Chapter Three

Monopolistic Competitive Market Structure

3.1 Definition and Characteristics

This market model can be defined as the market organization in which there are relatively many
firms selling differentiated products. It is the blend of competition and monopoly. 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. His monopoly is limited because the difference between his product
and others are small enough that they are close substitutes for one another.

This market is characterized by:

1. Differentiated product: the product produced and supplied by many sellers in the market is
similar but not identical in the eyes of the buyers. There is a variety of the same product. The
difference could be in style, brand name, in quality, or others. Hence, the differentiation of the
product could be real (eg. quality) or fancied (e.g. difference in packing).

2. Many sellers and buyers: there are many sellers and buyers of the product, but their number
is not as large as that of the perfectly competitive market.

3. Easy entry and exit: like the PCM, there is no barrier on new firms that are willing and able
to produce and supply the product in the market. On the other hand, if any firm believes that it is
not worth to stay in the business, it may exit.

4. Existence of non-price competition: Economic rivals take the form of non-price competition
in terms of product quality, advertisement, brand name, service to customers, etc. A firm spends
money in advertisement to reach the consumers about the relatively unique character of its
product and thereby get new buyers and develop brand loyalty. Many retail trade activities such
as clothing, shoes, soap, etc are in this type of market structure.

5. Firms have price inelastic demand; they are price makers because the good is highly
differentiated

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  Each firm in the industry (or Product group) produces differentiated product that are
close substitute.

3.2 Product differentiation and the demand curve

Chamberlin develops his theory of monopolistic competition based on some empirical facts.
There are very few monopolists because there are very few commodities for which close
substitutes do not exist. Similarly, very few commodities are entirely homogeneous to make
perfect competition assumption realistic. For instances there are no homogenous automobiles,
soaps, suits, television sets, grocery stores, magazines and others. They are differentiated. In
most cases, each producer tries to differentiate his product to make it unique and reduces the
number of its close substitutes. 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.

There are two types of product differentiation: real and imaginary /fancied (spurious)
product differentiation. Product differentiation is said to be real, if the products found in the
same product group differ in terms of their inheritance characteristics. They may be different in
the type of input used to produce the product; specification and location of the firm in terms of
convince to be accessed by the consumer. For example, shampoos with conditioner and without
conditioner are differentiated in their content. Grocery stores found near to the house of customer
and far from the house of a customer are differentiated in terms of their location.

Imaginary/Fancied (spurious) product differentiation is a case where the products are the same
but the producers that its product differs from other close substitutes convince consumers. Such
differentiation occurs through advertisement, difference in packing, design, brand name and
other sales promotion activities. Whatever the type, product differentiation determines the nature
of demand curve facing a give firm.

The demand curve facing a firm will depend on output decisions and prices charged by other
firms that produce similar product. That is the slope of demand curve facing the firm will depend

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on how similar the firm’s products are. If large number of firms produces identical or
homogenous products, then the demand curve facing the firms is flat. Each firm must sell its
product at market price. Any firm that tries to raise its price above market price would loss all of
its customers. On the other hand, if a firm has exclusive right to sell a particular product, it may
raise its price without losing all of its customers.

Firm can gain certain monopoly power through product differentiation by making a given
product unique to the mind of the consumer. This will create brand loyalty of consumer for a
product and given some discretion power for the firms to set the price of their product different
from their competitor price. As a result the demand facing individual firm becomes down
ward sloping. The firm did not loss its entire customer through price rise even though some of
them switch to its competitors product. However given the competitive element of
monopolistically competitive product group (large number of firm and easy entry), small rise in
price results in large fall in quantity demanded. For instance if price increases from P1 to P2 in
figure1.1, quantity demanded decreases from Q1 to Q2. Because increase in price leads the firm
to lose some of its customers.

Figure 3 .1: Demand curve of monopolistically competitive firm

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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. 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.
3.3 THE CONCEPT OF PRODUCT GROUP AND INDUSTRY
It is defined in perfect competition that an industry is a group of firms producing a homogenous
product. However, when products are differentiated like in the case of monopolistic competition,
one cannot define an industry in this narrow sense. There is no automobile, soap or furniture
industry. Each firm in the automobile, soap or furniture industry produces its own distinct
product. This implies product differentiation create difficulties in defining the boundaries of an
industry. Heterogeneous group cannot add together to from an industry and to their market
demand and supply schedule.

