Monopolistic Competition Chapter 16 PDF

# MONOPOLISTIC COMPETITION ## (PRICE AND OUTPUT DETERMINATION) ## INTRODUCTION From Marshall to Knight, perfect competition and monopoly were accepted as classical micro theory. But reactions started against it in the 1920 and 1930. People started saying that none of the two represented correctly...

# MONOPOLISTIC COMPETITION ## (PRICE AND OUTPUT DETERMINATION) ## INTRODUCTION From Marshall to Knight, perfect competition and monopoly were accepted as classical micro theory. But reactions started against it in the 1920 and 1930. People started saying that none of the two represented correctly the business firms and market behaviour. In 1926, Sraffa, first of all, pointed to the limitations of competition and monopoly. Harold Hotelling tried to show in 1929 that neither perfect competition nor monopoly reflected real market structure. Reality lies in between the two. Similarly, in 1930 F. Zeuthen expressed the opinion that monopoly and perfect competition were the outer edges of the reality. Reality must be searched between the two extremes. Towards the end of the 1920 and in the early part of 1930 economists turned their attention to this intermediate area. Two economists on the two sides of the Atlantic, the British economist, Joan Robinson and the American Edward Chamberlin succeeded in their endeavour. Chamberlin wrote his famous book, "The Theory of Monopolistic Competition" in 1933 and in that very year Robinson's "The Economics of Imperfect Competition" appeared. Thus the two books appeared virtually simultaneously, but independently. ## ROBINSON'S THEORY Professor Robinson broke away from the analytical framework of perfect competition and built up her analysis on the basis of firms in imperfect competition. Each firm in imperfect competition has a monopoly in its product though very close substitutes exist which are produced by other firms. Imperfect competition is a wide term that includes, the following situations of the market: (1) Monopolistic competition, wherein the number of sellers is quite large, (2) Oligopoly wherein the sellers are few in number, (3) Duopoly, where there are only two sellers. ## CHAMBERLIN'S THEORY Chamberlin's approach is different from Robinson's. While Robinson introduced monopoly element into perfect competition, Chamberlin found competition in a monopolised market a blending of monopoly and competition. The chief feature of monopolistic competition is a very considerable amount of competition with a small dose of monopoly power. Imperfect competition is a generic term. It is used in two ways: (i) It refers to any form of market structure other than perfect competition and includes monopoly, oligopoly and monopolistic competition, i.e., the case of one seller, that of a few sellers and that of many sellers. (ii) It refers to any market structure other than perfect competition and monopoly, i.e., any market structure falling between these two polar cases. In this chapter we shall develop Chamberlin's model of monopolistic competition. ## MEANING OF MONOPOLISTIC COMPETITION Monopolistic competition refers to a market situation in which there are many producers producing goods which are close substitutes of one another or where output is differentiated. According to J.S. Bains, "Monopolistic competition is market structure where there is a large number of small sellers, selling differentiate but close substitute products." In the words of Baumol, "The term monopolistic competition refers to the market structure in which the sellers do have a monopoly (they are the only sellers) of their own product, but they are also subject to substantial competitive pressure from sellers of substitute product." ## MAIN FEATURES OR CHARACTERISTICS OF MONOPOLISTIC COMPETITION The important features/characteristics of monopolistics competitions are as under: 1. **A Large Number of Firms** The first important feature of monopolistic competition is that under it there are a relatively large number of firms each satisfying a small share of the market. There are also a large number of buyers of that commodity. 2. **Product Differentiation** Product differentiation is another salient feature of monopolistic competition. The products produced by various firms are not identical but are slightly different from others, they remain close substitutes of each other. Therefore, their prices cannot be very much different from each other. 3. **Freedom of Entry and Exist** Under the monopolistic competition firms are free to enter and leave the industry as in case of perfect competition. Here it may be noted that Chamberlin has used the term 'group' rather than 'industry for the number of firms producing differentiated products under monopolistic competition. 