UNIT 11 MONOPOLISTIC

COMPETITION: PRICE AND

OUTPUT DECISIONS
Structure
11.0 Objectives
11.1 Introduction
11.2 Concept and Features of Monopolistic Competition
11.3 Demand Curve under Monopolistic Competition
11.4 Equilibrium under Monopolistic Competition
11.4.1 Individual Firm’s Equilibrium in Short-Run Period
11.4.2 Individual Firm’s Equilibrium in Long Run
11.4.3 Group Equilibrium in Monopolistic Competition
11.4.4 Equilibirium with Selling Costs

11.5 Perfect Competition, Monopoly and Monopolistic Competition:

Comparison
11.6 Theory of Excess Capacity under Monopolistic Competition
11.7 Let Us Sum Up
11.8 References
11.9 Answers or Hints to Check Your Progress Exercises

11.0 OBJECTIVES
After studying this unit, you will be able to:
• define the term monopolistic competition;
• explain the demand curve under monopolistic competition;
• state the equilibrium conditions of monopolistic competition;
• make comparison under perfect competition, monopoly and monopolistic
competition; and
• explain the theory of excess capacity under monopolistic competition.

11.1 INTRODUCTION
Pure monopoly and perfect competition are two extreme cases of market
structure. In reality, there are markets having large number of producers
competing with each other in order to sell their product in the market. Thus,
there is monopoly on one hand and perfect competition on other hand. Such a
mixture of monopoly and perfect competition is called as monopolistic
competition, it refers to a market situation in which there are large numbers of

Ms. Shruti Jain, Assistant Professor in Economics, Mata Sundari College (University of
Delhi), Delhi. 235
Market firms which sell closely related but differentiated products. Markets of
Structure products like soap, toothpaste AC, etc. are examples of monopolistic
competition.

11.2 CONCEPT AND FEATURES OF

MONOPOLISTIC COMPETITION
Monopolistic competition is a market in which firms can enter freely each
producing its own brand or a differentiated product. Thus, a firm under
monopolistic competition
a) Enjoys ‘monopoly position’ as far as a particular brand is concerned.
b) Since the various brands are close substitutes, its monopoly position is
influenced by the stiff ‘competition’ from other firms.
Examples of Monopolistic Competition:
1) When you walk into a departmental store to buy toothpaste, you will find
a number of brands, like Pepsodent, Colgate, Neem, Babool, etc.
i) On one hand, the market for toothpaste seems to be full of
competition, with thousands of competing brands and freedom of
entry;
ii) On the other hand, its market seems to be monopolistic, due to
uniqueness of each toothpaste and power to charge different price.
Such a market for toothpaste is a monopolistic competitive market.
2) A firm supplies branded good ‘Lux Soap’ in the market. There are many
other firms in the market which sell similar soaps (not identical) with
different brand names like Rexona, Palm Rose, etc., etc. Some times we
can find one company manufacturing and selling similar products with
several brand names at different prices. Their idea is to place each of
their products in ‘niches’ or slots which capture attention of a different
set of consumers. The firm supplying ‘Lux Soap’ enjoys a monopoly in
the sale of its own product. It also faces competition from firms selling
similar products. Same is the case with many other firms in the market
like plywood manufacturing, jewellery making, wood furniture, book
stores, departmental stores, repair services of all kinds, professional
services of doctors, technicians, etc. These firms and others which have
an element of monopoly power and also face competition over the sale of
product or service in the market are called monopolistically competitive
firm.
The following are the features or characteristics of monopolistic competition:-
1) Large Number of Sellers
There are large number of sellers producing differentiated products. So,
competition among them is very keen. Since number of sellers is large, each
seller produces a very small part of market supply. Every firm is limited in its
size.

