welcome back to our discussion on monopolistic competition in the earlier 2 modules we have
developed the assumptions about monopolistic competition we have understood what the products
look like in a monopolistic competition how are they differentiated how are they substitutable
and what does the demand curve look like and eventually we developed the uh the profit
maximizing condition for monopolistic competition and we saw that uh saw the profit maximizing
output level that the firm chooses to produce and then it basically traces back the output
along the demand curve and decides what price to charge in the market
then we went on to discuss that uh the average total cost that the firm has that is going
to determine if the firm is making any loss or profit or zero economic profit and if the
firm is making profit we saw that lured by that profit other firms are going to enter
the market and the firms which bear a loss even in the long run they are going to exit
the market so this is this was the standard theory about
monopolistic competition uh basically uh discussing on about how profit maximizing output and
price is determined in a monopolistic competitive setup and uh so like all our previous discussions
on perfect competition monopoly etc where we have looked at the welfare implications
of the market outcome so in this module also we are going to discuss about welfare or efficiency
implications of the monopolistic competition market outcome .
so uh talking about long run outcome and efficiency in the long run entry and exit happens till
average total cost is equal to price for all firms and hence economic profit is equal to
0 but unlike perfect competition price is not equal to minimum average total cost in
the long run hence price is equal to average total cost but it is more than the marginal
cost that is the firm continues to charge a markup of price over marginal cost in the
long run so in the long run although price is equal
to average total cost and the firm is basically uh having a economic profit equal to 0 but
still the price has a is a markup over the marginal cost of the firm at that level of
output so let me draw the figure again . so this is output this is price so
in the long run this is the q and this is the price
so in the long run the average so in the long run the cost is equal to price for this firm
so economic profit is equal to 0 thisis a typical firm that we are talking about and
economic profit is equal to 0 in the long run in the long run yet the price is more
than the marginal cost this is the marginal cost
so price is more than the marginal cost and hence this is a difference that is there between
perfect competition and monopolistic competition in case of perfect competition in case of
perfect competition in the equilibrium price is equal to average total cost is equal to
marginal cost so average total cost is equal to marginal cost at the minimum average total
cost so this was the equilibrium this was the long
run equilibrium in case of perfect competition but in case of monopolistic competition price
is equal to average total cost but is more than marginal cost so this is the equilibrium
in case of monopolistic competition so this is not minimum of average total cost but average
total cost is falling yet it is more than marginal cost hence there is a markup between
price and marginal cost in the long run for a monopolistic competitive outcome now monopolistic
competition is less efficienct than perfect competition so this is kind of evident from
this from the comparison of the 2 outcomes it is uh the the difference in efficiency
or difference in welfare is quite apparent from these 2 because in case of perfect competition
the price that is charged is minimum of average total cost
so basically in the market the price that is getting charged is the minimum price that
is possible it is the minimum average cost that the firms are incurring and they are
charging that price but in case of monopolistic competition although the firms are incurring
zero economic profit yet the price that they are charging is not the minimum cost at which
they can produce the average total cost is still higher than
the marginal cost and average total cost and marginal cost are the the average total cost
is basically falling here so basically that means that the firm is operating at excess
capacity it is possible for the firm to increase output and lower cost yet the firm is producing
at a level where average cost is higher than the marginal cost and average cost is uh falling
. so the monopolistic competitor operates at
excess capacity it operates at downward sloping path of the cost curve and hence produces
less than cost minimizing output production does not happen at minimum cost as in perfect
competition since price is more than marginal cost market quantity is less than socially
efficient quantity however government cannot intervene to reduce prices or increase quantity
because the firms are already operating at zero economic profit
so basically this means coming back to this diagram it basically means that uh production
does not happen here but production happens here where the average cost is falling so
average cost is falling in case of perfect competition the production happens here in
case of perfect competition but in case of monopolistic competition there is excess capacity
so it is possible for the firms to increase the output yet its cost is is going to keep
on decreasing yet the firm does not do that and it produces at a level where the average
cost is falling hence there is excess capacity at which the firm is operating yet the firm
is producing zero economic profit since here it is tangent to the the price line is tangent
to the average total cost hence there is inefficiency in the market in the sense that the price
that is getting charged in the market is more than the marginal cost
that is the benefit from the product the benefit that the or the willingness to pay for the
product by the buyers is higher than the cost at which the additional unit of output can
be produced by the seller so there is clearly a inefficiency existing there because here
in this situation it is possible for the firm to keep on increasing output and the the buyer
will keep on demanding higher output at a lower price and it is possible for the firm
