Prof. S.K. Garg Former Dean and Director, HPU, Shimla

Subject: Managerial Economics Paper: Managerial Economics Module 21: Monopolistic Competition Principal Investigator Co-Principal Investigator Paper Coordinator Content Writer Prof. S P Bansal Vice Chancellor Maharaja Agrasen University, Baddi Prof Yoginder Verma Pro Vice Chancellor Central University of Himachal Pradesh. Kangra. H.P. Prof. S.K. Garg Former Dean and Director, HPU, Shimla Mr. Suraj K.Walia Assistant Professor, Department of Economics R.K.S.D. (PG) College, Kaithal, Haryana 1

Items Subject Name Paper Name Module Title Module Id Pre- Requisites Objectives Keywords Description of Module Managerial Economics Managerial Economics Monopolistic Competition Basic knowledge of monopolistic competition To understand Price & Output determination in Monopolistic Competition Monopolistic competition, Group, Firm, Product Differentiation QUADRANT-I Module 1: Monopolistic Competition 1. Learning Outcome 2. Introduction and Definition of Monopolistic Competition 3. Assumptions / Features of Monopolistic Competition 4. Demand and Cost Curves under monopolistic Competition 5. Price and Output Determination/ Equilibrium under it 6. Concept of Excess Capacity 7. Selling Cost and Equilibrium Under it 8. Equilibrium with Product Differentiation 9. Group Equilibrium 10. Summary 1. Learning Outcome: After completing this module the students will be able to: Understand the Monopolistic Competition and its features. Understand the Demand and Cost curves under it. Know the Equilibrium of firm/price and Output determination under Monopolistic Competition. Know the concept of Excess Capacity. Understand the concept of Selling Cost and Equilibrium of firm with selling cost. Know about Product Differentiation and Equilibrium with it. Learn Group Equilibrium under Monopolistic Competition. 2

MONOPOLISTIC COMPETITION 2. INTRODUCTION The classical theory of price determination mainly includes pure competition and monopoly (i.e. No competition) up to 1920. Latter it was found that pure competition was not realistic as it was based on many unrealistic assumptions like homogeneous product. It was also not able to explain the realistic fact like price determination under selling cost and product discrimination. E.H. Chamberlin in his works The Theory of Monopolistic Competition and Joan Robinson in his work The Economics of Imperfect Competition in 1933 independently explains the model of monopolistic competition models. Though their works are different from each other but they arrive at the same conclusion/solution of market and firm equilibrium. Joan Robinson got the idea of falling demand curve from Sraffa s article The laws of Returns under Competitive Condition. In between pure competition and pure monopoly there is imperfect competition. In pure competition an individual seller compete with perfect substitutes of his own product while in pure monopoly a single seller doesn t face any competition from any substitute product. There are three important forms of imperfect competition. Forms of Imperfect Competition Monopolistic Competition (Large Number of Sellers) Duopoly (Only two sellers) Oligopoly (Few Sellers) MONOPOLISTIC COMPETITION Monopolistic competition is a market structure in which there are large numbers of sellers of a commodity selling heterogeneous or differentiated product which are close substitutes. We can see many examples from real world like tooth paste, soaps, and cold drinks etc. DEFINITION According to Left witch, Monopolistic competition is a market situation in which there are many sellers of a particular product, but the product of each seller is in some way differentiated in the minds of consumers from the product of every other seller 3