4. **Limited Influence over the Price** Each firm has limited control on the price of its product. Average and marginal revenue curves of a firm under monopolistic competition slope downwards as in case of monopoly, implying that more can be sold only at a lower price. However, unlike monopoly, complete control over price is not possible because of the availability of large number of close substitutes in the market. Accordingly the price policy of each firm is influenced to a great extent by the price policy of its competitors in the market. 5. **Non-price Competition** An important feature of monopolistic competition is that firms incur a considerable expenditure on advertisements and other selling costs to promote the sales of their products. Promoting sales of their product through advertisement is an important example of non-price competition. The expenditure incurred on advertisement is prominent among the various types of selling costs. The rival firms under monopolistic competition keenly compete with each other through advertisement by which they change the consumers' wants for their product and attract more customers. The advertisement and other selling outlays by a firm change the demand for its product as well as its costs. Thus, selling costs emerge as a significant component of the total cost of a firm. 6. **Imperfect Knowledge** Buyer and sellers lack perfect knowledge about the price of the product because it is not possible to compare the products of different firms due to product differentiation. Buyers tend to develop a short of brand loyalty. Respecting their brand-loyalty, they often tend to ignore information related to other brands in the market. Likewise, owners of factor services are also not fully aware about the price of factor services being offered by other firms in the market. ## THE NATURE OF DEMAND AND MARGINAL REVENUE CURVES UNDER MONOPOLISTIC COMPETITION It is important to understand the nature of the demand curve facing an individual firm under monopolistic competition. We know the demand curve facing a firm working under perfect competition is perfectly elastic at the ruling market price since it has absolutely no control over the price of the product. On the contrary, a firm working under monopolistic competition enjoys some control over the price of its product since its product is somewhat differentiated from others. If a firm under monopolistic competition raises the price of its product, it will find some of its customers going away to buy other products. As a result, the quantity demanded of its product will fall. On the contrary, if it lowers the price, it will find that buyers of other varieties of the product will start the purchasing its product and as a result the quantity demanded of its product will increase. It therefore follows that the demand curve facing an individual firm under monopolistic competition slopes downward. If a firm working under monopolistic competition wants to increase sales of its product, it must lower the price. It can raise the price if it is prepared to sacrifice some sales. Consider Fig. 1(A), DD is demand curve facing an individual firm under monopolistic competition. At price OP the quantity demanded is OQ. Therefore, the firm would be able to sell OQ quantity at price OP. If it wants to sell greater quantity OQ2, then it will have to reduce price to OR. If it restrict its quantity to OQ1, the price will rise to OM. Thus, every quantity change by it entails a change in price at which the product can be sold. Demand curve facing a firm will be his average revenue curve. Thus, the average revenue curve (AR) of the monopolistically competitive firm slopes downward throughout its length. Since average revenue curve slopes downward, marginal revenue (MR) curve lies below it. This follows from usual average-marginal relationship. The implication of marginal revenue curve lying below average revenue curve is that the marginal revenue will be less than the price or average revenue. When a firm working under monopolistic competition sells more, the price of its product falls, marginal revenue must be less than price. In Fig. 1(B) AR is the average revenue curve of the firm under monopolistic competition and slopes downward. MR is the marginal revenue curve and lies below AR curve. At quantity OQ, average revenue (or price) is OP and marginal revenue is HQ which is less than OP. Downward slope of demand curve under monopolistic competition is more elastic than under monopoly. It is because of the availability of a large number of closed substitutes of the product under monopolistic competition. We know that there are no closed substitues of the product under monopoly. Lack of close substitutes under monopoly imparts inelasticity of the firm's demand curve. ## FIRM, INDUSTRY AND GROUP The firm under monopolistic competition is one of many. So no single firm dominates the industry. Product of each firm has to face close competition with that of similar other firms. The elasticity of demand for the product of each firm is very high because the products are close substitutes for one another. It was Sraffa who in 1926 introduced the concept of product differentiation in economic theory in order