236
In other words, there are large numbers of firms selling closely related, but not Monopolistic
homogeneous products. Each firm acts independently and has a limited share Competition: Price
of the market. So, an individual firm has limited control over the market price. and Output Decisions
Large number of firms leads to competition in the market.
2) Product Differentiation
It is one of the most important features of monopolistic competition. In perfect
competition, products are homogeneous in nature. On the contrary, here, every
producer tries to keep his product dissimilar than his rival’s product in order to
maintain his separate identity. This boosts up the competition in market and at
the same time every firm acquires some monopoly power. Hence, each firm is
in a position to exercise some degree of monopoly (in spite of large number of
sellers) through product differentiation. Product differentiation refers to
differentiating the products on the basis of brand, size, colour, shape, etc. The
product of a firm is close, but not perfect substitute for products of other firms.
Implication of ‘Product differentiation’ is that buyers of a product differentiate
between the same products produced by different firms. Therefore, they are
also willing to pay different prices for the same product produced by different
firms. This gives some monopoly power to an individual firm to influence
market price of its product. Following points provide insight about the product
differentiation:
a) The product of each individual firm is identified and distinguished from
the products of other firms due to product differentiation.
b) To differentiate the products, firms sell their products with different
brand names, like Lux, Dove, Lifebuoy, etc.
c) The differentiation among different competing products may be based on
either ‘real’ or ‘imaginary’ differences.
i) Real Differences may be due to differences in shape, flavour,
colour, packing, after sale service, warranty period, etc.
ii) Imaginary Differences mean differences which are not really
obvious but buyers are made to believe that such differences exist
through selling costs (advertising).
d) Product differentiation creates a monopoly position for a firm.
e) Higher degree of product differentiation (i.e. better brand image) makes
demand for the product less elastic and enables the firm to charge a price
higher than its competitor’s products. For example, Pepsodent is costlier
than Babool.
f) Some more examples of Product Differentiation: i) Toothpaste:
Pepsodent, Colgate, Neem, Babool, etc., ii) Cycles: Atlas, Hero, Avon,
etc., iii) Tea: Brooke Bond, Tata tea, Today tea, etc.
3) Freedom of Entry and Exit
This feature leads to stiff competition in market. Free entry into the market
enables new firms to come with close substitutes. Free entry or exit maintains
normal profit in the market for a longer span of time.
4) Selling Cost
It is a unique feature of monopolistic competition. In such type of market, due
to product differentiation, every firm has to incur some additional expenditure
in the form of selling cost. This cost includes sales promotion expenses,
advertisement expenses, salaries of marketing staff, etc. 237
Market But on account of homogeneous product in perfect competition and zero
Structure competition in monopoly, selling cost does not exist there.
5) Absence of Interdependence
Large numbers of firms are different in their size. Each firm has its own
production and marketing policy. So no firm is influenced by other firm. All
are independent.
6) Two Dimensional Competition
Monopolistic competition has two types or aspects of competition aspects viz.
Price competition i.e. firms compete with each other on the basis of price. Non-
price competition i.e. firms compete on the basis of brand, product quality
advertisement.
7) Concept of Group
In place of Marshallian concept of industry, Chamberlin introduced the concept
of Group under monopolistic competition. An industry means a number of
firms producing identical product. A group means a number of firms producing
differentiated products which are closely related.
8) Falling Demand Curve
In monopolistic competition, a firm is facing downward sloping demand curve.
It means one can sell more at lower price and vice versa.
9) Lack of Perfect Knowledge
Buyers and sellers do not have perfect knowledge about the market conditions.
Selling costs create artificial superiority in the minds of the consumers and it
becomes very difficult for a consumer to evaluate different products available
in the market. As a result, a particular product (although highly priced) is
preferred by the consumers even if other less priced products are of same
quality.
Check Your Progress 1
1) What is monopolistic competition? Explain with few examples.
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2) Identify the features that shows the presence of monopolistic competition
in market.
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3) A market with few entry barriers and with many firms that sell
differentiated products is
A) purely competitive.
B) a monopoly.
C) monopolistically competitive.
D) oligopolistic.