According to J.S. Bains Monopolistic competition is market structure where there are a large number of small sellers selling differentiated but close substitute products 3. ASSUMPTIONS/FEATURES OF MONOPOLISTIC COMPETITION Monopolistic competition is intermediate situation of pure competition and pure monopoly. Its main assumptions are as follows: i. A Large Number of Firms and Buyers: The first and important feature of monopolistic competition is that in it there are large number of small firms or sellers and buyers also. Each firm covers a small portion of market demand. As these firms sell differentiated products which are close substitutes so competition is very tough. ii. Heterogeneous Products: As there are large numbers of small firms which are producing not same but similar products. These products are close substitutes of each other. Due to this reason there prices cannot be very much different from each other. iii. Partial control over Price: Under monopolistic competition a firm faces the downward demand curve which implies if a firm increases price, some customers will leave it or if it reduces the price some new customers will buy the product. So a firm has partial control over price under this competition. iv. Freedom of Entry and Exit: Chamberlin has used the term Group instead of industry for firms producing close substitutes goods. Under monopolistic competition competitive firms are free to join or leave the group at any time. There is no restriction on these firms. v. Non Price Competition: Non price competition is that competition in which firms take measure to increase their supply other than reducing the price. Firm spend lot of amount on advertisement, promotion offers, provide free service etc. to increase the sale of the product. vi. Selling Cost: this is the cost which a firm incurred to increase the sale of the product. It is wider that advertisement cost. It also increases the cost of sales man in it. In monopolistic competition each firm spent a lot of amount on sale as there are close substitutes available in the market. vii. Imperfect Knowledge: as there are differentiated product in the market which are close substitutes, sellers as well as buyers don t have full knowledge about the price and quality of the all the products available in the market. 4. DEMAND AND COST CURVES UNDER MONOPOLISTIC COMPETITION To know the price and output determination under monopolistic competition we must have an idea about the demand and cost curves under it. 4

a) Demand Curve: As stated earlier that under monopolistic competition a firm has partial control over prices of its product. By reducing its price it can increase the demand and by increasing the price it can reduce the demand. Figure 1: Demand Curve under Monopolistic Competition It is clear that demand curve is downward slopping under monopolistic competition as shown in figure 1. At OP price quantity demanded is OQ as price rises to OP1 quantity demanded reduces to OQ1. As price falls to OP2, quantity demanded rises to OQ2. Demand curve facing a firm will be its AR curve. It also will negatively sloping and corresponding to it MR will be below to it. b) Cost Curves: Under monopolistic competition cost curves are as traditional theory of cost. AC, MC, AVC, LAC, LMC are all U shaped. 5. PRICE & OUTPUT DETERMINATION IN MONOPOLISTIC COMPETITION/ EQUILIBIRIUM UNDER MONOPOLISTIC COMPETITION Equilibrium under monopolistic competition involves equilibrium of firm and equilibrium of group. Equilibrium of an individual firm under monopolistic competition involves equilibrium in three respects: A. Equilibrium regarding Price and output B. Equilibrium under Product Differentiation C. Equilibrium with Selling Cost. (A) EQUILIBRIUM REGARDING PRICE AND OUTPUT Under monopolistic competition AR is downward sloping indicating a firm can sell more by reducing output and MR is below it. A firm will be in equilibrium position when following two conditions are satisfied: i. Marginal revenue is equal to marginal cost (MR=MC) ii. Marginal cost curve cut marginal revenue from below (MC Cut MR from below) 5

Figure 2: Equilibrium of Firm Figure 2 shows the conditions of equilibrium. Both conditions are fulfilled at point E, so a profit maximising firm under monopolistic competition will produce OQ quantity of output and charge AQ price. We can discuss the equilibrium of a firm in short-run as well as in long-run. SHORT RUN EQUILIBRIUM OF FIRM Short run is the time period in which there are fixed as well as variable factors of production. Monopolistic firm can increase its output by increasing variable factor only up to existing production capacity. short-run time period is too short that no new firm can enter and no existing firm can leave the market so a firm can face three situations in short-run: Three Situations in Short Run Under Monopolistic Competition Super Normal Profit AR > AC Normal Profit AR=AC Minimum Losses AC > AR; AVC > AR (a) Super Normal Profit: A firm may get super normal profit in short period of a time. Super normal profit is a situation when average revenue (AR) is greater than average cost (AC) at the equilibrium output. AR > AC Figure 3: Super Normal Profit Figure 3 shows the super normal profit. Equilibrium is at point e. Firm will produce OQ level of output and OP price will be charged. Here average cost is BQ and average revenue is AQ. Per unit super normal profit is AB. Total super normal profit are PABP1. 6

