Topic One: Monopolistic Competitive Market Structure

1.1. Review of market structures

Definition of Market: “Economists understand by the term Market, not any particular market
place in which things are bought and sold, but the whole of any region in which buyers and
sellers are in such free intercourse with one another that the prices of the same goods tend to
equality easily and quickly” (A. Cournot).

Thus, the essentials of a market are: (a) a commodity which is dealt with; (b) the existence of
buyers and sellers; (c) a place, be it a certain region, a country or the entire world; and (d) such
intercourse between buyers and sellers that only one price should prevail for the same
commodity at the same time.
Market Structures: Market structure is best defined as the organizational and other
characteristics of a market. It refers to the size and design of the market. It relates to those
organizational characteristics of a market which influence the nature of competition and pricing
and affect the conduct of the business firms. Market structure commonly called as market is the
whole set of conditions under which a commodity is marketed.

o Perfect Competition: An ideal market characterized by a large number of sellers (buyers,

too), such that none is able to influence the price.
 Monopolistic Competition: A market characterized by a large number of sellers, each
with a small degree of control over the price.
 Oligopoly: A market characterized by a small number of sellers, each with significant control
over the price.
 Monopoly: A market characterized by a single seller that is able to dominate the supply side
of the market.
Three additional, and less well-known, market structures result from different degrees of
competition on the demand-side of the market.
 Monopsony: A market characterized by a single buyer that is able to dominate the demand-
side of the market.
Duopoly:

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1.2. Introduction and basic features of monopolistic competitive market
The markets situation in which there is many firms who are selling closely related (substitute)
but differentiated products then this form of market is called monopolistic competitive market.
Here product differentiation means that a consumer can distinguish the product of one producer
from that of the other producer. In monopolistic competitive market, some features/
characteristics of both- perfect competition and monopoly are found.

It is the most prevalent market organization in the manufacturing sector. In most of the
manufacturing industries, firms sell differentiated products. In other words, products are neither
homogeneous nor perfect substitutes but are differentiated and close substitutes. For example-
cars, television sets, refrigerators, cigarettes, soaps, tooth pastes, etc.
The Characteristics of Monopolistic Competition:

There are many sellers and many consumers in a given market. The implication of this
characteristic is that no firm can influence the market based on size alone. Means do not take into
account rivals’ reactions-many sellers & many buyers

Differentiated Products: Under monopolistic competition, each firm produces goods that are
slightly differentiated. Yet they are close substitutes. Because of this heterogeneity or product
differentiation firms under monopolistic competition cannot be called an industry. Rather, they
form a product group. This is because their products are somewhat dissimilar and not
homogenous as is the case under competitive industry.

There is free entry and exit in the group

When one monopolistically competitive firm is quite profitable, we may expect that other firms
will enter and set up businesses producing similar products, and established firms may change
the characteristics of the products they produce, to make those products more similar to the
successful one. If firms lose money and make negative economic profits, then some firms will
drop out of the industry one by one.

Non price competition such as product differentiation, competing on perceived quality,

advertising, and giving service and distribution outlets.

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Firms in monopolistic competition must use product differentiation & non-price competition to
sell their products.
1.3. 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 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.

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
on how similar the firm’s products are. If large number of firms produces identical or

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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 competitor’s 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 P 1 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.

Price

P2

P1

Demand

Q2 Q1 Quantity Demand

Figure1.1: Demand curve of monopolistically competitive firm

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. Thus, the demand curve will shift if:

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a) the style, services associated with the product like service delivery, or the selling strategy of
the firm changes;
b) competitors change their price, output, services or selling policies and
c) tastes, incomes, prices or selling policies of products from other industries change.
1.4. The concept of product group and industry
An industry is defined as a group of firms producing homogenous products. But in this market
structure, there are firms producing different products. Each firm is an industry by itself. This
made the market demand curve in existent to Chamberlain's model. To solve this problem, he
categorized the very close products under the same group. The group of products under the same
division is called product group. Products in the same group are expected to be technological and
economic substitutes. Technological substitutes are products which can technically cover the
same want. Example, all vehicles are technological substitutes in the sense that they provide
transport. Economic substitutes are products which cover the same want and have similar prices.
An operational definition of the “product group” is that the demand of each single product be
highly elastic and that it shifts appreciably when the price of the other products in the group
changes. In other words, products forming the group or industry should have high price and cross
elasticity. Therefore, for Chamberlain, an industry is defined as a group of firms producing
products in the same group or product group.

