11 – Monopolistic Competition

Introduction

Product differentiation is seen in monopolistic competition. A monopolistic competitive market can be defined as a market with a high number of enterprises and products that are close but not perfect substitutes. Monopolistic competition is prevalent in the real world. Monopolistically competitive enterprises produce around half of the economy’s overall output. The retail sector, including restaurants, clothing stores, and convenience stores, is one of the best examples of monopolistic competition.

Monopolistic competition is a market system in which a large number of independent enterprises sell products that are only marginally differentiated in the eyes of purchasers. As a result, the rival enterprises’ products are close but not perfect alternatives because purchasers do not consider them similar. This occurs when the same commodity is sold under different brand names, each slightly different from the others. Toilet soap brands include Lux, Liril, Rexona, Hamam, and others, while toothpaste brands include Colgate, Cibaca, Prudent, Promise, and others.

As a result, each company is the sole manufacturer of a specific brand or “product.” In terms of that specific brand, it is a monopolist. However, because many brands have close equivalents, a significant number of “monopoly” makers of these brands compete fiercely with one another. Monopolistic competition refers to a market structure in which there is competition among a large number of “monopolists.”

The distinction between competing items or brands may be based on real or fictitious variations in quality. Genuine brand differences relate to discernible changes in quality, such as shape, flavour, colour, packaging, after-sales service, warranty length, and so on. In contrast, imaginary differences refer to quality disparities that are not palpable but are made to be believed by purchasers who are “conditioned” to believe that such differences exist and are significant. Advertising frequently has the effect of leading purchasers to imagine or believe that the marketed brand possesses various traits. When there is product differentiation, each firm has some price control.

As a result, under monopolistic competition, an individual firm’s demand or average revenue curve is a gradually declining curve. It is extremely elastic, though not perfectly so. As a result, the firm’s marginal revenue curve is declining and is now below the average revenue curve at all levels of output. Monopolistic competition varies from perfect competition in this regard.

 11.1 Features Of Monopolistic Competition

The monopolistic competition combines elements of both perfect competition and monopoly. Despite having multiple sellers, each firm holds a certain level of monopoly due to product differentiation, fostering competition among them. Professor Edward Chamberlin introduced the concept of monopolistic competition in his seminal work, The Theory of Monopolistic Competition.

Features of Monopolistic Competition:

1. Fairly Large Number of Sellers: In monopolistic competition, there is a multitude of sellers, preventing any single entity from significantly influencing the market. Each seller maintains some independence in determining prices and output.

2. Fairly Large Number of Buyers: This market structure accommodates a considerable number of buyers.

3. Close Substitute Products: Sellers in monopolistic competition offer products that serve as close substitutes for each other, such as soaps and pens.

4. Free Entry and Exit: Firms face no restrictions on entering or leaving the market. New entrants can join if existing firms are making supernormal profits, provided they offer close substitutes.

5. Selling Cost: As products are closely substitutable, firms must invest in selling costs to enhance sales. These costs include advertising, promotions, discounts, and other strategies.

6. Product Differentiation: To maintain an independent identity, firms differentiate their products through brand names, design, size, colour, packaging, taste, advertising, and after-sales services. This product differentiation imparts a degree of monopoly.

7. Nature of the Demand Curve: The demand curve for a monopolistically competitive firm is more elastic compared to a monopoly. This elasticity results from the availability of close substitutes, where a price increase reduces sales by a larger proportion.

Concept of Group: Professor E. Chamberlin introduced the concept of a group under monopolistic competition. This group comprises products that are close substitutes economically and technically. In the long run, the group reaches equilibrium when all firms within it earn normal profits.

Product Differentiation: Product differentiation is a key characteristic of monopolistic competition, where products, though close substitutes exhibit small differences. Factors contributing to this differentiation include brand name, design, size, colour, taste, perfume, salesmanship, and after-sales services. This differentiation fosters customer loyalty, providing firms with some degree of monopoly and allowing them to charge different prices for their products. Maintaining this monopoly power over loyal customers is essential in the framework of monopolistic competition.

11.2 Equilibrium of a Firm Under Monopolistic Competition in the Short Run and in the Long Run

1. Short run equilibrium of a firm under monopolistic competition:

In the short run within a monopolistically competitive market, a firm can experience supernormal profits, normal profits, or losses. The following diagrams illustrate these three scenarios:

Excess Profit: Given the demand and cost curves, the firm determines the profit-maximizing output where MR equals MC. The equilibrium point E, with output OQ, sets the price at OP or QM. In this scenario, with price OP and output OQ, Total Revenue (TR) equals OQMP, and Total Cost (TC) equals OQER. Since TR exceeds TC, excess profit is calculated as REMP (OQMP-OQER).