To overcome this problem, Chamberlin introduces the concept of product group. It is formed by
lumping together firm’s producing similar products, which are close substitutes. They are group
of product with higher price and cross elasticity’s of demand. The consumer preference for each
product shifts to other product in the group when its price increases. For instance, we can form a
product group by putting together different model of automobiles. Automobiles are differentiated
product. They are close substitute (used for the same purpose) and their price and cross
elasticities of each automobile model are high. If the prices of one model increase consumers
shift their preference to other model.

How does chamberlain’s theory work with the idea of product group? During the determination
of equilibrium market price and output, industry demand and supply should be considered. This
can be possible by summation of individual demand and supply which need common price. With
product differentiation however, we cannot derive industry demand and supply curve as we did
for perfect competitive market. We do not have a single equilibrium price for differentiated
product, but a cluster of prices.

For this reason, in order to analyze his model of monopolistic competition, Chamberlin made
assumption about demand and cost of firms in the product group. That is every firm in the
product group faces the same demand curve with identical cost even though it is not the case in
real situation. Such assumption enables us to get unique equilibrium price and to treat firms and
market demand on the same graph. However, if firms supply different product to market then

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why should their demand and costs are identical? This is one point up on which Chamberlin
model of monopolistic competition was criticized.

Because each firm produces a somewhat different product under monopolistic competition, we
cannot define the industry, which refers to the producers of identical product. To overcome this
difficulty, Chamberlin redefined industry as a "product-group"- a group of firms/producers
producing similar (or closely related) products. Here, for simplicity we will continue to use the
term "industry" (to refer to all the sellers of the slightly differentiated products in a product
group). A product group is a group of firms selling product that are good but not
necessarily perfect substitutes .And of course a product group is not unique, since it depends
on how good we require the substitutes to be ,so there will be broader and narrower product
groups . Coke and Pepsi are both members of the product group of cola drinks, while Coke and
sprite are member of the broader product group carbonated soft drinks. Therefore, industry under
monopolistically competitive market structure refers to a group of firms that produce similar
products which are close but not perfect substitute and which have the same demand and cost
curves .

3.4 EQULIBRIUM OF MONOPOLOSTICALLY COMPETITIVE FIRM IN

SHORT RUN
By now we have get familiar with the different component of profit of monopolistically
competitive firm, i.e. their cost and demand structure. Each firm’s product in the Chamberlin
world is somewhat different from the product of its rivals. This situation gives rise to downward
sloping demand curve for the firm. This implies a decrease in the price of individual product
results in increase in sales volume of the firm by attracting customers of other rivalry firms. On
the other hand, increase in price will result in decrease in the sales volume of the firm. This is
because some customers shift their preference to other product because of increase in price.
Such relationship between price and sells volume of firms can be indicated by individual demand
curve as a result individual demand curve also known as planned sale curve.

As in the case of monopoly, since the demand curve of monopolistically competitive firm is
negatively sloped, the corresponding marginal revenue sloped downward. This is indicated by
figure 3.2. Q1 and P1 represent short run equilibrium level of output and price respectively. . Both
are characterized by the intersection of marginal revenue (derived from effective demand curve)
and the firms marginal cost curve. Having achieved this point, the firm would have no incentive

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to change its price from p1. The equality of marginal revenue and marginal cost at output Q1
means that firm believes that it would maximize its profit by maintaining its price at p1. At the
indicated point monopolistically competitive firm earn a positive profit equals to the area of
shaded region.

Figure 3.2(a) Short run equilibrium under monopolistic competition.

However, the fact that firms are at equilibrium will not grant positive abnormal profit to the
firms. This is totally depending on a point at which marginal revenue equals to marginal cost. As
indicated in figure 3.2 (b) below, if the point of intersection MR=MC (marginal cost equals
marginal revenue) takes places where average cost equals to the demand curve, the firm earns
zero (normal) profit single their cost equal to their revenue at this point.

Figure 3.2(b) Short run equilibrium under monopolistic competition.

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If the point of intersection takes place, where demand curve is below the average cost curve, the
firm incurs a loss equal to the shaded region indicated by figure 1.3(c). This is because their total
cost greater than total revenue.

Therefore, for monopolistically competitive firm to earn positive abnormal profit at equilibrium
in the short run, the equality between MR and MC should take places when demand curve is
greater than short run average cost curve.

