Business Economics BUSINESS ECONOMICS. PAPER No. : 1, MICROECONOMIC ANALYSIS MODULE No. : 23, MONOPOLISTIC COMPETITION

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1 Subject Business Economics Paper No and Title Module No and Title Module Tag 1, Microeconomic Analysis 23, Monopolistic Competition BSE_P1_M23

2 TABLE OF CONTENTS 1. Learning Outcomes 2. Introduction 3.Features of Monopolistic Competition 3.1 Product Differentiation 3.2 The Concept of the Industry and Product Group 3.3Free Entry and Exit 3.4 Number of Buyers and Sellers 3.5 Non-Price Competition 3.6 Independent Behaviour 4. Equilibrium of Monopolistic Competition 4.1 Assumption in Analyzing Firm Behaviour 4.2 Individual Equilibrium 4.3 Group Equilibrium 4.4 Equilibrium of Monopolistic Competition with Chamberlin s Approach 4.5 Excess Capacity under Monopolistic Competition 5. Summary

3 1. Learning Outcomes This module will help you to understand market structure of monopolistic competition; price and output determination under monopolistic competition; equilibrium of its market structure; and excess capacity creation under monopolistic competition. 2. Introduction Perfect Competition and Monopoly are the two extreme cases of market structure. In practice, one hardly observesany suchsituation,which fit into such kinds of market structure. The assumptions in perfect competition and monopoly are not exactly happening in the real world. There are always some deviations from the assumptions. For example, the assumption of homogenous products in perfect competition does not resemblethe products available in real word. Economists like Chamberlin and Joan Robinson contributed a lot to the economic literature by trying to reconcile the two extremes so that they can fit into the real word. Their individual contributions to the economic literaturebrought a new market structure which is known as Monopolistic Competition. Therefore, monopolistic competition is a blending of both monopoly and perfect competition, which we can observe from the industries with similar market structures viz. shoes, restaurants, soft drinks, and clothing industries. In all these industries, products are homogenous but they are slightly differentiated. They are close but not perfect substitute for the buyers. For example, the soft drinks like Pepsi and Coke are homogenous but slightly differentiated products with respect to brand name, packing design etc. Thus, monopolistic competition is a form of market structure in which a large number of firms are supplying homogenous but slightly differentiated product. The products of the competing firms are close but not perfect substitutes because for buyers they are not identical as they are slightly differentiated. This is a kind of market structure, where there iscompetition among a large number of monopolists and therefore is known to economists as monopolistic competition. 3. Features of Monopolistic Competition 3.1 Product Differentiation The products produced by different firms are not homogenous, they are heterogeneous. However, the products of the same firm are close substitutes to each other. In order to make the product unique, producers make their products different from others consciously. Firms adoptdifferent ways todifferentiate the products. For example soft drinks like Pepsi, Coke, and ThumpsUp etc. In these cases the firms simply change the chemical composition, appearance, brand name,advertising, packing material etc. to make new and differentiated products in order to attract

4 the buyers. Thus in monopolistic completion firms produce homogenous but slightly differentiated products. This differentiation among competing products can be attributed to real or imaginary differences in quality. Sometimes advertisement has the impact of drawing the attention of the buyers to imagine or believe that the advertisedproduct has better qualities. 3.2 The Concept of the Industry and Product Group Industry is defined as a collection of firms producinga homogeneous product in case of perfect competition.in case of differentiated product, we cannot define an industry by this definition. So we will call the firmsproducing close substitutes as product groups. Also, there is a problem in defining a product group. Because the degree ofsubstitutability is a relative concept so we cannot preciselydefine a product group. According to Chamberlin, product groups should includeproducts, which are closely related and which are close technological and economic substitutes. The demand for each single product is highly elastic.when the prices of other products in the group change the demand for this product shifts.according to Chamberlin, products forming the group should have high price and crosselasticities. 3.3Free Entry and Exit There is freedom of entry and exit from the product group. Being attracted by the supernormal profit earned by some firms,newfirms will enter into the product group. Similarly, if existing firms are makinglosses, firms will quit group. 3.4 Number of Buyers and Sellers There are a large number of buyers and sellers in a market of monopolistic competition. 3.5 Non-Price Competition Non-price competition is observed in monopolistic competition. In order to increase the demand for their products firms engage themselves in non-price competition through advertisement, by giving free gifts etc. 3.6 Independent Behaviour Firms in monopolistic competition behave independently. Because of large number of buyers and sellers, the economic impact of one firm s decision does not affect any other firm in the group. This indicates that there is no rivalry among firms in the group. 4. Equilibrium of Monopolistic Competition 4.1 Assumption in Analyzing Firm Behaviour In monopolistic competition the group demand curve of theproducts which are close substitutes to each other is negatively sloped. It is assumed that all the firms in the group are identical, facing similar demand andcost conditions. Thus, if all the firms charge the same price, then they will have identical marketshares. We thenmake the following two heroic assumptions Demand Curves

