Monopolistic CompetitionAyyappan13-501-005

Definition and history

The model of monopolistic competition describes a common

market structure in which firms have many competitors, but each one sells

a slightly different product.

Monopolistic competition as a market structure was first identified in the

1930s by American economist Edward Chamberlin, and English economist

Joan Robinson

In the case of restaurants, each one offers something different and

possesses an element of uniqueness, but all are essentially competing for

the same customers.

Characteristics

• Many sellers and buyers

• Product differentiation

• Free entry and exit

• In Short Run

• In Long Run

• Advertisement and propaganda is a major feature

• Brand names

Many sellers and buyers

• The number of firms in monopolistic competition is fairly large. Each firm

produces or sells a close substitute for the product of other firms in the

product group or industry. Product differentiation is thus the hallmark of

monopolistic competition.

Product differentiation

• The firms sell differentiated products. Product differentiation may be real

or imaginary. Real differentiation is done through differences in the

materials used, design, colour etc. Imaginary differences may be created

through advertisement, brand name, trade marks etc

There are three important forms of product differentiation:

Differentiation by style or type

Differentiation by location – dry cleaner near home vs. cheaper dry cleaner

far away

Differentiation by quality – ordinary vs. gourmet chocolate or branded

Comparing perfect and monopolistic competition

Comparing Perfect & Monop. Competition yesnone, price-takerfirm has market power?

downward-sloping

horizontalD curve facing firm

differentiatedidenticalthe products firms sell

zerozerolong-run econ. profits

yesyesfree entry/exit

manymanynumber of sellers

Monopolistic competition

Perfect competition

Comparing Monopoly and Monopolistic competition

yesyesfirm has market power?

downward-sloping

downward-sloping

(market demand)D curve facing firm

manynoneclose substitutes

zeropositivelong-run econ. profits

yesnofree entry/exit

manyonenumber of sellers

Monopolistic competition

Monopoly

Aspects

Monopolistic competition has two types of competition aspects viz.

• Price competition i.e. firms compete with each other on the basis of price.

• Non price competition i.e. firms compete on the basis of brand, product

quality advertisement.

 

Price determination

• Under monopolistic condition different firms produces different varieties

of product ,there for different prices for their own productwill be

determined in the market depending up on their respective demand and

cost condition.

• under monopolistic competition the producer must take optimal

adjustment not only in the price charged and as regard as quantity of output

sold but also in the design of the product and the way in which he

promotes the sales

The Firm’s Short-Run Output and Price Decision

A firm that has decided the quality of its product and its

marketing program produces the profit-maximizing

quantity at which its marginal revenue equals its marginal

cost (MR = MC).

Price is set at the highest price the firm can charge for the

profit-maximizing quantity.

The price is determined from the demand curve for the

firm’s product.

• .

Price and Output in Monopolistic Competition

– The firm produces the quantity at which marginal revenue equals marginal cost

– and sells that quantity for the highest possible price.

– It makes an economic profit (as in this example) when P > ATC.

Price and Output in Monopolistic Competition

• Profit Maximizing Might be Loss Minimizing– A firm might incur

an economic loss in the short run.

– Here is an example.– In this case, P <

ATC.

Long Run: Zero Economic Profit In the long run, economic profit induces entry.

And entry continues as long as firms in the industry make an economic profit—as

long as (P > ATC).

In the long run, a firm in monopolistic competition maximizes its profit by producing

the quantity at which its marginal revenue equals its marginal cost, MR = MC.

As firms enter the industry, each existing firm loses some of its market share.

The demand for its product decreases and the demand curve for its product shifts

leftward.

The decrease in demand decreases the quantity at which MR = MC and lowers

the maximum price that the firm can charge to sell this quantity.

Price and quantity fall with firm entry until P = ATC and firms earn zero

economic profit.

Long run zero profit

• In the long run, equilibrium of a monopolistically competitive

industry, the zero-profit-equilibrium, firms just break even.

The typical firm’s demand curve is just tangent to its average

total cost curve at its profit-maximizing output.

Long run zero profit

MRMC

DMC

MC

ATC

Z

QMC

MC= ATC

MC

Point of tangency

Price, cost, marginal revenue

Quantity

Entry and Exit Shift Existing Firm’s Demand Curve and Marginal Revenue Curve

(a) Effects of Entry (b) Effects of Exit

Exit shifts the existing firm’s demand curve and its marginal revenue curve rightward.

MR2

MR2

MR1

MR1

D1 D

1D2

D2

Entry shifts the existing firm’s demand curve and its marginal revenue curve leftward.

Price, margina

l revenue

Price, margina

l revenue

Quantity Quantity

The Role of Advertising

In industries with product differentiation, firms advertise in order to

increase the demand for their products.

Advertising is not a waste of resources when it gives consumers useful

information about products.

Either consumers are irrational, or expensive advertising communicates

that the firm's products are of high quality.

Advertisement for Pepsodent