3.5 EQULIBRIUM OF MONOPOLOSTICALLY COMPETITIVE FIRM IN

LONG RUN
In the long run just like perfect competition, monopolistically competitive firm make change to
the scale of their plant to minimize cost of production. They also decides to leave industry if they
see the prospect to earning negative profit and enter in to the industry if there is a prospect of
earning positive profit. Such adjustment process leads to long run equilibrium level of output and
price, which is characterized by the tangency of long run average cost curve and demand curve.
It is also characterized by the equality of long run marginal cost and marginal revenue. At this
point total revenue equals to total cost resulting in zero economic profit. This will create
disincentive to enter the market. The adjustments to such point takes place through change in the
position of demand curve resulted from enter and exit of firms or price adjustment by the
existing firm or a combination of the two.

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In order to analyze how long run equilibrium level of output and price for a firm and an industry
on the same diagram, Chamberlin made two heroic assumptions. Firms have identical cost and
consumer preferences are evenly distributed among different product. That is even though
the products are differentiated; all firms assumed to have identical cost and demand curves.
Under these assumptions, it is possible to get a unique market equilibrium price. Given the above
assumption, Chamberlin developed three distinct model of long run equilibrium.
 Equilibrium with new firm entering the industry
 Equilibrium with price competition
 Equilibrium with price competition and free entry of new firms
A. Model 1 Equilibrium with new firms entering the product group
In this model, the existing firms are assumed to be in short run equilibrium realizing abnormal
profit, i.e., existing firm do not have any incentive to adjust their price . Therefore, how is long
run equilibrium run achieved? According to the equilibrium with new enter model, equilibrium
position can be attained through entry of new firms who are attracted by the short run positive
economic profit. The entry of new firms and exit of old firms can causes shift in demand curve
facing any single firm. That is increase in the number of firms through entry in the product group
shifts the individual demand curve of the firm inward to the left. This is because market demand
(Which is relatively fixed) divided among more firms. The market share of individual firms
decreases causing inward shift of individual demand curve of a firm. Therefore, entry and exit
push demand curve facing any single firm toward equilibrium position where it is tangent to long
run average cost curve.
As indicated in figure 3.4 below firm with long run average cost of LAC, long run marginal cost
of LMC and facing a demand curve dd1 , will set price at a point where marginal revenue equals
to marginal cost in the short run. At this point firms in the product group earn abnormal
profit of area ABCP1. Therefore, there is no incentive for these firms to change their price P1 and
output Q1. However, the abnormal profits obtained by existing firms attract other new firms to
enter in to the market in the long run.

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Figure 3.4: long run equilibrium with new entry of firms

As shown in figure 3.4, firms found in the product group reach short run equilibrium at price
level p1 and they do not have any incentive to change its price from p1. However, the abnormal
profit earned by existing firms attracts other new firms in to the market. When new firms enter
in to the market, the market share of individual firm decreases. This will causes inward shift in
individual demand curve. Assuming that cost curves will not shift as entry occurs, each shift in
demand curve result in establishment of new equilibrium at a point where new marginal revenue
intersect marginal cost curve. That is, as more and more new firms entry in to the product group,
there is continuous shift in the original demand curve, dd1 . Such adjustment process continues
until the shifted demand curve dd2 , tangent to long run average cost curve (LAC) at point E. At
point E, a firm charges p2 and produces Q2 level of output and earns zero economic profit. When
firms reach such tangency point, there is no further entry since further entry makes firms to earn
negative profit (loss). Thus, the long run equilibrium becomes stable when the shifted demand
curve is tangent to the long run average cost curve.

B. Model 2 Equilibrium with price competition

Equilibrium with price competition model assumes the number of firms in the industry is
compatible with long run equilibrium. Therefore, no entry or exit that will take place in the long
run. However, since short run equilibrium price is higher than long run equilibrium price, long
run equilibrium level of price attained through price competition among firms in the product
group.

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To conduct the analysis of how long run equilibrium achieved under the assumption of price
competition model, the second demand curve represented DD’ is introduced as shown in figure
3.5. It is a curve that shows the actual sale of a firm at each price level after adjustment of price
to capture more share of the market. This demand curve sometimes called actual sales or share of
the market curve since it indicate the share of each firm in the product group. When competitors
change their price, the market share of each firms changes and individual demand curve shifts
accordingly. Connecting points that show market share of a firm when price adjustment made by
competitor firm independently gives actual sales curve (market demand). A movement along

DD’ shows change in the actual sales of the existing firms as all of them adjusts their price
simultaneously and have similar market share as before the price adjustment made.

