MONOPOLISTIC COMPETITION

Monopolistic competition is a market structure quite similar to perfect competition in that vigorous price competition among a large number of firms and individuals is present. The major difference between these two market structures is that at least some degree of product differentiation is present in monopolistically competitive markets. As a result, firms have at least some discretion in setting prices. However, the presence of many close substitutes limits the price-setting ability of individual firms, and drives profits down to a normal rate of return in the long-run. As in the case of perfect competition, above- normal profits are only possible in the short-run before rivals are able to take effective counter measures.

Examples of monopolistically competitive market structures include a broad range of industries producing clothing, consumer financial services, professional services, restaurants, and so on. The conditions which prevail in a monopolistic competitive market can be summarized as follows:

1. There are relatively large numbers of firms, each satisfying a small, but not micro- scopic, share of the market demand for similar, but not identical, products.

2. The product of each firm is not a perfect substitute for the products of product group represents several closely related, but not identical, products that serve the same general purpose for consumers. The sellers in each product group can be considered competing firms within the industry.

3. The firms in the market do not consider the reactions of their rivals when choosing their product prices or annual sales targets.

4. Relative freedom of entry and exit of firms exist in monopolistically competitive mar- kets.

5. Neither the opportunity nor the incentive exists for the firms in the market to cooper- ate in ways that decrease competition.

Equilibrium

A firm in this market has limited control over the prices of their products. Generally, the consumers prefer the products of specific sellers and are ready to pay more, but within specific limit, to satisfy their preferences. The condition for the equilibrium of a firm is that it maximizes profit and the group or industry will be in equilibrium when each firm within

NOTES

the group is in equilibrium earning normal profits and there is no tendency to enter into or exit from the group.

Let us first consider the equilibrium of a single firm. A single firm may be regarded as a monopolist. Its equilibrium condition can, therefore, be determined by the same way as in case of a monopolist. Its AR (same as the demand curve) curve is downward sloping and the MR curve lies below the AR curve. The firm will be in equilibrium where MR=MC to maximize profits. At the equilibrium point, the firm may be earning normal profits or more than normal profits or less than normal profits as it happens in the case of a monopolist. In the above figure, let AR1 and MR1 be the AR and the MR curves of the first firm and MC1 be the MC curve of the firm. The equilibrium level of output is OQ1 and the equilibrium price level is OP1. The firm maximizes total profits. But under group equilibrium, the equality of MR and MC is not the sufficient condition for profit maximization though it is the necessary condition. Industry equilibrium is possible only when each firm is earning only normal profits, that is, the point where AR=AC for each firm. This is so because, if the existing firms earn more than normal profits, new firms will enter into the industry. This will reduce the volume of abnormal profits of the existing firms. Entry will continue until all the firms earn only normal profits. The situation of the group equilibrium can be analyzed with the help of the figure given below.

1

2 2

In the above figure the firm is in equilibrium at point E where the AR curve is tangent to the LAC curve and the output level of OQ . It can be proved that at the output level where AR is tangent to AC. MR must be equal to MC. We know that,

MR = AR + Q. dAR/dQ and MC = AC + Q. dAC/dQ, where, Q is the level of output. Now, when the level of output is the same, if AR = AC and it is such that dAR/dQ = dAC/dQ i.e. AR is tangent to AC, MR will be equal to MC. Note that each firm will be in equilibrium at a point on the AC curve which is to the left of its minimum point, F. if the firm operates under perfect competition, equilibrium will be achieved at the lowest point of the AC curve,

Market Structure Analysis

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where the level of output is OQ and the price is OP . The long run equilibrium point under monopolistic competition (E) must be at the falling portion of the AC curve because here AR is falling and such an AR curve can be tangent to the AC curve only at the latter’s downward sloping portion.

This property of equilibrium under monopolistic competition is known as the excess capacity theorem. This means that under monopolistic competition excess capacity remains in each firm in the sense that more output can be produced at a lower cost. Suppose that the number of firms is reduced but the output level of each firm is increased so that the total output of the industry remains the same. In this case, each firm will produce the output at a lower cost and hence total cost of obtaining the same level of output by eliminating some firm will be lower. Thus excess capacity remains under monopolistic competition and this capacity can be utilized by eliminating some firms form the industry. For social standpoint, monopolistic competition is inferior to perfect competition. Under perfect competition, capacity is fully utilized. Production takes place at the minimum point of the average cost curve. But this condition is not fulfilled under monopolistic competition.