Monopolistic Competition: A clear economic analysis with 7 figures

Learning Objectives

• Monopolistic Competition: Meaning and Features
• Price and output determination under monopolistic competition
• Short run analysis of Equilibrium
• Long Run analysis of Equilibrium

Monopolistic Competition

Meaning

Monopolistic competition or monopolistic market is the market structure characterized by a large number of buyers and sellers with a large number of differentiated products and a provision of free entry and exit from the marketplace. The concept of monopolistic competition put forth by Chamberlin is more realistic than either perfect competition or pure monopoly.

"The Product Differentiation" is the distinguishing feature that makes the monopolistic competition a blend of perfect competition and monopoly. In the monopolistic competition, products are not identical as in perfect competition, but neither are they remote substitute as in monopoly.

Therefore, Monopolistic competition lies in the mid-way between the perfect competition and the monopoly.[1]

The major features of monopolistic competition

• A large number of firms

The most important feature of monopolistic competition is the presence of a large number of firms each satisfying a small share of the market demand for the product. Due to the existence of a large number of firms, there is cut-throat competition among the firms. The monopolistic competition is marked with a large number of small sellers or firms as opposed to the oligopoly, where a few large firms dominate the market.

• Product differentiation

The second feature of monopolistic competition is the presence of a large number of firms producing a differentiated product, but they are a close substitute for each other. The substitutability of goods, the monopolistic competition is marked with stiff competition. Therefore, the price variation among the product is very insignificant, but not identical as of perfect competition.

• Free entry and exit

This is another feature of monopolistic competition. In a monopolistically competitive industry, it is easy for new firms to enter and the existing firms to leave the market. When the existing firms are enjoying the supernormal profit, other firms outside the industry gets attracted, as a result, the new firms enter the industry which leads to the expansion of the output. Consequently, the price of the product tends to fall in the long run. Similarly, in the period of recession, when the existing firms are suffering from frequent losses, the existing firms unable to cover the variable cost quits the marketplace.

• The downward sloping demand curve

The demand curve in the perfectly competitive market is horizontal means that firm has no control over the price, while the demand curve of monopoly is downward sloped which signifies that the monopoly firm has control over either price or quantity, but not both. The monopolistic competition lies in the midway of the perfect competition and monopoly. The demand curve of monopolistic competition is downward sloping, but not steep as of monopoly. Thus, it signifies that monopolistically competitive firms have very weak control over either price or quantity, but not both.

• Non – price competition

Monopolistic firms operate in a highly competitive market. Despite the presence of the differentiated product, no firms exert excessive market power to control either pricing decision or production decision. Monopolistic firms do not entertain to compete in terms of price as it erodes their profit. If one of the monopolistic firms increases the price of its product, then the customer switches to substitute products.

On other hands, if the monopolistic firms decrease the price of its product, then other competing firms also cut the price down. In both situations, the monopolistic firm is in a loss. Thus, the monopolistic firms compete in terms of non – price factors such as the advertisement, after – sales services, discounts, membership schemes, and so on. Therefore, monopolistic firms bear a significant amount of selling cost.

Hence, the monopolistic competition is the blend of perfect competition and monopoly. Free entry and exit and a large of firms are the features of perfect competition, while product differentiation and downward sloping demand curve are the features of monopoly.

Price and Output Determination under Monopolistic Competition

Following the marginal approach, the profit of the monopolistic firm is maximum when its marginal revenue equals its marginal cost. The demand curve of the monopolistic firm is downward sloping, as a result, the marginal revenue curve is also negatively sloped. The MR curve is twice steeper than the demand curve. The marginal cost curve is ‘U’ shaped. The monopolistic firm’s equilibrium is achieved at the point of intersection between the rising marginal cost curve cuts the falling MR curve.

Symbolically,

Necessary Condition: MR = MC

Sufficient Condition: Slope of MC > Slope of MR

The falling MR intersects with the rising MC at point 'Q'. Thus, the equilibrium point for the monopolistic firm is Q with equilibrium output 'OM' and equilibrium price 'OP'.

Short run analysis of Equilibrium

A monopolistic firm operating in profit

If the average cost curve lies below the average revenue curve at the equilibrium price and quantity, then the monopolistic firm is enjoying the profit.

In the figure, the monopolistic firm is experiencing a profit; at equilibrium price and quantity, the average revenue (AR) is greater than the short-run average cost (SAC), so the shaded area in the figure signifies the short-run profit.

A monopolist firm operating in loss

If the average cost curve lies above the average revenue curve at the equilibrium price and quantity, then the monopolistic firm is suffering loss.

In the figure, the monopolistic firm is experiencing a loss; at equilibrium price and quantity, the average revenue (AC) is less than the short-run average cost (SAC), so the shaded area in the figure signifies the short-run loss.

Long Run Analysis of Equilibrium

In the long run, the monopolistic firm experiences a normal profit. It signifies that the short-run average cost curve is just tangent to the average revenue (AR) curve. New firms are attracted to the industry when the existing firms are experiencing supernormal profit, which eventually lowers the profit, and the existing firms quit when they are unable to cover the variable cost. The monopolistic firms experience a normal profit in the long run due to such a tendency of entry and exit of the firms.

The figure clearly illustrates the long run profit position of the monopolistic firm. At the equilibrium price and quantity, the AR curve and the LAC curve are tangent to each other, which is denoted by point 'T' in the figure. Hence, the monopolistic firms are enjoying the normal profit.

Excess Capacity and Monopolistic Exploitation

The monopolistic firms operate in less than full capacity. This tendency of monopolistic firms signifies its market power and the power to raise price above the marginal cost. The price in monopolistic competition is not equal to MC as in perfect competition, but the difference between Price and MC is not as high as in monopoly. Thus, there exists some degree of monopolistic exploitation which is clearly explained in the figure below.

In the figure, QR is the excess capacity or idle capacity because the firm can produce up to point 'L' when MC and LAC intersect with each other. The prevalence of excess capacity pushes the price up from P_E to P. The gap between P_E and P is the monopolistic exploitation.

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More Online Resources

Monopolistic Competition | Wikipedia

Monopolistic Competition | Business Economics

References

[1] Ahuja. H.L. (1970). Advance Economic Theory: Microeconomic Analysis (p. 782). New Delhi: S. Chand & Company Ltd.

Suggested Readings:

 Ahuja. H.L. (1970). Advance Economic Theory: Microeconomic Analysis. New Delhi: S. Chand & Company Ltd. 

Kutosoyiannis, A. (1979). Modern Microeconomics. Houndsmill: Macmillan Press Ltd.