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 Monopolistic
11.3 DEMAND CURVE UNDER MONOPOLISTIC Competition: Price
COMPETITION and Output Decisions

Under monopolistic competition, large number of firms selling closely related

but differentiated products make the demand curve downward sloping. It
implies that a firm can sell more output only by reducing the price of its
product.
As seen in Fig. 11.1, output is measured along the X-axis and price and
revenue along the Y-axis. At OP price, a seller can sell OQ quantity. Demand
rises to OQ1, when price is reduced to OP1. So, demand curve under
monopolistic competition is negatively sloped as more quantity can be sold
only at a lower price.

Fig. 11.1

MR < AR under Monopolistic Competition: Like monopoly, MR is also less

than AR under monopolistic competition due to negatively sloped demand
curve.
Demand Curve: Monopolistic Competition Vs. Monopoly:
At first glance, the demand curve of monopolistic competition looks exactly
like the demand curve under monopoly as both faces downward sloping
demand curves. However, demand curve under monopolistic competition is
more elastic as compared to demand curve under monopoly. This happens
because differentiated products under monopolistic competition have close
substitutes, whereas there are no close substitutes in case of monopoly.
Let us prove this with the help of Fig. 11.2.

239
Market
Structure

Fig. 11.2

We know, price elasticity of demand (by geometric method) at a point on the

demand curve is given by: Ed = Lower segment of demand curve / Upper
segment of demand curve.
At price ‘OP’, price elasticity of demand under monopolistic competition is
BC/AB and under monopoly is EF/DE. Fig. 11.2 reveals that BC > EF and DE
> AB. So, BC/AB > EF/DE.
It means, demand curve in case of monopolistic competition is more elastic as
compared to demand curve under monopoly.

11.4 EQUILIBRIUM UNDER MONOPOLISTIC

COMPETITION
A firm under monopolistic competition has to face various problems which are
absent under perfect competition. Since the market of an individual firm under
perfect competition is completely merged with the general one, it can sell any
amount of the good at the ruling market price.
But, under monopolistic competition, individual firm’s market is isolated to a
certain degree from those of its rivals with the result that its sales are limited
and depend upon:
1) Its price,
2) The nature of its product, and
3) The advertising outlay it makes.
Thus, the firm under monopolistic competition has to confront a more
complicated problem than the perfectly competitive firm. Equilibrium of an
individual firm under monopolistic competition involves equilibrium in three
respects, that is, in regard to the price, the nature of the product, and the
amount of advertising outlay it should make.
Equilibrium of the firm in respect of three variables simultaneously – price,
nature of product, selling outlay – is difficult to discuss. Therefore, the method
of explaining equilibrium in respect of each of them separately is adopted,
keeping the other two variables given and constant.
Moreover, as noted above, the equilibrium under monopolistic competition
involves “individual equilibrium” of the firms as well as “group equilibrium”.
We shall discuss these two types of equilibrium first in respect of price and
240 output and then in respects of product and advertising expenditure adjustments.
11.4.1 Individual Firm’s Equilibrium in Short-Run Period Monopolistic
Competition: Price
The demand curve for the product of an individual firm, as noted above, is and Output Decisions
downward sloping. Since the various firms under monopolistic competition
produce products which are close substitutes to each other, the position and
elasticity of the demand curve for the product of any of them depend upon the
availability of the competitive substitutes and their prices.
Therefore, the equilibrium adjustment of an individual firm cannot be defined
in isolation from the general field of which it is a part. However, for the sake of
simplicity in analysis, conditions regarding the availability of substitute
products produced by the rival firms and prices charged for them are held
constant while the equilibrium adjustment of an individual firm is considered
in isolation.
Since close substitutes for its product are available in the market, the demand
curve for the product of an individual firm working under conditions of
monopolistic competition is fairly elastic. Thus, although a firm under
monopolistic competition has a monopolistic control over its variety of the
product but its control is tempered by the fact that there are close substitutes
available in the market and that if it sets too high a price for its product, many
of its customers will shift to the rival products.

