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Here is an essay on ‘Monopolistic Competition’ for class 11 and 12. Find paragraphs, long and short essays on ‘Monopolistic Competition’ especially written for school and college students.
Essay on Monopolistic Competition
Essay Contents:
- Essay on the Definition of Monopolistic Competition
- Essay on the Assumptions of Monopolistic Competition
- Essay on the Consequences of Product Heterogeneity
- Essay on Competition Sans Product Variation and Sales Effort
- Essay on the Comparison of Monopolistic Competition with Perfect Competition and Monopoly
- Essay on Product Variation
- Essay on the Assessment of the Theory of Monopolistic Competition
Essay # 1. Definition of Monopolistic Competition:
Monopolistic Competition is a market model wherein a large number of buyers purchase heterogenous products that are close substitutes from a large number of sellers. Sellers can vary their products, or act on the demand for their product through sales promotion. They can enter and exit freely in the long run.
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In monopolistic competition, sellers interact closely but are unconscious of their interaction. Each seller concentrates solely on the perceived demand curve for his product and bases his price-output-product variation-sales effort decisions on it. Since entry and exit are free, firms earn just normal profits in the long run.
Both monopoly and competitive elements are evident in the model. Each seller behaves as if he were a monopolist facing his perceived demand curve. But competitive elements are introduced by the interaction of the large number of sellers marketing close substitutes, as well as by free entry and exit. Thus monopoly and perfect competition find an interface in monopolistic competition.
Essay # 2. Assumptions of Monopolistic Competition:
Monopolistic Competition rests on five critical assumptions.
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These are:
(i) Large numbers,
(ii) Product heterogeneity,
(iii) Uniformity,
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(iv) Symmetry, and
(v) Free entry and exit.
(i) Large Numbers:
As in perfect competition, we assume that there are a large number of atomistic buyers and sellers. This implies that they compete independently and do not form combinations.
A consequence of this assumption is that a single seller cannot conceive of influencing the market price. As in perfect competition, he is too small and isolated to do so. Large numbers in conjunction with the symmetry assumption is also responsible for the single seller’s myopia.
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Seller’s Myopia:
The single seller is assumed to ignore his interaction with other sellers, inspite of experience and evidence to the contrary. This is called seller’s myopia.
It may be justified as follows:
Since he is only one among very many sellers, the single seller expects that his actions will not be noticed ‘in the crowd’. Hence, he expects no reaction to his decisions. Secondly, while making his decisions, he does not make conscious allowance for other sellers’ decisions because they are simply too many to keep track of. Hence, the single seller ignores both the actions as well as the reactions of other sellers.
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The justification for ignoring other sellers derives only in part from large numbers. Why look at all other sellers? Why not confine attention only to a small circle of sellers which directly and strongly interacts with the single seller? No such circle exists because of the symmetry assumption.
(ii) Product Heterogeneity:
Any difference in the products sold by different firms is called product heterogeneity. Product heterogeneity covers all kinds of difference between products or services associated with them. For instance, even “service with a smile” for otherwise homogenous products, can make them different.
Differences in products may be called real if they differ in inputs used, specifications, location or even associated services. For instance, it is only the difference in inputs that distinguishes a sandalwood soap from a glycerine soap. Similarly, in India, electronic goods assembled are ‘really’ different from imported items because of the maintenance services that go with them.
On the other hand, the differences in the products may only be fancied. These are the differences perceived by the buyers under the influence of advertising, packaging, design, brand name, or just plain prejudice. Irrespective of whether the differences are fancied or real, it is sufficient that they are perceived by the buyers, for us to assert that product heterogeneity exists.
Product heterogeneity is a central concept in monopolistic competition. It provides the turning point for most of the critical developments in Chamberlin’s theory: the uniformity assumption, consumer bonding, product variation and sales efforts.
(iii) Uniformity:
Product heterogeneity contradicts the concept of a market. If the products of different firms are different, there are at least as many markets as there are firms. What then, is to happen to our ‘market’ model? Clearly ‘heroic assumptions’ are required to save our analysis from disappearing even before it has begun! One such assumption made by Chamberlin has been called the ‘uniformity’ assumption.
The uniformity assumption states that the demand and cost curves of all the firms supplying the product are identical. This implies that product heterogeneity is only, ‘peripheral’ both in terms of production processes and consumer tastes. Since differences are only peripheral, the products of different firms must be close substitutes from the point of view of both consumers as well as producers. This group of close substitutes is called the product group. The product group is exchanged in a market. Since the product group consists of close substitutes, its components have a high cross elasticity of demand.