to derive a downward sloping demand curve of the firm. Chamberlin elaborated this concept and its implications. The demand curve of the firm is dependent not only on its price policy but also on its quality and selling activities. Thus he introduces two additional variables in the theory of firm, the product itself and selling activities, besides price. But product differentiation is a source of difficulties in the analysis of the industry. Homogeneous products present no difficulty in adding the demand and supply of numerous firms in the industry to form market demand and supply curves. Because of product differentiation, the products of different firms are heterogeneous products. In order to get a summation of individual demand and supply curves, there must be a common denominator. This common denominator is lost in the case of product differentiation because each firm produces differentiated commodity; so there is nothing like a single price in perfect competition. The concept of industry, therefore, does not remain very useful. So Chamberlin uses the concept of a "group" or a "product group". A group is several firms whose products are close technological and economic substitutes. The real connotation of a group lies in the fact that an industry consists of two or more groups of closely competitive firms. Take, for example, an automobile industry. One group of firms manufactures small cars; another group luxury cars; a third group only jeeps; a fourth group heavy vehicles like trucks. Within any one group, close competition exists, but between groups competition may not be keen. In view of the above, Chamberlin's analysis of monopolistic competition deals largely with the individual firm and does not refer directly to the Industry. Because of product differentiation, no two firms produce the same material. So it is almost impossible to define an industry in a situation like this. ## EQUILIBRIUM OF FIRM UNDER MONOPOLISTIC COMPETITION ### OR ### PRICING UNDER MONOPOLISTIC COMPETITION #### **Assumptions** Chamberlin's analysis of price-output determination under monopolistic competition is based on the following assumptions : (i) Large number of small firms each producing closely substitute products; (ii) Each firm produces on the assumption that rival firms do not pay any attention to its activities. So a small cut in price can lead to large increase in its sales. Chamberlin assumes that as a result of price cutting by one firm, other firms may resort to larger price cutting but the firms doing it first are unable to understand that others are doing it in reaction. In other words, there is absence of inter-dependence. (iii) Each firm tries to maximize profit. (iv) There is no analysis of industry equilibrium. Instead, Chamberlin considers group equilibrium. #### **Short-period Analysis of the Firm** Short-period analysis of the firm under monopolistic competition is similar to that of other markets. It is chiefly concerned with the present adjustments made by the firm. It has no time to change the scale of production; so new firms do not make firm. It has time to change price and output adjustments. Besides, the firm is in a position to change its demand curve to some extent through advertisements and quality change. In short-period, a firm will be in equilibrium when (i) its MC = MR and, (ii) MC curve cuts MR curve from below. However, quantum of profit available to a firm in equilibrium depends upon the demand for the product and the efficiency of the firms. In this time period, the firm may face any of the three situations (in a state of equilibrium) : (1) Super Normal Profit, (2) Normal Profit, and (3) Losses. Each firm produces and sells its product in close competition with other similar firms. Firm's output, price and maximum profit in the short-period are presented in the figures given below : (1) **Super Normal Profit**: Fig. 2 shows that SAC and SMC are short-period average cost and marginal cost curves of the firm. AR is the demand curve (D) of the firm which has a negative slope, so MR, the marginal revenue curve, lies below the AR curve. Firm is in equilibrium at point E. Here, MC = MR and SMC curve cuts MR curve from below. Point E indicates that the firm's equilibrium output is OQ. Price of equilibrium output is OP (= AQ). This equilibrium price AQ is greater than average cost BQ (AQ > BQ). Hence the firm earns super normal profit equivalent to the difference between AQ and BQ, i.e., AB per unit. Total super normal profit of the firm in equilibrium is ABCP, the shaded area. (2) **Normal Profit**: Fig. 3 illustrates equilibrium of the firm with normal profits. Equilibrium is struck at point E where (i) MR = MC, and (ii) SMC curve cuts MR curve from below. OQ is the equilibrium output. Price of the equilibrium output is OP (= AQ) and average cost is also OP (= AQ), because AR curve is touching SAC curve at point A. Hence, at the level of equilibrium output, AR is equal to SAC and the firm earns normal profit. (3) **Losses**: