Monopolistic Competition: Demand Curves and Equilibrium
Monopolistic Competition Characteristics
This type of market structure is characterized by:
- When goods are close substitutes, each firm faces a demand curve that slopes downward.
- Each of the companies acts as if its own decisions on price and quantity do not affect the behavior of other firms in the industry.
The result of this approach is that the company actually faces two demand curves: one describing the situation when it is the only one to alter the price (the dd curve) and the other describing the situation when all prices change at the same time (the DD curve). In the initial situation where all firms charge p', each selling Q'. If one company lowers its price to P'', it will sell Q''. But if others also lower their prices, each firm will sell only Q''.
Short-Run Profit Maximization
The Chamberlin monopolistically competitive firm maximizes its short-run economic profit by equating marginal revenue and marginal cost. The short-run economic profit is the shaded area of the graph. The DD curve cuts the dd curve at the price which maximizes profit. This is due to the Chamberlinian symmetry assumption among existing firms. The DD curve is the set of points along which the quantity sold by each firm would move with the price if the prices of all firms varied at once. While the dd curve is the set of points along which the quantity sold by a firm varies with the price when all other prices remain fixed.
Entry and Demand Shift
As in perfect competition, the existence of profits attracts more firms. In perfect competition, the entry of new firms shifts the industry supply curve to the right, resulting in lower equilibrium prices. That is, under perfect competition, the entry of new firms causes the horizontal demand curve of each firm to shift downward. In the Chamberlin model, the demand curve (dd) of each firm shifts to the left. Assuming that all firms compete on equal terms for a portion of the total industry demand, entry causes a proportional reduction in the quantity each firm can sell at a given price. Each firm essentially claims an equal share of industry demand, and with more firms in the industry, that share necessarily diminishes.
Long-Run Equilibrium
After the demand shift to the left caused by entry, each firm has the opportunity to adjust its capital stock and choose its new profit-maximizing production level. As long as firms continue obtaining positive profits, entry will continue. The position of long-run equilibrium is reached when the dd demand curve has shifted to the left to a point that is tangent to both the long-run average cost curve and the short-run average cost curve. The firm produces quantity Q*, charges price P*, and earns zero economic profit.