Fig. 11.3

Assuming the conditions with respect to all substitutes such as their nature and
prices being constant, the demand curve for the product of a firm will be given.
We further suppose that only variables are price and output in respect of which
equilibrium adjustment is to be made.
The individual equilibrium under monopolistic competition is graphically
shown in Fig. 11.3. DD is the demand curve for the product of an individual
firm, the nature and prices of all substitutes being given. This demand curve
DD is also the average revenue (AR) curve of the firm.
AC represents the average cost curve of the firm, while MC is the marginal
cost curve corresponding to it. It may be recalled that average cost curve first
falls due to internal economies and then rises due to internal diseconomies.
241
Market Given these demand and cost conditions a firm will adjust its price and output,
Structure at the level which gives it maximum total profits. Theory of value under
monopolistic competition is also based upon the profit maximisation principle,
as is the theory of value under perfect competition.
Thus a firm, in order to maximise profits, will equate marginal cost with
marginal revenue. In Fig. 11.3, the firm will fix its level of output at OM, for at
OM output marginal cost is equal to marginal revenue. The demand curve DD
facing the firm in question indicates that output OM can be sold at price MQ =
OP. Therefore, the determined price will evidently be MQ or OP.
In this equilibrium position, by fixing its price at OP and output at OM, the
firm is making profits equal to the area RSQP which is maximum. It may be
recalled that profits RSQP are in excess of normal profits because the normal
profits which represent the minimum profits necessary to secure the
entrepreneur’s services are included in average cost curve AC. Thus, the area
RSQP indicates the amount of supernormal or economic profits made by the
firm.
In the short-run, the firm, in equilibrium, may make supernormal profits, as
shown in Fig. 11.3 above, but it may make losses too if the demand conditions
for its product are not so favourable relative to cost conditions. Fig. 11.4
depicts the case of a firm whose demand or average revenue curve DD for the
product lies below the average cost curve, indicating thereby, that no output of
the product can be produced at positive profits.

Fig. 11.4

However, the firm is in equilibrium at output ON and setting price NK or OT.

By adjusting price at OT and output at ON, it is able to minimise its losses. In
such an unfavourable situation, there is no alternative for the firm except to
make the best of the bad bargain.
We thus see that a firm in equilibrium under monopolistic competition, as
under pure or perfect competition, may be making supernormal profits or
losses depending upon the position of the demand curve relative to the position
of the average cost curve. Further, a firm may be making only normal profits
even in the short run if the demand curve happens to be tangent to the average
242 cost curve.
It should be carefully noted that in individual equilibrium of the firm in Fig. Monopolistic
11.3 and 11.4, the firm having once adjusted price at OP and (respectively will Competition: Price
have no tendency to vary the price any more. If it varies its price upward, the and Output Decisions
loss due to fall in quantity demanded will be more than possible gain owing to
the higher price. If it cuts down its price, the gain due to the increase in
quantity demanded will be less than the loss due to the lower price. Hence,
price will remain stable at OP and OT in the two cases respectively.

11.4.2 Individual Firm’s Equilibrium in Long Run

In the preceding sections, we have discussed that in the short run, firms can
earn supernormal profits. However, in the long run, there is a gradual decrease
in the profits of the firms. This is because in the long run, several new firms
enter the market due to freedom of entry.
When these new firms start production the market supply would increase and
the price would fall. This would automatically increase the level of competition
in the market. Consequently, AR curve shifts from right to left and
supernormal profits are eliminated. The firms will be able to earn normal
profits only.
In the long run, the AR curve is more elastic than that of in the short run. This
is because of an increase in the number of substitute products in the long-run.
The long-run equilibrium of monopolistically competitive firms is achieved
when average revenue is equal to average cost. In such a case, the firms receive
normal profits.

