8.4 Monopolistic competition
Although economics textbooks tend to concentrate more on discussing perfect
competition and monopoly, monopolistic competition and oligopoly are more
prevalent in practice. The theory of monopolistic competition, as an intermediate
form of market structure between perfect competition and monopoly,
was originally developed by Chamberlin9 in 1933. Its characteristics
were summarized in Table 8.1 and we can now examine the conditions for
monopolistic competition in more detail.
8.4.1 Conditions
There are five main conditions for monopolistic competition to exist:
1 There are many buyers and sellers in the industry.
2 Each firm produces a slightly differentiated product.
3 There are minimal barriers to entry or exit.
4 All firms have identical cost and demand functions.
5 Firms do not take into account competitors’ behaviour in determining price
and output.
As far as the first condition is concerned, there may be a few large dominant
firms with a large fringe of smaller firms, or there may be no very large firms
but just a large number of small firms. Grocery retailing is an example of the
first situation, while the car repair industry is an example of the second. In
both cases there is product differentiation, and the significance of this is that
firms are not price-takers, but, rather, have some control over market price.
However, this control is not as great as that of the monopolist for two reasons.
First the firms’ products have closer substitutes than the product of a monopolist,
making demand more elastic. The second reason is related to the third
condition above: the low barriers to entry mean that any supernormal profit is
competed away in the long run. This also involves the fourth condition, that
firms have identical cost curves. We can now examine this situation
graphically.
8.4.2 Graphical analysis of equilibrium
In the short run the equilibrium of the firm in monopolistic competition is
very similar to that of the monopolist. Profit is again maximized by producing
the output where MC¼MR. Supernormal profit can be made, depending on the
position of the AC curve, because the number of firms in the industry is fixed.
The only real difference between the two situations is that in Figure 8.9,
relating to monopolistic competition, the demand curve (and hence the MR
curve) is flatter than the demand curve in Figure 8.6 relating to monopoly. This
is because of the greater availability of substitutes.
In the long run, new firms will enter the industry, attracted by the supernormal
profit. This will have the effect of shifting the demand curve downwards for
existing firms. The downward shift will continue until the demand curve becomes
tangential to the AC curve (LAC in this case), at which point all supernormal profit
will have been competed away. This situation is illustrated in Figure 8.10.