Thus, the product group consists of products with very ‘high’ cross elasticities of demand. How high must the cross elasticity of demand be? At the very least, the cross elasticity of demand within a product group should be higher than the cross elasticity of demand with products outside the group. In this sense, the product group can be identified by a gap in the chain of substitutes. The product group delimits the market.
Another important consequence of the uniformity assumption is that it enables us to speak of a single market price in spite of a heterogenous product – this is because rational firms that face identical demand and cost curves can be expected to independently choose the same price and output. As a result, we can now analyse the decisions of a single firm and generalize over the entire market.
(iv) Symmetry:
The assumption of symmetry holds that the effects of every seller’s actions are diffused evenly over all other sellers. Since the effects of actions are diffused evenly, there is no small group of closely interacting sellers whose behaviour can be used by the seller as informational input while making his decisions. This makes the myopia of the single seller a little more plausible.
(v) Free Entry and Exit:
In the long run, entry and exit are free under Monopolistic Competition as under Perfect Competition. This ensures that only normal profits are earned by a firm in the long run equilibrium of the product group.
Essay # 3. Consequences of Product Heterogeneity:
Product heterogeneity leads to some typical features of Monopolistic Competition—consumer bonding, attempts to vary products, and sales efforts by firms. Sales efforts, product variation and heterogeneity are together described as product differentiation.
These concepts are explained below:
(i) Consumer Bonding:
Product heterogeneity implies that buyers are no longer randomly and impersonally related to sellers. A buyer is no longer indifferent as to who he buys from, since the products of different sellers are perceived to be different. There exists, therefore, a bonding between each seller and his buyers.
But this bonding does not create exclusive sets of clientele for each seller converting him into a virtual monopolist of his own brand. This is due to the uniformity assumption which makes product differences peripheral. As a result, consumer loyalties are not exclusive and there is a large overlap and mobility between the consumer sets of different sellers.
Consumer bonding implies a downward sloping demand curve for the single seller. A single seller can now charge a higher price than the market price without losing all his clientele. Further, at the going market price and with a given sales effort, he can expect to sell only a definite quantity and not more. This is because he cannot draw away all the custom from other sellers whose differing products satisfy the buyers’ taste for variety. The buyers’ taste for variety sets a limit to what the single seller can hope to sell at the going market price. And even a lower price can bring only a part of the market demand to his product.
Thus, because of consumer bonding, the single seller experiences a downward sloping demand curve at the going market price. This demand curve of the firm is conventionally called the dd curve, and it is illustrated in Fig. 11.1. An important aspect of the dd curve is its sensitivity to the market price. If the going market price decreases, the dd curve also shifts downwards.
(ii) Product Variation:
Now that products can be different, it may pay the firm to enhance or reduce the differences. Thus, the very quality of a product, and not merely its quantity, is variable. The process of choosing the quality of a product is called product variation. Product variation caters to and even cultivates the consumers’ desire for variety, and many would consider it to be the essence of competition. Unfortunately, it defies measurement and therefore it cannot be captured in mathematical or geometric models.
(iii) Sales Efforts:
With heterogenous products and product variation, sales can no longer be taken for granted. Sales depend on sales efforts. A part of this effort may be quantified in the expenditure on sales promotion and advertisement. The efficacy of this expenditure can (in principle) be measured in terms of the addition to the revenue it makes. Hence, sales effort is a measurable notion. It can therefore be formally introduced into analysis as selling costs, which is another choice variable available to the firm.
(iv) Product Differentiation:
Product heterogeneity, variation and sales efforts are together called product differentiation. Thus product differentiation has two connotations. In a passive sense, product differentiation is present when products are heterogenous. In an active sense, product differentiation is the process by which the firm varies its product (product variation), or varies the perceptions that buyers have of its product (sales efforts).
Because of the differences in the product, the firm encounters a downward sloping dd curve for its product. By altering its product or the buyers’ perceptions, the firm alters its dd curve. This ability to influence the demand for its product makes the analysis of the behaviour of the firm that much more difficult.
Essay # 4. Competition Sans Product Variation and Sales Effort:
We will discuss here the properties of the basic model of monopolistic competition. This is characterized by heterogenous products. However, firms make no attempt to vary their products or the perceptions of their products in the minds of the buyers. Thus, they take the demand for their products as given and do not attempt to change it.