Figure 3.5: long run equilibrium with price competition

Given the assumption of the model, how long run equilibrium is achieved through price
competition? Let us began from short run equilibrium position like P3 and see how long run
equilibrium achieved through price adjustment of existing firm. As an attempt to maximize its
profit a given firm reduce its price to increases its market share. However, the attempt is not
realized, because all other firms having the same demand and cost condition have the incentive
to act in the same way simultaneously. Each firm attempt to maximize their profit, ignoring the
reaction of other competitor on the assumption that the effect of other firms on demand of its
product is not significant.

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Such action of firms shifts the individual demand curve inward resulting in small amount of sale
than expected amount on the shifted demand curve dd2 along the share curve. In the future if
firms learn from their post experience, they will not do the same since it reduce their profit.
However according to the model firms suffer from myopia and cannot learn form their
experiences. It continues to behave on the assumption that its new demand dd2 will not shift
further upon lowering their price. Thus the firm lower it price again in an attempt to get
maximum profit, still other firms also do the same thing. This will causes inward shift in demand
curve to dd3. The process will continue until the LAC tangent to the intersection point of the
shifted individual demand curve and actual sales curve at point E. This point represents long run
equilibrium of monopolistically competitive firm competing through price adjustment.

C. Model 3 Equilibrium though price competition and free entry

Is the assumption of equilibrium with price competition model and new entry of firms to reach
on long run equilibrium holds in real world? That means, is the number of firms in the product
group in the short run is optimal as in the second model and is equilibrium achieved through free
entry or exit only as in the first model. As Chamberlin suggests in actual life long run
equilibrium is achieved both through price adjustment of existing firms and by new entry. This is
the main assumption of the third model that we consider next.

As it is indicated Figure 3.6, price adjustment is made along the dd curve while entry (exit)
cause shifts in DD curve. Equilibrium of the firm is stable if DD curve tangent to LAC at the
intersection point between dd and DD curve (actual sales equals to planned sales). Let us see
how the long run equilibrium of tangency solution achieved through price adjustment, entry and
exit of firms. At short run equilibrium point, firms in the industry get abnormal economic profit.
New firms being attracted to such abnormal profit, enter in to the market. This will cause shift in
DD1 curve inward stepwise as more new firm’s entry take place until they start to earn normal
profit. At the same time, existing firms independently reduce their price on myopic assumption
to maximize their profit through increasing market share emanated from price reduction.
Reduction in price cause planned sales curve, dd shift inward along DD curve and assumed to
stop at a point where dd curve tangent to LAC curve. However, if they continue price reduction
below tangency point, each firm realizes a loss instead of positive or normal profit

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Figure 3.6: Equilibrium with price competition and free entry and exits

For example if firms reduce their price below P they start to incur a loss and financially weak
firms will eventually leave the industry first, so that surviving firms will have a large share. Exit
will continue until dd curve (planned sales curve) tangent to the average cost curve at the cutting
point of DD curve at point E as indicated in figure 3.6 . This point is the long run equilibrium of
monopolistically competitive firm obtained through price competition and entry of new firms
and exit of old firms.

3.6 Excess capacity and welfare loss in monopolist competition

As you remember from chapter one, firm in perfect competitive market structure operate at
a minimum point of long run average cost curve in the long run. That means, it used plants at
their full capacity and produced output at a minimum feasible cost. This implies resources
allocated efficiently by firm operating in perfect competition market structure
compared to firms in other market models. In addition, output production decision take place at a
point where P=LMC = min LAC in the long run. Thus, prices and output set at equilibrium
maximize the total consumers and producer surplus compared to other firms operating in
imperfect market structure. On this ground, we can use perfect competition firm decision as a
benchmark to analyze the efficiency and welfare implication of firms operate in other market
environment. Do firms in monopolistically competitive firm will tend to operate with excess
capacity? In other words, is monopolistically competitive firm expanding production in the long
run to a point at which its cost minimized?