In the short period, a firm in equilibrium may incur loss of fixed cost. It is illustrated through Fig. 4. The firm strikes equilibrium at point E where MC = MR and MC curve is cutting MR curve from below. The firm produces OQ units of output. Equilibrium price is OP (= AQ) and average cost is OC (= BQ). Corresponding to the point of equilibrium, average cost of the firm is more than the price (AC > AR). Hence, the firm suffers a loss equivalent to (BQ - AQ = AB) per unit of output. However, the firm manages to cover its variable cost, as (corresponding to the point of equilibrium) price (AR) = AVC (average variable cost). The diagram shows that (corresponding to the point of equilibrium) AR curve touches the AVC curve (at point A). Thus, in case of equilibrium the firm covers only AVC from the prevailing price AQ. It is incurring loss of fixed cost equivalent to AB per unit. The total loss of the firm will be BAPC, the shaded area. It is to be noted that in a state of equilibrium, a firm tries to minimise its losses by covering as much of fixed cost as possible. The maximum loss it can afford to sustain (during the short period) is of course upto the total fixed cost, as fixed cost are incurred even before output starts taking place and therefore are beyond the control of the firm. Accordingly, during the short period, a firm may not discontinue its production so long as variable costs are recovered. Thus, Fig. 4 shows equilibrium just at a point (A) where only price (AR) = AVC (average variable cost). ## The Group In monopolistic competition, each firm's demand curve is highly elastic. It is influenced by the prices charged by other firms. A supply curve cannot be drawn for a group of firms under monopolistic competition. A supply curve shows the amounts forthcoming at different prices. It can be so drawn for an industry under perfect competition because each firm produces identical product and gets identical prices. But in monopolistic competition each firm in a group produces a different product and charges a different price. We proceed by assuming that the demand curve of the firm is given. Now each seller, acting independently but jointly, attempts to adjust its output to the given demand curve in such a way that MC = MR. If the total output of the firms equals the total demand of the sellers, the group will be in temporary equilibrium. If firms' total output varies from the buyers' total demand, equality will be attempted through changes in sellers' total demand. In a state of group equilibrium, firms may earn profit or may not or may incur losses. All the three possibilities exist. ## Long-run Analysis In the long-run under the monopolistic competition all inputs of a firm are variable and thus firms are able to change the scale of their plant and are able to leave or enter the market. Since there is free entry and exit in monopolistic competitive market, the long-run equilibrium of a firm is struck only at a point where it generates normal profits (AR = AC). In the long run, the firms under monopolistic competition will (i) neither earn super normal profits, (ii) nor incur losses but (iii) earn only normal profits. This is how it happens : (i) **Firms will not earn Super Normal Profits**: If super per normal profits are earned, new firms will enter the product group. They will begin to produce closely related products. Accordingly, market price of the product tends to fall; otherwise existing producers will start losing their market share to the new entrants. However, fall in product price, triggers a fall in profits. This process would continue till all firms in the product group generate only normal profits. Thus, each firm, even when it continues to enjoy market control owing to product differentiation, is pushed to a point where it earns only normal profits. It happens owing to freedom of entry and exit in the product group. But it happens only in the long run, because entry and exit is possible only in the long run. (ii) **Firms will not Incur Loss**: In the long run, no firm will incur loss either. If the producer suffers loss in the long run, it would be prudent for him to quit the product group. Suffering losses in the long run when all costs are variable costs is not a rational choice. In case of losses, when the marginal producers quit the group, market supply of the commodity will fall. Given its demand, price of the product will rise and enable the existing firms to wipe out their losses. This process of price rise (triggered by quittal of the marginal firms) would continue till the existing firms start making normal profits. Price and output determination in the long run is explained with the help of Fig. 5. In this diagram, LAC is long-run average cost curve and LMC is long-run marginal cost curve; AR is average revenue and MR is marginal revenue curve. LMC = MR and LMC is cutting MR curve at point E which is equilibrium point. OQ is the equilibrium output and OP (= AQ) is the price of equilibrium