5 We assume that the demand curves of all firms are symmetrical, which implies that market share of every firm isthe same and equal to a constant proportion of total market demand Cost Curves Also we assume that both average and marginal cost curves are symmetrical for each firm in monopolistic competition. 4.2 Individual Equilibrium The position and elasticity of demand curve for the product of firms under monopolistic competition depend upon the availability of the competing substitutes and their prices. For the sake of simplicity in analysis, conditions regarding the availability of substitute products produced by the rival firms and prices charged for them are held constant while the equilibrium adjustment of an individual firm is considered in isolation. Since close substitutes of the product of the firm are available in the market, the demand for the product of an individual firm working under monopolistic competition is fairly elastic. Fig. 4.1 Individual Equilibrium Under Monopolistic Competition with Super Normal Profit The individual equilibrium under monopolistic competition in short run is graphically shown in Fig.4.1. DD is the demand curve for the product of an individual firm, the nature and prices of all substitutes being given. This demand curve DD is also the average revenue curve of the firm. AC represents the average cost curve of the firm, while MC is the marginal cost curve corresponding to it. Given these demand and cost conditions, a firm will adjust its price and output at the level which gives it maximum total profits. A firm in order to maximize profits will equate marginal

6 cost with marginal revenue. In Fig. 4.1 at the equilibrium point E, price is determined as MQ=OPand quantity of output produced is OM. Thus, the area RSQP indicates the amount of supernormal profits made by the firm. In the short run, the firm, in equilibrium, may make losses too if the demand conditions for its product are not so favourable relative to cost conditions. Fig.4.2 depicts the case of a firm the firm making losses equal to the area GTKH. Fig.4.2 Individual Equilibrium Under Monopolistic Competition with Losses Thus a firm, in equilibrium, under monopolistic competition,may be making supernormal profits or losses depending upon the position of the demand curve relative to the position of the average cost curve in short run. Further, a firm may be making only normal profits even in the short run if the demand curve happens to be tangent to the average cost curve. 4.3 Group Equilibrium Each firm within a group has monopoly of its own particular product. However, its market is interwoven with those of his competitors who produce closely related products. The price and output decisions of a firm will affect his rival firms who may in turn react to the price and output policies. This interdependence of the various producers upon one another is prominent feature of monopolistic competition. The qualitative differences among the products lead to the large variations in cost and demand curves of the various firms. The demand curves of the products of various firms differ in respect of elasticity as well as position. Similarly, cost curves of the

7 various firms differ in respect of shape and position. As a result of these heterogeneous conditions surrounding each firm, there will be differences in prices, in outputs and profits of the various firms in the group. Chamberlin in monopolistic competition make that under the heroic assumption both demand and cost curves for all the products are uniform throughout the group. Further, to facilitate exposition of this theory, Chamberlin introduces a further assumption which has been called symmetry assumption by Prof. Stigler. It is that the number of firms being large under monopolistic competition, an individual s actions regarding prices and output adjustment will have a negligible effect upon his numerous competitors so that they will not think of retaliation for readjusting their prices and outputs. The demand and cost curves of each of the firms in the group are DD and AC as depicted in Fig.4.1. Each firm will set price OP at which marginal cost is equal to marginal revenue and hence profits are maximum. Although all firms are making supernormal profits, there is no reason for anyone to cut down price below OP.These supernormal profits will however attract new firms in the field. New entrants are free to produce closely related products which are very similar to the products of existing firms. Thus, under monopolistic competition there can be freedom of entry only in the sense of freedom to produce close substitutes. When the new firms attracted by the supernormal profits enjoyed by the existing firms enter into the field, the market would be shared between more firms and as a result the demand curve for the product of each firm will shift downward i.e., to the left. This process of entry of new firms and the resultant shift in the demand curve to the left will continue until the average revenue curve becomes tangent to the average cost curve and the abnormal profits are completely wiped out. This is shown in Fig.4.3 where average revenue curve is tangent to average cost curve at point T. Fig.4.3 Group Equilibrium Under Monopolistic Competition in Long Run Marginal cost and marginal revenue curves will intersect each other, exactly vertically below T. Therefore, the firm is in long-run equilibrium but setting price LT or OK and producing OL

