Monopolistic Competition

5. Heavy selling costs. Advertising, display, packaging, sponsorship. Under perfect competition selling costs are zero, and under monopoly they are mostly institutional. Here they are central, because the whole task is to persuade buyers that this variety is not the same as that one. Chamberlin's point is that selling costs do not merely shift demand between sellers; they can also shift the demand curve for the whole group.

6. Non price competition is more important than price competition. Firms compete by improving the product, by advertising, by service and by packaging, rather than by cutting price, because a price cut is easily matched.

7. Imperfect knowledge. Buyers do not know all prices and cannot compare all qualities, which is precisely what makes differentiation work.

8. The group, not the industry. Because the products are not the same good, Chamberlin replaced the word industry with product group, meaning the collection of firms making closely related varieties. The boundary of a group is always to some extent arguable.

Price and output

In the short run the firm behaves exactly like a small monopolist. It faces its own downward sloping demand curve, marginal revenue lies below it, and it produces where marginal cost equals marginal revenue, charging what the demand curve will bear at that output. It may earn supernormal profit, normal profit or a loss.

In the long run entry does its work, but not in the way it does under perfect competition. New firms enter the group with their own varieties. Each entrant takes a slice of the existing firms' custom, so every existing firm's demand curve shifts left and becomes more elastic, because there are now more substitutes. Entry continues until supernormal profit has gone.

The long run result, and the single most examined proposition in the topic. Equilibrium is reached where the firm's demand curve is tangent to its average cost curve. At that point price equals average cost, so only normal profit is earned, exactly as under perfect competition. But because the demand curve slopes downward, it can only touch the average cost curve at a point where average cost is still falling, which is to the left of the minimum of the average cost curve.

Two consequences follow, and both are examinable.

• Excess capacity. The firm produces less than the output at which its average cost would be lowest. The difference between that output and the one actually produced is called excess capacity, and it is the standing charge against this market form. Every restaurant with empty tables, every salon with an idle chair and every coaching class with vacant seats is an instance.
• Price above marginal cost. As under monopoly, though by a smaller margin.

The relationship to the other three forms

The last row is the honest summary. Monopolistic competition costs the consumer something in price and gives them something in choice, and there is no way to have both.

A worked example: a street of coaching classes

The market. Eleven coaching classes for Semester I law subjects operate within a kilometre of a college in Mumbai.

Where the monopoly element is. Vidya Classes has a teacher whose lecture notes students copy from each other, a hall five minutes from the college and an evening batch. No other class has that combination. If Vidya raises its fee from 9,000 to 9,600 rupees, it loses some students but not all: a student who values that teacher, or who can only come in the evening, stays.

Where the competition element is. If Vidya raises its fee to 15,000, it loses nearly everybody, because ten close substitutes are a short walk away. That is what a highly elastic downward sloping demand curve means.

What the firms actually compete on. Not price, which clusters within a narrow band, but on the things that differentiate: a free demo lecture, printed notes, a test series, a photograph of last year's toppers, batch size, air conditioning, and the reputation of one teacher.

The long run. Vidya earns well in its first two years. Two former teachers open their own classes. Vidya's enrolment falls from 180 to 120, its demand curve has shifted left and become more elastic, and its fee no longer earns supernormal profit. It now runs a hall built for 200 with 120 students in it. That is excess capacity, and it is the normal state of this market rather than a failure of management.

What the law contributes. The characteristic abuse here is not a high price but a false difference: a claim of a success rate nobody can verify, or a photograph of a topper who never enrolled. That is why the answer to this market form is consumer protection law rather than competition law: the Consumer Protection Act 2019 makes a false or misleading representation about the standard or quality of goods or services an unfair trade practice, and that is the wrong this market characteristically produces. Competition law has little to say here, because no firm in the group is dominant.

What beginners get wrong

"Monopolistic competition means a few big firms." That is oligopoly. Here there are many firms, none of which watches any particular rival.

"Product differentiation means the products are really different." It means buyers believe they are different, whether or not a chemist could tell them apart. A branded and an unbranded paracetamol tablet may be chemically identical and are in different product varieties economically.

"Excess capacity means the firm is badly run." It is the predicted long run outcome of the model. Every firm in the group has it.

"Advertising is waste." Partly. It also conveys real information and finances media. A balanced answer says that informative advertising has value and that combative advertising, which merely moves customers between near identical products, largely does not.

Limits and criticism

The product group cannot be defined precisely. How close must a substitute be to be inside the group? Chamberlin never answered this satisfactorily and it remains the model's weakest joint.