output. At equilibrium output OQ average revenue curve is tangent to long-run average cost curve at point A. Implying that in equilibrium, price and average cost are equal; i.e., AR = LAC. Hence, the firm earns only normal profit. At the point of tangency A of AR and LAC, profits are maximised; since at any other price on the average revenue curve, long run average cost (LAC) is greater than average revenue and the firm would be incurring losses. With normal profits for all firms in the group, there will be no incentive for new firms to enter or disincentive for the existing firms to quit the product group in the long-run. ## Group Equilibrium Chamberlin's analysis of group equilibrium in the long-run is based on a heroic assumption, namely, that each firm has identical demand and cost curves. It implies that the firm's demand and cost curves are also the demand and cost curves of the group and the firms have equal shares of the market. If a new firm enters into the group, its demand and cost curves will be identical with those of the existing firms. Let us now assume that in this simple situation, the firms were incurring losses in the short-period. In the long-run, therefore, some firms will leave the industry. The effect of this will be decrease in the supply of the product of the group, rise in price and upward shift in the demand curves of the remaining firms. Long-run equilibrium is established when each firm's demand curve rises to DD1 (Fig. 6) to which the long-run average cost LAC is tangent. It is obtained at the output OQ, which satisfies the fundamental condition of equilibrium, i.e., MC = MR. Take the opposite case. Suppose the firms were earning abnormal profit in the short-run. In this event some new firms will enter into the group resulting in the expansion of total output of the group, decrease in price and upward shift in the demand curve. Long-period equilibrium is established when the demand curve of every firm touches the LAC, i.e., is tangent to LAC. Fig. 6 is relevant in this case as well. At the point of tangency between demand curve and long-run average cost, P = LAC and profits, in the sense of abnormal profits, are zero. A few important characteristics of this equilibrium state need to be noted : * The long-run equilibrium position in monopolistic competition differs from that in perfect competition since P ≠ LMC (i.e., price does not equal long-run marginal cost). In Fig. 6, price is PQ which is greater than long-run marginal cost RQ. * Production takes place on the downward sloping segment of the LAC. It means that the firm in monopolistic competition produces its desired output at more than minimum cost. * Thus, the firm under monopolistic competition is inherently less efficient than it counterpart in perfect competition because it produces with excess capacity. ## Short and Long-period Equilibrium : A Comparative Analysis Short and long-run equilibrium in monopolistic competition can be compared with the help of Figs. 7 through 9. The comparison is done on the basis of the following 3 assumptions : (a) large number of buyers; (b) product differentiation; and (c) absence of blocked entry into or exit from the group. Short-run equilibrium is established in monopolistic competition in the same way as in monopoly. The firm does not sell at the given price. It tries to maximize profit by bringing about changes in price and output. As shown in Fig. 7, the equilibrium price and output are OP1 and OQ1 respectively. Abnormal profit of the firm is given by the area P1RST. Abnormal profit earned by the firm in the short-period will attract new firms in the group. Entry of new firms will lead to a decline in the share of each firm in the total supply and a shift in the demand curve of the firm to the left. This process will come to an end with the competing away of super normal profit. Fig. 8 depicts the intermediate state, i.e., the situation before coming to the state of zero profit. It is clear from the figure that profit is earned on output between OQ3 and OQ2. In Fig. 9, the final position of long-run equilibrium has been presented. Where profit becomes zero and P = LAC. This state is obtained at the price P4. Fig. 9 is a special case of long-run equilibrium where monopoly price is determined because P > MC but there is no monopoly profit. This state of monopoly price without monopoly profit is possible only in monopolistic competition. Product differentiation leads to monopoly price but freedom of entry into and exit from the group wipes out monopoly profit. Bober says that we should take lesson from this particular price (i.e., P4 in Fig. 9). Absence of profit does not imply absence of monopoly element. But the presence of profit, that is, abnormal profit, does not always mean the presence of monopoly power. Substantial profit can be earned in the short-period under perfect competition. “He states on thin ice who identifies profits with monopoly and monopoly with profits." ## THEORY OF EXCESS CAPACITY