 Cost in a monopolistically competitive market

At this point it is important to remember the shape and relationships between the different types
of costs that we discussed in perfect competition. Do you remember how they behave? Good.
This is important because costs in a monopolistically competitive market are assumed to behave
just like the case in a perfectly competitive market. The average variable cost, marginal costs and
average total cost curves are all U-shaped. This implies that there is only a single level of output
which can be optimally produced.

The only difference in monopolistic competition as long as costs are concerned is the inclusion
of selling costs. A firm in a perfectly competitive industry will not advertise at all as it can sell
all it wants to sell without cutting its price. In a monopolistic competition, however, product
differentiation provides the rationale for the selling expenses to be incurred by the firm: with
advertising and other selling activities the firm seeks to accentuate the difference between its

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product and the product of other firms in the group. In general advertising will shift the demand
and will make it less elastic by strengthening the preferences of the consumers for the advertised
product, and thereby developing some form of brand loyalty.

It is also argued that the selling costs curve is U-shaped; that is, there are economies and
diseconomies of advertising as output changes. Initially, expansion of output will not require an
equi-proportional increase in selling costs, and this leads to a fall in the average selling
expenditure. However, beyond a certain level of output, the firm will have to spend more per unit
in order to attract customers from other firms: as output expands the firm has to attract customers
which are well used to the product of other firms. The U-shaped selling cost, added to the U-
shaped production cost, yields a U-shaped average total cost curve.

1.5. Short- Run Equilibrium in Monopolistic Competition:

A perfectly competitive firm is a price-taker. It can choose the level of output only. This means
that quantity of output is the only choice variable for a perfect competitor. On the other hand, a
pure monopolist can choose either the price it charges or the quantity of output it produces, but
cannot simultaneously choose both. What about a monopolistically competitive firm? The
choice-related variables for a monopolistically competitive firm are: (i) price (or quantity), (ii)
product variation, and (iii) selling expenses.
In this section, we examine how a monopolistically competitive firm determines its best level of
output and price in the short run and long run on the assumption that the firm has already decided
on the characteristics of the product to produce and on the selling expenses to incur. Once the
firm has decided on product variation and selling expenses, it can choose only the price it
charges (which also implies the level of output chosen). Note that the choice of price
automatically determines the optimal level of output and thus we do not treat price and quantity
as two distinct variables of choice.

As for a firm under any type of market structure, the best level of output for a monopolistically
competitive firm is determined by the equality of marginal revenue and marginal cost (i.e., MR =
MC). In the short run, the firm maximizes its profit at a point where MR = MC provided that
price is at least as high as the average variable cost, (as long as i.e., P≥AVC ). There are three
possible situations (profit levels) for a monopolistically competitive firm in a short run

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equilibrium: production at positive profit, production at normal (zero) profit, and production at
loss.

The monopolistically competitive firm maximizes profit or minimizes loss in the short run. It
produces a quantity Q at which MR = MC and charges a price P based on its demand curve.

◦ When P > ATC, the firm earns abnormal profit.

◦ When P = ATC, the firm earns an economic/normal profit.
◦ When P < ATC, the firm incurs a loss.

Efficiency requires that the marginal benefit (price) of the consumer equal the marginal cost of
the producer. In monopolistic competition, price exceeds marginal cost, which is an indicator of
inefficiency. Inefficiency arises from product differentiation. So, the inefficiency brings a gain
for consumers by offering greater product variety.

A monopolistically competitive firm prices in the same manner as a monopolist—where MC =

MR. But the monopolistic competitor is not only a monopolist but a competitor as well.

The demand curve of a monopolistically competitive firm is highly, but not perfectly, elastic.
The price elasticity of demand for a monopolistic competitor depends on the number of rivals
and the degree of product differentiation. The larger the number of rival firms and the weaker the
product differentiation leads the greater the price elasticity of each firm’s demand.

Zero economic profit

The demand curve:

 tangent to ATC curve

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  at quantity where MR = MC
 P =ATC

• Exercise
Given P=30-5Q and ATC=20/Q+4Q-6, answer the above questions A to C. Having this
information
A. Determine the optimal level of output and price in the short run.
B. Calculate the economic profit (loss) the firm will obtain (incur).
C. Show the economic profit (loss) of the firm. Note that the total shaded area must be
equal to the profit (loss) obtained in B above

1.6. The long run equilibrium

1. If firms are making losses in short run, they incentive to exit the market, decrease number
of products, increases demand faced by each firm, demand curve shifts right and each
firm’s loss – declines until: zero economic profit.
2. If 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 and each
firm’s profit – declines until: zero economic profit.

