The equilibrium under monopolistic competition, involves ‘ individual or partial equilibrium’ of the firms as well as ‘group equilibrium’. In the former case, an individual firm adjusts its own price or output independently to a given situation of demand for his product.
On the other hand, in the latter case, market adjustments of all prices and outputs take place.
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Short Run Analysis (Partial Equilibrium):
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As the typical firm is one of a large number of firms in the group, increase in its sales as a result of reduction in the price will produce loss of sales distributed more or less equally over the other firms. Consequently, each rival firm will suffer too little loss in customers to induce it to change the price.
Thus, the AR curve in Fig. 15.1 is drawn on the assumption that the competitors will not react to changes in the particular firm’s price, besides usual ceteris paribus assumption. Though Chamberlin does not use marginal revenue (MR) and marginal cost (MC) curves, these curves are included in our diagram facilitating exposition and comparison with other market structures.
In the short run, Chamberlin firm acts like a monopolist. Given demand and cost curves, it maximises the profit by producing OQ output at price OP corresponding to equilibrium point ‘E’ in Fig. 15.1, where MC equals MR. The firm may earn supernormal profits (shown by shaded area Fig 15.1 (a)), suffer losses (shown by shaded area in Fig 15.1 (b)) or may get just normal profits (Fig. 15.1 (c)).
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The short run average cost (SAC) curve will lie below; above and just pass through demand curve AR in these three cases respectively. Thus, short-run equilibrium of a firm under monopolistic competition is like that of a monopolist.
On account of different degrees of consumer preferences, elasticities of demand curves of different firms may be different under monopolistic competition. Further, cost curves of the firms may also differ from each other. Accordingly, prices charged by various firms may not be identical.
Therefore, some firms may earn profits, while others may suffer losses depending upon the position of the average cost curve relative to the position of demand curve. Still others may get only normal profits even in the short run, if the average cost curve happens to be tangent to the demand curve.
Long Run Analysis (Group Equilibrium):
Product differentiation creates problems in the analytical treatment of the industry, since unlike homogeneous products; heterogeneous products cannot be added to form the market demand and supply. Therefore, Chamberlin replaces the term ‘industry’ by ‘group’. A group includes products which are closely related, i.e., the products which are close technological and economic substitutes.
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While technological substitutes satisfy the same want, economic substitutes have similar prices. Most of the shampoo brands are technological as well as economic substitutes. However, highly expensive shampoo brand produced by Oriflame or Amway may only be technological substitute (but not economic substitute) for Clinic Plus, Sunsilk and Head and Shoulders shampoo brands.
Product differentiation allows each firm to charge different price for its product. Further, product demand curve representing its share of the market also differs in elasticity (shape) and position. Likewise, cost curves of firms representing the efficiencies of firms will also differ in shape and position. As a result of these heterogeneous conditions in respect of various matters and consequent differences in prices and outputs, profits of the various firms in the group will differ.
Chamberlin simplifies the analysis by ignoring these diverse conditions surrounding each firm and considers ‘uniformity assumption’ that both demand and cost curves for all the products are uniform throughout the group. In other words, all firms have an equal share in the market and possess the same level of skill and efficiency.
Under this simplifying assumption, consumer’s preferences are required to be evenly distributed among the different varieties. Thus, with the help of the equilibrium of one firm, equilibrium of the ‘group’ can be shown on the same diagram.
Besides the above uniformity assumption, it is assumed that any adjustment of price or output by a single firm will have a negligible influence upon its each of the numerous competitors. That is why, competitors do not retaliate by readjusting their prices and outputs and act independently. Stigler calls it ‘symmetry assumption’.
The firm initially may earn super normal profits. Though existing firms (like this typical firm) do not have any incentive to adjust their price, but new entrants are attracted by lucrative profit margins. As new firms enter the group, the total market demand for the product must be shared out amongst larger number of firms reducing the market share of each firm. Since each firm can expect to sell less now at each price, the demand curve of the firm shifts to the left.
Until the demand curve is tangent to average cost curve consequent upon the rise in factor cost with rise in the demand for factors. Each shift to the left of the demand curve will be followed by a price output adjustment, as the firm reaches a new equilibrium position by equating the new marginal revenue curve to its marginal cost.
This process will continue until supernormal profits are eliminated. The final equilibrium position is indicated by point E in Fig. 15.2, where price OP is equal to the long- run average cost (LAC). This point corresponds to output OQ.
There will be no further entry into the group, since profits are just normal. Any firm will lose by either raising or lowering the price, as such attempt would cause price to fall short of LAC. Thus, resulting loss of revenue would more than offset the lower cost of production. Similarly, in the event of losses in the short run, inefficient firms will leave the market. This will reduce supply and raise price resulting in zero loss ultimately in the long run.
