Price and Output under Monopolistic Competition

The Concept of Imperfect Competition: Monopolistic Competition and Oligopoly

• Perfect competition and monopoly are rarely found in the real world and therefore do not accurately represent most actual market situations.

• As a result, many conclusions derived from the theory of pure competition were found inapplicable to the behaviour of real-world business firms.

• One major reason was the existence of internal economies of scale enjoyed by firms in reality, a phenomenon inconsistent with the assumptions of perfect competition.

• The need to make price theory more realistic led to its reformulation by Edward Hastings Chamberlin and Joan Robinson, who independently and simultaneously developed the theories of monopolistic competition and imperfect competition respectively.

• Joan Robinson’s theory was influenced by Piero Sraffa, who argued that analysis based on free competition should be abandoned in favour of studying monopoly and imperfect market structures.

• The central idea of the theories of monopolistic competition and imperfect competition is that perfect competition and pure monopoly are merely two extreme limiting cases, with numerous intermediate market forms lying between them.

• These intermediate market structures differ according to the relative strength of competitive and monopolistic elements, that is, by varying degrees of imperfection.

• The extreme form of pure monopoly exists when a seller faces no competition from substitute products.

  • Since all goods compete for consumers’ income and are therefore substitutes to some degree, complete monopoly is extremely rare.

  • According to Sraffa, pure monopoly would exist only when a single person or agency controls the supply of all economic goods.

• At the opposite extreme lies perfect competition, where every seller’s product is completely identical or homogeneous and faces perfect substitutes supplied by rival firms.

• Between these two extremes exist numerous market forms containing both competitive and monopolistic characteristics.

• In the terminology of Chamberlin and Robinson, pure monopoly is an extreme form of imperfect competition, and the two most important forms of imperfect competition are:

  • Monopolistic competition.

  • Oligopoly.

• The fundamental distinguishing feature of imperfect competition is that the demand curve facing an individual firm slopes downward, unlike under perfect competition.

• Because the demand curve slopes downward, the marginal revenue (MR) curve lies below the demand curve.

• The relationship between price, marginal revenue, and elasticity of demand is crucial for distinguishing between pure and imperfect competition.

• The difference between price and marginal revenue at a given output depends on the price elasticity of demand.

  • Under perfect competition, price elasticity of demand is infinite, so price equals marginal revenue (P = MR).

  • Under imperfect competition, price elasticity of demand is less than infinite, so price exceeds marginal revenue (P > MR).

• The difference between price and marginal revenue (or marginal cost at equilibrium) is regarded as the degree of monopoly power.

• The relative magnitudes of price and marginal revenue at equilibrium help identify different degrees of monopoly power across market structures.

• A larger gap between price and marginal revenue indicates a greater monopoly element, while a smaller gap indicates a stronger competitive element and a lower degree of monopoly power.

Product Differentiation and Monopolistic Competition

• Monopolistic competition, developed by Edward Hastings Chamberlin, is considered more realistic than either perfect competition or pure monopoly, as it reflects the conditions prevailing in most real-world markets.

• Prior to Chamberlin, competition and monopoly were viewed as mutually exclusive alternatives; Chamberlin argued that most actual markets contain both competitive and monopolistic elements simultaneously.

• The essence of monopolistic competition is product differentiation, making it a blend of competition and monopoly.

• Product differentiation means that products of different firms are not homogeneous but are only slightly different, remaining sufficiently similar to act as close substitutes for one another.

• The existence of product differentiation introduces a monopoly element into the market, and the greater the degree of differentiation, the stronger the monopoly element.

• When many firms produce differentiated products:

  • Each firm enjoys a monopoly over its own product.

  • Each firm simultaneously faces competition from sellers of close substitutes.

  • Firms become “competing monopolists”, creating the market structure known as monopolistic competition.

• Under monopolistic competition, products are neither identical as in perfect competition nor without substitutes as in monopoly; instead, they are close but imperfect substitutes.

• Every seller possesses monopoly power over its own differentiated product but faces strong competitive pressure from rival firms producing similar alternatives.

• Indian examples of monopolistic competition include:

  • Toothpaste brands such as Colgate, Binaca, Forhans, Pepsodent, Signal, and Neem.

  • Bathing soaps such as Lux, Godrej, Breeze, Hamam, Palmolive, and Jai.

  • Toothbrush brands and numerous retail and service establishments such as shops and barber salons.