Fig. 11.5: Shows the long-run equilibrium position under monopolistic competition

In Fig. 11.5, P is the point at which AR curve touches the average cost curve
(LAC) as a tangent. P is regarded as the equilibrium point at which the price
level is MP (which is also equal to OP') and output is OM.
In the present case average cost is equal to average revenue that is MP.
Therefore, in long run, the profit is normal. In the short run, equilibrium is
attained when marginal revenue is equal to marginal cost. However, in the long
run, both the conditions (MR=MC and AR=AC) must hold to attain
equilibrium.

11.4.3 Group Equilibrium in Monopolistic Competition

The concept of group equilibrium was introduced by Chamberlin. The price-
output equilibrium of all firms is known as group equilibrium. Group
equilibrium represents the price and output of firms having close substitutes.
243
Market However, due to product differentiation, it is difficult to form market demand
Structure schedules and supply.

For overcoming the problem Chamberlin gave a concept called product group,
which includes products that are technological and economic substitute of each
other. Technological substitutes are the products having technical similarity,
while economic substitutes are the products that have same prices and fulfill
the same want of consumers.

A product group refers to a group in which the demand for each product is
highly elastic. Here, the demand for a product changes with the changes in the
prices of other products within the group, and, the price and cross elasticity of
demand for products forming the group is high.

In an industry, different types of groups exist automatically. In automobile

industry makers of cars and trucks are two different product groups.

The main competition would be among those organisations manufacturing

similar products (cars or trucks) which are close substitutes of each other. Due
to product differentiation, there is a large variation in the demand and cost
curves of firms. Their price, output, and profits also differ.

Therefore, to simplify product group analysis, Chamberlin has given two

assumptions, which are as follows:

i) The demand and cost curves of all products in the group are the same or
uniform. The uniformity assumption. The preferences of consumers are
evenly distributed and the difference in preferences does not lead to
variation in cost.

ii) In monopolistic competition, a large number of sellers are not able to

influence each other’s decisions. The changes in prices or level of output,
of firm would have insignificant influence on its competitors. This is
termed as the symmetry assumption.

These two assumptions form the basis for group equilibrium analysis. If an
organisation within the group has established a popular brand, it is more likely
to earn supernormal profits. However, in the long run, other organisations
would strive to emulate the product design and features. In such a case,
supernormal profits would vanish. This is a general case of all monopolistically
competitive organisations.

On the other hand, if the entire group is earning supernormal profits, then
external organisations would get attracted towards the group, until the legal or
economic barriers are imposed.
In Fig. 11.6, P is the equilibrium point at which output is OM, price is MP, and
average cost is MT. In such a case, marginal cost is equal to marginal revenue.
Therefore, firms are earning supernormal profits (P'PTT'). However, these
supernormal profits disappear in the long run.

244
 Monopolistic
Competition: Price
and Output Decisions

Fig. 11.6: The short-run group equilibrium

Fig.11.7: The long-run group equilibrium

In Fig. 11.7, it can be seen that the supernormal profits have disappeared. It
also depicts that average revenue (AR) is tangent to LAC, which implies that
price is equal to average revenue. Marginal revenue gets equal to marginal cost
at the output level of OM. This shows that in the long run, all firms in the
industry are making normal profits.

