Edward Hastings Chamberlin of Harvard University developed a systematic theory of monopolistic competition. Under this market structure, both monopoly and perfect competition elements are blended together. Like perfect competition, there are a large number of sellers.
Thus, the actions of any individual seller do not have any perceptible influence on other sellers in the market. Further, like perfect competition, the number of buyers is also assumed to be large and that resources can easily be transferred in and out of the industry.
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But, monopolistic competition also resembles the monopoly model in the sense that products of individual sellers are unique and differentiated. The greater is the degree of differentiation, the greater is the degree of monopoly element.
A firm under monopolistic competition faces competition from rival firms producing similar products (close substitutes). At the same time, unlike a perfectly competitive firm, it has some influence over the price of the product. That is why, it has downward sloping average revenue and marginal revenue curves.
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The greater is the difference between average revenue (price) and marginal revenue, the greater is the degree of imperfection and vice-versa. The main features of monopolistic competition are discussed here.
1. Many Sellers:
The numbers of firms under monopolistic competition are fairly large, though, it is not as large as found under perfect competition. Each firm shall be a small sized firm controlling only a small part of the total market. Since there are many sellers under monopolistic competition, actions of individual sellers go unheeded by others.
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Thus, each seller can take decisions more or less independently without worrying about the reactions of other sellers. Greater is the number of firms in the market, the more elastic the demand curve would be and vice versa. There is no possibility of any collusion or any secret understanding between the firms either with regard to the price or output so as to maximise joint profits.
2. Product Differentiation:
Product differentiation is one of the most distinguishing features of monopolistic competition. According to Chamberlin, it is the basic characteristic of monopolistic competition. He defines product differentiation as follows.
“A general class of product is differentiated, if any significant basis exists for distinguishing the goals (or services) of one seller from those of another. Such a basis may be real or fancied, so long as it is of any importance whatever to buyers, and leads to a preference for one variety of the product over another.
Differentiation may be based upon certain characteristics of the product itself, such as exclusive patented features, trademarks, trade names, peculiarities of the package or container, if any or singularity in quality, design, colour or style. It may also exist with respect to the conditions surrounding its sale.
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There is more scope for individual action, if the product is differentiated. In such a situation, no individual seller will lose all his customers, if he raises the price. Some former buyers may switch to his competitors. However, at least some of his loyal customers will continue to purchase this differentiated product even at a higher price on account of their strong preference for it.
We often find people going to the same physician, the same barber, the same agent, the same teacher, the same grocery shop, the same brand of dental cream, the same brand of razor blades, etc., year after year. Further, the seller need not be afraid of losing much sales to his rivals, when the latter reduce the prices of their brands, unless price reduction is substantial.
Product differentiation actually creates brand loyalty of the consumers and the products are commonly known by brand names or trademarks. There will be competition between rival brands of the products. As consumers acquire special preferences for particular brands of say, cigarettes, tooth pastes, etc., they generally demand them, even if their prices are higher than those of rival brands. Tata, Godrej, HMT, Hindustan Lever, Shaw Wallace, etc. are certain brands, which command goodwill in the market.
Product differentiation may involve qualitative material or workmanship differences in the products. Different toilet soaps with qualitative differences like Camy (milk based), Cinthol (lime based) Rexona (coconut oil based), Neema, Breeze (rose based), Pears (glycerine based), Margo (neem based) are good examples of real product differentiation.
Mere attractive shape, size, style, colour, design or wrapping, convenient location, free home delivery, free installation, after sales service, free gifts, guarantees and warranties, including policies on return of merchandise, etc., may also create consumer’s preferences and loyalties.
The way of doing business, reputation for fair dealing, courtesy, efficiency, patronage, convenient shopping hours and other intangible factors surrounding the sale of the product may make the product different. A product is differentiated, so long as a basis exists for preferring it to another, whether such a basis for preference is real or illusory.
In other words, product differentiation exists, when the firm’s product differs (due to difference in taste, smell or quality of inputs) or is perceived to differ (due to branding, packaging or advertising) from those of competitors. Thus, if the buyer perceives the products of two different firms to be different, then they shall be considered different, even if there is no qualitative difference in them.
Product differentiation may involve unique selling proposition (USP), as the firms tend to offer to their customers something different and better than what competitors do. Domino’s pizza competes with others on the basis of its ‘home delivery ability’ with their fleet of delivery boys on scooters, executing the order in less than half an hour from the time, the order is placed.
When such differentiation of the product exists, even if it is slight or imaginary, buyers will be paired with sellers not in a random manner (as under perfect competition), but according to their preferences.
3. Sales Promotion or Selling Cost:
Advertising and other selling expenses have an important role under monopolistic competition on account of imperfect knowledge on the part of buyers. Advertising broadens the market and encourages competition.
