In 1932, Chamberlin and Robinson proposed the model of monopolistic competition. The term was invented by them to express the idea that under certain market situations, each producer is a sort of monopolist – but between such monopolists, there exists a perfect competition. This type of market structure is a combination of elements from perfect competition and monopoly competition. Here, there is a large numbers of firms producing commodities similar to one another, but not identical.
Pure competition and pure monopoly rarely exists in the real world; most firms subject to some competition, but not the extent that would exist under pure competition. Even though most firms are faced with a large number of competitors producing highly substitutable products, firms still have the control over the price of their output – they can not sell all they want at a fixed price, nor will they lose their sales if they raise the price slightly. Monopolistic competition resembles perfect competition to a large extent, the major exception being that there is a certain amount of product differentiation in this type of market structure. This differentiation may not always be real. All the producers here are monopolists in their own product markets
Chamberlin’s theory retains two assumptions of purely competitive market structure:
Each firm makes its decisions independently of all others; i.e. each producer assumes that competitor’s price, advertising and so on are invariant with respect to its own actions. Thus, price changed by one firm is assumed not to cause other firms to react by changing their prices.
There are a large number of firms in the industry all producing the similar products. The assumption of totally homogeneous product is removed; each firm is supposed to be able to differentiate its product at least to some degree from those of rival firms.
Major Characteristics of Monopolistic Competition
In real life, we find neither monopoly competition nor perfect competition. The term monopolistic competition is only invented to describe this situation. A monopolistic competitive market is characterized by the following features:
1.Large number of buyers and sellers (each one acting independently)
2.Barriers to Entry and Exit are low
3.Advertising and Media exposures are maximum
4.Product Differentiation is principle weapon (either real or fancied)
Large number of buyers and sellers: For monopolistic competition to exist, there must exist a large number (not as large as that in the case of perfect competition) of firms, so that, each one believes that the other firms in the market will ignore its actions. Each independently operating firm in the industry must have a small enough market share so that it believes that its actions will not create any reaction among its competitors. A simple example may clarify the point.
Suppose an industry is made up of 101 firms. Now if a particular firm reduces its price by only 10 percent, it sells may rise by, say, 20 percent. Suppose, this firm’s market share increases by 200 units. In other words, it will take away only 200 units of sales from its hundred competitors or 0.2 percent from each. As it would cause a fall in sale of their rivals from 1000 to 998, the competitors are hardly expected to react fervently in this case.
Free entry and Exit: in this type of market structure, firms outside the industry do not find it at all difficult to enter the industry. Likewise, firms established in the industry find it fairly easy to exit. However, entry and exit are not totally free as they are in pure competition.
Due to the existence of non-identical products, new firms are unlikely to gain immediately the level of consumer acceptance attained by long established firms. Similarly, exit is slightly costlier than that of in pure competition. It is because, if a monopolistically competitive firm leaves an industry, it suddenly loses the consumer’s acceptance that it had managed to build up over the years.
Advertising and Media exposure: In monopolistic market, there is huge non-price competition among the firms. Advertising lies in the heart of such non-price competition. Advertising is supposed to provide meaningful information to the customers – even before a product is physically introduced in the market. it is not possible for the customers to know about every product, its physical characteristics, durability or price at every moment of time. Firms believe that, by providing detailed information regarding the product to people, it will be possible to convert latent demand into actual sales.
Product Differentiation: To say that products are differentiated, it is meant that the products may be (more or less) good substitutes, but they are not perfect substitutes. Monopolistic product differentiation can be done on the basis of two factors. First, products can be differentiated on the basis of certain characteristics of the product such as exclusive patented features, trademarks and some special types of packages or wrappers. This type of differentiation can be termed as fancied product differentiation.
Second, differentiation may be based on the conditions surrounding the sale of the product and after sales service. The product is differentiated if the after sales services rendered by the firm are different from those of other firms in the market. But, real product differentiation takes place when there are differences in product specifications or differences in location of the firm which determines whether the product is available conveniently to the customers.
A differentiation strategy attempts to offer products and services that are considered unique or innovative in the industry. If a firm is successful in differentiating its products and services from those of its competitors, it can generate sizeable profits. This is because successful differentiation allows a firm to change premium prices. A firm may differentiate its products and services in various ways like design (e.g. Mercedes), brand image (e.g. Coca Cola), features (e.g. Cadillac), technology (e.g. Intel microprocessor), customer service (e.g. Hilton Hotels), quality (e.g. Sony) and so on. A differentiation strategy is very effective when differentiation factors are essential for the customers and hard for competitors to imitate.
Equilibrium under Monopolistic Competition:
Firms: As most of the products have close substitutes, the demand curve for a monopolistic market is considerably elastic; slopes downward from left to right, the marginal cost being equivalent to the marginal revenue. The proposition is based on the assumption that every firm wants to maximize its net revenue. The individual firm under monopolistic competition is faced with downward sloping average revenue curve and the marginal revenue is always less than the average revenue.
The degree of differentiation exists; each firm’s product has a unique demand schedule. If such a firm wishes to increase its sales it must either reduce the price or shift the demand curve by some from of sales pressure like advertisement, special service etc. If shifting the demand curve is not practicable, the only way to increase sales would be price reduction. Increase of sales by reduction of price reduces the marginal revenue of the firm. But when marginal revenue is grater than the marginal cost, it is profitable to expand production.
The total revenue reaches the maximum point at the level of output where the marginal revenue is equal to the marginal cost. The equality between marginal revenue and marginal cost determines the most profitable output and the position of equilibrium for the individual firm under monopolistic competition. This proposition is based on the assumption that every firm tries to maximize its net revenue. Under monopolistic competition, the net revenue which the firm seeks to maximize is, [Price * Output] – [Production Cost + selling Cost].
Group Equilibrium: Due to free entry each firm in a monopolistically competitive industry reaches its long-run zero profit equilibrium. When all the firms reach such equilibrium, the whole industry is said to be in equilibrium which is better known as group equilibrium.
While every producer wants to enjoy profit-maximization in a monopoly market, from the customers’ point of view the perfect competitive market is the most desired one. Thus, it is beyond any iota of doubt that the monopolistic competition, being the ‘most perfect’ after perfect competition and the ‘least imperfect’ form of imperfect competition, is the best rational approach we have in the existing corporate world.
Ghosh, A, and Saha, N.C. Economic Theory, Imperfect Competition, chap 12
ICFAI Center for Management Research, Economics for Managers, chaps 6 – 7
Mitra, J.K. Economics, Imperfect Competition, chap, 15
Mitra, J.K. Economics, Market Forms, chap, 12