(b) Normal Profit: A firm may earn normal profit under monopolistic competition. It is the situation when average revenue (AR) is equal to average cost (AC) at the equilibrium level of output. AR = AC Figure 4: Normal Profit Figure 4 shows the normal profit. Firm s equilibrium is at point E. Firm is producing OQ level of output and charging OP level of price. Here average revenue and average costs are equal i.e. AQ. So form is getting normal profit. (c) Minimum Losses: A firm may incur minimum losses in short-run. It is a situation when average cost (AC) is greater than average revenue (AR) but a firm covers its average variable cost. AC > AR AVC AR Figure 5: Minimum Losses Figure 5 shows the minimum losses. Equilibrium of firm is at point E. Firm is producing OQ level of output and OP1 price will be charged. Here average cost is AQ and average revenue is BQ. Average cost is greater than average revenue. Firm is incurring losses PP1BA. But here firm is covering average variable cost i.e. BQ. So these losses are minimum losses. LONG RUN EQUILIBRIUM OF FIRM Long run is the time period when all the factors of production are variable. The firm can change the size of the plant and machinery. New firms can enter into the market or existing can leave the market. A firm will produce that level of output where long rum marginal cost is equal to marginal revenue curve. A firm will earn normal profit in long run under monopolistic competition because 7

If there is super normal profit, new firms will enter into the group so it will increase the supply into the market and price will fall. Again there will be normal profit. In the long run to increase the demand a firm will reduce the price of the product following it other firms will also reduce the price, resulting normal profit to all the firms in the group. If there are losses to the firm in the short run it will try to recover it in long run but still it incur losses in the long run it will exit the group. So in monopolistic competition each firm earns normal profit in the long run. AR = LAC Figure 6: Normal Profit in Long Run Figure 6 is depicting long run equilibrium of firm. Here equilibrium is at point E. Firm is producing OQ level of output and will charge OP price. Here firm is getting normal profit as average revenue is equal to average cost i.e. AQ. If there is super normal profit, new firms will enter in the market or if firms are incurring losses then they will leave the group. So in long run each firm will get normal profit. 6. EXCESS CAPACITY It is the situation when a firm is not producing at the socially optimum level of output. The Excess capacity is possible only in long run. Chamberlin and Joan Robinson both have revealed that under monopolistic competition a firm producing at the downward portion of long run average cost curve not at the minimum point of it which is socially optimum level of output. There are mainly three reasons of existence of excess capacity i.e. i. A downward sloping demand curve is the main reason. As downward sloping average revenue curve can be tangent to U shaped long run Average cost only at the falling portion ii. Entry of a very large number of firms due to which these firms share market demand curve so that each firm produces a smaller output that optimum capacity. Excess capacity is beneficial in some respect because it increases consumer s welfare by providing variety in products. 8

Figure7: Excess Capacity Figure 7 shows the long run equilibrium and excess capacity of firm under monopolistic competition. Here firm is in equilibrium at point E. Firm is producing OQ level of output and charging OP level of price. Socially optimum point of production is pint E1 on long run average cost curve, which is minimum point of average cost. A firm should produce upto this point but under monopolistic competition it is producing less then this point which is known as excess capacity. QQ1 is excess capacity which a firm not producing. 7. SELLING COST To increase the sale of the product or to increase the profits a firm may indulge in two type of competition (a) Price Competition: it involves reducing price to increase sale and (b) Non Price Competition: It involves increase the sale by other than price cutting. It includes changing the quality of the product, advertisement, providing free services with the product and free gift with product. Selling cost is one of the parts of non price competition. This is different from advertisement expenditure. Advertisement expenditure includes cost incurred only on getting the product advertised in newspaper and magazines etc. selling cost includes the salaries and wages of salesman, allowance to retailers for displaying their product and other promotional activities. a. Average Selling Cost Curve: It is believed that selling cost is subject to varying returns. In beginning increasing returns to selling cost implying more return that expenditure incurred. After a point diminishing returns, implying less return that selling cost incurred. So average selling cost (ASC) is U shaped as shown in figure 8. Figure8: Average Selling Cost 9

