Monopolistic competition: price and output determination; features of oligopoly

1. Meaning

Most real markets are neither perfectly competitive nor monopolies. Edward H. Chamberlin (The Theory of Monopolistic Competition, 1933) and Joan Robinson (The Economics of Imperfect Competition, 1933) worked out the theory of these mixed markets independently in the same year. Monopolistic competition is a market with many firms selling differentiated products that are close but not perfect substitutes: soaps, toothpastes, shampoos, restaurants, tailoring shops, branded clothing. Each firm has a small monopoly over its own brand, but competes with many close substitutes.

2. Features

1. Large number of sellers, each with a small share of the market; each acts independently.
2. Product differentiation: real (quality, design, materials) or imagined (brand name, packaging, advertising, location, after-sales service). This gives each firm some control over its price.
3. Free entry and exit.
4. Selling costs: expenditure on advertising, salesmen, displays and promotion, to shift the demand curve to the right and make it less elastic. Selling costs are peculiar to this market: under perfect competition there is no need for them, and a monopolist has no rival to compete with.
5. Downward-sloping and highly elastic demand curve, because close substitutes exist.
6. Group instead of industry: since products differ, Chamberlin spoke of a “product group” of firms producing close substitutes.
7. Non-price competition: firms compete through quality, advertising and service as much as through price.

3. Short-run equilibrium of the firm

Each firm faces a downward-sloping AR and an MR below it, like a monopolist, though AR is more elastic. It produces where MR = MC, MC cutting MR from below, and charges the price on the AR curve above that output.

• If price exceeds AC at that output, the firm earns supernormal profit.
• If price equals AC, normal profit.
• If price is below AC (but above AVC), a loss, borne in the short run.

Illustration: a soap maker’s MR = MC at 1,000 cakes a day; the demand curve shows a price of Rs. 40 at that output, and AC is Rs. 34. Supernormal profit = (40 − 34) × 1,000 = Rs. 6,000 a day.

4. Long-run equilibrium: the group

Supernormal profit attracts new firms producing close substitutes. Each existing firm loses some customers, so its demand (AR) curve shifts to the left and becomes more elastic. Entry continues until supernormal profit disappears. Losses work the other way: firms leave, and the demand curves of those remaining shift right.

Long-run equilibrium is reached when, for each firm:

• MR = LMC, and
• AR = LAC, the AR curve being tangent to the LAC curve.

Because AR slopes downward, the tangency must be on the falling part of LAC, to the left of its minimum point. The firm earns only normal profit.

Described diagram: LAC is U-shaped; the downward-sloping AR touches it at T, to the left of its lowest point M. LMC cuts MR from below directly beneath T. Output OQ at T is less than OQ′ at M; price QT is above the minimum cost Q′M.

5. Selling costs and the equilibrium

Chamberlin also analysed the firm’s choice of selling costs. Advertising raises the average cost curve (adding selling cost per unit) but also shifts demand to the right. The firm increases selling outlay as long as the extra revenue it brings exceeds the extra cost. In the long run competitive advertising by all firms may leave each with much the same sales but higher costs, which is a criticism of this market form.

6. Comparison with the other markets

7. Oligopoly: features

Oligopoly (Greek oligoi, few) is a market with a few sellers of a homogeneous or differentiated product. Indian examples include telecom services, cement, cars and aviation. Where there are exactly two sellers it is duopoly.

1. Few sellers, each with a large share of the market.
2. Interdependence: the decisive feature. Each firm must consider how rivals will react to its price or output change. A price cut by one invites cuts by all.
3. Indeterminate demand curve: since rivals’ reactions are uncertain, a firm cannot know its demand curve.
4. Advertising and selling costs are very important; Baumol called advertising a matter of life and death for the oligopolist.
5. Price rigidity: prices tend to stay put even when costs change.
6. Group behaviour: firms may collude, form cartels or follow a price leader.
7. Barriers to entry: large capital, patents, economies of scale.

Kinked demand curve (Paul Sweezy, 1939): an oligopolist expects that if it raises its price, rivals will not follow, so it will lose many customers (demand above the current price is elastic); if it cuts price, rivals will follow, so it gains few customers (demand below the current price is inelastic). The demand curve therefore has a kink at the ruling price, and the MR curve has a vertical gap beneath the kink. MC can move up or down within the gap without changing price or output, which explains price rigidity.

Collusion among oligopolists to fix prices or share markets is a cartel. Under the Competition Act, 2002, such an agreement is presumed to have an appreciable adverse effect on competition (section 3(3)) and is therefore void (section 3(2)). Principles of Economics covers both markets briefly in monopolistic competition, oligopoly and duopoly.

How this is examined

January 2026 set “Explain price and output determination under monopolistic competition” as Q.4 (16 marks, 100-mark paper) and as the alternative in Q.4(a) (10 marks, 80-mark paper), with “Write short note on features of Oligopoly” (6 marks) in Q.4(b). For the long answer: meaning, features, short-run equilibrium with three cases, long-run tangency, excess capacity and selling costs. For oligopoly: definition, six or seven features with interdependence first, and the kinked demand curve in a paragraph.