To answer this question let us revisit Chamberlin’s long run equilibrium of monopolistically
competitive firm. Long run equilibrium of the firm under monopolistic competition attained at a
point where the perceived demand curve is tangent to LAC curve. Since the demand curve is
downward sloping, the LAC is also downward sloping at the point of tangency. Thus, unlike

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prefect competition, the firm’s equilibrium will not achieved at the minimum point of average
cost curve. Instead, the tangency between the LAC curve and demand curve take places at down
ward sloping portion of the LAC curve. That is, firms in monopolistic competition construct a
plant smaller than the minimum cost size and operate it at less than the minimum cost output.
Therefore monopolistically competitive firm in the long run produce output below their full
capacity (below the optimal point). Their cost of production is higher than that of pure
competition. This is because monopolistic competition firm incurs additional cost, which is
known as selling cost.

Figure 3.6 Excess capacity monopolistically competition firm

It is clear from figure 3.6, the short run cost curves of monopolistically competitive firm who
behave in Chamberlin way building smaller plant size than a minimum cost plant and operate at
point E. In addition, long run average cost curve is tangent to demand curve at point E before it
reach minimum point. Therefore, firm in monopolistic competition would not even be producing
at the minimum of it short run average cost, point E. This implies monopolistically competitive
firm working at suboptimal scales without exhaustively using the advantage of economies of
scale. They are operating with excess capacity defined as the difference between the long run
equilibrium level of output and the output level at a minimum point of LAC (equilibrium point of
perfect competitive firms). It is the difference between M and Q2

From social benefit point of View, Monopolistic competition decision did not maximize social
welfare since equilibrium price is higher than MC and output is below social desired level. If

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attempt is made to equalize price and marginal cost, the firm incurs a loss in the long run. This is
because long run marginal cost curve intersect DD2 (shifted actual sales curve) below long run
average cost curve. This implies the social desired point, P=MC cannot achieve with the
assumption of monopolistically competitive market structure.

However, Chamberlin argued that the crisis of excess capacity and misallocation of resource is
valid only if one assumes that demand curve of individual firm is horizontal. If demand curve is
down ward sloping and firms enter in to price competition while entry is free, then point M
cannot be considered as social optimal level of output. Consumer wants to have varieties of
products. Product differentiation and downward sloping demand curve reflect the desires of
consumer to pay higher price in order to have choice among differentiated products. If such
products produced at higher cost than minimum amount, it is socially acceptable rather than
considered as social cost. Therefore, the difference between M and Q2 would not be a measure of
excess capacity for Chamberlin. Rather it represents social cost of producing and offering
consumers a large diversity of products. For Chamberlin, excess capacity is the result of non-
price competition coupled with free entry. In this case firm ignores it dd curve (since on price
adjustment are made) and concern itself with its market share. In other words, actual sales curve

(DD) becomes the relevant demand curve of firms. Thus for Chamberlin excess capacity is the
difference between Q2 and Q1 indicated in figure 1. Recently, different types of research suggest
that the argument of excess capacity is somewhat myopic. Avinash dixit, Michael Spence,
Joseph stiglitz and other have suggested that product diversity offered to consumers by
monopolistically competitive firm support the idea of social benefit. Consumers have got more
chance to select form wide variety of products when products are differentiated (diversified) and
so the society benefit consumers have got more change to select from with variety of products
when products are differentiated (diversified) . The society benefit more than its cost and social
welfare is maximized.

Figure 3.7 Chamberlin excess capacities

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In general, compared to firm in a perfect competitive market, firm under monopolistic
competition probably produces less and set a higher price. The demand curve confronting the
monopolistic competitor would not be perfectly elastic as in perfect competitive firm. Its
marginal revenue therefore, is lower than price compared to the equality of marginal revenue
with price in perfect competitive market. On the other hand, monopolistically competitive firms
are likely to have lower profit greater output, and lower price compared to monopolistic firm.

3.7 Critiques of Chamberlin large group monopolistic competition market model

This model could be attacked on the following points;-

 The assumption of product differentiation is incompatible with the assumption of

independent action and free entry of firms. It assumes that the firm actions are
independent but firms are dependent on each other. There are also entry barrier for new
firms.
 It is difficult to accept the myopic behavior of business firm implied in the model.
Normally, business firms learn from their experience.
 The concept of industry is destroyed by recognition of product differentiation.
Heterogeneous products cannot be added together to form industries demand curve in
order to come up with a unique Equilibrium price.
 The model assumes a large number of firms with higher price elasticity of product sold in
monopolistic competitive market. However, the do not objectively defined the number of
firms and the level of elasticity required to have a monopolistic competitive market
structure.

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