Monopolistic Competition: Concept, Characteristics and Criticism

1 year ago

Atiqur Rahman

12 minutes

Introduction

Monopolistic competition is a market structure which lies between perfect competition and monopoly, and thus it has the features or characteristics of both markets.

The concept of monopolistic competition is more realistic than perfect competition and monopoly and we can even relate this type of market structure with the one which is prevailing in our current markets.

The model of monopolistic competition was given by Professor E. H Chamberlin in his book “The Theory of Monopolistic Competition” in 1933.

Definition of Monopolistic Competition

By definition, monopolistic competition refers to a market structure in which a large number of sellers sell differentiated products, which are close substitutes for one another. Here, a close substitute is one whose cross-elasticity is close to unity or greater. The monopolistic competition combines the basic elements of both perfect competition and monopoly.

The element of monopoly in monopolistic competition arises from the fact that each firm has an absolute right to produce and sell a branded or patented product. Other firms are prevented by laws from producing and selling a branded product of other firms. This gives a firm monopoly power over the production, pricing and sale of its own-branded product.

For example, consider the toilet soap industry. There are a number of brand names available in the market, e.g., Lux, Liril, Palmolive, Fairglow, Pears, Fa, Rexona, Lifebuoy, Carmel, Godrej, Cinthol, Ponds, Dove, Dettol and so on. Each of these branded toilet soaps is produced and sold by a company having monopoly power over the product.

Similarly, Maruti Udyog Limited has monopoly power for producing and selling cars under the brand name Maruti. No other car manufacturing company can produce and sell cars under this brand name. So is the case with all other car manufacturing companies.

The element of competition comes from the fact that each branded product has several close substitutes, and firms selling branded products of the same generic category have to compete for the market share.

Considering our example of toilet soaps again, all the companies producing and selling these branded toilet soaps are in intensive competition to capture the largest possible market share. One index of the competition between them is the amount that they spend advertising their product. These features of the toilet soap industry make it monopolistically competitive.

The toothpaste industry with a number of branded product names (e.g. Binaca, Colgate, Close-up, Pepsodent, Forhans, Cibaca, Neem, Meswak, Signal, Promise, Prestige and so on) is another example of monopolistic competition.

So is the case with major industrial products in India, e.g., electrical tubes and bulbs, TV sets, refrigerators, air conditioners, personal computers, textile goods, tea, coffee, cigarettes, soft drinks, cold creams, shampoos, detergents, shaving blades, shaving cream, hair oils, hair dyes, shoes, wrist watches, steel, cement, mobile phones and so on.

Characteristics of Monopolistic Competition

1. Large Number of Buyers and Sellers:

In a monopolistic competitive market, there exist a large number of both the buyers and sellers of the product. This is the same feature as the perfect competition. However, there is one difference that competitive firms are very small relative to the size of the market, whereas, in monopolistic competition, the firms are not so small in relation to the size of the market.

2. Product Differentiation:

Since various firms under monopolistic competition compete with each other, thus, they compete by selling differentiated products that are either similar or close substitutes of each other. Hence the prices of the products are not too much different from each other. Moreover, the cross-price elasticity of demand for the products is large but not infinite.

3. Freedom of Entry and Exit:

It is relatively easy for new firms to enter a monopolistic competition market industry and for the existing firms to leave the industry. If the industry is profitable, new firms will enter the industry, and similarly any firm can leave the industry if it incurs losses. This feature of free entry and exit is based on low start-up costs and no exit costs.

4. Market Power:

Firms under monopolistic competition face a downward sloping demand curve (AR), and the marginal revenue (MR) curve lies below it because the firms sell differentiated products (which are and can be close substitutes), and any reduction in the price by the seller would attract the customers of the other product towards it.

Therefore, a fall in the price of one product will increase the demand for that product; hence, firms under monopolistic competition have some influence on the price. Moreover, the demand curve is comparatively more elastic in this market structure, but it is not perfectly elastic.

5. Non-Price Competition:

Firms under monopolistic competition compete not only in terms of prices but also on other non-price variables which the firm spends on advertising like marketing cost, sales promotion expenses etc.

6. Absence of Interdependence Among Firms:

In monopolistic competition, each firm acts more or less independently and has its own price policies regarding price and output. Hence, the change in the pricing policy of one firm does not have a significant effect on the price and output of the other firm.

7. Concept of Industry Under Monopolistic Competition:

The industry is defined as the number of firms selling homogeneous/identical products. However, with product differentiation, the definition of industry becomes ambiguous. Hence, Professor Chamberlin has replaced the concept of the industry with a “group of firms” producing differentiated products which are close substitutes of each other and have a high cross-price elasticity of demand.

Comparison of Monopolistic Competition with Perfect Competition and Monopoly

	Monopolistic Competition	Perfect Competition	Monopoly
1	A large number of firms	✔
2	Monopoly power- face downward sloping demand and MR curves		✔
3	Free entry and exit	✔
4	Firms can earn super-normal profits in the short run		✔
5	Economic profits are zero, P=AC in the long run	✔
6	Non-pricing competition – advertising		✔
7	Pricing – P>MC (MR=MC) (deadweight loss)		✔

Short-Run Equilibrium of the Monopolistic Competitive Firm

Assumptions of Monopolistic Competition Theory

Chamberlin has made the following explicit and implicit assumptions to develop his theory of monopolistic competition.

