•Let us consider a market structure where
•The number of firms is large,
•There is free entry and exit of firms,
•But the goods produced by them are not homogeneous.
•Such a market structure is called monopolistic competition.
•This kind of a structure is more commonly visible.
•There is a very large number of biscuit producing firms.
•However, the biscuits being produced are associated with some brand name and are distinguishable from one another by these brand names and packaging and are slightly different in taste.
•The consumer develops a taste for a particular brand of biscuit over time, or becomes loyal to a particular brand for some reason, and is, therefore, not immediately willing to substitute it for another biscuit.
•Only if the price difference becomes large, the consumer would be willing to choose a biscuit of another brand.
Change of consumer’s choice
•If the price difference is large, the consumer would be willing to choose a biscuit of another brand.
•A consumers’ preference for a brand will often vary in depth, so the change in price required for the consumer to change her brand may vary.
•Therefore, if price of a particular brand is lowered, some consumers will shift to consuming that brand.
•Lowering of the price further will lead to more consumers shifting to the brand with the lower price.
•Hence, the demand curve faced by the firm is not horizontal (perfectly elastic) as is the case with perfect competition.
•The demand curve faced by the firm is also not the market demand curve, as in the case with monopoly.
•In the case of monopolistic competition, the firm expects increases in demand if it lowers the price.
•Since the demand curve of a firm is also its AR curve, this firm, therefore has downward sloping AR curve.
•The marginal revenue is less than the average revenue, and also downward sloping.
Price and quantity
•The firm increases its output whenever the marginal revenue is greater than the marginal cost.
•It will increase production as long as the addition to its total revenue is greater than the addition to its total costs.
•This firm will choose to produce the quantity that equates its marginal revenue to its marginal cost.
•So a firm under monopolistic competition will produce less than the perfectly competitive firm.
•Given lower output, the price of the commodity becomes higher than the price under perfect competition.
•This situation is one that exists in the short run.
Long term perspective
•The market structure of monopolistic competition allows for new firms to enter the market.
•If the firms in the industry are receiving supernormal profit in the short run, this will attract new firms.
•As new firms enter, some customers shift from existing firms to these new firms.
•So existing firms find that their demand curve has shifted leftward, and the price that they receive falls. This causes profits to fall.
•The process continues till super-normal profits are wiped out, and firms are making only normal profits.
•If firms in the industry are facing losses in the short run, some firms would stop producing and exit from the market.
•The demand curve for existing firms would shift rightward.
•This would lead to a higher price, and profit.
•Entry or exit would halt once supernormal profits become zero and this would serve as the long run equilibrium.