Q30 — Monopolistic Competition: Equilibrium of Firm & Group (Short Run & Long Run)

Introduction

In the theory of product markets, monopolistic competition occupies an intermediate position between perfect competition and monopoly. It combines the element of competition (large number of firms) with the element of monopoly (product differentiation and some control over price). In the prescribed text “Microeconomics” by T.R. Jain & V.K. Ohri for B.Com Semester I (Panjab University), equilibrium under monopolistic competition is analysed in terms of the individual firm and the group of firms, both in the short run and the long run.

To answer this question in an examiner-friendly manner, we shall first explain the meaning and features of monopolistic competition and then discuss equilibrium of the firm and equilibrium of the group in the short run and long run with proper diagrams and interpretation.

I. Meaning and Features of Monopolistic Competition

1. Meaning

The concept of monopolistic competition was developed by Prof. E.H. Chamberlin. It refers to a market situation in which a relatively large number of firms sell products which are similar but not identical. Each firm produces a differentiated variety and therefore enjoys some monopoly power, but the presence of many close substitutes also makes the market competitive.

Definition (exam-style):
Monopolistic competition is a market structure in which a fairly large number of firms sell differentiated products which are close substitutes of one another, there is free entry and exit of firms, and each firm has some degree of monopoly power over its own variety but faces competition from rival brands.

2. Essential Features

Large number of firms:
There are many firms in the industry, each with a relatively small market share. No single firm can influence the market conditions for the entire group, but each has some control over its own individual demand due to product differentiation.
Product differentiation:
Each firm produces a slightly differentiated product — through brand name, quality, design, colour, packaging, after-sale service, etc. The products are close substitutes but not perfect substitutes. This gives each firm some monopoly element.
Freedom of entry and exit:
In the long run, firms can freely enter the industry when existing firms earn supernormal profits and can exit when they suffer losses. This ensures that in the long run only normal profits are earned.
Selling costs:
Firms incur selling costs (advertising, sales promotion, publicity, etc.) to differentiate their brands and attract customers. This is an important feature distinguishing monopolistic competition from perfect competition.
Downward sloping firm demand curve:
Because of product differentiation, each firm faces a downward sloping demand curve (AR curve). It can raise price without losing all customers, but demand is still relatively elastic due to availability of close substitutes.
Firm vs group:
Under monopolistic competition, Chamberlin uses the term “group” instead of “industry”. A group consists of all firms producing close substitutes (e.g. all brands of toothpaste). Each firm belongs to a group, but has some individuality due to differentiation.

Typical real-life examples: branded soaps, toothpastes, shampoos, garments, restaurants and fast-food outlets — where each brand is differentiated but many close substitutes are available.

II. Equilibrium of the Firm under Monopolistic Competition in the Short Run

1. Concept of Equilibrium of Firm

A firm is in equilibrium when it has no tendency to change its level of output; that is, when it maximises its profit (or minimises its loss). As in other market structures, the fundamental condition of equilibrium is:

MR = MC and MC cuts MR from below.

Under monopolistic competition, each firm faces a downward sloping demand (AR) curve and a corresponding MR curve lying below it. On the cost side, we have the usual short-run AC and MC curves.

2. Diagram: Short-run Equilibrium of the Firm

Fig. 1 — Short-run equilibrium of a firm under monopolistic competition: equilibrium at E where MR = MC. Firm produces Q* and charges price P* from the AR curve. Since P* > AC, the firm earns supernormal profit (shaded area).

3. Short-run Profit Positions

In the short run a firm under monopolistic competition may earn:

Supernormal profits: If at the equilibrium output Q* we have P* > AC, the firm earns supernormal profit equal to (P* − AC) × Q* (shaded rectangle in Fig. 1).
Normal profit: If at Q* the AR curve is tangent to the AC curve (P* = AC), the firm earns only normal profit.
Losses (subnormal profit): If at Q* we have P* < AC but P* > AVC, the firm incurs losses yet continues to produce in the short run, as it covers its variable costs and part of fixed costs.

Thus, short-run equilibrium of a firm under monopolistic competition is similar to monopoly equilibrium in form, but the demand curve is more elastic due to the presence of close substitutes.

III. Short-run Equilibrium of the Group under Monopolistic Competition

As noted earlier, Chamberlin uses the term group instead of industry. A group consists of all firms producing close substitute brands of a product (for example, all soap brands).

1. Determination of Group Equilibrium (Short Run)

In the short run:

The number of firms in the group is given (entry and exit do not take place immediately).
Market demand for the product is distributed among these firms according to their brand loyalty, advertising, location and other differentiation factors.
Each firm independently adjusts its output and price to maximise its own short-run profit where MR = MC.

At the group level, the short-run equilibrium is reached when all firms are simultaneously in their short-run equilibrium (MR = MC), though some may be earning supernormal profits, some normal profit and some losses, depending on their individual cost and demand situations.

In this sense, short-run group equilibrium under monopolistic competition is characterised by:

A given number of differentiated firms.
Each firm facing its own downward sloping demand curve.
Different price–output combinations for different firms.

IV. Long-run Equilibrium of Firm under Monopolistic Competition

In the long run, firms can adjust their plant size and, more importantly, new firms can enter the group and existing firms can exit. The process of entry and exit plays a crucial role in determining long-run equilibrium.

