Market Structure: Monopolistic Competition | Economics Optional Notes for UPSC PDF Download

Monopoly

It is a market situation in which there is a single firm selling the commodity, and there is no close substitute for the commodity. It is derived from two Greek words, “monos” meaning single, and “poly” meaning seller.

Features

1. Single seller and large lumber of buyers: 

• There is a single seller of a commodity, and it may be in the form of a firm, a group of firms, a joint stock company, or a state corp. or govt. undertaking. 
• However, there are a large number of buyers who have weak bargaining power and no influence on the price.
• Implication: Since a monopoly produces the industry’s entire output, there is no distinction between firm and industry. A monopoly firm is also an industry in itself. Having full control over the supply makes a monopoly price-maker. Monopoly firm usually exploits the buyers by charging a higher price for their product. This firm is able to earn supernormal profits in the long run.
  

2. No close substitute: 

• The product sold by monopolists has no perfect substitute. 
• Implication: Because cross elasticity is zero, the consumers have to buy the product from a monopolist or go without it.
• The monopoly firm has no fear of competition from new or existing products. This feature helps monopolist to determine the price he likes.

3. Barriers to entry: 

• There are legal, natural, or technical barriers to the entry of new firms so as to avoid competition and control the supply and hence the price of the commodity. 
• Barriers can be in the forms of patent rights, control over technique, or raw material, govt. Laws etc.
• Implication: Thus firm is able to earn supernormal profit in the long run.
  

4. Full control over price: 

• A monopoly firm is an industry in itself and hence a price maker. 
• The above-noted feature makes the firm exert full control over the supply of the product and hence full control over the price of the product.
• As a result, a monopoly firm can earn abnormal profits and losses in the long run.
  

5. Possibility of price discrimination: 

• A monopolist often charges different prices to different customers or markets or uses for the same product. 
• This price policy is called price discrimination, and the monopolistic practice of this is termed a discriminating monopoly. It can be of three types
  (i) Personal price discrimination: In this, the same product is sold at different prices to different kinds of buyers.
  For example Railway ticket is cheaper for senior citizens as compared to young citizens, and doctor charges more for a rich person and less for a poor patient for the same service.
  (ii) Geographical discrimination: Under this same product is sold at different places.
  For example Electricity charges are lower for rural areas compared to urban areas, food corporation of India (FCI) sells rice at different prices in Jammu and Kashmir, and Himachal Pradesh.
  (iii) Use basis discrimination: In this type, the same product is sold at different prices on the basis of different use. The electricity board charges different rate slabs for electricity being used for commercial, industrial, agricultural, and household purposes.
• Implication: A monopolist can increase its profit if it is possible to charge different prices from different markets. So consumers are exploited.
  

6. The demand curve is downward sloping: 

• To sell more quantity, a monopoly firm has to reduce the price of the product in spite of being a price maker. 
• Full control over price doesn’t mean that a firm can sell any amount at a fixed price.

• If he fixes a high price, buyers will purchase less. Thus an inverse relationship exists between the price fixed by monopolists and the quantity sold. This makes the demand curve(ar curve) downward sloping, and the MR curve is below the AR curve.
• Implication: The monopolist tries to increase profit by restricting the supply of products and fixing high prices. Accordingly, the greater the monopoly power in any market, the lesser would be the output and the higher would be the price. This form of the market goes in favor of the seller.

Monopolistic Competition

It is a market situation that has elements of both perfect competition and monopoly.
Markets of products like soap, toothpaste, ac, tea, cycles, etc are examples of monopolistic competition.

Features

1. A large number of sellers and buyers: 

• Each firm acts independently, each firm has a limited share of the market, and the size of each firm is small. However, this number is less than the number of sellers in perfect competition.
• Implication: A large number of firms leads to competition in the market. This prevents the firm from having full control over price. However, firms are in the position to influence the price of its own product depending upon the popularity of their brands.

2. Freedom of entry and exit: 

• The freedom to enter and exit is there, but firms don’t have absolute freedom to enter into the industry as some firms are legally patented and carry a brand name.
• Implication: There are many sellers, but each producer is the sole producer of its brand or product. Thus it enjoys a “monopoly“ position as far as a particular brand is concerned. However, since the various brands are close substitutes, its monopolistic position is influenced due to stiff “competition” from other firms. All firms earn normal profits in the long run.

3. Product differentiation: 

• Product differentiation refers to differentiating the product on the basis of brand, size, color, shape, etc. Differentiating can be based on
  (a) Real difference: It may be due to differences in shape, flavor, color, packing, after-sale service, warranty period, design, workmanship, color, packaging, etc.
  (b) Imaginary differences: It means differences that are not really obvious, but buyers are made to believe that such differences exist through selling costs (advertising), display, attractive showrooms, credit facilities, and home delivery systems.
  Examples: We have product differentiation in soaps, toothpaste, and cosmetics.
• Implication: High degree of product differentiation ( better brand image) increases demand for the product and enables the firm to charge a price higher than its competitor's products. Product differentiation creates a monopoly position for a firm i.e. Somemonopoly power to influence the price. This gives monopolistic partial control over price as if a particular product is preferred by the consumer, he will be ready to pay a higher price.

