The Monopolistic Market
It is a cardinal fact that the potential of any firm to earn long-run profits and to take any important decision, is directly dependent on the market structure in which it operates - Monopolistic Competition introduction. The market can be divided mainly into two major categories – perfect competitive market and imperfect market. The imperfect market structure can further be segmented into monopoly, duopoly, oligopoly and monopolistic markets. However, in the modern era, the monopoly and perfect competition, being two extreme forms of market competition, have ceases to exist.
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In the year 1932, E.H. Chamberlin and J. Robinson proposed the concept of a new type of market competition which is a combination of features from perfect competition and monopoly and is termed as monopolistic competition. The theory of monopolistic competition provided a more realistic explanation of actual market structure prevailing in the practical world. The theory suggests that in every market structure, each producer resembles the characteristics of monopolists – but within these natural monopolists, there is an existence of perfect competition. Thus, monopolistic competition can be defined as a market situation that resembles perfect competition in most respects, except for the presence of product differentiation. If this product differentiation is extremely successful, all the producers become virtually monopolists in their differentiated product markets.
The monopolistic competition is characterized by certain inherent features as follows:
1. Large number of sellers
2. Free entry and exit of firms in the market
4. Product differentiation
Large number of sellers: Like a pure competitive market, a monopolistically competitive market is characterized by the existence of many sellers, although the number is not as large as that in the case of the former. Hence, in a monopolistically competitive market, there exist a large number of firms each one being independent to one another. Each firm’s market share is so small that its actions hardly create any reaction among its competitors.
Free entry and exit in the market: In a monopolistically competitive market, the barriers to entry and exit are low but not absolutely free. Due to certain product differentiation, the long-established firms generally possess loyal customers who are often unwilling to switch over to a new product. Similarly, exit from one industry to another can be a difficult task for the firms in a monopolistically competitive market because, it can affect their long-established customer’s acceptance which are always difficult to regain.
Advertizing: In monopolistically competitive markets, along with severe price-competition, there exists a huge non-price-competition between the firms. Advertising is a technique of demand manipulation. Firms advertise in an attempt to shift customers demand curves for their products to the right. This implies that they can sell more at the same price.
Firms also advertize to make the demand curves for their products more elastic. This means that the consumers become less responsive to the price increase.
Product Differentiation: the most important feature of monopolistic competition is product differentiation. It means that basically similar products are changed in the some way to create some differences among them, at least in the eyes of the customers.
The above figure shows the demand curves of firms A and B. consumers view firm A’s product as being slightly differentiated from the bulk of the industry’s output and hence firm A is close to being a price-taker. On the other hand, firm B has successfully differentiated its products, and consumers are, therefore, less willing to seek substitutes for B’s output. Accordingly, B’s demand is not sensitive to changes in price.
A product differentiation can be of two types – real or fancied. The differentiation is said to be fancied when the products varies from one other in terms of packaging, trademarks, logos etc. A real differentiation, on the other hand, takes place when the products are differentiated in terms of qualities, specifications, features and after sales services. The basic intention of product differentiation is to remove the perfect elasticity of the firm’s demand curve. Instead of being price-takers facing horizontal demand curve, the firm determines its optimal price/output combination. The degree of price flexibility depends on the strength of a firm’s product differentiation. Strong differentiation results in greater consumer loyalty, thereby, gaining more control over the price. In other words, the more differentiated a firm’s product, the lower the substitutability of other products for it.
Demand under Monopolistic Competition
The demand curve for the product of any firm under conditions of monopolistic competition is downward sloping and is highly elastic in nature. The high elasticity is due to the existence of various substitutes for a product. Due to the existence of (highly) differentiated products in a monopolistically competitive market, the sellers enjoy some price discretion. If a firm reduces the price below than that of the competitors’ levels, it will be able to attract some of the competitors’ customers. On the other hand, if a single firm raises the price, it may suffer a significant loss in its sales as customers may switch to close substitutes items. Thus the monopolistically competitive firm is faced with a negatively sloped demand curve that is quite price-elastic over a considerable range.
Let n and q be the number of firms and output produced by them in the industry respectively. If v be the amount of advertising, then its price is given by:
P (q, v) = A / (n * q + B) + ad(v)
Here, A and B are positive constants and ad(v) is the advertising function which is given by:
ad(v) = -c1*v2 + c2*v.
Where c` and c“ are positive constants and the negative (-) sign signifies the diminishing marginal returns for advertizing.
Short-run Price-Quantity Decisions
The nature of equilibrium of a firm in the short run in monopolistic competition is depicted in the figures below.
Figure (3) Short-run equilibrium of a monopolistically competitive firm
The firm’s equilibrium output is at the level (point A) where the marginal revenue equals to marginal cost i.e. MR = MC (Figure 2 – top diagram). P* is the equilibrium price and the resulting profit is shown by B and B’ (Fig 2 – bottom). The total revenue curve is actually increasing at a decreasing rate. At point A, MR = MC and the gap between TR and TC is maximum. At those points where the profit is zero, price is equal to average cost (Z’). Profit can also be calculated by using another formula: Total profit = (price – average cost) x quantity. This is shown by the green-shaded area. At those quantities at which the profit is zero, price is equal to the average cost. Thus, Q* is indeed the optimal output. To the right of Q*, MR<MC and the total profit falls because production of each extra unit adds more cost than to revenue. Similarly, to the left of Q*, MC < MR – since each unit adds less to cost than to revenue, some potential profit will be lost if the firm stops producing extra output before reaching the point A. Hence, A is undoubtedly the equilibrium point.