The theory of excess (or unutilised) capacity is associated with monopolistic competition in the long-run and is defined as "the difference between ideal (optimum) output and output actually obtained in the long-run." Optimum output of a firm have been regarded to be the output where long-run average cost is a minimum. Under the monopolistic competition the firm have excess capacity because these do not produce at the minimum point on its LAC curve. In other words, excess capacity is a situation of unused capacity in which each firm is producing its output at an average cost that is higher than it could be at its optimum capacity output. Consider Fig. 10. Here the firm achieves its long-run equilibrium at point E. At this point LMC = MR and the AR curve is tangent to the LAC curve. The equilibrium or actual output is OQ. The ideal output of the firm is OQ1 at which LAC is minimum. The difference between optimum output (OQ1) and actual output (OQ) indicates excess capacity. In other words, Excess Capacity = Optimum Output - Actual Output OQ1 - OQ = OQ1 - OQ Excess capacity exists because in the long-run equilibrium (showing normal profits only) downward sloping AR curve can be tangent to the U-shaped AC curve only to the left of the minimum point of AC. ## NON-PRICE COMPETITION (1) **Product Differentiation** A substantial part of the competition that is monopolistic is not price competition but non-price competition. The two chief forms of non-price competition are product variation and advertising. Chamberlin uses the term product variation for quality competition. Non-price competition takes the forms of (a) manipulation of qualities of the products by the firms and (b) advertising activities, while the prices remain constant. **Equilibrium of the Firm** We start with the firm, the price of whose product is fixed by custom or inertia and does not change for months. Its product is, however, differentiated in colour, durability, packaging, workmanship, design or services. Attempts are made to convince the buyers that, through these methods, the commodity is improved and so they should purchase more of that brand which is so improved. Larger sale adds, on the one hand, to the receipts or revenue of the firm and, on the other, to its total costs. So the firm will try to select that variant of the product which maximises profit. In Fig. 11, long-run average cost of the two variants is represented by CA for variant A and CB for variant B. OP is the constant price. In this diagram output sold is inserted arbitrarily. The horizontal line drawn from point P is not a demand curve, just a horizontal line. If the firm chooses variant A, it sells amount OA and obtains a net profit of PRST. The firm is able to sell a larger amount of variant B which is equal to OB. Larger sale leads to the increase in total costs and so net profit is smaller than that from A. For other variants like C, D, E, F, .......the firm can calculate sales, costs and net profits.. One of these variants will be such which yields maximum net profit in a way similar to the one where price is the variable and one of the prices is the optimum. While analysing product differentiation, Chamberlin does not think in terms of technological improvement in quality over time. His firm uses existing technology to modify its product. Tastes also do not change and technical and business innovations are absent. ## The Group We continue to assume that all firms have the same costs and shares of the market but there is quality competition, i.e., product is the variable. In this case too, group equilibrium is attained when the LAC is tangent to the demand curve. This happens through the entry of new firms into the group when all firms are alike and make net profits or through the exit of some firms from the group when all firms are alike but are incurring losses. Equilibrium is attained for the firms and group because tangency means equality of price and full costs and so no incentive for the firm either to enter into or leave the group. ## (2) Selling Costs Selling costs are those costs which are incurred in marketing and distributing a product, including the costs of advertising, sales promotion, packaging, salesmanship, etc. Thus the term "selling costs" is broader than advertising. Chamberlin makes a difference between selling costs and production costs. Production costs are costs incurred in making a product, transporting it and making it available to consumers with given wants. Selling costs are costs incurred to change consumers' wants. Though selling costs have broader connotation than advertising costs, Chamberlin uses them interchangeably. By advertising a firm tries to promote the sales of its product, i.e., to increase the number of consumers who prefer its product to those of its competitors. This can be done in two different ways : (i) Advertisements inform consumers of the existence and location of products to which they are directed. It is called informative