to keep on uh increasing output yet getting a yet incurring a average cost which is uh
yet it’s it’s in this region basically in this region it is see this is the this
is the perfectly competitive output so it is possible for the firm to keep on
or it is possible to imagine that the firm will continue to increase its output because
till the point where its average cost is minimum so it is it is possible to imagine the price
also to fall to that level where average cost equals marginal cost equals the price charged
in the economy in that case there would be perfect efficiency would be reached but that
is not happening here because the firm is charging a price which is higher than the
marginal cost so however the problem is in case of monopoly
also the same thing was happening in case of monopoly also the uh although in case of
monopoly there was not zero economic profit but in case of monopoly also this inefficiency
was there there was this deadweight loss and in case of monopoly also uh the firm was charging
a price higher than the marginal cost because it has some amount of market power but in
that case the government could step in and say that you have to increase your output
so it it could it was possible for the government to actually direct the monopoly to increase
its output lower its price etc but in case of monopolistic competition that is not possible
because in the long run the monopolistic competitive market where there is free entry and exit
that ensures that the firm is producing at a level where it earns zero economic profit
so in such a situation if the government intervenes and tries to reduce the price even further
in that case the firms are going to incur negative economic profit or loss in that case
so uh so the firm is going to exit the market so so because of that it is not possible for
the government to intervene in such a case because the firms are already earning zero
economic profit so although there is inefficiency in the market yet the government cannot do
anything here so what are the welfare implications .
now there are broadly 2 welfare implications of monopolistic competitive market output
the first is the product variety externality of consumers that is introduction of new products
and new entrants in the market raises surplus for consumers what does this mean thisbasically
means as i said that whenever the firm is incurring any positive economic profit other
firms are going to enter the market now these new firms are going to bring in
more differentiated products Uh remember that every firm is striving to make its product
different in the eyes of the consumers from the existing products so as that keeps on
happening the consumers are benefited because they have more and more choice and the product
could be differentiated on the basis of quality also remember
so one can imagine that the product differentiation actually makes the consumer better off the
consumer gets a whole variety of choice to choose from and the consumer also gets better
quality better variety of products and because of that the consumer surplus actually increases
the benefit its willingness to pay for a product that keeps on increasing because it is getting
better and better product and so its consumer surplus increases
also because as more entrants are there more entrants are entering the market this demand
curve gets split between lot of uh across different other firms and because of which
the individual firms get to charge lower and lower prices so as they keep on charging lower
and lower prices the uh consumer is better off because on the one hand he is getting
better choices more variety of products better quality products but also lower prices for
products as there are lot of sellers in the market
but there is a flip side to it because welfare is not only about consumers a economy consists
of both consumers and producers so welfare is dependent on the welfare of both consumers
as well as producers so although the consumers welfare is increasing what happens to producers
welfare now as the second point says the business stealing externality faced by the producers
is another welfare implication when new firms enter the market existing firms may lose customers
face losses and sometimes may have to leave the market
so uh so one can imagine that in a monopolistic competitive market setup since its easy to
enter the market its possible for new firms to enter and uh bring in new varieties of
products and it is possible for the firms to actually steal ideas steal products uh
product ideas from the existing firms and make them even better and in the process they
steal business from the existing firms who may have to leave the market so that is also
possible so such amount of competition in the market
because its free entry and exit it is possible to imagine that in such kind of market setup
there are continuously churning of new producers in the market new sellers are entering the
market and as a result the old sellers are getting wiped out from the market as new and
new products are developed and uh circulated in the market so that is a negative welfare
implication on the producers in the market the net result of the above are hard to measure
and hence there is not much that the policy makers can do so on the one hand while consumers
are better off on the other hand there one can imagine a whole lot of insecurity on the
parts on the uh amongst the producers because as new and new entrants enter the market and
wipe wipe off the uh existing profits wipe away businesses altogether wipe away products
altogether from the market so however the its a its a natural phenomenon
that keeps on happening and there is little that the government or any policy maker can
do uh in such kind of market so uh coming back to another uh so we already saw from
the diagram that the firm is operating at excess capacity it is operating at a level
where average cost curve is declining and it is tangent to the price line or the demand
curve and hence the firm is operating at zero economic profit
but one may wonder uh what is the logic behind it why does the firm operate at excess capacity
why does the firm operate at excess capacity and not at the minimum point what is the logic
or intuition behind it now there could be 3 or 4 reasons behind it one uh could imagine