It assumes firms ignore each other. In a group of eleven coaching classes on one street, they plainly do not.

The tangency result assumes identical cost and demand curves for every firm, which conflicts with the premise that the products differ.

The waste charge is contested. Excess capacity is a cost, but variety is a benefit that the perfectly competitive benchmark values at zero. Consumers who pay more for a differentiated product are revealing that they value the difference, and it is not obvious that an economist should overrule them.

Quick revision

1. Monopolistic competition: many sellers, differentiated but closely substitutable products, fairly free entry. Developed by Chamberlin and Joan Robinson, both in 1933.
2. Product differentiation may be real, imagined or in the conditions of sale. Its effect is to give each firm its own downward sloping but highly elastic demand curve.
3. Selling costs are central and non price competition matters more than price competition.
4. Chamberlin's product group replaces the word industry, because the products are not the same good.
5. Short run: behaves like a small monopolist, MC equals MR, profit or loss possible.
6. Long run: entry drives the demand curve left and makes it more elastic until it is tangent to the average cost curve. Only normal profit is earned, at an output below minimum average cost.
7. Excess capacity is the difference between the least cost output and the output actually produced, and it is the standing criticism of this form.
8. The consumer's trade off: a higher price than perfect competition would give, in return for variety.
9. The legal answer to this market is consumer protection law rather than competition law, because the characteristic wrong is a false claim of difference rather than a high price, and no firm in the group is dominant.

Test yourself

1. Define monopolistic competition and state its features. It is a market structure in which a large number of sellers offer differentiated but closely substitutable products, with relatively free entry and exit, so that each firm has limited control over the price of its own variety while facing close competition from the others. Its features are a large number of sellers acting independently; product differentiation, whether real, imagined or in the conditions of sale; a downward sloping but highly elastic demand curve for each firm; relatively free entry; heavy selling costs; the predominance of non price competition; imperfect knowledge; and the replacement of the concept of an industry by Chamberlin's product group.

2. What is product differentiation, and what is its economic significance? Product differentiation is the making of one seller's product distinguishable from another's, whether by real differences of quality and design, by brand, packaging and advertising, or by the conditions of sale such as location, credit and service. Its economic significance is that it converts a seller who would otherwise face a horizontal demand curve into one facing its own downward sloping curve, so that a modest rise in price loses some customers but not all of them, and the seller acquires a limited power over its own price.

3. Explain the long run equilibrium of a firm under monopolistic competition, and the idea of excess capacity. In the long run new firms enter the product group with their own varieties, so each existing firm's demand curve shifts to the left and becomes more elastic, and supernormal profit is competed away. Equilibrium occurs where the firm's demand curve is tangent to its average cost curve, so that price equals average cost and only normal profit is earned. Because the demand curve slopes downward, the point of tangency must lie on the falling portion of the average cost curve, to the left of its minimum. The firm therefore produces less than the output at which its cost per unit would be lowest, and the shortfall is called excess capacity.

4. Distinguish monopolistic competition from perfect competition and from monopoly. It differs from perfect competition in that products are differentiated rather than homogeneous, in that each firm has a downward sloping rather than a horizontal demand curve, in that selling costs are heavy rather than absent, and in that long run output falls short of the minimum cost output so that excess capacity persists. It differs from monopoly in that there are many sellers rather than one, that close substitutes exist so the demand curve is much more elastic, that entry is relatively free, and that supernormal profit cannot survive in the long run.

5. Why is advertising heavy under monopolistic competition and absent under perfect competition? Because under perfect competition the products are identical and knowledge is perfect, so there is nothing to tell buyers that they do not already know and no way for one seller's output to be preferred to another's. Under monopolistic competition the whole basis of the firm's limited market power is that buyers see its variety as distinct, and advertising both creates and sustains that perception. Chamberlin also pointed out that selling costs can expand the demand for the group as a whole and not merely redistribute it within the group.

6. "Excess capacity under monopolistic competition is social waste." Discuss. On one view it is: firms produce below the output at which average cost is lowest, so resources are used less efficiently than they would be under perfect competition, and combative advertising that merely moves customers between near identical products adds cost without adding output. On the other view the comparison is unfair, because the perfectly competitive benchmark offers no variety at all and values choice at zero, whereas consumers who pay a higher price for a differentiated product are showing that they value the difference. The balanced answer is that excess capacity is a real cost, that some advertising is informative and some is not, and that the loss must be weighed against a gain in variety that the benchmark model cannot measure.