Page 181 - DECO405_MANAGERIAL_ECONOMICS

Managerial Economics

Notes one another. This type of market structure, where there is competition among a large number of
"monopolists" is called monopolistic competition.
The differentiation among competing products or brands may be based on real or imaginary
differences in quality. Real differences among brands refer to palpable differences in quality
such as shape, flavour, colour, packing, after sales service, warranty period, etc. In contrast,
imaginary differences mean quality differences which are not really palpable but buyers are
made to imagine or are "conditioned" to believe that such differences exist and are important.
Advertising often has the effect of making buyers imagine or believe that the advertised brand
has different qualities. When there is product differentiation, each firm has some degree of
control over price.
As a result, under monopolistic competition, the demand or average revenue curve of an
individual firm is a gradually falling curve. It is highly elastic but not perfectly so. Therefore,
the marginal revenue curve of the firm is also falling and lies below the average revenue curve
at all levels of output. It is in this respect that monopolistic competition differs from perfect
competition.
In addition to product differentiation, the other three basic characteristics of monopolistic
competition are:

1. There are a large number of independent sellers (and buyers) in the market.
2. The relative (proportionate) market shares of all sellers are insignificant and more or less
equal. That is, seller concentration in the market is almost non existent.
3. There are neither any legal nor any economic barriers against the entry of new firms into
the market. New firms are free to enter the market and existing firms are free to leave the
market.
In other words, product differentiation is the only characteristic that distinguishes monopolistic
competition from perfect competition.
Firms selling slightly differentiated products under different brand names compete not only
through variations in price but also through variations in product quality (product variation)
and changes in advertising or selling costs. Thus, under monopolistic competition, an individual
firm has to maximise profits in relation to variations in three policy variables, namely, price,
product quality, and selling costs. (In contrast, under perfect competition there is competition
only through price variation).
Assumptions in Analysing Firm Behaviour

We analyse the conditions and process of long run equilibrium under monopolistic competition
with the assumption that competing firms keep their selling costs and product quality constant
and compete only through price variation. We then assume that

1. The demand curve of each individual firm has the same shape (elasticity) and position
(distance from the y-axis). That is, we assume the demand curves of all firms to be
symmetrical. This assumption implies that market share of every firm is the same and
equal to a constant proportion of total market demand. That is, if total market demand is
Q and an individual firm's demand is q then q=KQ, where K is a constant fraction for all
firms.
2. The cost curves, both average and marginal, are symmetrical for each firm.
These two assumptions are 'heroic' or unrealistic but we need to make them for logical
convenience in order to analyse the long run equilibrium of a typical firm under monopolistic
competition.

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