11.4.4 Equilibrium with Selling Costs

Selling Costs: Concept
“Selling costs are costs incurred in order to alter the position or shape of the
demand curve for the product.” E.H. Chamberlin
Selling costs play the key role in monopolistic competition and oligopoly.
Under these market forms, the firms have to compete to promote their sale by
spending on advertisements and publicity.
Moreover, producer has not to decide about price and output only. He also
keeps in view how to maximise the profit.
Thus, cost on advertisement, publicity and salesmanship add to the cost or
supply curve of the product while also contributing to rise in its demand. The
Selling costs is a broader concept than the advertisement expenditures.
Advertisement expenditures are part of selling costs.
In selling costs we include the salaries of sales persons, incentives to retailers
to display the products, besides the advertisements. It was Chamberlin who
introduced the analysis of selling costs and distinguished it from the production 245
Market costs. The production costs include all those expenses which are spent on the
Structure manufacturing of the commodity, its transportation cost of handling, storing
and delivering of the commodity to actual customers because these add utilities
to a commodity.
On the other hand, all selling costs include expenditures in order to raise
demand for a commodity. In short, selling costs are those which are made to
‘create’ the demand for the product. Transport costs should not be included in
selling costs; rather these should be included in the production costs. Transport
costs actually do not increase the demand; it only helps in meeting the demand
of the consumers.
In general, “those costs which are made to adopt the product to the demand are
costs of production; those made to adopt the demand to product are costs of
selling.”
The concept of selling cost is based on the following two assumptions:
1) Buyers do not have any perfect knowledge about the different types of
product.
2) Buyers’ demand and tastes can be changed.
While production costs include outlays incurred on services engaged in the
manufacturing of the product like land, labour and capital etc, the selling costs
include all the costs incurred to change the consumer’s preference from one
product to another. These raise the demand of a product at any given price.
“Production costs create utilities in order that demands may be satisfied while
selling costs create and shift the demand curves themselves.”
Selling costs influence equilibrium price-output adjustment of a firm under
monopolistic competition. In the Fig. 11.8 APC is the initial average
production cost. AR1 is the initial average revenue curve or initial demand
curve. The initial price is OP and the firm earns profits shown by the first
shaded rectangle PQRS.