8 quantity of his product. Because average revenue is equal to average cost, the firm will be making only normal profits. Since all firms are alike in respect of demand and cost curves, the average revenue curves of all will be tangent to their average cost curves and all firms will therefore be earning only normal profits. 4.4 Equilibrium of Monopolistic Competition with Chamberlin s Approach Chamberlin s alternative approach makes use of two types of demand curves- perceived demand curve and proportional demand curve. The demand curve facing an individual firm, as perceived by it describes the demand for the product of one firm on the assumption that all other firms in the industry or group keep the prices of their products constant. The number of firms being large in a product group under monopolistic competition, it is assumed that each firm is so small relative to the whole group that it thinks that the price change by it will have a negligible impact upon its competitive firms, with the result that they would not think of reacting to the change in price by it in retaliation. On the other hand,the proportional demand curve facing an individual firm shows the demand of the product when the prices of all firms of the product group change simultaneously in the same direction and by the same amount so that they charge same or uniform price. So, the proportional demand curve of a firm will be less elastic than its perceived demand curve, since equal change in price by all firms of the industry simultaneously will prevent the movement of customers from one seller to another. The proportional demand curve of each firm slopes downward and is a fractional part of the total market demand curve. The greater the number of firms in a product group, the smaller the share of an individual firm at a given price. Therefore, the proportional demand curve facing an individual firm shifts to the left as more and more firms enter to the product group or industry. The proportional demand curve DD and the perceived demand curve dd are shown graphically in Fig.32.4.

9 Fig.4.4 Perceived and Proportional Demand Curves An individual firm perceives that its demand is elastic and it can increase it profits by cutting down its price. Therefore, we construct the perceived demand curve dd passing through point A as being more elastic than the proportional demand curve DD. However, since each firm in the product group will think independently that its price reduction will have a negligible effect upon each of his rivals and therefore assumes that others would keep their prices constant, the actual movement would not be along the perceived demand curve dd but along the proportional demand curve DD.Therefore, DD shows the actual sales by each firm when the prices of all change equally and identically Short-Run Equilibriumof Monopolistic Competition in Chamberlin s Approach The firm is initially at point A on the proportional demand curve DD in Fig.4.5. Firm s perceived demand curve d 0d 0 has been drawn through point A. Each firm s share of demand for its product is equal to OM 0 and all of them are charging uniform price OP 0. With Firm s initial position at A on the proportionate demand curve DD, it perceives that it can increase its profits by cutting down price below OP 0 thinking that other firms would not react. It is observed from the Fig. 4.5 that if the firm cuts down price to OP 1, it can maximize its profits by producing OM 1 output which is demanded at price OP 1 provided others do not react to it. The perceived marginal revenue curve MR 0 corresponding to the perceived demand curve d 0d 0intersects the marginal cost curve, MC at the OM 1 level of output. Thus, given the perceived demand curve d 0d 0 passing through point A on the proportional demand curve, the profit maximizing-output is equal to OM 1, which implies that the firm will have advantage to lower its price from OP 0 to OP 1 so as to raise quantity demanded of its product to OM 1 Level. Each firm in monopolistically competitive

10 industry will perceive independently that if they lower their price below the prevailing one, they can attract customers from others thinking that others would not react. Fig.4.5 Price Cutting with Perceived Demand Curve But as a matter of fact since all firms would try to cut down their prices thinking others would not react, each firm will not be in equilibrium at point A. Instead, the firm will find themselves at point B on the proportional demand curve, getting a proportionate share of the increase in market demand at the lower price OP 1. Thus each firm will be working at point B on the proportional demand curve and producing OM 2output. Thus, as a result of price cutting the perceived demand curve of each firm will slide down the proportional demand curve to point B.With point B on the new perceived demand curve d 1d 1, the firm thinks that it can increase its profit if it lowers its price below OP 1 provided that others will not react. Because the new perceived marginal revenue curve MR 1 corresponding to the new perceived demand curve d 1d 1lies above the marginal cost curve MC in the relevant region. Though its earlier attempt to increase profits by lowering price was retaliated by others, each firm again believes that if it lowers the price and thereby bringing about increase in quantity demanded of its product, it can increase its profits. Though each firm perceives in the same way and cuts down its prices independently, itwould not succeed in snatching away customers from its rival firms. As a result, each firm instead of moving along to a point on the perceived demand curve for maximizing its profits will land itself on the proportional demand curve getting the same proportionate share from the increase in quantity demanded of the product at the lower price. In this way the process of price cutting competition and sliding down of perceived demand curve on the proportional demand curve would continue until a firm has reached a point where it cannot perceive to increase its profits by reducing its price.the firm in this situation will be maximizing its profits and will have therefore no advantage to lower the price of the product further.