advertisement. (ii) They attempt to influence the nature of consumers' preferences to the benefit of the firm's products. It is called competitive advertisements. While analysing advertising expenditure, we proceed by assuming that all other things, i.e., price, quality, buyers' income are constant. Our task is to see the type of relation that can be established between the advertising expenditures of a firm and the sales volume of its product. This relation is given in the curve of selling costs. In Fig. 12, SC is a selling costs curve. In appearance the selling costs curve is U-shaped, thus somewhat different from the modern L-shaped cost curve. It is clear from SC curve that for OA' quantity of sale, per unit selling costs come to AA', for OB' quantity, average cost is BB', and so forth. The shape of the curve is such that average cost of advertising first declines due to the initial economies of scale for advertising. The unit cost of advertising reaches a minimum somewhere and then it begins to rise due to the increasing costliness of expanding sales. Economists are of the opinion that the eventual rise of the curve of selling costs must take place and it is different from the L-shaped average production cost. The shape and position of the selling costs curve for a firm's product in a given period of time depend not only on advertising expenses but also on the following factors : * the prices of the product and those of its substitutes; * the quality of the product and those of its substitutes; * incomes of the buyers; and * resistance of the buyers to attempts made by advertisements to change their tastes. Change in any one or more of these variables will change the shape and position of the SC curve. ## Optimum Selling Costs Now the problem is to know the optimum amount that should be spent on advertisements. A profit-maximising firm must spend an amount such that the combined marginal cost of production and that of advertisement is equal to the price the firm gets for its product, as shown in Fig. 13. In the figure OP is the fixed price of the product. The horizontal line from P should be viewed as if it is also the marginal revenue curve. It implies that the firm can sell more without lowering price because of advertising. It has been assumed in the diagram that average cost of production, i.e., per unit production cost is constant as shown by PC line. The selling costs curve is superimposed on the production cost curve. The equilibrium output is OA. The firm will not produce and sell more than OA because in that event it will add more to its cost than to income reducing net profits. Most economists believe that advertisement is not an important determinant of firm's sale. The consensus seems to be that advertising probably affects the composition of spending more than it does the volume of sale. As J. K. Galbraith says in his The Affluent Society : "On some distant day, the voice of each individual seller may well be lost in the collective roar of all together...It will be worth no one's while to speak, for since all speak none can hear." In some industries advertising has become a very large part of the cost of doing business. It may act as an important financial barrier to the entry of new firms. In a number of empirical studies, there have been attempts to probe the economic implications of advertising. These studies suggest that perhaps the micro-economic effects of advertising are not as adverse as economists have traditionally presumed. It is for the reason that a substantial part of total advertising is of an informative type and so is a basic means of informing consumers about prices and terms of sale. Further, advertisement has not been a mechanism to reduce competition but frequently a means for new firms to gain entrance to a group. By enhancing sales, advertising may enable firms to secure a minimum efficient scale and so acquire economies of scale. Recent theoretical and empirical work suggests that advertising should be treated as a capital expenditure. ## Conclusion The monopolistically competitive firm has to deal with three variables, namely, price, product and promotion in seeking maximum profits. In other words, its profits depend on the choosing the specific variety of product, the price at which to sell it and the level of advertising expenses. Thus the study becomes quite complex and is not amenable to a simple, meaningful economic model. ## DIFFERENCES BETWEEN PERFECT COMPETITION AND MONOPOLISTIC COMPETITION The following are the main differences between perfect competition and monopolistic competition : 1. **Nature of the Product** Under perfect competition, each firm produces and sells a homogeneous product so that no buyer has any preference for the product of any individual seller over others. On the other hand there is product differentiation under monopolistic competition. Products are similar but not identical. Products of different firms are close substitutes. They differ from each other in design, colour, flavour, packing, etc. 2. **Degree of Control over Price** Under perfect competition, price is determined by the forces of demand and forces of supply for the whole industry. Every firm has to sell its product at that price. The firm is price taker and it can not influence price by its single action. It has to adjust its output to that price. On the other hand, under monopolistic competition every firm has its own-price policy and has a partial control over price owing to product differentiation. 