• A producer of a particular brand has a monopoly over that brand name but cannot determine price and output independently because consumers can switch to competing substitute brands.

• A product is considered differentiated whenever consumers have a basis for preferring one seller’s product over another’s, whether that preference is real or imagined.

• Product differentiation causes consumers to choose sellers according to their preferences rather than randomly, as assumed under perfect competition.

• There are two broad bases of product differentiation:

  • Differentiation based on characteristics of the product itself, such as patents, trademarks, brand names, packaging, quality, design, colour, style, or exclusive features.

  • Differentiation based on conditions surrounding the sale of the product, such as location, reputation, goodwill, courtesy, efficiency, business practices, and quality of service.

• Although genuine differences in quality and design matter, differentiation is often created through advertising, brand names, trademarks, and attractive packaging even when products are physically similar.

• In retail trade, consumers are influenced not only by the product itself but also by factors such as the seller’s location, reputation, manner of dealing, and overall business environment.

• These tangible and intangible factors create consumer preferences and thereby differentiate products.

• Since virtually all products possess some degree of differentiation, most real-world markets contain both monopoly and competitive elements.

• For example, each retailer has monopoly control over the unique combination of product, location, reputation, and service offered by that establishment, but simultaneously faces competition from other retailers offering similar products under different conditions.

• Therefore, differentiation based on selling conditions also combines monopoly and competition in the same market.

• Unlike a monopolist, whose demand curve is treated as given, a firm under monopolistic competition cannot regard its demand curve as fixed because its sales depend on the prices and characteristics of competing substitute products.

• The demand for an individual firm’s product is affected by the actions of rival firms selling close substitutes, creating significant competitive interdependence.

• Consequently, monopolistic competition involves not only individual equilibrium but also group equilibrium, reflecting adjustments among a collection of competing monopolists.

• To analyse this market structure, Chamberlin introduced the concept of a group instead of an industry.

• The term industry is appropriate under perfect competition because all firms produce homogeneous products.

• Under monopolistic competition, products are differentiated, making the concept of industry less useful.

• A group refers to a collection of firms producing closely related but non-identical products.

• The concept of group is necessary because firms within the group influence one another through competition among close substitutes.

• The demand facing one producer depends on the prices and characteristics of rival products within the same group.

• Such competitive interrelationships do not exist under perfect competition, where firms produce homogeneous products and can sell any quantity at the prevailing market price.

• A producer within a group cannot be analysed in isolation because the demand for its product is closely linked to the actions of rival firms.

• Each producer remains a monopolist over its own differentiated product, but its market is intertwined with those of competing sellers.

• The common business usage of the term competition corresponds more closely to monopolistic competition (and oligopoly) than to perfect competition.

• Expressions such as price cutting, under-selling, meeting competition, cut-throat competition, unfair competition, and securing market share have little relevance under perfect competition because firms simply accept the market price.

• Under perfect competition, firms face no need for pricing strategies, advertising, or customer attraction efforts.

• Real-world competitive behaviour involving advertising, pricing policies, market capture, and rivalry occurs primarily under monopolistic competition and oligopoly, where products are differentiated but closely related.

Important Features of Monopolistic Competition

It is important to understand the important characteristics of monopolistic competition. The knowledge of these features will enable the students to know how this form of market structure is different from perfect competition and oligopoly. We explain below its important features.

1. A large number of firms:

• A key feature of monopolistic competition is the presence of a relatively large number of firms, each supplying only a small share of total market demand.

• The large number of firms creates intense competition among sellers.

• Unlike perfect competition, firms under monopolistic competition do not produce identical products.

• Instead, they produce differentiated products that are close substitutes for one another.

• Product differentiation makes competition among firms genuine and vigorous, as each firm seeks to attract consumers to its own version of the product.

• Because there are many firms in the market, the size of each individual firm is relatively small.

• This distinguishes monopolistic competition from oligopoly, where only a few firms operate and each firm is typically of large size.

2. Product differentiation:

• A second important feature of monopolistic competition is product differentiation, under which the products of different firms are not identical but are slightly different from one another.

• Despite these differences, the products remain close substitutes, enabling consumers to switch from one firm’s product to another.

• The products of firms under monopolistic competition are therefore similar but not the same, distinguishing this market structure from perfect competition where products are homogeneous.

