Monopolistic competition normally exists when the market has many sellers selling differentiated products, for example, retail trade, whereas oligopoly is said to be a stable form of a market where a few sellers operate in the market and each firm has a certain amount of share of the market and the firms recognize their dependence on each other.
Edward Chamberlin, who developed the model of monopolistic competition, observed that in a market with large number of sellers, the products of individual firms are not at all homogeneous, for example, soaps used for personal wash. Each brand has a specific characteristic, be it packaging, fragrance, look etc., though the composition remains the same. This is the reason that each brand is sold individually in the market. This shows that each brand is highly differentiated in the minds of the consumers. The effectiveness of the particular brand may be attributed to continuous usage and heavy advertising.
As defined by Joe S.Bain ‘Monopolistic competition is found in the industry where there are a large number of sellers, selling differentiated but close substitute products’. Take the example of Liril and Cinthol. Both are soaps for personal care but the brands are different. Under monopolistic competition, the firm has some freedom to fix the price i.e. because of differentiation a firm will not lose all customers when it increases its price.
Monopolistic competition is said to be the combination of perfect competition as well as monopoly because it has the features of both perfect competition and monopoly. It is closer in spirit to a perfectly competitive market, but because of product differentiation, firms have some control over price. The characteristic features of monopolistic competition are as follows:
- A large number of sellers: Monopolistic market has a large number of sellers of a product but each seller acts independently and has no influence on others.
- A large number of buyers: Just like the sellers, the market has a large number of buyers of a product and each buyer acts independently.
- Sufficient Knowledge: The buyers have sufficient knowledge about the product to be purchased and have a number of options available to choose from. For example, we have a number of petrol pumps in the city. Now it depends on the buyer and the ease with which s/he will get the petrol decides the location of the petrol pump. Here accessibility is likely to be an important factor. Therefore, the buyer will go to the petrol pump where s/he feels comfortable and gets the petrol filled in the vehicle easily.
- Differentiated Products: The monopolistic market categorically offers differentiated products, though the difference in products is marginal, for example, toothpaste.
- Free Entry and Exit: In monopolistic competition, entry and exit are quite easy and the buyers and sellers are free to enter and exit the market at their own will.
Nature of the Demand Curve
The demand curve of the monopolistic competition has the following characteristics:
Less than perfectly elastic: In monopolistic competition, no single firm dominates the industry and due to product differentiation, the product of each firm seems to be a close substitute, though not a perfect substitute for the products of the competitors. Due to this, the firm in question has high elasticity of demand.
Demand curve slopes downward: In monopolistic competition, the demand curve facing the firm slopes downward due to the varied tastes and preferences of consumers attached to the products of specific sellers. This implies that the demand curve is not perfectly elastic.
PRICE AND OUTPUT DETERMINATION IN SHORT RUN
In monopolistic competition, every firm has a certain degree of monopoly power i.e. every firm can take initiative to set a price. Here, the products are similar but not identical, therefore there can never be a unique price but the prices will be in a group reflecting the consumers’ tastes and preferences for differentiated products. In this case the price of the product of the firm is determined by its cost function, demand, its objective and certain government regulations, if there are any. As the price of a particular product of a firm reduces, it attracts customers from its rival groups (as defined by Chamberlin). Say for example, if ‘Samsung’ TV reduces its price by a substantial amount or offers discount, then the customers from the rival group who have loyalty for, say ‘BPL’, tend to move to buy ‘Samsung’ TV sets.
As discussed earlier, the demand curve is highly elastic but not perfectly elastic and slopes downwards. The market has many firms selling similar products, therefore the firm’s output is quite small as compared to the total quantity sold in the market and so its price and output decisions go unnoticed. Therefore, every firm acts independently and for a given demand curve, marginal revenue curve and cost curves, the firm maximizes profit or minimizes loss when marginal revenue is equal to marginal cost. Producing an output of Q selling at price P maximizes the profits of the firm.
In the short run, a firm may or may not earn profits. Figure-1 shows the firm, which is earning economic profits. The equilibrium point for the firm is at price P and quantity Q and is denoted by point A. Here, the economic profit is given as area PAQR. The difference between this and the monopoly case is that here the barriers to entry are low or weak and therefore new firms will be attracted to enter. Fresh entry will continue to enter as long as there are profits. As soon as the super normal profit is competed away by new firms, equilibrium will be attained in the market and no new firms will be attracted in the market. This is the situation corresponding to the long run and is discussed below.
PRICE AND OUTPUT DETERMINATION IN LONG RUN
We have discussed the price and output determination in the short run. We now discuss price and output determination in the long run. You will notice that the long run equilibrium decision is similar to perfect competition. The core of the discussion under this head is that economic profits are eliminated in the long run, which is the only equilibrium consistent with the assumption of low barriers to entry. This occurs at an output where price is equal to the long run average cost. The difference between monopolistic competition and perfect competition is that in monopolistic competition the point of tangency is downward sloping and does not occur at minimum of the average cost curve and this is because the demand curve is downward sloping1.
Looking at figure-2, under monopolistic competition in the long run we see that LRAC is the long run average cost curve and LRMC the long run average marginal curve. Let us take a hypothetical example of a firm in a typical monopolistic situation where it is making substantial amount of economic profits. Here it is assumed that the other firms in the market are also making profits. This situation would then attract new firms in the market. The new firms may not sell the same products but will sell similar products. As a result, there will be an increase in the number of close substitutes available in the market and hence the demand curve would shift downwards since each existing firm would lose market share. The entry of new firms would continue as long as there are economic profits. The demand curve will continue to shift downwards till it becomes tangent to LRAC at a given price P1 and output at Q1 as shown in the figure. At this point of equilibrium, an increase or decrease in price would lead to losses. In this case the entry of new firms would stop, as there will not be any economic profits. Due to free entry, many firms can enter the market and there may be a condition where the demand falls below LRAC and ultimately suffers losses resulting in the exit of the firms. Therefore under the monopolistic competition free entry and exit must lead to a situation where demand becomes tangent to LRAC, the price becomes equal to average cost and no economic profit is earned. It can thus be said that in the long run the profits peter out completely.
One of the interesting features of the monopolistically competitive market is the variety available due to product differentiation. Although firms in the long run do not produce at the minimum point of their average cost curve, and thus there is excess capacity available with each firm, economists have rationalized this by attributing the higher price to the variety available. Further, consumers are willing to pay the higher price for the increased variety available in the market.
[You should appreciate that P=AC is the only compatible long run equilibrium under both perfect competition and monopolistic competition. The reason is that there are no entry barriers. However, because the demand curve is downward sloping in monopolistic competition the point at which P=AC occurs to the left of the minimum point of the average cost curve, rather than at the minimum point, as in perfect competition.]