The Behaviour of the Firm:
Due to our assumptions, every seller in monopolistic competition acts oblivious of other sellers. There are too many other sellers for him to take cognisance of and by the symmetry assumption, he can neither identify nor be identified by a smaller group. Being one among many, he acts on the assumption that his actions will go unnoticed by other sellers, just as he in turn ignores the other sellers while making his own decisions.
With too many sellers in the market, the single seller cannot influence the market price. And at the market price he can attract only a definite maximum demand (qc). Since his product is different from the other, the single seller can also set a price different from the market price.
The dd Curve:
The product price chosen by the seller depends upon his perceived demand curve. The single seller imagines that the demand for his product is independent of the price/sales plans of other sellers. He thinks that his demand depends only on the price he charges for his product. This demand curve which is perceived by the seller, and on which he bases his optimizing decisions, is called the dd, ex-ante, or the planned demand curve (Fig. 11.1). Algebraically,
dd: pk = B – bqd …[1]
where, k refers to the kth firm, qd is the expected sales at pk and B, b > 0.
Based on the dd curve, the firm chooses a profit maximizing level of output and price. This price-output combination may coincide with the market price and its current sales at the market price. In that case, the firm will accept the status quo. But if they do not coincide, the firm will deviate from the market price.
Let us suppose that the single seller deviates from the market price and plans a level of sales different from his current sales. This situation is illustrated in Fig. 11.2. Here at the market price pm. the single seller is selling qc currently. However, since his marginal costs cut his perceived marginal revenue at qd, he tries to change his sales. He now desires to sell qd and sets a price pd accordingly.
Group Interaction – Short Run:
The single seller can indeed manage to sell qd at pd if he were to be the only one to deviate from the market price. But since all other sellers face the same demand and cost conditions (by the uniformity assumption), everyone chooses to charge pd for their product. This changes the market price, and the differential advantage of charging a price different from the market price is lost. As a result, his actual sales (qk) turn out to be different from what he had planned (qd). This is illustrated in Fig. 11.3, where at pd the actual sales qk is less than the planned sales qd. The DD Curve:
We call the relation between the actual sales qk and the price charged by the firm, the DD, ex-post or the actual demand curve of the firm. It emerges from the simultaneous identical action of all the sellers in the market.
The DD curve is always steeper than the planned demand curve dd. This is shown in Fig. 11.3. This means that at a lower price, the actual expansion in demand will be less than the firm expects. And the contraction in demand will be less than expected at a higher price. The actual demand equals the expected demand at the current market price. Hence, the DD and the dd curves intersect at the current market price and sales.
Short Run Adjustments:
Whenever the firm tries to deviate from the current market price, it experiences the actual demand curve DD. However, it never tries to investigate or estimate it. Instead, when its actual demand falls short of the planned demand, the firm sees this as a downward shift in its dd curve. Based on this new dd curve, it revises its choice of the optimal price-output combination.
Each time the firm tries to deviate from the market price on the basis of its dd curve, it winds up selling more or less than it expected to. Each time this happens, it is perceived as a fresh shift in the dd curve calling for a fresh choice of an optimal price-output combination. This process of adjustment may go on indefinitely. Or it may lead to equilibrium.
Short Run Equilibrium:
If in the process of adjustment, the firm ends up with such a dd curve that the optimal production equals its current sales at the market price, it will not try to deviate from the market price. Nor will the other firms, since they are identically placed. Hence, the market price will prevail, and all firms will sell identical quantities at this price. At this price, the group is in equilibrium.
Group equilibrium in the short run is illustrated in Fig. 11.4. This shows that the firm’s marginal costs cut its marginal revenue at the level of its current sales (qc). Since, at the current sales, the actual and planned demand are equal, we may say – The short run equilibrium of the product group is established when each firm sells a quantity at which its marginal revenue equals its marginal costs, and the dd and DD curves intersect.
Group Interaction – Long Run:
In the long run, the firm’s profit maximizing output is chosen with reference to long run costs. With this exception, the whole of the above analysis applies. However, if the consequent group equilibrium promises abnormal profits to the single seller, new firms enter, depressing profits to the normal level. Conversely, the prospects of less than normal profits drive some firms out of the industry until profits rise to the normal level. Firms can make only normal profits in long run equilibrium. Hence, the equilibrium average costs must equal the product price.