Salesmen salaries, other expenses of sales department, window displays and different types of demonstrations are some examples of selling expenses. Sellers often create and exploit irrational consumer preferences through subtle advertisement and salesmanship. Thus, advertisement plays an important role in creating imperfections in the market.
Advertisement may, however, be broadly classified as promotional advertisement and competitive advertisement. The former is generally needed, when a new product is introduced in the market. Such advertisements aiming at informing the customers about the product, its uses and qualities are informative and desirable.
These advertisements enable them in making a more rational and better choice between goods resulting in market efficiency. Advertisement by tea companies during the pre-independence era in India was undertaken to develop the taste for tea and hence to popularise its consumption.
Informative advertising by trade associations, etc., expands the sales of all the firms, as it attracts customers towards the product of the group rather than towards a particular brand produced by a particular firm. However, advertising in this form is not much.
Most of the advertisements today are competitive in nature. Their aim is to persuade and motivate the consumers towards particular brands of the product by altering their tastes and preferences. Competitive advertising is invariably manipulative and increases the sales of one seller at the expense of others.
Such an advertisement seeks to accentuate the difference between the product advertised and other products. ‘Forhans’ used to be the major player in the toothpaste market at one time. Then came ‘Close Up’ and ‘Colgate’, altering consumers’ preferences through massive advertising. Now, ‘Pepsodent’ has assumed this position by using positive as well as negative emotional appeals.
Advertising assumes still greater importance, particularly, when there is product differentiation. In such a situation, advertising renders the function of convincing the ignorant buyers of the superiority of the product.
Even when the products of two sellers are identical, advertising increases and intensifies the demand of the product advertised. Hence, while product differentiation necessitates incurring selling expenses, they in turn are likely to produce product differentiation.
4. Identical Demand and Cost Curves:
Demand and cost curves are assumed to be identical under monopolistic competition. This highly simplifying assumption will mean similar effects on the demand and cost conditions of the firms on account of changes in the quality of their products and/or selling costs.
Both product differentiation and sales promotion increase the demand of the product in question and make it more inelastic, creating opportunities for increasing profit earnings. The greater the product differentiation, the more inelastic will be the firm’s demand curve.
However, the demand curve of a monopolistically competitive firm is more elastic (i.e., less steep) than the demand or average revenue curve of a monopoly firm. The reason is that the product of the firm under monopolistic competition has close substitutes available in the market, while the product of the monopoly firm has no substitutes available in the market.
Product differentiation provides the rationale for selling costs. These selling costs will shift the demand curve to the right. It will not only induce the present buyers to buy more, but also attract new buyers. Selling costs will also make the demand curve inelastic by strengthening the preferences of the buyers for the advertised product.
The elasticity of the new demand curve will on one hand depend on the perception of the existing and new buyers regarding the superiority of the seller’s product. On the other hand, it will depend on the price sensitivity of the existing and new buyers.
It was Chamberlin, who explained the implications of product differentiation on the pricing and output decisions as well as on advertising by the firm. He suggested that the demand is influenced not only by the price policy of the firm, but also by the style of the product, the services associated with its sale and the selling activities of the firm. The demand curve will shift if (i) the style, services or the selling policy of the firm changes, (ii) competitors change their price, output, services or selling strategies.
Further, the nature of the cost curves under monopolistic competition is assumed to be same as under traditional theory. The implication is that there will be only one optimum level of production. The U-shaped cost curves, namely marginal cost, average cost curves shift upward with product differentiation and consequent advertising.
5. Free Entry and Exit:
Under monopolistic competition, there is freedom of entry and exit of the firms in the long run. New firms enter the group, when the existing firms earn super normal profits by differentiating their products. This will result in a decrease in the demand of existing products at least to some extent and or an increase in the cost.
6. Other Characteristics:
Other characteristics of monopolistic competition are actually the basic assumptions of Chamberlin’s large group model. These assumptions are mostly same as those of pure competition except that of homogenous product (which is replaced by the assumption of product differentiation).
(i) The goal of the firm is profit maximisation both in the short-run as well as in the long-run.
(ii) The prices of factor inputs and technology are given.
(iii) The firm is assumed to behave as if it possessed information regarding the demand and cost curves with certainty.
(iv) The long-run is assumed to consist of a number of identical short-run periods, independent of one another, so that decisions in one period neither affect future periods nor are affected by past actions. However, the optimum decision for one period is the optimum decision of any other period. Thus, maximisation of profits in the short-run implies maximisation of profits in the long-run.
(v) Chamberlin makes one heroic assumption that the demand and cost curves for all products are uniform throughout the group implying that consumer’s preferences are evenly distributed among the different sellers. Further, differences between the products do not give rise to differences in the costs.
Thus, the equilibrium of a single firm reflects the equilibrium of the ‘group’ as a whole. Even Chamberlin himself admits that this assumption is unreal, but, considers it useful for simplifying the analysis of ‘group equilibrium’.