Fig. 11.8: Equilibrium with selling costs

246
ACC1 is the average composite costs curve, which includes the average selling Monopolistic
cost (ASC). Average selling cost is equal to the vertical distance between APC Competition: Price
and ACC1. The new demand curve is AR2. It is obtained after incurring selling and Output Decisions
costs or after making advertisements.
It is, obvious, that the demand for the product has increased as a result of
selling costs. The profits have also increased as a result of selling costs. The
profits after incurring selling costs at OM1 level of output become equal to the
shaded area P1Q1R1S1. Note that these profits are greater than the initial level
of profits when no selling cost was incurred, i.e., P1 Q1 R1 S1 > PQRS.
ACC2 is the average composite cost when more additional selling cost is
incurred, as a result of which the demand for the product further increases. The
new demand curve is AR3 which indicates a higher demand for the product.
The profits are also greater than before since the shaded area P2Q2R2S2 >
P1Q1R1S.
It is, thus, obvious that the demand for the product is increasing as a result of
the selling costs. Since selling costs are included in the cost of production,
therefore price of the product is also increasing as a result of selling costs.
Profits are also increasing as a result of higher selling costs and increased
demand.
Here, question arises, how long a firm may go on incurring expenditure on
selling costs? It will continue to make expenditure on selling costs as long as
any addition to the revenue is greater than the addition to the selling costs. The
firm will stop incurring expenditure on selling costs when the total profits are
at the highest possible level.
This would be the point at which the additional revenue due to advertising
expenditure equals the extra expenditure on advertisement. It should, however,
be noted clearly that the effects of advertisement on prices and output are
uncertain. Advertisement by a firm may be considered successful if the
elasticity of demand for its product falls.
Check Your Progress 2
1) Will the demand curve for a firm under monopolistic competiton be
horizontal or downward sloping?
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2) On which factors equilibrium of individual firm depend under
monopolistic condition?
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3) Construct the diagram showing long run equilibrium of firm in
monopolistic competition.
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247
Market
Structure
11.5 PERFECT COMPETITION, MONOPOLY,
AND MONOPOLISTIC COMPETITION:
COMPARISON
The upcoming discussion will help you to make a comparison between perfect
competition, monopoly and monopolistic competition.
1) Structural Differences
Under perfect competition, there are innumerable numbers of firms who
produce homogeneous goods. Each firm in the market is so small that it cannot
exert any influence on price and output. Each firm, thus, behaves as a price-
taker.
Under monopolistic competition, there is quite a large number of sellers who
sell slightly different products. Product differentiation enables a firm to
exercise some power over price and output. This means that sellers behave
as ‘price-makers’. However, a monopoly seller has full control over its price-
output decision.
There is complete freedom of entry and exit of firms — both in perfect
competition and in monopolistic competition. This condition is true during the
long period only. In the short run, entry or exit is ruled out in both these market
forms. But a monopoly business is characterised by the absence of a rival
seller. Entry of new firms is either legally prohibited in monopoly, or may not
be financially feasible.
2) Behavioural Differences
A firm behaves as a price-taker under perfect competition, and the demand
curve faced by it is a horizontal one. Since price is fixed, AR curve coincides
with the MR curve. A monopoly firm, however, faces a negatively sloped
demand curve because it can have perceptible influence over price and output.
Consequently, MR curve is also negative sloping and lies below the AR curve.
This is also true under monopolistic competition. The only difference between
monopoly and monopolistic competition is that the demand curve faced by a
monopolistically competitive seller is relatively more elastic.
Since price is fixed for a competitive firm, it has only to undertake output
decisions. Further, products sold by competitive firms are perfect substitutes.
Because of complete product homogeneity, no firm finds any incentive to
spend money on any kind of sales promotional activity.
A monopoly firm also does not find any urgency to spend money on
advertisement since there is no rival seller. But a monopolistically competitive
seller has to incur some sort of “selling costs” just to provide information
about its product or rivals’ products. In fact, in order to attract more and more
customers, additional expenditure on selling cost is a necessity.
In every market, sellers adopt independent price-output policy. But all sellers
of all market forms follow one basic principle. The basic behavioural rule is
the equality between MC and MR. Under perfect competition, since AR = MR,
MC = MR = AR = P. But, in monopoly and in monopolistic competition, this
behavioural rule is slightly altered to MC = MR < AR = P, since in these two
markets, AR > MR.
248
A monopoly firm or a monopolistically competitive firm produces in that Monopolistic
region of its demand curve where the coefficient of elasticity of demand is Competition: Price
greater than one. But, under perfect competition, coefficient of elasticity of and Output Decisions
demand is infinite.
3) Optimum Capacity and Sub-Optimal Capacity of Production
A competitive firm always produces at the minimum point of its AC curve.
This means that a firm utilises its plant optimally. Since AR curve is a
horizontal one, a competitive firm will always produce at the lowest point of its
AC curve. It is then said that perfect competition leads to optimum economic
efficiency.
But, under monopoly, or under monopolistic competition, the demand curve is
negative sloping. It is due to the nature of this demand curve that a firm fails to
operate at the minimum point of its AC curve. It operates somewhere to the left
of the lowest point of the AC curve.
The implication of this is that resources are not utilised optimally under
imperfect competition. Imperfect competition leads to economic inefficiency.
As a result, a higher price for the product is charged and lower output is
produced. In this sense, perfect competition is an ideal market where social
welfare gets maximised. But social welfare gets reduced in monopoly or in
monopolistic competition.
4) Supply Curve
Under perfect competition, MC curve above the shut-down point is the short
run supply curve. But, under monopoly, or monopolistic competition, the
supply curve remains indeterminate. In other words, in these market forms,
MC curve is not the supply curve.

11.6 THEORY OF EXCESS CAPACITY UNDER

MONOPOLISTIC COMPETITION
The doctrine of excess (or unutilised) capacity is associated with monopolistic
competition in the long-run and is defined as “the difference between ideal
(optimum) output and the output actually attained in the long-run.”