3. **Nature of Revenue Curves** Under the perfect competition, the demand curve (AR) of a firm is perfectly elastic and the marginal revenue (MR) curve coincides it. As against this, the demand curve of a firm is elastic and downward sloping under monopolistic competition, and its corresponding MR curve lies below it. Downward sloping AR curve indicates that higher sale is possible only at a lower price. Relationship between Price and Marginal Cost Under perfect competition equilibrium price and MC are equal (P = MC). t, under the monopolistic competition, in the equilibrium, price is necessarily her than marginal cost (because AR is above MR). Size of the Firm AR > MR, Hence P > MC. Another difference between the two market situations relates to their size. In the long-run, competitive firms are of the optimum size and produce to their 1 capacity because price (AR) = LMC = LAC at its minimum. But under monopolistic competition, the firms are of less than the optimum size and possess excess capacity because the AR curve is downward sloping and cannot be tangent to the LAC curve at its minimum point. The firm's equilibrium ndition is Price (AR) = LAC > LMC = MR. ## Selling Costs In perfect competition, the firms sell a homogeneous and exactly identical product and need not incur selling costs. Therefore, firms get no benefit from the non-price competition. But monopolistically competitive firms obtain nefits from product differentiation and selling costs. ## Supply Curve Under perfect competition, supply curve can be drawn both for a firm as well as industry. But under monopolistic competition the supply curve cannot be drawn either for a firm or a group of firms. ## Resource Allocation and Economic Welfare Under perfect competition there is optional allocation of resources, implying maximisation of economic welfare. Contrary to it, under monopolistic competition, there is neither optimal allocation of resources nor economic welfare is maximised. ## Valuation Chamberlin's model of monopolistic competition has been subjected to a number of criticisms, some of which are valid while others are not: (i) Product differentiation and independent action by the competitors cannot go together. Similarly, product differentiation and free entry are not consistent assumptions. (ii) Chamberlin's heroic model cannot be accepted because it is far removed from the real world. (iii) Chamberlin's model is indeterminate due to the effects of product variations and selling costs. (iv) Monopolistically competitive firms produce somewhat short of the most efficient, i.e., minimum average cost, output. Production is done at a higher average cost than the minimum attainable. So the monopolistically competitive price is higher than the perfectly competitive price. This higher than competitive price prevails even in the long-run in order to manage a normal profit. (v) Monopolistically competitive industries tend to be overcrowded with firms, each of which is underutilized. It means that each firm under monopolistic competition operates at less than optimum capacity. (vi) In the long-run, it gives rise to the so-called "wastes" of monopolistic competition. These wastes result from the following: * underutilized plants; * consumers made to pay higher than competitive prices; and * producers making only normal profits in the long-run. Some economists, however, argue that price and output results of monopolistic competition are not much different from those of perfect competition because of close substitution between products of different firms and highly elastic nature of demand curve. Further, product not being homogeneous consumers can choose from a variety of products. This offsets any deviations from competitive price and output. ## QUESTIONS **Long Answer Type Questions** 1. Discuss the concept of monopolistic competition. Distinguish it from imperfect competition. 2. Distinguish price competition from non-price competition. 3. Discuss the determination of price under monopolistic competition. 4. What is product differentiation? Examine the equilibrium of firm in the case of product differentiation. 5. What are selling costs? What is the optimum amount of selling costs? 6. What are the main differences between perfectly competitive price and monopolistically competitive price? 7. How are the resources allocated under monopolistic competition? **Multiple Choice Questions** 1. Competition becomes imperfect due to: (A) Conusumer's Preference for the product of