There are a large number of firms selling slightly differentiated products, which are close substitutes for one another.
The number of firms in a product group is so large that their activities, especially manoeuvring of price and output, go unnoticed by the rival firms.
Demand and cost curves for all the products and for all the firms of the group are uniform, i.e., firms face identical demand (including perceived one) and cost curves.
Consumer preferences are evenly distributed among the different products, and product differentiations are not such that they make a difference in cost.

Since monopolistically competitive firms have downward-sloping demand curves, so they have some market power and can influence the price as each firm sells a differentiated product which is not exactly similar to the product of the other firm but, yes, somewhat substitute to the product of the other firms.

Moreover, there exist no major barriers to entry or exit in monopolistic competition; thus, this feature puts a limit on the profits of the firms.

Now because of the free entry, the new firms will keep entering a monopolistic competition market until economic profits are driven to zero.

Short run equilibrium of monopolistically competitive firm — Short-run equilibrium of monopolistically competitive firm

Here, AR is the demand curve of the monopolistic competitive firm, which is downward sloping because they sell differentiated products. MR is the corresponding marginal revenue curve. MC is the marginal cost curve, and AC is the Average cost curve of a monopolistic competitive firm.

A profit-maximizing firm will produce where it’s MR = MC. In this case, P>AC, so firms earn super normal profits, as indicated by the rectangle area in fig 1.

Here the second-order condition is also satisfied at the equilibrium, i.e. dMR/dQ < dMC/dQ.

Long-Run Equilibrium of a Monopolistically Competitive Firm

The long-run conditions differ from the short-run conditions because, in the long run:

(i) new firms enter the industry,
(ii) firms indulge in price competition,
(iii) changes take place simultaneously and
(iv) firms advertise their product more vigorously.

When monopolistically competitive firms earn positive or supernormal profits in the short run, then this attracts new firms to enter the market and hence new potential firms start producing their own differentiated product in the market. This reduces the economic profit of the market as the existing firms lose their market share, and their demand curve shifts down. This will go on till all the firms earn only normal profits, and the economic profits come to zero.

Long run equilibrium of a monopolistically competitive firm — Long-run equilibrium of a monopolistically competitive firm

In order to maximize profits, firms will produce where MR = MC. Here one point to note is that the demand curve is tangent to the firm’s AC curve, which implies P = AC and economic profits = 0.

Hence we can write the following long-run equilibrium conditions under monopolistic competition:

MR = MC
dMC/dQ < dMR/dQ
P = AC

Monopolistic Competition and Economic Efficiency

Perfectly competitive firms are economically efficient because they maximize the sum of producer and consumer surplus, whereas monopoly leads to a loss in the social welfare of the society. Let’s see here if the monopolistically competitive firms are efficient or not and how they are compared with the competitive firms.

There are basically two sources of inefficiencies in monopolistic competitive firms:

1). Under monopolistic competition, equilibrium price exceeds marginal cost, whereas under perfect competition P=MC

Comparing perfect competition with monopolistic competition- deadweight loss

Since under monopolistic competition P>MC, this means that the value to the consumers of the additional units of output exceeds the cost of producing that output. The sum of consumer and producer surplus can be maximized if the output is expanded up to the point where P = MC by the MKL region in fig 3.

Hence, the MKL region is the deadweight loss under monopolistic competition that arises due to the existence of monopoly power (downward sloping demand curve). Hence social welfare is not maximized under monopolistic competition.

2). Because of the free entry and exit assumption under perfect competition and monopolistic competition, long-run equilibrium occurs where P = AC, i.e., economic profits = 0 in the long run. However, there is one important difference in both types of market, i.e., in the case of a competitive firm, zero profits occur at the minimum of the average cost curve.

However, under monopolistic competition, zero profits occur on the falling portion of the average cost curve and not at its minimum. This happens because firms face a downward-sloping demand curve, and therefore the zero point occurs to the left of the minimum of the average cost curve. Hence, firms under monopolistic competition operate with excess capacity.

Criticism of Chamberlin’s Theory of Monopolistic Competition

Chamberlin’s Theory has Low Predicting Power.
Chamberlin’s Model is challenged on Theoretical Grounds.
Chamberlin’s Model Makes Unrealistic Assumptions like assuming identical cost and revenue curves are not justified, assuming no interdependence is not reasonable, and assuming that firms do not learn is not correct.
Chamberlin’s Measure of Excess Capacity is logically inconsistent.
Chamberlin’s Model Lacks Empirical Validity.

Despite these damaging criticisms, Chamberlin’s theory of monopolistic competition is regarded as a significant contribution to the theory of value and remains a subject matter of microeconomics for the analytical rigour and insight that it provides in analyzing a monopolistically competitive market.

Monopolistic Competition: Concept, Characteristics and Criticism

Introduction

Definition of Monopolistic Competition