Under, the Monopolistic Competition, there are a large number of firms that produce differentiated products which are close substitutes for each other. In other words, large sellers selling the products that are similar, but not identical and compete with each other on other factors besides price.
- Monopolistic competition occurs when an industry has many firms offering products that are similar but not identical.
- Unlike a monopoly, these firms have little power to set curtail supply or raise prices to increase profits.
- Firms in monopolistic competition typically try to differentiate their product in order to achieve in order to capture above market returns.
- Heavy advertising and marketing is common among firms in monopolistic competition and some economists criticize this as wastefull.
Features of Monopolistic Competition
- Product Differentiation
This is one of the major features of the firms operating under the monopolistic competition, that produces the product which is not identical but is slightly different from each other. The products being slightly different from each other remain close substitutes of each other and hence cannot be priced very differently from each other.
- Large number of firms
A large number of firms operate under the monopolistic competition, and there is a stiff competition between the existing firms. Unlike the perfect competition, the firms produce the differentiated products which are substitutes for each other, thus make the competition among the firms a real and a tough one.
- Free Entry and Exit
With an intense competition among the firms, the entity incurring the loss can move out of the industry at any time it wants. Similarly, the new firms can enter into the industry freely, provided it comes up with the unique feature and different variety of products to outstand in the market and meet with the competition already existing in the industry.
- Some control over price
Since, the products are close substitutes for each other, if a firm lowers the price of its product, then the customers of other products will switch over to it. Conversely, with the increase in the price of the product, it will lose its customers to others. Thus, under the monopolistic competition, an individual firm is not a price taker but has some influence over the price of its product.
- Heavy expenditure on Advertisement and other Selling Costs
Under the monopolistic competition, the firms incur a huge cost on advertisements and other selling costs to promote the sale of their products. Since the products are different and are close substitutes for each other; the firms need to undertake the promotional activities to capture a larger market share.
- Product Variation
Under the monopolistic competition, there is a variation in the products offered by several firms. To meet the needs of the customers, each firm tries to adjust its product accordingly. The changes could be in the form of new design, better quality, new packages or container, better materials, etc. Thus, the amount of product a firm is selling in the market depends on the uniqueness of its product and the extent to which it differs from the other products.
The monopolistic competition is also called as imperfect competition because this market structure lies between the pure monopoly and the pure competition.
PRICING UNDER MONOPOLISTIC COMPETITION
Price determination under Monopolistic Competition: Equilibrium of a firm
In monopolistic competition, since the product is differentiated between firms, each firm does not have a perfectly elastic demand for its products. In such a market, all firms determine the price of their own products. Therefore, it faces a downward sloping demand curve. Overall, we can say that the elasticity of demand increases as the differentiation between products decreases.
Fig. above depicts a firm facing a downward sloping, but flat demand curve. It also has a U-shaped short-run cost curve.
Conditions for the Equilibrium of an individual firm
The conditions for price-output determination and equilibrium of an individual firm are as follows:
(a) MC = MR
(b) The MC curve cuts the MR curve from below.
In Fig., we can see that the MC curve cuts the MR curve at point E. At this point,
- Equilibrium price = OP and
- Equilibrium output = OQ
Now, since the per unit cost is BQ, we have
- Per unit super-normal profit (price-cost) = AB or PC.
- Total super-normal profit = APCB
The following figure depicts a firm earning losses in the short-run.
From Fig., we can see that the per unit cost is higher than the price of the firm. Therefore,
- AQ > OP (or BQ)
- Loss per unit = AQ – BQ = AB
- Total losses = ACPB
If firms in a monopolistic competition earn super-normal profits in the short-run, then new firms will have an incentive to enter the industry. As these firms enter, the profits per firm decrease as the total demand gets shared between a larger number of firms. This continues until all firms earn only normal profits. Therefore, in the long-run, firms, in such a market, earn only normal profits.
As we can see in Fig. above, the average revenue (AR) curve touches the average cost (ATC) curve at point X. This corresponds to quantity Q1 and price P1. Now, at equilibrium (MC = MR), all super-normal profits are zero since the average revenue = average costs. Therefore, all firms earn zero super-normal profits or earn only normal profits.
It is important to note that in the long-run, a firm is in an equilibrium position having excess capacity. In simple words, it produces a lower quantity than its full capacity. From Fig. above, we can see that the firm can increase its output from Q1 to Q2 and reduce average costs. However, it does not do so because it reduces the average revenue more than the average costs. Hence, we can conclude that in monopolistic competition, firms do not operate optimally. There always exists an excess capacity of production with each firm.
In case of losses in the short-run, the firms making a loss will exit from the market. This continues until the remaining firms make normal profits only.