Chapter 15, Problem aWYWL

To determine

Monopolistic Competition

Concept Introduction:

Monopolistic Competition - An imperfect market competition where there are large numbers of sellers selling differentiated product and is called monopolistic competition. It exhibits the elements of both a monopoly and perfect competition.

Explanation of Solution

The monopolistic market structure is a deviation from perfection with a faint degree of monopoly due to product differentiation creating an idea of difference from the other sellers’ product. It is an imperfect competition where large number of buyers and sellers interact in the product market for the determination of the equilibrium quantity and price of the goods/services negotiated. The defining features of the monopolistic competition within the framework of EH Chamberlain’s work “The Theory of Imperfect Competition” are-

1. Large number of firms The number of sellers in the market though far less than that in pure competition is so large that no single seller can influence market price. Every seller however, has some loyal buyers and each buyer and seller can affect the quantity demanded and supplied.
2. Relative freedom and exit of firms - This refers to an economic predicament where the firms can enter the market of an economic good with few or no major barriers to the entry and exit. The entry and exit of firms is not free like that in the perfect competition but insignificant in comparison to that in an oligopolistic, duopoly or monopoly market structure.
3. Product differentiation - The products produced by different sellers are close but imperfect substitutes. They differ in color, form, packing, size, name etc creating brand affinity. This differentiation helps create smaller markets of monopoly within the broader imperfect competitive framework. Further, this creates indirect barriers to entry of new sellers becoming a source of competitive advantage.
4. Imperfect information - The price of and profitability from the same good varies across the markets owing to the lack of complete knowledge of the market conditions to the buyers and sellers.
5. Transportation Costs The positive and varying transportation costs across the markets leads to the similar or near similar goods being sold at different prices in different markets, domestic or international.
6. Advertising affects demand − Advertising, the most prevalent audio-visual form of marketing communication plays a significant role in the monopolistic competition as the sellers extensively resort to it to send across the non-personal message through mass media to promote or sell their product. In addition to the physical product differentiation, the advertisements create a psychological product differentiation in the minds of the buyers.
7. Inelastic Demand According to Prof. Lerner − “ The condition of imperfect competition arises when a seller has to face the falling demand curve.” In the monopolistically competitive markets, the sellers are price makers though with limited isolated monopoly powers. The product differentiation allows the sellers to price the output at a higher than efficient level yielding supernormal profits in the short run. In the long run however, this supernormal component is competed away by the new entrants into the market and the firms earn only normal profits.
8. Inefficient The downward sloping demand curve implying an inelastic demand, establishes the firm/market equilibrium at a lower than efficient level. The Marginal Revenue and Marginal cost interacts at a cost level where the production plant is sub-optimally utilized. The Average Cost at the point of production is above minimum while the firm is still to reap the economies of large scale production.