The long run equilibrium of the firm is illustrated in Fig. 11.5. It may be seen that the long run equilibrium is established at the level at which the MC and MR curves, and the dd and DD curves intersect, as in the short run.
There, however, are two points of contrast with short run group equilibrium. First, in the long run, the reference is to long run costs. Secondly, the long run average costs are equal to the product price in long run equilibrium. This is ensured by the tangency of the dd curve to the LAC at the equilibrium output. This additional condition of group equilibrium in the long run, is not necessary for short run equilibrium.
The Excess Capacity Theorem:
In long run equilibrium, the firm invariably finds itself operating at a level where average costs are falling. This has been illustrated in Fig. 11.5.
The argument underlying falling average costs in long run equilibrium is as follows:
First, the firm’s dd curve must touch the LAC curve at equilibrium output. This ensures that at the equilibrium output, the average costs equal the product price, and the firm just makes a normal profit.
Second, the dd curve must not cut the LAC curve at the equilibrium output. This is because, if it cuts the LAC curve, it will be above the LAC somewhere. In this range, a price higher than average costs can be charged, holding out the prospects of abnormal profits. But abnormal profits are not possible in the long run.
From the above, it follows that the dd curve must be tangential to the LAC curve at the equilibrium output. However, since the dd curve slopes downwards, the LAC curve must also slope downwards at the point of tangency, i.e., at the equilibrium output. Hence, at the equilibrium output, the long run average costs must be falling.
Since average costs decline in long run equilibrium, excess capacity is inevitable in monopolistic competition. In this, monopolistic competition contrasts with perfect competition.
Essay # 5. Comparison with Perfect Competition and Monopoly:
Equilibrium conditions under monopolistic competition resemble conditions obtained under monopoly in some aspects, and those obtained under perfect competition in other aspects.
As under monopoly, the firm’s demand curve slopes down to the right with the result that price in monopolistic competition is greater than marginal cost. This is because AR > MR = MC. Moreover, as under monopoly, the size of the gap between price and marginal cost is inversely related to the elasticity of demand which the firm perceives for its product. In contrast, the planned demand curve of the price taking firm under perfect competition is horizontal. As a result, its marginal costs equal the price in equilibrium.
In the long run, firms can only make normal profits in monopolistic as well as in perfect competition, whereas this is not invariable under monopoly. However, unlike under perfect competition, the single firm in monopolistic competition always operates with excess capacity in the long run.
Finally, as in perfect competition, the entry of new firms depresses the sales and profits of existing firms in monopolistic competition. However, unlike in perfect competition, the product price does not necessarily fall with entry in monopolistic competition.
Essay # 6. Product Variation:
In the model considered, the single seller made no attempt to alter the product, or to influence its demand. The demand was taken as given, and the seller merely reacted with price- output decisions. In this section, we examine how the seller can choose the quality of his product.
Product variation is the act of choosing a particular variety of product from a portfolio of alternatives. The range of alternatives available in monopolistic competition must not be so wide as to make the firm’s product radically different from the others, since such a difference will confer the status of a monopoly upon the firm. To preserve competition, product variation must breed both similarity and difference.
The firm will choose the most profitable of the alternative varieties. This variety may be identified by the firm by estimating the dd and cost curves corresponding to each variety, and then calculating the profit maximizing price, output, and the maximum profits from the estimated dd and cost curves. The maximum profits promised by the different varieties may then be compared, and that variety which is the most profitable be chosen.
A slightly different approach to product variation and pricing is proposed by Lancaster.
Lancaster’s Model of Product Variation:
Lancaster suggests that a product is not a single whole, but a bundle of characteristics. Characteristics can be added to or subtracted from the bundle without radically changing the production techniques. For instance, a lace frill can be removed from a skirt, which can be embroidered instead. This does not involve a change in the production techniques. In pricing its product bundle, the firm must bear in mind how the market is implicitly pricing its different characteristics.
To bring out the meaning of implicit pricing, let us takes a specific example, say of tea. Suppose that tea is made with three characteristics: tea-leaf, sugar and milk. Denoting a spoonful of leaf and sugar by T and S, respectively, and a unit of milk by M, let us assume that tea is being sold in the market in three varieties. Ordinary tea (1T + 1M+ 1S) priced at Rs. 1.25; strong tea (2T+ 1M+ 1S) is priced at Rs. 1.50; milk tea (1T+ 2M + 2S) is priced at Rs. 2.25.