11 Fig.4.6 Short-run Equilibrium of the Firm As a result of price competition the perceived demand curve has slided down to the point H on the proportional demand curve DD and accordingly price has fallen to OP 2 and each firm is producing and selling OM 3 output as seen in Fig. 4.6.Each firm will be in equilibrium at this price output combination and will have no incentive to change its price. Thus, according to Chamberlin s approach short-run equilibrium under monopolistic competition is reached and firm will be maximizing its profits when the following two conditions are satisfied: i) The price-output combination is such that perceived marginal revenue curve intersects the marginal cost curve so that MR=MC. ii) The price-output combination at which MR=MC is the point at which perceived demand curve dd intersects the proportional demand curve DD. Thus in the short run,firm s equilibrium occurs at the point on proportional demand curve and perceived demand curve at which marginal revenue is equal to marginal cost Long Run Equilibrium of the Firm and Group in Chamberlin s Approach Attracted by supernormal profits enjoyed by firms in short run,new firms will enter into the industry. As a result of the entry of new firms, the market demand curve for the good would be shared by more firms which would cause the proportionate demand curve to shift to left. Along with the shift of the proportionate market demand curve, the perceived demand curve will also shift to the left. The process of entry will continue until the perceived demand curve dd become tangent to the long- run average cost curve LAC as seen in Fig.4.6. Further, it is observed that due to the availability of more substitutes as a result of entry of more firms the perceived demand curve has become more elastic. The tangency of the perceived demand curve dd with the long-run

12 average cost curve LAC shows that the firms are making only normal profits. Hence there will be no tendency for new firms to enter into the group. Consequently, when perceived demand curve dd becomes tangent to the average cost curve LAC, the product group as a whole will be in equilibrium. Fig.4.6 Long-run Equilibrium of the Firm and Group When sufficient numbers of new firms have entered the group and price cutting has been made, the demand curve dd has fallen to the position of tangency with the long-run average cost curve LAC in Fig.4.6. The proportional demand curve DD will intersect the dd and LAC at the point of tangency. If too many firms have entered the group the perceived demand curve dd will fall to the position below that of the tangency and the firms will be making losses. As a result some firms will leave the group and DD along with dd curve will shift to the right. The following two conditions are necessary forgroup equilibrium. i) The perceived demand curve must be tangent to the LAC; and ii) The proportional demand curve facing individual firm must intersect both the perceived demand curve and LAC at the point of tangency. In the Chamberlin s approach, the two competitive forces- the entry of firms and the price cuttingbehaviourare observed to be operating simultaneously and these force the dd curve to shift and become tangent to the LAC curve. Then the DD curve cuts both of them at the point of tangency which brings group equilibrium in Chamberlin s approach. 4.5 Excess Capacity under Monopolistic Competition In the long-run equilibrium of monopolistic competition, the perceived demand curve is tangent to thelac curve. Both the perceived demand curve and the LRAC aredownward sloping at point of tangency. The firm sequilibrium unlike in perfect competitionwould never be at the minimum point of the LAC curve. Therefore,it is argued that the firm s output under monopolistic competition is not theoptimumoutput from welfare point of view and there exists excess capacity,

13 which is an under-utilization of resources of the society. The optimum output is associated with the minimum point of the LAC curve. The excess capacity is the difference between the optimaloutput and the actual output attained by the firm in the long-run as shown in Fig.4.6.In Fig. 4.6, ON is the optimal output as it corresponds to minimum point of LACcurve and OQ is the long-run equilibrium output in a monopolistic competition. Thus the excess capacity equal toon minus OQ, which is equal to QN.Therefore, according to Chamberlin, excess capacity is equal to QN which has arisen due to the free entry of the firms but absence of price competition. 5. Summary Both monopoly and perfect competition are extreme forms of market structure and are rarely seen in real world. Chamberlin blends these two market structuresand develops the concept of monopolistic competition.the conditions of short-run and long-run equilibrium under monopolistic competition differconsiderably from those of monopoly and perfect competition. In short-runthere is excess profit and in the long-run these disappear as new firms enterthe market. Under monopolistic competition firms do notoperate at optimal plant size. They work with excess capacity.