• Because products are close substitutes, the prices charged by different firms cannot differ substantially, as large price differences would encourage consumers to shift to rival products.

• The existence of similar yet differentiated products creates the basis for competition among firms, since each producer competes with sellers of closely substitutable products.

3. Some influence over the Price:

• Under monopolistic competition, each firm produces a product variety that is a close substitute for the products of rival firms.

• If a firm reduces the price of its product, some consumers purchasing competing product varieties will switch to it, causing the quantity demanded of its product to increase.

• Conversely, if a firm raises the price of its product, some of its customers will shift to similar products offered by competing firms, reducing the quantity demanded for its product.

• Because consumers respond to price changes in this manner, the demand curve facing an individual firm under monopolistic competition is downward sloping.

• As a result of the downward-sloping demand curve, the firm’s marginal revenue (MR) curve lies below its demand curve.

• Unlike a perfectly competitive firm, a firm under monopolistic competition is not a price taker and possesses some degree of control over the price of its own product.

• A higher price enables the firm to sell only a smaller quantity of output, while a lower price enables it to sell a larger quantity.

• Therefore, a firm operating under monopolistic competition must determine an appropriate price-output combination that maximises its profits.

4. Non-price competition:

• An important feature of monopolistic competition is the substantial expenditure incurred by firms on advertising and other selling costs to promote the sales of their products.

• Advertising expenditure is the most prominent form of selling cost and represents an important method of non-price competition.

• Expenditure on advertising and sales promotion affects both the demand for the firm’s product and the firm’s costs of operation.

• Similar to decisions regarding price and product variation, a firm under monopolistic competition adjusts its advertising expenditure to maximise profits.

• The problem of determining the optimal level of selling expenditure is unique to monopolistic competition and does not arise under perfect competition.

• A perfectly competitive firm has no need to advertise because it can sell any quantity of output at the prevailing market price without incurring advertising expenses.

• Therefore, advertising expenditure by a perfectly competitive firm would serve no useful purpose.

• Firms under monopolistic competition engage in intense rivalry through advertising, using it to influence consumers’ preferences, increase demand for their products, and attract customers from competing firms.

• Since firms compete not only through price but also through advertising and sales promotion, a complete analysis of equilibrium under monopolistic competition must include the determination of the optimal level of advertisement expenditure and other selling costs.

5. Product Variation:

• Product variation is an important form of non-price competition under monopolistic competition and arises because firms sell differentiated products.

• This problem does not exist under perfect competition, where products are homogeneous and identical across firms.

• Firms under monopolistic competition continuously attempt to modify their products so that they better satisfy the preferences and wishes of consumers.

• Product variation may take several forms, including:

  • Improvements in the quality of the product.

  • Technical changes and innovations.

  • Introduction of a new design.

  • Use of better materials.

  • Changes in packaging or containers.

  • More prompt, efficient, or courteous customer service.

  • Adoption of a different method of conducting business.

• The quantity a firm can sell depends partly on the extent and effectiveness of its product differentiation relative to competing products.

• When product differentiation is possible, sales depend on the firm’s ability to distinguish its product from rival products and make it attractive to a specific group of buyers.

• The principle of profit maximisation applies not only to pricing decisions but also to decisions regarding the nature and characteristics of the product.

• A firm will choose that form of product variation, given its price, which yields the maximum profit.

• A complete explanation of equilibrium under monopolistic competition must therefore include:

  • Price equilibrium.

  • Selling-cost (advertising) equilibrium.

  • Product equilibrium, which determines the most profitable form of product differentiation.

6. Freedom of entry and Exit:

• An important characteristic of monopolistic competition is the freedom of entry and exit of firms from the industry.

• Free entry implies that when existing firms earn super-normal profits, new firms are attracted into the industry.

• Entry of new firms increases the number of product varieties and expands the total market output.

• The increase in output intensifies competition and causes the price of the product to tend to fall in the long run.

• However, entry under monopolistic competition is not as easy or as free as under perfect competition.

• Under perfect competition, new firms can enter the industry and produce identical products, enabling them to compete immediately with existing firms.

• Under monopolistic competition, new entrants can only introduce new brands or product varieties rather than identical products.

• Newly introduced brands or product varieties may initially face difficulty competing with well-established brands that already possess consumer recognition and market acceptance.

• Therefore, although entry and exit are generally free under monopolistic competition, the presence of product differentiation makes entry relatively more difficult than under perfect competition.