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GM 05 Managerial economics AIMA PGDM assignment
Monopolistic competition is a market
situation in which there are many sellers of a particular product but the
product of each seller is in some way differentiated in the minds of consumers
from the product of every other seller.
Featuresof a Monopolistic Competition
- In
Monopolistic Competition, a buyer can get a specific type of product only
from one producer. In other words, there is product differentiation.
- The firms
have to incur selling expenses since there is product differentiation.
- There is a
large number of sellers with inter-dependent demand and supply conditions.
Sellers are price-makers and the demand curve for the product of an
individual seller is downward sloping. The demand is not perfectly
elastic.
- The firm can
improve or deteriorate the quality of its products too. Improving the
quality helps in increasing the demand and price of the product. On the
other hand, deteriorating the quality helps reduce the average cost of
production.
- The
firms compete for inputs too. Also, they need to operate within a given
technological range. Therefore, no firm can produce a better quality
product at a lower average cost.
- Firms are
expected to know its demand and cost conditions. Further, they must use
this knowledge to maximize its expected profit income.
- Any firm can
leave the group of firms belonging to a specific product group. Also, new
firms can enter the group and produce close substitutes of the existing
products in the group. This ensures that no firm incurs losses or earns
super-normal profits.
- In
Monopolistic Competition, every firm must pursue the goal of profit
maximization.
- It is assumed that all firms in this market structure have identical cost and demand conditions.
Monopolistic competition and Productdifferentiation
Yes, Product
differentiation is an outcome of monopolistic competition or vice-versa as
monopolistic competition is the market structure which combines typical
features of monopoly and perfect competition. Similar to perfect competition
there are many small firms in the market. Their decisions are assumed to be not
interdependent. There is free entry of firms to the market with monopolistic
competition. But due to product differentiation each firm behaves like a
monopolist at its narrow segment of an aggregate market of close substitutes.
Each firm has market power to influence the price for its product choosing the
volume of output. The distinguishing feature of monopolistic competition which makes it as a blending of
competition and monopoly is the differentiation of the product. This means
that the products of various firms are not homogeneous but differentiated
though they are closely related to each other. Product differentiation does not
mean that the products of various firms are altogether different.
They are only
slightly different so that they are quite similar and serve as close
substitutes of each other. When there is any degree of differentiation of
products, monopoly element enters the situation. And. the greater the
differentiation, the greater the element of monopoly involved in the market
situation.
When there are
a large number of firms producing differentiated products, each one has a
monopoly of its own product but is subject to the competition of close
substitutes. Since each is a monopolist
and yet has competitors, there is a market situation which can be aptly
described as “monopolistic competition.”
With
differentiation appears monopoly and as it proceeds further, the element of
monopoly becomes greater. Where there is any degree of differentiation
whatever, each seller has an absolute monopoly of his own product, but is
subject to the competition of more or less imperfect substitutes. Since each is
a monopolist and yet has competitors we may speak of them as ‘competing
monopolists’ and with peculiar appropriateness, of the forces at work as those
of monopolistic competition.”
Many examples of
product differentiation can be taken from market such as there are various
manufacturers of toothpaste which produce different brands such as Colgate.
Patanjali Dant kanti, Binaca, Forhans, Pepsodent, Signals, Neem etc. Thus, the
manufacturer of ‘Colgate’ has a monopoly of producing it (nobody else can
produce and sell the toothpaste with the name ‘Colgate’) but it faces
competition from the manufacturers of Patanjali, Forhans, Binaca, Pepsodent
etc. which are close substitutes of Colgate. A general class of product is
differentiated if a basis exists for preferring goods of one seller to those of
others. Such a basis for preference may be real or fancied; it will cause
differentiation of the product. When such differentiation of the product
exists, even if it is slight, buyers will be paired with sellers not in a
random fashion (as in perfect competition) but according to their preferences.
Monopolistic
competition corresponds more to the real world economic situation than perfect
competition or monopoly and product differentiation pops out to keep market
monopolistic as well as competitive. Thus, it can be said that product
differentiation an outcome of
monopolistic competition or vice-versa.
In monopolistic competition, a firm takes the prices charged by its rivals as given and ignores the impact of its own prices on the prices of other firms.
Unlike in
perfect competition, firms that are monopolistically competitive maintain spare
capacity. Models of monopolistic competition are often used to model
industries.
Firm’s behaviour in short run underMonopolistic competition
Like monopolies, the suppliers in
monopolistic competitive markets are price makers and will behave similarly in
the short-run. Also like a monopoly, a monopolistic competitive firm will
maximize its profits by producing goods to the point where its marginal
revenues equals its marginal costs. The profit maximizing price of the good
will be determined based on where the profit-maximizing quantity amount falls
on the average revenue curve. The profit the firm makes is the amount of the
good produced multiplied by the difference between the price minus the average
cost of producing the good.
Since monopolistically competitive
firms have market power, they will produce less and charge more than a firm
would under perfect competition. This causes deadweight loss for society, but,
from the producer’s point of view, is desirable because it allows them to earn
a profit and increase their producer surplus. Because of the possibility of
large profits in the short-run and relatively low barriers of entry in
comparison to perfect markets, markets with monopolistic competition are very
attractive to future entrants.
As seen from the chart, the firm
will produce the quantity (Qs) where the marginal cost (MC) curve intersects
with the marginal revenue (MR) curve. The price is set based on where the Qs
falls on the average revenue (AR) curve. The profit the firm makes in the short
term is represented by the grey rectangle, or the quantity produced multiplied
by the difference between the price and the average cost of producing the good.
Firm’s behaviour in long run under
Monopolistic competition
Like
monopolies, the suppliers in monopolistic competitive markets are price makers
and will behave similarly in the long-run. Also like a monopoly, a monopolistic
competitive firm will maximize its profits by producing goods to the point
where its marginal revenues equals its marginal costs. The profit maximizing
price of the good will be determined based on where the profit-maximizing
quantity amount falls on the average revenue curve.
While a
monopolistic competitive firm can make a profit in the short-run, the effect of
its monopoly-like pricing will cause a decrease in demand in the long-run. This
increases the need for firms to differentiate their products, leading to an
increase in average total cost. The decrease in demand and increase in cost
causes the long run average cost curve to become tangent to the demand curve at
the good’s profit maximizing price. This means two things. First, that the firms
in a monopolistic competitive market produce a surplus in the long run. Second,
the firm is only able to break even in the long-run; it will not be able to
earn an economic profit.
Long Run Equilibrium of Monopolistic
Competition:
In the long
run, firms in a monopolistic competitive market will produce the amount of
goods where the long run marginal cost (LRMC) curve intersects marginal revenue
(MR). The price is set where the quantity produced falls on the average revenue
(AR) curve. The result is that in the long-term the firm will break even.