Since the three combinations are available at three prices, the implicit prices for the characteristics can be calculated by solving the system:
These prices of the characteristics are called implicit prices or shadow prices. These shadow prices set an upper limit to the price any seller can charge for his own product. Thus, suppose that a seller wants to market special tea (2T + 2M + 2S). Since it adds one spoon of tea leaf to milk tea which is priced at Rs. 2.25, and since one spoon of tealeaf is implicitly priced at Rs 0.25; the price of special tea cannot exceed Rs. 2.50. If the seller tries to market special tea at more than Rs. 2.50, the milk tea vendors will simply add one spoon of leaf to their own tea and sell special tea at Rs. 2.50.
In principle then, the demand curve for special tea slopes down, beginning from Rs. 2.50. Based on this demand curve, the procedure can be implemented, and the most profitable product can be chosen from the alternative varieties available to the firm.
Product Variation and Uniformity:
Varieties differ in their demand-cost implications. This destroys the uniformity assumption. Without the uniformity assumption, we have to take recourse to a ‘representative firm’ in order to analyse the model. But this concept voids our analysis of significance. For instance, take the proposition that “the representative firm operates with excess capacities in long run equilibrium.” What does this proposition imply for actual firms that are not ‘representative’? Nothing! Chamberlin’s ‘heroic’ assumptions are crucial to his analysis. This limitation prevents integration of product variation into the basic model of Monopolistic Competition.
Essay # 7. Assessment of the Theory of Monopolistic Competition:
Chamberlin’s theory made definite contributions when it was introduced, but its limitations have become increasingly evident over time.
Contributions:
1. The chief tools of non-price competition – product variation and advertisement were first introduced into microeconomic analysis through the theory of Monopolistic Competition.
2. The theory of Monopolistic Competition revealed that some characteristics of perfect competition, such as the long run absence of excess capacities, resulted from product homogeneity and not from large numbers. Since products in real markets are usually heterogenous, the use of properties of perfect competition as a bench mark in evaluating actual markets is cast into doubt by this finding.
3. Chamberlin’s model independently solved a contemporary theoretical problem in economics. This was the problem of reconciling excess capacity with large group competition.
4. Monopolistic competition can be used to analyse retail trade, as well as markets for consumer products sold by a large number of sellers in sticky demand conditions.
Limitations:
1. Product variation and sales expenditure are not explicitly included in the basic model. This is due to the ambiguity over their effect on the dd and DD curves. As a result, their implications are not rigorously analysed.
2. The theory assumes irrational behaviour on the part of the sellers. The sellers never learn to use their actual demand curve DD for their calculations inspite of the persistent movement of their sales along the DD rather than the dd curve.
3. The product group is not operationally defined. It is not clear how high the cross and price elasticities of demand must be before we characterize firms as being engaged in monopolistic competition, rather than being just monopolies.
4. The uniformity and symmetry assumptions are untenable. We have already seen the problem with the uniformity assumption. As regards symmetry, Kaldor suggests that the influence of the product and price variation by the firm will be concentrated in the immediate circle of sellers surrounding the firm, and the effects will be diffuse outside this circle.
Hence, within this circle there will be conscious interaction among a small number of sellers, and the whole large group market will consist of a number of overlapping circles of consciously interacting sellers. Conscious seller interaction is studied by oligopoly theory, and so Kaldor’s suggestion is to use oligopoly theory rather than monopolistic competition to study large group competition.
5. Once we relax the uniformity assumption, rigorous analysis is not possible. As Stigler remarks, “in the general case we cannot make a single statement about economic events in the world we sought to analyse … (although) many such statements are made by Chamberlin.”
6. Once selling costs are introduced into analysis, the excess capacity theorem no longer has the same significance. This is because declining LACs may not reflect excess productive capacities.
7. Finally, the model has limited relevance. It cannot be applied to markets that have only a few sellers. Even its application to markets for intermediate products is doubtful, unless the quality of the intermediate good carries over to the final product, creating a sticky final demand. If final demand is not sticky, the buyers of intermediate goods may be highly price sensitive. In such a case, the firm’s dd curve will not slope down to the right, but will be horizontal, as in perfect competition. In Monopolistic Competition, as in perfect competition, sellers interact unconsciously.
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