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Normal Profit: Achieving normal profit is a rare condition. Due to changes in demand and cost conditions, the firm may just cover its production costs. In the equilibrium at point E1, where MR and MC curves intersect, the output is OQ1, and the price is OP1. TR equals OQ1R1P1, and TC equals OQ1R1P1. With TR equal to TC, the firm attains normal profit.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Loss: Under certain demand and cost conditions, a firm may operate at a loss. In equilibrium at point E2, where MR and MC curves intersect, the output is OQ2, and the price is OP2. TR equals OQ2L2P2, and TC equals OQ2N2M2. Since TC exceeds TR, the firm incurs a loss calculated as P2L2N2M2.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

In the short run, when a firm faces losses, it must decide whether to continue operations. If the firm can cover its total variable cost (TVC), it will persist; otherwise, it should cease operations when TR is less than TVC.

2. Long run equilibrium of a firm under monopolistic competition:

Moving to the long run equilibrium of a firm in monopolistic competition, adjustments in fixed factors of production become possible. As all costs are variable, firms unable to cover production costs will exit the market due to free entry and exit. With new firms entering and existing firms earning supernormal profits, the long-run outcome is that all firms will make only normal profit.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

This case of normal profit is depicted in the diagram, where equilibrium is at point E, MR and MC curves intersect, output is OQ, price is OP, TR is OQRP, and TC is OQRP. As TR equals TC, normal profit is realized.

 11.3 Production Cost and Selling Cost

1. Production Cost:

The cost of production includes all costs incurred by the firm to produce a commodity and get it to stores. It includes what you pay for land, wages, and interest on your money. fees for depreciation, taxes, and so on. Producing a commodity is the goal of production cost.

On the other hand, selling cost is meant to get more people to buy its product on the market. Substitute cost is crucial for the firm under monopolist competition because of the availability of substitutes. Firms try to get the word out that their product is superior to other products on the market by using cost selling techniques.

Some of the ways that selling costs are incurred are through TV ads, newspaper ads, pamphlets, billboards, giving away free samples or gifts, offering discounts on products, holding exhibitions, providing after-sales services, and so on.
The following diagram can help you understand the idea of production and selling cost.

The difference between Average Cost (AC) and Average production Cost (APC), as illustrated in the diagram, is the Average Selling Cost (ASC).

2. Selling cost:

One of the most essential aspects of monopolistic competition is the selling cost. There is no need for selling cost in perfect competition because the commodities are homogeneous. Similarly, in the absence of substitute products, selling cost is not required under monopoly. However, in the case of monopolistic competition, because close substitute products are accessible, the firm must pay selling costs.
Therefore, the selling cost is the cost that the company incurs to market their product or to increase market demand for the product. The following are examples of incurring selling costs:

a. Advertising is the most common type of selling cost. The firm is attempting to demonstrate how its product is superior to other products on the market through advertising. Television, radio, newspapers, billboards, pamphlet distribution, and other forms of advertising are available.

b. Exhibitions can be held at the local, state, national, and worldwide levels. The goal of the expo is to increase product sales.

c. Window dressing- different products such as clothing, electrical gadgets, and other consumer durables are shown to consumers to convey information about the product and to attract customers.

d. Free samples- in the case of items such as soaps, tea, biscuits, oil, hand wash, and so on. Companies give away free samples to attract a large number of customers.

e. Gifts – Companies will give you numerous gifts if you spend a certain amount of money.

f. Discounts- another method for attracting a large number of clients is to offer them substantial discounts. Once the product’s market is established, the discount may be removed.

g. After-sales services- excellent after-sales services play a crucial part in earning client trust. Along with superior after-sales services, warranty duration, customer relations, and so on, it is also necessary for their product to sell more in the market.

Effects of selling cost;

The cost of selling influences consumer demand. It makes people aware of the current commodity and also informs them about how their product is superior than substitutes accessible in the market. The following graphics illustrate the effect of selling cost on demand.

-The X axis in the graphs above represents amount demanded, and the Y axis represents price.

-The initial demand curve, shown by diagram DD, has price OP and output OQ. -The demand curve moves to the right, to D1D1 and then to D2D2, as a result of selling costs.

-At the same price OP, the producer can sell OQ1 and OQ2 in greater quantities.
-The second diagram demonstrates that, with price as the OP and quantity as the OQ, DD is the original demand curve minus selling costs.

-When selling costs are incurred, the demand curve gets flatter. D1D1, for example. The firm’s demand will rise to OQ2 if it lowers its price to OP1.

-However, the firm will be able to sell more—that is, OQ1 at price OP1—at the same time as it incurs the selling costs.

Effect of selling cost on profit:
The following diagram can be used to show how selling costs affect profit.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

In the depicted diagram, the X-axis represents output, and the Y-axis represents both cost and revenue. In a scenario without selling costs, the AR and MR curves are downward-sloping, starting from the lower side of the Y-axis. The APC and MPC curves represent average and marginal production.

The initial equilibrium point is E, where the MPC and MR curves intersect. At this point, the equilibrium output is OQ, and the price is OP. Total Revenue (TR) is OQRP, and Total Cost (TC) is OQNM. Since TR exceeds TC, the profit is calculated as MNRP.

Now, if the firm incurs selling costs, the demand for goods increases, causing the AR curve to shift upward to AR1. Consequently, the MR curve also shifts to MR1. When selling costs are added to production costs, new average and marginal cost curves are formed. The new equilibrium point is E1, where the output is OQ1, the price is OP1, TR is OQ1R1P1, and TC is OQ1N1M1. As TR still exceeds TC, the profit is calculated as M1N1R1P1.