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  At equilibrium, ATC equals price and economic profits are zero. This occurs at the point of
tangency of the ATC and demand curve at the output chosen by the firm.
Chamberlin developed three distinct model of long run equilibrium.
1. Equilibrium with new firm entering the industry
2. Equilibrium with price competition
3. Equilibrium with price competition and free entry of new firms

 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 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 P 1 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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As shown in figure, firms found in the product group reach short run equilibrium at price level p 1
and they do not have any incentive to change its price from p 1. 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 cause 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 dd tangent to long run average cost curve (LAC) at point E. At point E, a firm
charges p2 and produce 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.

Equilibrium with Price Competition

Unlike the previous model, here it is assumed that the number of firms in the industry is
compatible with long run equilibrium. i.e, the number of firms is just optimal. Therefore, no
entry or exit will take place. But the going price in the short run is assumed to be higher than the
equilibrium one. That means firms are not maximizing their short run profits and to achieve they
will try to adjust their prices, and this in turn will spur price competition.

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The analysis of this case is done by the introduction of a second demand curve, labeled DD’ in
Figure 1.7 which shows the actual sales of the firm at each price after accounting for the
adjustment of the prices of other firms in the group. DD’ is also called the actual sales curve or
share-of-the-market curve, since it incorporates the effects of actions of competitors to the price
changes by the firm. The DD’ curve shows the full effect upon the sales of the firm which
results from any change in the price it charges.

DD’ is the locus of points of shifting dd’ curves as competitors, acting simultaneously, change
their price. The change in the price does not take place as a deliberate reaction to other firms’
reductions, but as an independent action aiming at the profit maximization of each firm acting
independently of the others. The DD’ curve shows a constant share of the market and it has the
same elasticity as the market demand at any one price.

The DD’ curve is steeper than dd’ curve because the actual sales from reduction in price are
smaller than expected on the basis of dd’ as all firms reduce their price and expand their own
sales simultaneously. A movement along DD’ represents changes in the actual sales of existing
firms as all of them adjust their price simultaneously and identically with their share remaining
constant. A shift in the DD’ is caused by entry of new firms or exit of the existing firms from the
product group and shows a decline or increase in the share of the firm.

Assume the firm is at non equilibrium position defined in the Figure 1.7, by Po and quantity Xo.
The firm, in an attempt to maximize profits, lowers the price at P 1 expecting to sell, on the basis

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of its individual demand curve, quantity X’o. This level of sales is not actually realized because
all other firms, faced by the same demand and cost conditions, have the incentive to act in the
same way (reduce price) simultaneously. Each of the firms attempts to maximize its own profit,
ignoring the reactions of competitors, on the assumption that the effect on the demand of other
firms in the group is negligible. Thus, all firms, acting independently, reduce their price
simultaneously to P1. As a result, dd’ (the expected sales) curve shifts downwards (d 1d’1) and
firm A instead of selling the expected amount X’ 0 sells actually a smaller amount X 1 on the
shifted demand curve d1d’1 and along the market share (actual sales) curve DD’.

One stronger assumption about a firm in this situation is that it is unable to anticipate similar
shifts in the future if it decided to reduce its price. That is, the firm is myopic or short sighted not
to learn from its past mistakes and take d 1d’1, as if it will not shift. It continues to behave on the
assumption that its new demand (d1d’1) will not shift further because the effect of its own
decisions on other sellers’ demand would be negligible. Thus, it lowers its price again to reach
equilibrium but rather than the expected sales X ’0, the firm achieves actual sales X2, because all
firms act identically, though independently.

The process steps when the demand curve shifts and gets tangent to the LAC curve. The long run
equilibrium is determined by the tangency of dd’ and the LAC curve (point e on Figure 1.7). Any
further reduction in price will not be attempted since the average cost would not be covered.

Long Run Equilibrium through Price Competition and Free Entry

These two models have very restrictive assumption; the first model believes that all firms are
operating at their profit maximizing level while the second assumes that the number of firms in
the product is just optimal. But in practice it is difficult for either one or both of these
assumptions not to hold always. In reality, long run equilibrium is achieved both by price
adjustments of the existing firms and by new entry.

Price adjustments are shown along the dd’ curve while entry (exit) cause shifts in the DD’ curve.
Equilibrium is stable if the dd’ curve is tangent to the AC curve and expected sales are equal to
actual sales , that is, if the DD’ curve cuts the dd’ curve at the point of its tangency to the AC
curve. Using Figure 1.8, let us see how this process takes place.

