Monopolistic Competition; Meaning, Features and Market equilibrium

 

Monopolistic Competition; Meaning, Features and Market equilibrium

Khemraj Subedi, Associate Professor

M.Phil (Economics)

Meaning

Monopolistic competition is a market structure that lies in between perfect competition and monopoly having features with large numbers of buyers and sellers; imperfect information; low entry, and exit barriers; similar but differentiated products. Therefore, monopolistic competition consists with features of both perfect competition and monopoly.  A monopolistic competition is more common than pure competition or pure monopoly.

The first theoretical analysis of monopolistic competition was simultaneously developed by two economists working independently of one another: The British economist Joan Robinson (who introduced the concept in her 1933 book Economics of Imperfect Competition) and the American economist Edward Hastings Chamberlin (whose ideas on the subject were published in his Theory of Monopolistic Competition, published that same year). While economists recognized that most businesses in the developed world functioned under conditions of monopolistic competition or oligopoly, the concepts were, because of their complexity, difficult to integrate into the framework of existing economic ideas, whereas theories based on perfect competition remained useful despite their limitations. It was not until the 1970s that mainstream economists commonly began addressing markets characterized by monopolistic competition.

 

Definition

According to Prof. Leftwich – “Monopolistic Competition (or imperfect competition) is that condition of industrial market in which a particular commodity of one seller creates an idea of difference from that of the other sellers in the minds of the consumers.”

Features of Monopolistic Competition

1.      Large number of sellers: In a market with monopolistic competition, there are a large number of sellers who have a small share of the market.

2.     Product: differentiation: In monopolistic competition, all brands try to create product differentiation to add an element of monopoly over the competing products. This ensures that the product offered by the brand does not have a perfect substitute. Therefore, the manufacturer can raise the price of the product without having to worry about losing all its customers to other brands. However, in such a market, while all brands are not perfect substitutes, they are close substitutes for each other. Hence, the seller might lose at least some customers to his competitors.

3.     Freedom of entry or exit: Like in perfect competition, firms can enter and exit the market freely.

4.     Non-price competition: In monopolistic competition, sellers compete on factors other than price. These factors include aggressive advertising, product development, better demand, after sale services, etc. Sellers don’t cut the price of their products but incur high costs for the promotion of their goods. If the firms indulge in price-wars, which is the possibility under perfect competition, some firms might get thrown out of the market.

5.     Trade mark and patent right; Monopolist use trademarks to ensure product differentiation. Likewise, they take exclusive right of using new technology invented by them in the name of patent.

6.     Downward sloping Demand curve: Monopolist tend to reduce price taking into consideration the elasticity of demand to increase profit.

Conditions for the Equilibrium of an individual firm under Monopolistic Competition

The conditions for price-output determination and equilibrium of an individual firm are as follows:

1.     MC = MR

2.     The MC curve cuts the MR curve from below.

In the following Fig. 1, we can see that the MC curve cuts the MR curve at point E. At this point,

·       Equilibrium price = OP and

·       Equilibrium output = OQ

Now, since the per unit cost is BQ, we have

·       Per unit super-normal profit (price-cost) = AB or PC.

·       Total super-normal profit = APCB

Price-output determination under Monopolistic Competition: Equilibrium of a firm

In monopolistic competition, since the product is differentiated between firms, each firm does not have a perfectly elastic demand for its products. In such a market, all firms determine the price of their own products. Therefore, it faces a downward sloping demand curve. Overall, we can say that the elasticity of demand increases as the differentiation between products decreases.

Fig. 1 above depicts a firm facing a downward sloping, but flat demand curve. It also has a U-shaped short-run cost curve.

The following figure depicts a firm earning losses in the short-run.

From Fig. 2, we can see that the per unit cost is higher than the price of the firm. Therefore,

·       AQ > OP (or BQ)

·       Loss per unit = AQ – BQ = AB

·       Total losses = ACPB

Long-run equilibrium

If firms in a monopolistic competition earn super-normal profits in the short-run, then new firms will have an incentive to enter the industry. As these firms enter, the profits per firm decrease as the total demand gets shared between a larger number of firms. This continues until all firms earn only normal profits. Therefore, in the long-run, firms, in such a market, earn only normal profits.

As we can see in Fig. 3 above, the average revenue (AR) curve touches the average cost (ATC) curve at point X. This corresponds to quantity Q₁ and price P₁. Now, at equilibrium (MC = MR), all super-normal profits are zero since the average revenue = average costs. Therefore, all firms earn zero super-normal profits or earn only normal profits.

It is important to note that in the long-run, a firm is in an equilibrium position having excess capacity. In simple words, it produces a lower quantity than its full capacity. From Fig. 3 above, we can see that the firm can increase its output from Q₁ to Q₂ and reduce average costs. However, it does not do so because it reduces the average revenue more than the average costs. Hence, we can conclude that in monopolistic competition, firms do not operate optimally. There always exists an excess capacity of production with each firm. In case of losses in the short-run, the firms making a loss will exit from the market. This continues until the remaining firms make normal profits only.