This illustrates that the introduction of selling costs leads to an increase in commodity demand from OQ to OQ1. This rise in demand elevates the price from OP to OP1. Consequently, the profit after accounting for selling costs surpasses the profit level before the inclusion of selling costs, represented by the inequality MNRP < M1N1R1P1.

11.4. Role of Advertisement

1. Brand Differentiation: Advertising plays a crucial role in creating and maintaining brand differentiation in monopolistic competition. In markets with numerous sellers offering similar products, firms often rely on advertising to establish a unique brand identity. For instance, in the smartphone industry, companies like Apple and Samsung invest heavily in advertising to distinguish their products through design, features, and brand image.

2. Product Awareness and Information: Advertising helps in creating awareness and providing information about products. In monopolistic competition, where consumers have various options, firms use advertising to highlight the distinctive features of their products. For example, a clothing brand might use advertisements to showcase new styles or materials, helping consumers make informed choices.

3. Consumer Loyalty: Effective advertising can foster consumer loyalty by building a connection between the brand and its audience. In monopolistic competitive markets, firms aim to create a loyal customer base that prefers their products over competitors. For instance, a soft drink company may run campaigns emphasizing its unique taste to build consumer loyalty.

4. Market Expansion: Through advertising, firms can expand their market reach. By reaching a wider audience, a firm can attract new customers and increase its market share. An example is a tech company launching advertising campaigns to introduce a new product to a broader demographic and gain market presence.

Arguments for Advertising in Monopolistic Competition:

1. Competition Stimulation: Advertising fosters healthy competition by encouraging innovation and improvement. In monopolistic competition, firms strive to offer better products or services, leading to overall market advancement. For example, smartphone companies competing for customer attention often introduce innovative features or technologies.

2. Information Provision: Advertising serves as a valuable source of information for consumers. In markets with diverse product offerings, advertising helps consumers make informed choices by providing details about product features, benefits, and pricing.

3. Economic Growth: A robust advertising industry contributes to economic growth by creating jobs and supporting various related sectors, such as media and marketing agencies. The economic impact of advertising is particularly significant in a monopolistic competitive market where firms actively engage in promotional activities.

Arguments Against Advertising in Monopolistic Competition:

1.  Consumer Manipulation: Critics argue that advertising can manipulate consumer preferences and create artificial needs. In monopolistic competition, firms might employ psychological tactics to influence consumer behaviour, potentially leading to purchases based on emotional appeal rather than rational decision-making.

2. Wasteful Expenditure: Detractors claim that advertising expenses can become a significant part of a firm’s budget, contributing to higher product prices. In monopolistic competitive markets, the competition for consumer attention may lead to excessive spending on advertising rather than focusing on product improvement.

3. Unfair Advantage: Some argue that large firms with substantial advertising budgets gain an unfair advantage over smaller competitors. This can hinder smaller businesses from competing effectively in the market, potentially leading to reduced diversity and innovation.

In conclusion, while advertising plays a vital role in monopolistic competition by promoting brand differentiation, providing information, fostering consumer loyalty, and expanding market reach, it also faces criticism for potential consumer manipulation, wasteful expenditure, and creating an uneven playing field. The impact of advertising in monopolistic competition is a complex interplay between market dynamics, consumer behaviour, and regulatory frameworks.

11.5 Wastages Under Monopolistic Competition

Under monopolistic competition, various types of wastages can occur, as outlined below:

1. Excess Capacity: Excess capacity is a prevalent issue in monopolistic competition where a firm’s equilibrium is achieved at a suboptimal level of output. This results in the underutilization of resources, leading to excess capacity. In the diagram, the contrast between perfect competition and monopolistic competition is evident. Under perfect competition (at point E), the firm reaches optimum output (OQ) with minimal costs and lower prices (OP). In monopolistic competition (at point E1), the firm produces less-than-optimal output (OQ1) and sells at a higher price (OP1). Q1Q, which represents the unused capacity, reflects the excess capacity in monopolistic competition.

Implications:

-Underutilization of capacity contributes to unemployment concerns.

-If firms fail to boost demand despite heavy selling costs, it results in wasteful expenditure.

-Excessive advertising expenditure raises the prices of goods and exploits consumers.

 

 

 

 

 

 

 

 

 

 

 

 

 

2. Unemployment: The underutilization of production capacity in monopolistic competition leads to unemployment issues. As firms operate below their full potential, the problem of unemployment becomes prominent.

3. Exploitation of the Consumer: The necessity for selling costs due to product differentiation in monopolistic competition results in consumers paying higher prices for products. This situation can be perceived as exploitation of consumers who bear the burden of increased costs.

4. Selling Cost: Monopolistic competition prompts firms to undertake significant expenses on advertising to enhance product sales. If these efforts fail to increase sales, the incurred expenditure is considered wasteful.

5. Lack of Specialization: The presence of numerous firms producing closely substitutable products limits the scope for specialization. Consequently, the benefits associated with large-scale production are not fully realized in monopolistic competition.