1. Adjustment from Short Run to Long Run

If firms are earning supernormal profits in the short run, this attracts new firms into the group in the long run. New entrants introduce their own differentiated brands, leading to a substitution effect which reduces the demand for each existing firm’s product (its AR curve shifts leftwards).
Conversely, if some firms are incurring losses, they will leave the group in the long run, increasing the demand faced by the remaining firms.
Entry and exit continue until each firm is earning only normal profit; i.e. no firm has an incentive to enter or leave the group.

2. Long-run Equilibrium Conditions

For a firm under monopolistic competition, long-run equilibrium requires:

MR = MC (profit-maximisation condition), and
AR is tangent to long-run AC (LAC) at the equilibrium output, so that the firm earns only normal profit (P = LAC).

Because AR is downward sloping, the tangency point between AR and AC occurs to the left of the minimum point of AC, which implies that the firm operates with excess capacity in the long run.

3. Diagram: Long-run Equilibrium of the Firm (Excess Capacity)

_LR P_LR = LAC Q_c Min LAC

Fig. 2 — Long-run equilibrium of a firm under monopolistic competition: AR is tangent to LAC at E and MR = LMC at the same output Q_LR. The firm earns only normal profit (P_LR = LAC). Output Q_LR is less than Q_c (output at minimum LAC), indicating excess capacity.

4. Excess Capacity of the Firm

The diagram shows that the firm’s long-run equilibrium output Q_LR is less than Q_c, the output corresponding to minimum LAC. The difference (Q_c − Q_LR) is called excess capacity. It implies that in long-run equilibrium, a firm under monopolistic competition does not use its plant to the full capacity; it produces less than the output at which per-unit cost is minimum.

This is a major difference from perfect competition, where in long-run equilibrium each firm produces at minimum LAC and there is no excess capacity.

V. Long-run Equilibrium of the Group under Monopolistic Competition

1. Meaning of Group Equilibrium (Long Run)

Long-run equilibrium of the group under monopolistic competition is attained when:

The number of firms in the group is such that all firms are earning only normal profits.
No new firm has an incentive to enter (since there are no supernormal profits).
No existing firm has an incentive to leave (since losses are absent).
Each firm is in its own long-run equilibrium (MR = LMC and AR tangent to LAC).

Thus, long-run group equilibrium is a situation in which all firms are simultaneously in long-run equilibrium and the number of firms is stable.

2. Process Leading to Group Equilibrium

Starting from a short-run situation where some firms earn supernormal profits:

Supernormal profits attract new firms into the group. New firms introduce additional differentiated varieties.
Entry of new firms shifts the demand curve (AR) of each existing firm leftwards, because total demand is now shared among a larger number of close substitutes.
This continues until all supernormal profits are competed away and each firm’s AR curve becomes tangent to its LAC curve.
Any further entry would cause losses, so entry stops; any exit would recreate supernormal profits, so exit is discouraged. The number of firms becomes stable.

Consequently, in long-run group equilibrium:

Each firm operates with excess capacity but earns normal profit.
The group as a whole supplies the quantity demanded at the ruling prices of different brands.
The pattern of product differentiation and brand loyalty becomes relatively stable.

VI. Comparison with Perfect Competition and Significance

Key differences (Long-run equilibrium of firm)

Price and cost:
Under perfect competition: P = MC = minimum LAC.
Under monopolistic competition (long run): P = LAC > MC, and P is set on a downward sloping demand curve.
Output and capacity:
Perfect competition: firm operates at minimum LAC (no excess capacity).
Monopolistic competition: firm operates to the left of minimum LAC (excess capacity).
Number of firms:
In monopolistic competition, the group contains a large number of firms with differentiated products; free entry and exit drive profits to normal in the long run.
Selling costs and product variety:
Selling costs are significant and many differentiated varieties exist. This may increase consumer choice, but leads to duplication of costs and excess capacity.

Exam Tip (for full 15 marks): In Panjab University exams, write this answer in the following sequence: (i) precise definition and main features of monopolistic competition; (ii) short-run equilibrium of the firm with a neat AR–MR–AC–MC diagram and discussion of supernormal profits; (iii) short-run group equilibrium (given number of differentiated firms, each in short-run equilibrium); (iv) long-run equilibrium of the firm with AR tangent to LAC, MR = LMC and explanation of excess capacity using a clear diagram; and (v) long-run group equilibrium (entry–exit process leading to normal profits for all firms). End with a brief comparison with perfect competition, highlighting excess capacity and normal profits. Underline key phrases like “AR tangent to LAC”, “MR = MC”, “excess capacity” and “product differentiation” to impress the examiner.

Conclusion

To conclude, monopolistic competition is characterised by a large number of firms, product differentiation, selling costs and free entry and exit. In the short run, each firm attains equilibrium where MR = MC and may earn supernormal profits, normal profit or losses. The group equilibrium in the short run simply reflects each firm being in its own short-run equilibrium with a given number of differentiated competitors. In the long run, entry and exit of firms adjust the number of firms such that each firm’s AR curve becomes tangent to its LAC curve at the output where MR = LMC, so that only normal profit is earned and no firm has any incentive to enter or leave. At the same time, the firm operates with excess capacity, producing less than the output corresponding to minimum LAC. This integrated treatment of the equilibrium of the firm and the group under monopolistic competition is fully consistent with the approach of T.R. Jain & V.K. Ohri and is of high examination value for B.Com (Sem I), Panjab University.

These notes form part of a carefully curated set of important questions which have frequently appeared in past university examinations and therefore carry a high probability of being reflected, in whole or in part, in future question papers. However, they are intended as high-quality academic support material only and should not be treated as a guarantee or assurance of any specific questions being asked in forthcoming exams.