Efficiency of firms in monopolistic competition

·       Allocative inefficient. The above diagrams show a price set above marginal cost

• Productive inefficiency. The above diagram shows a firm not producing on the lowest point of AC curve
• Dynamic efficiency. This is possible as firms have profit to invest in research and development.
• X-efficiency. This is possible as the firm does face competitive pressures to cut cost and provide better products.

Limitations of the model of monopolistic competition

• Some firms will be better at brand differentiation and therefore, in the real world, they will be able to make supernormal profit.
• New firms will not be seen as a close substitute.
• There is considerable overlap with oligopoly – except the model of monopolistic competition assumes no barriers to entry. In the real world, there are likely to be at least some barriers to entry
• If a firm has strong brand loyalty and product differentiation – this itself becomes a barrier to entry. A new firm can’t easily capture the brand loyalty.
• Many industries, we may describe as monopolistically competitive are very profitable, so the assumption of normal profits is too simplistic.

Perfect Competition VS Monopolistic Competition VS Monopoly

A monopolistically competitive firm faces a demand for its goods that is between monopoly and perfect competition. Figure 8.4a offers a reminder that the demand curve as faced by a perfectly competitive firm is perfectly elastic or flat, because the perfectly competitive firm can sell any quantity it wishes at the prevailing market price. In contrast, the demand curve, as faced by a monopolist, is the market demand curve, since a monopolist is the only firm in the market, and hence is downward sloping.

 Above figure shows perceived Demand for Firms in Different Competitive Settings. The demand curve faced by a perfectly competitive firm is perfectly elastic, meaning it can sell all the output it wishes at the prevailing market price. The demand curve faced by a monopoly is the market demand. It can sell more output only by decreasing the price it charges. The demand curve faced by a monopolistically competitive firm falls in between.

The following table clarifies the difference amongst Perfect competition, Monopolistic competition and Monopoly.

	Market Power	Number of Firms	Efficient Market	Product Differentiation	Profits	Elasticity of Demand
Perfect Competition	None	Infinite	Yes	No	Normal profits	Perfect Elasticity
Monopolistic Competition	Low	Many	Not efficient	Mild levels	Super normal in short-term / normal in long-term	Highly elastic in long-run
Monopoly	High	One	Not efficient	Only across industries	super normal	Inelastic

Number of Firms

First of all, the number of firms is relatively low. As there is more than one firm, it does not classify as a monopoly, but significantly fewer than under perfect competition. This is due to the fact that in monopolistic competition, many firms slightly differentiate themselves from each other.

As a result, new entrants seek to add value in a slightly different way. In the end, this limits the number of firms that are willing and able to enter the market; but not significantly enough to deter the plethora of competitors.

Market Power

It is also important to highlight that in monopolistic competition, firms actually have very low market power. Whilst it sounds similar to monopoly; the ability of individual firms to set prices in the market is non-existent. None really have significant market share, so are unable to force the hand of competitors. So unlike a monopoly, firms in monopolistic competition cannot set prices; yet they have more power than under perfect competition.

Efficiency

Firms in both a monopoly and under monopolistic competition are inefficient; largely in contrast to perfect competition. To explain, firms in monopolistic competition are inefficient due to two main reasons: first of all, it operates with excess capacity; and second of all, it charges a price that is in excess of marginal cost.

Product Differentiation

Under monopolistic competition, firms slightly differentiate their products. For example, tea bags rely on quality and brand name to differentiate, yet under a perfectly competitive market, they would be exactly the same.

Profits

In a monopolistic market, profits can range from supernormal in the short-term, to ordinary in the long-term. By contrast, perfect competition is generally locked in equilibrium, only earning small amounts of profit. We then have a monopoly market, which, quite understandably, makes supernormal profits.

Elasticity of Demand

Demand in monopolistic competition can be highly elastic as there are a number of competitors. Switching costs are low, so consumers are easily able to switch to substitute goods. By contrast, perfect competition is perfectly elastic due to the infinite number of competitors. We then have monopolies which are purely inelastic. This is largely as a result of the lack of competition which leaves consumers with little choice but to pay the higher prices.

Summary and Conclusions

Monopolistic competition refers to a market where many firms sell differentiated products. Differentiated products can arise from characteristics of the good or service, location from which the product is sold, intangible aspects of the product, and perceptions of the product.

If the firms in a monopolistically competitive industry are earning economic profits, the industry will attract entry until profits are driven down to zero in the long run. If the firms in a monopolistically competitive industry are suffering economic losses, then the industry will see an exit of firms until economic profits are driven up to zero in the long run.

A monopolistically competitive firm is not efficient because it does not produce at the minimum of its average cost curve or produce where P = MC. Thus, a monopolistically competitive firm will tend to produce a lower quantity at a higher cost and charge a higher price than a perfectly competitive firm.

Monopolistically competitive industries do offer benefits to consumers in the form of greater variety and incentives for improved products and services. There is some controversy over whether a market-oriented economy generates too much variety.

 

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