first is the very obvious which very very obvious reason is these are all differentiated
products . so these are all differentiated products so
there are whole lot of products which have a negatively sloping demand curve so they
have negatively sloping demand curve so these are very highly differentiated products and
they have different negatively sloping demand curve and hence uh there is no way they can
be tangent to the minimum point of the average total cost curve uh for the firm
so each of these firms so this is say firm 1 firm 2 firm 3 so each of these firms have
a negatively sloping demand curve and negatively sloping demand curve can be tangent only to
the declining portion of the average cost curve and hence this is the outcome where
uh it is operating at a level where there is excess capacity because there is uh there
is a negatively sloping demand curve Had this been a homogenous product then all the firms
would be facing a flat demand curve all the firms will be facing a horizontal demand curve
and in that case they would be operating at a minimum of the average cost
now the second uh reason is that if you imagine such a market where there are whole lot of
uh product differentiation and all the firms are existing coexisting in this market and
each is trying to behave like a not a monopoly but each firm has some control over its consumers
and they are focusing on product differentiation and catering to this demand curve
what they are not focusing on is that they are not focusing on minimizing cost they are
not focusing on minimizing cost but they are focusing on retaining these consumers and
charging them a price which is uh minimum in the long run that they can charge so intuitively
one could imagine that the firms are coexisting in a live and let live kind of environment
where they each of them is focusing on product differentiation and not really focusing on
price competition they are not competing with each other in terms of price but they are
competing or they are trying to create their own niche clientele by product differentiation
and that is how we have developed this model and hence there is excess capacity at which
they have to operate because they each of them is facing a negatively sloping demand
curve and uh another intuition behind uh excess capacity is when we discussed about the long
run when we said that there is a profit to be made and there are firms existing in the
periphery who are sitting and watching the market and as soon as there is profit to be
made these firms enter the market now what happens in such a scenario in such
a scenario what happens is this demand curve it gets split up into too many firms so so
imagine this is a uh a group of consumers who used to buy from this single seller minty
toothpaste and now they know that there are whole lot of other flavours available in the
market different kinds of products packaging etc so now they get as new and new entrants
are there in the market this demand curve gets split up between 3 4 more firms or even
more firms so in that case the existing firms or the
new firms each of these firms are now going to cater to even lesser and lesser number
of consumers so obviously they will be operating at excess capacity because capacity has already
been created its like having a if you uh imagine that there is a residential new residential
area coming up and initially there was only one uh initially there was only one store
for one grocery store and gradually more and more grocery stores coming up in that area
because they know that profit is to made thisone single store is uh making a profit
so more and more grocery stores enter the market or enter that in that residential area
more and more grocery stores come up so now instead of the one grocery store now 10 more
grocery stores are all going to cater to the uh existing number of residents who are residing
in that area so basically each of them is now going to operate at excess capacity
so it is not possible for each of them to operate at marginal average cost instead they
are all going to operate at excess capacity and since each of them is product differentiating
since the firms each of them is focusing on product differentiation so that also is uh
kind of reason for the firms to operate at excess capacity and come up with more and
more ideas for better product differentiation and maybe uh have different this this basically
uh is reason enough for the firms to to operate at excess capacity so that they can keep on
improving on the product differentiation that they are already doing in the market and because
of this for better differentiation of product they probably would like to uh keep on operating
at a excess capacity so this these were the welfare implications
of a monopolistic competitive market and we have seen that although uh unlike monopoly
the monopolistic competitive firm does not have uh more than zero economic profit or
positive economic profit like perfectly competitive firms the monopolistic competitive firm has
zero economic profit in the long run because of entry and exit but like a monopolist the
monopolistic competitive firm has its own unique product in the sense that they keep
on product differentiation to make keep their products different from the other products
although all these products are kind of substitutable so in generally speaking these products are
substitutable but yet the firms strive to make their products different or create the
perception that the products are better than the other products in the market in the eyes
of the consumer thisthey do through different either making their products themselves slightly
different or through marketing through advertising through locational advantages uh through packaging
so this is what the firms strive to uh they strive to keep on doing and it makes sense
for them to operate at excess capacity to keep on differentiating their product from
the rest of the market so in the following module we are going to see the role of advertisement
in monopolistic competition and we are going to see that if uh what are the opinions of
people whether advertising is good or bad thisis what we are going to do in the following
module and complete our discussion on monopolistic competition Thank you