4. Selling cost: 

• Selling costs are the expenses that are incurred for promoting sales or for inducing customers to buy the good of a particular brand. 
• These include the cost of advertisement through newspapers, tv, and radio, free sampling, show windows, salaries of salesmen, and costs of other sales promotion activities. These costs are also called advertisement costs.
• Implication: Selling cost creates artificial superiority in the minds of the consumer. As a result firm’s demand curve shift to the right. However, it also tends to increase the cost of production.

5. Lack of perfect knowledge: 

• Due to a large number of buyers and product differentiation, it is not possible to compare the prices of different products, and thus, buyers are not fully aware of the prevailing prices of all products.

6. Non-price competition: 

• Monopolistic firms generally don’t disturb the price of products, and they attract customers by giving free gifts, services, coupons, and other attractive schemes. 
• Thus non, price competition refers to competing with other firms by offering free gifts, making favorable credit terms, etc without changing the prices of their own products.
  For example: With the purchase of surf, customers get a bucket free or a scratch card to win exotic holidays with every purchase of Samsung product or a 0% finance facility.
• Firms under monopolistic competition compete in a number of ways to attract customers. They use both price competition (i.e., competition by reducing the price of the product) and non-price competition to promote their sales.

7. Downward sloping demand curve: 

• It means to sell more, a firm has to reduce price, but due to the availability of close substitutes, it is more elastic or flatter than the demand curve of a monopoly firm. 

8. Less mobility: 

• There is no perfect mobility of factor owners as fop are not fully aware of prices being paid by different firms to factor owners for their services.

Chamberlin’s Model Assumptions

Product Differentiation and Non-price Competition

• We get downward sloping curves with product differentiation. The products of different sellers are similar yet differentiated. To promote product differentiation, the firms incur considerable expenditure on advertising.

Myopia

• The myopic vision of firms arises when the long run consists of identical short runs. Here, the decisions of one period do not impact the decisions of other periods.

Heroic Assumption (uniformity assumption)

• Chamberlain assumes that both the demand and the cost curves for all differentiated are uniform throughout the group.
• There is an interpretation that while each product is different, the consumer tastes for each are the same. It does not affect the price much.

Monopolistic Competition Vs. Oligopoly

• In monopolistic competition, the firm’s actions wean the consumers from other firms.
• However, the loss of the firm is so insignificant that it doesn’t notice or care to respond. This happens due to the close sustainability of the products.
• In the case of an oligopoly market, the firms choose to respond to the changes that they observe in their consumers.

Product Differentiation and Demand Curve

• Chamberlin suggested that it is not just the price and the quantity that affect the demand curve. It is also the product and the selling activities of the firm.
• A change in the selling strategy of the firm, or consumer tastes, or products of other firms, can cause the demand curve to shift left or right.
• Due to product differentiation, the producer gets some monopoly power. However, due to the close sustainability, there is limited power.

Industry and Product Group

• A product group consists of products which are close and technical substitutes. This means they have high cross elasticities.
• Due to the differentiation of the products, there will be no unique price in the group. But, this might cause a cluster of prices. However, this cluster changes as and when the demands and the costs change.

Long-Run Firm and Group Equilibrium under Monopolistic Competition

• In the case of a short run, each firm behaves like a monopolist in its demand curve. However, it can’t stay there forever due to the supernatural π, new firms will enter. Though the new firms cannot produce the same product but can get somewhat close to it.
• Due to this, the firm’s demand curve will shift to the left from dd to d’d’. The final equilibrium will be tangent to the LAC Curve and the firm will operate at less than full capacity. The tangency to the LAC Curve ensures no supernatural profits remain.
• Even in the long-run, the firm can only make normal profits. Its price is higher and the output is lower as compared to PC. This shows that the existence of supernatural profits is not an indicator of monopoly power.
• Another significant implication is that as more and more firms enter, the LR in the demand curve of the firm keeps on becoming flattered. This happens because the firm is earning supernormal profit and the new firm will try to produce a closer substitute to it.
• The new firms that enter the group will occupy positions between the old demand curves.

Economic Efficiency under Monopolistic Competition

• In the model, the firm never touches the minimum LAC. the amount by which the LR output falls short of the socially ideal output. That is why there is excess capacity.
• One of the reasons for this action is the downward sloping demand curve. Another reason could be the entry of large firms in the market. The markets get split among the great number of firms and excess capacity results.
• It is also believed that in the monopolistic competition, the firms spend on advertising and other selling costs.
• Chamberlin argues that the social cost of producing the social cost of providing differentiated goods to consumers. Therefore, it is not the real excess capacity.
• The real excess capacity will be when the firms abandon the price competition and begin to compete on the non-price terms and more differentiation. In the case price competition is absent, the demand curve is irrelevant.
• However, Kaldor argues that the presence of the institutional monopolies might break the excess capacity theory of Chamberlin. Institutional monopoly may be a cost advantage. That is something that can give supernatural profits. Thus, it can reduce excess capacity.
• Adding to this, Kaldor said that one can also reduce excess capacity. But switching production also has some costs.