A market structure in which several or many sellers each produce similar, but slightly differentiated products. Each producer can set its price and quantity without affecting the marketplace as a whole.
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 is a case of imperfect competition. Monopolistic competition has been introduced by American economist Prof. Edward Chamberlin, in his book 'Theory of Monopolistic Competition' published in 1933.
Equilibrium under monopolistic competition
Under monopolistic competition, as in all other market situation each firm attempts to maximize its profits. It will, therefore, choose that price and level of output which gives maximum profits and this will be achieved at the point where its marginal revenue is equal to marginal cost. In other words, the equilibrium of a firm under monopolistic competition is attained when its marginal revenue equals marginal cost.
However, in order to maximize its profit, a firm under monopolistic competition has to face more complicated problems than those faced by a purely competitive firm. There are three important problems pertaining to price and output policy which a firm has to consider under monopolistic competition. The firm can maximize its profits by-
1. Changing the price of the products or products variation 2. Improving the quality of the product or product variation 3. Incurring selling costs
Short run equilibrium under monopolistic competition
Prof. Chamberlin has used the word individual equilibrium to connote short run equilibrium of the firm under monopolistic competition. Let us now study how this equilibrium is attained by the firm.
We shall start with basic assumption that every firm attempts to maximize its profits and will, therefore, choose that level of price and output which enables it to secure maximum profits. As discussed previously, the firm will go on producing till the extra receipts to be had from the additional unit are more than the extra costs to be incurred in the production of that unit.
In other words, profits will be maximized when marginal revenue is equal to marginal cost. As long as the marginal revenue is greater than the marginal cost, it is in the interest of the firm to expand its output because the total gain in the shape of additional revenue is more than the additional to the total cost. Similarly, if marginal revenue is less than the marginal cost, it is to the advantage of the firm to reduce its output because the loss in the additional revenue will be less than the additional to the total cost.
The equilibrium position of the firm will be attained at the point where its marginal revenue is equal to marginal cost. The firm will stop its output at this point, and will be earning maximum profits.
Another points to be emphasized is that in the short run equilibrium of a firm under monopolistic competition, The firm earns supernormal profits, the firm earns only normal profits, and the firm is incurring losses. In the short run, a firm under monopolistic competition may be able to earn supernormal profits because other firms are not in a position to bring out closely similar products in that period. Nor can the new firms enter the group during the short period. In the short run, therefore, supernormal profits can be earned by a firm.
In the long run, however, these supernormal profits will be competed away by the entry on new firms, and only normal profits will be earned by all the firms.
Similarly, it is also likely that in the short run under monopolistic...