Long-run Adjustment in Monopolistic Competition
When new firms join the industry, each existing firms loses some sales to the new entrants – at the same price, fewer units can be sold. This situation is depicted in figure 3. The long run equilibrium occurs at the point A where MR = MC. But, there is another condition of the long-run equilibrium, i.e. P = AC. This condition is fulfilled at the point E where the AC curve is tangent to the downward sloping demand curve. When P = AC, excess profit per unit must be zero. This is shown by the point B and B`. So the long run equilibrium output is Q* which corresponds to the equality not only between MR and MC but also between AR (=P) and AC. At this level of output, TR = TC and the total profit is zero. In the short run, if the demand curve is below the AC curve, some old firms make losses and resultantly they will leave the industry. The demand curve for the remaining firms then shifts to the left. This process will continue until each firm reaches the zero-profit equilibrium point which is better known as the break-even point.
Similarly, from TR-TC analysis, it can be concluded that if the output is less than Q*, AC will be greater than price or TR > TC and the profit is negative. This is also same in case the output goes above the Q* level. Thus, only when the output is Q*, TR = TC and the economic profit reaches the zero level. Thus, no firms in the monopolistic competition can make excess profit in the long run. In other words, all firms gradually reach the zero-profit long-run equilibrium which is also known as the break-even point.
As there are no barriers to entry and exit, each firm in monopolistic competition reaches the break-even point. When all the firms reach such equilibrium, the entire market equilibrium is established. This equilibrium is termed as group equilibrium. When there is imperfect competition among a group of producers, the limits of the industry can not be easily defined. In fact, in monopolistic competition, most firms belong to two or more industries. This is why it is often referred to as Chamberlin’s ‘large group’.
Efficiency Loss and Excess Capacity
The monopolistic competition is similar to pure competition in the sense that there is a large number of firms selling a product that has been differentiated from that sold by other firms in the industry. Hence, although the products sold by the monopolistically competitive firms are good substitutes, they are not perfect substitutes. This, in turn, implies that the monopolistically competitive firms have some control over the price, especially in the short run. The local retail grocery stores are examples of such competition.
Even though the firm under monopolistic competition is a very small part of the market as under pure competition, the demand curve for its product is download sloping. For customers at large are likely to have different degrees of loyalty to the firms from whom they make their purchases. A small reduction in one firm’s price may only attract its competitors’ most valued customers, but if a firm reduces its price by a high margin, it may be possible for them to attract a huge portion of such loyal customers of its rivals.
In monopolistic competition, naturally, the equilibrium of the firm is at the point when marginal cost equals to the marginal revenue. Again, in the short run, the firm may or may not earn profit as in the case of pure competition. There is, no doubt, the possibility of earning profit along with the equal chances of incurring loss. The actual situation is that, in monopolistic competition, similar to pure competition, both profits and losses disappear in the long run. The long run equilibrium of the firm in each market is a tangency solution i.e. P = AC and no firm neither can make excess profit nor it has to incur losses. The average cost curve is driven toward tangency with the demand curve in the long run as depicted in fig. 5.
The equilibrium point L will be the point of tangency between the average cost curve and the negatively sloping demand curve D. For any output other than the equilibrium output Qm, the average cost of production will be higher than the price and, hence, the firm will incur loss. The average cost curve is U-shaped as shown in the above figure. This implies that both very small and very large outputs are difficult and expensive to produce.
It is a matter of the fact that from the economical point of view as a whole, competitive arrangement appears to be superior to that under monopolistic competition. From the society’s viewpoint, there is a need some sort of amalgamation of business firms. The above figure shows that, by growing larger, firms can successfully reduce their unit costs than that in point L. the implication is that, if some firms are eliminated, the output will remain unchanged. Instead of 12 firms producing 5000 units each, we can, for an example, reduce the number of firms to 3, each producing 20,000 units. Thus, the total output remains the same. Moreover, each firm will, as a result of such growth, have lower unit costs. Thus, if the same output is produced at lower unit costs, for example, if the AC falls from $10 to $8 (say), the total cost to the firms producing 60,000 units will fall from $ 600000 to $ 480000. Hence, there is a net gain of $12,000 to the society with absolutely no reduction in the output. This result has been termed by Chamberlin as excess capacity theorem in monopolistic competition.
Hence, to conclude, only if the elimination of firms results in an important reduction in the variety of products available to the consumer, so that a real decrease in the consumer choice opportunities occurs, there is a strong reason for the society to ‘prefer’ the product differentiation equilibrium point, i.e. the break-even point L.
However, every firm wants to be a monopolist in order to enjoy profit maximization. Similarly, from the viewpoint of the customers’ a perfectly competitive market is the most desired one. A monopolistic competition is the ‘most perfect’ form of market after perfect competition. On the other hand, it is the ‘least imperfect’ form of imperfect competition. Thus, it is beyond any iota of doubt that the monopolistic competition is the most rational and realistic form of market structure prevailing in the modern world (Steven 2007).
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