrium of Firm with Selling Cost

Equilibrium of firm with selling cost has been shown in figure 11. AR and MR are initial average

and marginal revenue curves. APC and MC are initial average production cost and marginal cost

curves. Initial equilibrium is at point E. Firm is producing OQ level of output and charging OP

price. Here firm is getting normal profits. To increase profit firm incure selling cost. Due to it

Figure 9: Effect of Selling Cost on Demand

Figure 10: Effect of Selling Cost on Production Cost

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demand curve shirt upwards so new average and marginal revenue curve are AR1 and MR1. Cost

curves also shift upwards. Now AC and MC1 are average and marginal cost curves. New

equilibrium is at point E1. Firm will produce OQ1 level of output and charge OP1 price. Now firm

is getting super normal profit P1P2CB. A firm will incur that level of selling cost which maximise

its profit.

8. EQUILIBRIUM WITH PRODUCT DIFFERENTIATION

Saraffa introduces the downward sloping demand curve as well as the concept of product

differentiation. But Chamberlin explains the concept of product differentiation on the basis of price

and output determination. Product differentiation means that goods are close substitutes. They can

be different in colour, packing, size, quality and packing etc. there are many examples in real

worlds like tooth pastes, soaps and cold drinks etc. Here we have used Prof. Chamberlin approach

to show how a firm will take decision regarding production. We assume price of the product to be

constant. There is only one variety which gives highest profit to the firm.

Here we have taken three varieties A, B and C of a good. Average costs of these are AA, BB, and

CC respectively

Figure 12: Equlibrium with Product Deifferentiation

Figure 11: Equilibrium with Selling Cost

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Firm is charging OP price for these three varieties. For A variety firm is selling OQ level of output

and getting PDD1D2 super normal profit. For B variety firm is selling OQ1 level of output and

getting PSS1S2 super normal profit. For C variety firm is producing OQ2 level of output and getting

PEE1E2 super normal profit. As variety C is giving highest profit so firm will produce more

quantity of C variety.

9. GROUP EQUILIBRIUM UNDER MONOPOLISTIC COMPETITION

Prof. Chamberlin used the term ‘Group’ for the firms producing close substitutes goods under

monopolistic competition. For example there is group of different firms producing cold drink like

Coca Cola, Marinda, and Pepsi etc. Group equilibrium refers to the adjustment of ‘price and output’

of a number of producers whose goods are close substitutes. To discuss group equilibrium, we

consider two assumptions:

a. Uniformity Assumption: according to which demand and supply curve of firms under group

are same.

b. Symmetry Assumption: There is large number of firms so that no individual firm can

influence the decision regarding the price and output of other firms.

Figure 13 explains the group equilibrium. DD is initial demand curve for the group and CC is cost

curve. Initial equilibrium is at point A. Here all the firms in group are getting super normal profit

i.e. PP1EA. As all firms in the group are getting super normal profit, new firms will enter into the

group and demand curve will fall down to D1D1. Now equilibrium will be at point E. Here all firms

will get normal profit. So in group all firms will get normal profit.

Figure 13: Group Equilibrium

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10. SUMMARY

Monopolistic competition is a market situation in which there are large number of buyers and

sellers selling heterogeneous products. These products are close substitutes. Average and marginal

revenue are downward sloping and more elastic. Cost curves follow traditional theory. Firm’s

equilibrium is at the point where marginal revenue (MR) and marginal costs (MC) is equal and

marginal cost curve cut marginal revenue from below. In short run a firm may get super normal

profit, normal profit or minimum losses. In long run each firm gets normal profit. If there are super

normal profit new firms will join the group and price will fall. If there are losses in long run firms

will leave the group. In long run under monopolistic competition each firm produce less than social

optimum level of output which is known as excess capacity. A firm can also differentiate its

product to increase its profit.