b. Effect of Selling Cost on Demand The sole objective of selling cost is to increase demand. An equal increment in advertisement expenditure brings first increasing returns, then diminishing returns. It means as selling cost is incurred in equal amount initially the demand increases more and latter increases less. It is shown in figure 9. Initially as selling cost in incurred demand increases DD to D1D1 then D2D2 with increasing returns and then D3D3 which indicated diminishing returns. Figure 9: Effect of Selling Cost on Demand c. Effect of Selling Cost on Cost Due to selling cost, average production cost curve shifts upward which is shown in figure 10. It shows if selling cost is incurred on proportional basis the average production cost curve CC increases upward in same ratio i.e. C1C1. Average Cost= Average Production Cost+ Average Selling Cost Figure 10: Effect of Selling Cost on Production Cost d. Equilibrium of Firm with Selling Cost Equilibrium of firm with selling cost has been shown in figure 11. AR and MR are initial average and marginal revenue curves. APC and MC are initial average production cost and marginal cost curves. Initial equilibrium is at point E. Firm is producing OQ level of output and charging OP price. Here firm is getting normal profits. To increase profit firm incure selling cost. Due to it 10

demand curve shirt upwards so new average and marginal revenue curve are AR1 and MR1. Cost curves also shift upwards. Now AC and MC1 are average and marginal cost curves. New equilibrium is at point E1. Firm will produce OQ1 level of output and charge OP1 price. Now firm is getting super normal profit P1P2CB. A firm will incur that level of selling cost which maximise its profit. Figure 11: Equilibrium with Selling Cost 8. EQUILIBRIUM WITH PRODUCT DIFFERENTIATION Saraffa introduces the downward sloping demand curve as well as the concept of product differentiation. But Chamberlin explains the concept of product differentiation on the basis of price and output determination. Product differentiation means that goods are close substitutes. They can be different in colour, packing, size, quality and packing etc. there are many examples in real worlds like tooth pastes, soaps and cold drinks etc. Here we have used Prof. Chamberlin approach to show how a firm will take decision regarding production. We assume price of the product to be constant. There is only one variety which gives highest profit to the firm. Here we have taken three varieties A, B and C of a good. Average costs of these are AA, BB, and CC respectively Figure 12: Equlibrium with Product Deifferentiation 11

Firm is charging OP price for these three varieties. For A variety firm is selling OQ level of output and getting PDD1D2 super normal profit. For B variety firm is selling OQ1 level of output and getting PSS1S2 super normal profit. For C variety firm is producing OQ2 level of output and getting PEE1E2 super normal profit. As variety C is giving highest profit so firm will produce more quantity of C variety. 9. GROUP EQUILIBRIUM UNDER MONOPOLISTIC COMPETITION Prof. Chamberlin used the term Group for the firms producing close substitutes goods under monopolistic competition. For example there is group of different firms producing cold drink like Coca Cola, Marinda, and Pepsi etc. Group equilibrium refers to the adjustment of price and output of a number of producers whose goods are close substitutes. To discuss group equilibrium, we consider two assumptions: a. Uniformity Assumption: according to which demand and supply curve of firms under group are same. b. Symmetry Assumption: There is large number of firms so that no individual firm can influence the decision regarding the price and output of other firms. Figure 13: Group Equilibrium Figure 13 explains the group equilibrium. DD is initial demand curve for the group and CC is cost curve. Initial equilibrium is at point A. Here all the firms in group are getting super normal profit i.e. PP1EA. As all firms in the group are getting super normal profit, new firms will enter into the group and demand curve will fall down to D1D1. Now equilibrium will be at point E. Here all firms will get normal profit. So in group all firms will get normal profit. 12

10. SUMMARY Monopolistic competition is a market situation in which there are large number of buyers and sellers selling heterogeneous products. These products are close substitutes. Average and marginal revenue are downward sloping and more elastic. Cost curves follow traditional theory. Firm s equilibrium is at the point where marginal revenue (MR) and marginal costs (MC) is equal and marginal cost curve cut marginal revenue from below. In short run a firm may get super normal profit, normal profit or minimum losses. In long run each firm gets normal profit. If there are super normal profit new firms will join the group and price will fall. If there are losses in long run firms will leave the group. In long run under monopolistic competition each firm produce less than social optimum level of output which is known as excess capacity. A firm can also differentiate its product to increase its profit. 13