Definition: Monopolistic competition is a type of market structure (imperfect competition) where a large number of firms sell differentiated products that are similar but not identical. In other words, the similar products or services offered by sellers are substitutes for each other but have certain differences.
The objective of differentiation is to create or evolve a product that both potential and existing customers see as unique. Some customers can be so loyal to such a product or service that even a price increase will not make them change to substitutes. Products or services can be differentiated in a variety of ways, e.g., advertising, brand recognition, value addition, etc.
Content: Monopolistic Competition
- Short-Run Supernormal Profit
- Normal Profit in the Long Run
- Monopolistic Competition vs Perfect Competition
Monopolistic Competition Explained
Early classical price theory (up to 1920) discussed only two market models: pure competition and monopoly. However, these two theories did not include selling cost and product differentiation. Hence, economists of that era became dissatisfied with these theories due to other observations that were yet to be theoretically accounted for.
Monopolistic competition as a market structure was introduced in the 1930s by American economist, Edward Chamberlin (regarded as the founding father of the theory of monopolistic competition) and the English Keynesian economist, Joan Robinson. Chamberlain wrote “The Theory of Monopolistic Competition” while Robinson contributed“The economics of Imperfect Competition.” Both books were first published in 1933.
A monopolistic competitive market is a combination of monopoly and perfect competition. Whilst monopoly and perfect competition are at different extremes of the spectrum, monopolistic competition is somewhere in between. It is similar to a monopoly because of the possibility of short-run supernormal profits but also has fewer barriers to entry and exit similar to perfect competition. Monopolistic competition is more practically evident in real-world economies, unlike perfect competition and monopoly.
The presumptions considered for stating that a market has monopolistic competition are as follows:
- A huge number of sellers and buyers are in the group;
- Differentiated products that are close substitutes for each other;
- Free or few barriers to entry and exit of firms in the group;
- The goal of each firm is profit maximization, both in the short run and in the long run ;
- Factor prices and technology are given;
- The firm is assumed to behave as if it knew its demand curves and cost curves with certainty;
- The long run is made up of a number of identical short-run periods;
- According to Chamberlin, both demand and cost curves for all products are uniform throughout the group.
Given below are some of the unique features of a monopolistic competition that differentiates it from other forms of the market:
- Product differentiation
- Many sellers and many buyers
- Producers have some degree of control over price but no firm is dominant enough to unilaterally set the market price
- Consumers appreciate non-price differences among the competitors’ products (non-price competition)
- Firms operate with the knowledge that their actions do not impact the actions of other firms
- Few barriers to entry and exit
- Profit maximization is the main goal of every firm; the profit-maximising condition is that marginal cost should equal marginal revenue (MC=MR)
- Factor prices and technology are given
- A firm behaves as if it knows its demand and cost curves with certainty
- Potential supernormal profits in the short run
- Firms can only earn normal profits in the long run
- Elastic demand curve
- Each firm spends a substantial amount (selling costs) on publicity, including advertisement
- Imperfect Information; buyers and sellers do not have perfect information
Short-Run Supernormal Profit
In the diagram below, the profit maximisation condition is MC (marginal cost) = MR (marginal revenue). At output level Q, the firm charges P for its product, and the average revenue curve (AR) intersects QP at point A. At that point, the AR curve is higher than the average total cost (ATC) curve, meaning that revenue (PAQ) is higher than cost (CBQ). Hence, the firm enjoys short-run supernormal profit (area PABC).
Normal Profit in the Long Run
In the long run, the monopolistic competitive firm will only earn normal profits. This is because new firms will enter the market to compete for the excess profits in the market thus leading to a shift in the demand curve to the left and a consequent decrease in price. New sellers will continue to enter the market until only normal profit is available. At that point, firms have attained long-run equilibrium.
Two conditions must hold in the long run:
- MC must be equal to MR
- AC must also be equal to AR.
Both conditions are satisfied at point A below. Unlike the short run where revenue was higher than cost, both variables are the same in the long run (area PAQ). This implies that the firm is now earning normal profit since the short-run supernormal profit has been competed away by new entrants to the market.
Since the firm benefits most in the short run, it will adopt measures (such as increased innovation, and further product differentiation) to try to maintain the profitable short-run conditions.
Monopolistic Competition vs Perfect Competition
Some of the essential differences between monopolistic competition and perfect competition are:
|Basis||Monopolistic Competition||Perfect Competition|
|Number of sellers/buyers||Many sellers, many buyers||Infinite sellers, many buyers|
|Market power||Some degree of power||None|
|Price determination power||Some degree of power (price setter); due to product differentiation which can lead to brand loyalty, firms have a limited capacity to determine prices||None (price taker); the forces of demand and supply determine the prices of goods and services|
|Types of products||Differentiated (unidentical) or not perfect substitutes||Homogenous/standardized (identical) or perfect substitutes|
|Elasticity of demand||Highly elastic in the long run (downward sloping demand curve)||Perfectly elastic (horizontal demand curve)|
|Average revenue/Marginal revenue relationship||The average revenue (AR) curve is positioned above the marginal revenue (MR) curve (AR >MR)||The average revenue (AR) curve intersects the marginal revenue (MR) curve (AR = MR)|
|Profit maximizing condition||Marginal revenue (MR) = Marginal cost (MC)||Marginal revenue (MR) = Marginal cost (MC)|
|Short-run super normal profits/losses||Yes||Yes|
|Long run normal profits||Yes||Yes|
Examples of Monopolistic Competitive Firms
Farming exhibits the characteristics of a monopolistic competitive market. There are a huge number of farmers all over the world that produce similar crops which can be differentiated based on quality, size, etc. Fruits like a banana, for example, can be used to illustrate the monopolistic competitive nature of farming.
A Large Number of Sellers
India is the world’s largest banana producer with a large number of sellers producing the fruit all over the country.
Similar but Non-Identical Product
Though the Cavendish cultivar is the most widely grown (around 44% as of 2020) there is a wide variety of bananas in India with over 20 varieties cultivated commercially.
Bananas can be differentiated according to factors like quality, and size. In terms of quality, you may consider whether the fruit was grown organically or inorganically. Though the size is predominantly determined by the type of species, it can also be influenced by the supply of the essential conditions and nutrients needed for proper maturity.
Limited Price Determination Power
Because there are readily available substitutes for his or her produce, the banana farmer does not have the price-setting powers enjoyed by a monopolist. However, due to product differentiation which can induce brand loyalty, the farmer has limited power to, for example, increase his or her price without losing customers.
Few Barriers to Entry and Exit
The relatively low cost of farming (apart from mechanized farming) makes it easy to enter or exit the industry. This explains why the agriculture sector is the highest employer of labour in many countries, especially poorer or lower-income countries.
Apart from farming, monopolistic competition can be found in virtually every industry, e.g., hotels, fashion, restaurants, bakeries, etc.