Fig. 11.6
We know that under perfect competition, the demand curve (AR) is tangential
to the long-run average cost curve (LAC) at its minimum point and conditions
of full equilibrium are fulfilled: LMC = MR and AR (price) = Minimum LAC.
This means that in the long-run, the entry of new firms forces the existing firms
to make the best use of their resources to produce at the lowest point of average
total costs. At point E in Fig. 11.6, abnormal profits will be competed away 249
Market because MR = LMC = AR = LAC at its minimum point E and OQ will be the
Structure most efficient output which the society will be enjoying. This is the ideal or
optimum output which firms produce in the long-run.
Under monopolistic competition, the demand curve facing the individual firm
is not horizontal as under perfect competition, but it is downward sloping. A
downward sloping demand curve cannot be tangent to the LAC curve at its
minimum point.
The double condition of equilibrium LMC = MR = AR (P) = Minimum LAC
will not be fulfilled. The firms will, therefore, producing at less than the
optimum level even when they are earning normal profits. No firm will have
the incentive to produce the ideal output, since any effort to produce more than
the equilibrium output would involve a higher long-run marginal cost than
marginal revenue.
Thus each firm under monopolistic competition will be producing at less than
the optimum level and work under excess capacity. This is illustrated in Fig.
11.7 where the monopolistic competitive firm’s demand curve is d and MR1 is
its corresponding marginal revenue curve. LAC and LMC are the long-run
average cost and marginal cost curves.
The firm is in equilibrium at E1 where the LMC curve cuts the MR1curve from
below and OQ1 output is set at the price Q1 A1. OQ1 is the equilibrium output
but not the ideal output because d is tangent to the LAC curve at A1 to the left
of the minimum point E. Any effort on the part of the firm to produce beyond
OQ1 will mean losses as beyond the equilibrium point E1, LMC > MR1. Thus
the firm has negative excess capacity measured by OQ1 which it cannot utilise
working under monopolistic competition.
A comparison of the equilibrium positions under monopolistic competition and
perfect competition with the help of Fig. 11.7 reveals that the output of a firm
under monopolistic competition is smaller and the price of its product is higher
than under perfect competition. The monopolistic competition output OQ1 is
less than the perfectly competitive output OQ, and the monopolistic
competitive price Q1A1 is higher than the competitive equilibrium price QE.
This is because of the existence of excess capacity under monopolistic
competition.

Fig. 11.7
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Check Your Progress 3 Monopolistic
Competition: Price
1) In what respects monopolistic competition is different from other two and Output Decisions
extreme forms of market structure.

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2) What do you understand by the term ‘excess capacity’?

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11.7 LET US SUM UP

Monopolistic competition is a market structure in which there are many firms
selling closely related commodities. Its assumptions are: Large number of
buyers and sellers, Differentiated products, Free entry and exit, aim of the firm
is profit maximisation. Product differentiation exist which can be real or
artificial. Its effect is that the firm has some degree of price-making power.
Under monopolistic competition in the short-run, firm maximises profit where
MR=MC and the MC curve intersects MR curve from below. In the long-run,
due to free entry and exit of firms, firm earns normal profit. Economic profits
are zero.
Excess Capacity Theory states that it is a long-run concept and is the difference
between least cost output and profit maximising output. While, under perfect
competition, there is no excess capacity and under monopolistic competition,
excess capacity always exists.

11.8 REFERENCES
1) Dr Deepashree (2016), Introductory Micro Economics, Mayur
Paperbacks, Chapter on Theory of Market structure.
http://www.economicsdiscussion.net

2) Varian, Hal (1999), Intermediate Microeconomics, W.W Norton &Co,

New York, Chapter 24 & 25, page no. 415-455.

11.9 ANSWERS OR HINTS TO CHECK YOUR

PROGRESS EXERCISES
Check Your Progress 1
1) Read Section 11.1 and answer
2) Read Section 11.2 and answer
3) (c) 251
Market Check Your Progress 2
Structure
1) Read Section 11.3 and answer
2) Read Section 11.4 and answer
3) Read Sub-section 11.4.1 and answer
Check Your Progress 3
1) Read Section 11.5 and answer
2) Read Section 11.6 and answer

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