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It is assumed that profits at point e 1 are assumed abnormal. Hence, new firms are attracted until
DD shifts to DD’. One might think that long run equilibrium takes place at e 2 (with price P and
output X) since only normal profits are earned. However, this is not the case because each
entrepreneur thinks that dd is his/her demand curve and believes that if he/she reduces his/her
price their sales would expand along dd and profits would increase. However, each firm has the
same incentive and all firms reduce their price. As price is reduced by all firms, dd slides down
D’D’ and every firm realizes a loss instead of positive abnormal profits. For example, at position
d’d’ the firm has reduced its price to P’ but, as all firms act similarly, X 1 is produced with a total
loss equal to the shaded area ABP’C. However, the firm acts on ‘the myopia curve’ d’d’ and so
long as this lies above the LAC it believes that it can obtain the profits by cutting its price. The
loss increases still further since dd slides further down along D’’.

This process would not stop even when dd becomes tangent to the LAC. This would be so if the
firms could produce X*. However, there are many firms in the industry and the share of the firm
is only X2. The firm still on the ‘myopia assumption’ believes that it can reach X* if it reduces
price to P*. However, all firms do the same and d*d* falls below the LAC with ever increasing
loss. The financially weakest firms will leave the industry first, and allow the surviving firms to
have larger share. D’D’ moves to the right along with dd. Exit will continue until dd becomes
tangent to the AC curve and DD cuts dd at the point of tangency, E. Equilibrium is then stable at
point E with normal profits earned by all firms no entry or exit taking place. The equilibrium
price, P*, is unique and each firm has a share equal to OX*.

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  Non-price Competition

The firm attempts to establish its product as a different product from that offered by its rivals.
Differentiation means that in the consumer’s mind, the product is not the same. Firms may
differentiate products by perceived quality, reliability, color, style, safety features, packaging,
purchase terms, warranties and guarantees, location, availability (hours of operation) or any other
features.
Advertising and Monopolistic Competition

Perfectly competitive firms have no incentive to advertise, but monopolistic competitors do. The
goals of advertising are to increase demand and make demand more inelastic. Advertisements
costs are made to persuade consumers to buy a particular good rather than another. Advertising
increases ATC. The increase in cost of a monopolistically competitive product is the cost of
“differentness”. Differentiation exists so long as advertising convinces buyers that it exists.
Firms will continue to advertise as long as the marginal benefits of advertising exceed its
marginal costs. The goals of advertising include shifting the demand curve to the right and
making it more inelastic. Advertising shifts the ATC curve up.
Brand names may signal information regarding the product, reducing consumer risk. It is
valuable to a firm; it makes the demand less elastic and can enable the firm to earn higher profits.
Once a consumer has had a positive experience with a good, the price elasticity of demand for
that good typically decreases—the consumer becomes loyal to the product.
 Excess Capacity and welfare loss under Monopolistic Competition
Excess capacity is the difference between the ideal output (output associated with the minimum
level of long run average cost curve) and the output actually attained. Long run equilibrium is the
tangency point of the demand curve to long run average cost curve and at this point marginal
cost is equal marginal revenue and price equals to average cost, but price is greater than marginal
cost, while in perfect market long run equilibrium is where price is equal to marginal cost,
average cost, and marginal revenue. As a result, P will be higher and output will be lower in
monopolistic competition as compared to pure competition but profit is normal. In monopolistic
competition there are too many firms each producing an output less than optimal that is at a cost
higher than the minimum where tangency of average cost and demand curves occurs at the
falling part of long run average cost curve. Firms in this market incur selling costs. In

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monopolistic competition market there are too many firms each working with excess capacity. In
long-run, a monopolistic competitor will operate with excess capacity
The gap is the social cost of producing and offering consumers differentiated products. Excess
capacity is a misallocation of resources in the long run. Because firms don’t employ enough of
the economic resources to reach the minimum average cost.

As compared to perfect competition, in monopolistic competition, there is a loss of welfare that

is not being appropriated either by consumers or producers which is called dead weight loss.
This is shown in the area B and C in Figure below. Pmc and Ppc are prices in monopolistic and
competitive market structures respectively, while Qmc and Qpc are equilibrium quantities in
monopolistic and competitive markets respectively. The change (reduction) in consumers’
surplus as a result of monopolistic competition is equal to area A + B. Reduction from
producers’ surplus is C while increase in producer’s surplus is A.
Therefore, B + C would be deadweight loss. Moreover, prices are higher and output lower in
monopolistic competition as compared to perfect competition.

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