Q31 — Effect of Product Differentiation & Selling Costs under Monopolistic Competition

Introduction

Monopolistic competition, as analysed by Chamberlin and presented in “Microeconomics” by T.R. Jain & V.K. Ohri, is characterised essentially by two features: product differentiation and the presence of selling costs. These two elements distinguish monopolistic competition from perfect competition and play a decisive role in determining the equilibrium of the firm and the group in both the short run and the long run.

In this answer we shall first explain the meaning of product differentiation and selling costs, and then examine in detail how they affect the demand curve, cost curves and the equilibrium position of a firm operating under monopolistic competition, with the help of clear diagrams and examination-oriented explanation.

I. Product Differentiation and its Effect on Equilibrium

1. Meaning of Product Differentiation

Product differentiation means that each firm produces a product which is similar but not identical to the products of other firms. The differences may be real or imagined, but they are sufficient to create brand loyalty and to give each firm some degree of monopoly power over its own variety.

Real differentiation: Differences in quality, design, ingredients, performance, location, packaging, after-sale service, etc.
Imaginary differentiation: Psychological differences created mainly through branding, trademarks, advertising slogans and image-building.

Under monopolistic competition, product differentiation is the basic reason why each firm faces its own downward sloping demand (AR) curve and not a perfectly elastic demand as in perfect competition.

2. Effect on the Firm’s Demand Curve (AR) and MR

Because of product differentiation:

Each firm faces a downward sloping AR curve, representing demand for its particular brand. The firm can raise price without losing all customers, as some remain loyal to its brand.
The presence of many close substitutes makes demand relatively elastic, though not perfectly elastic. The exact elasticity depends on the degree of differentiation and brand loyalty.
The corresponding MR curve lies below the AR curve, as the firm must reduce price on all units to sell an additional unit.

3. Effect on Short-run Equilibrium of the Firm

In the short run, given its differentiated product and selling costs, the firm’s equilibrium is determined by the familiar condition:

MR = MC and MC cuts MR from below.

Successful product differentiation (better quality, stronger brand image, superior design) has the effect of:

Shifting the firm’s AR curve to the right (increase in demand for the brand).
Making the AR curve steeper (less elastic) due to increased brand loyalty.
Consequently shifting the MR curve rightwards and altering the MR–MC intersection.

The result is that the firm may now be able to charge a higher price and sell a larger quantity, thereby earning supernormal profits in the short run.

Fig. 1 — Effect of product differentiation: successful differentiation shifts the firm’s demand curve from AR₀ to AR₁ and MR₀ to MR₁, raising equilibrium output from Q₀ to Q₁ and price from P₀ to P₁, thereby increasing profit in the short run.

Thus, product differentiation allows the firm to enjoy some monopoly power and to earn supernormal profits in the short run by shifting its demand curve outward and making it less elastic.

4. Effect on Long-run Equilibrium

In the long run, however, free entry of new firms into the group offsets the advantages gained by individual firms through product differentiation:

Supernormal profits attract new differentiated brands into the group.
The entry of new firms shifts the AR curve of each existing firm leftwards, as total demand is now shared among more close substitutes.
This process continues until each firm’s AR curve becomes tangent to its LAC curve at the output where MR = LMC, so that only normal profit is earned.
Because AR is downward sloping, the tangency occurs to the left of the minimum point of LAC, leading to excess capacity in long-run equilibrium.

Product differentiation therefore explains why, under monopolistic competition, firms in long-run equilibrium operate with excess capacity and normal profit.

II. Selling Costs and their Effect on Equilibrium

1. Meaning of Selling Costs

Selling costs are the expenditures incurred by a firm to promote the sale of its product and to influence the demand curve in its favour. These costs are different from production costs, which are incurred to create the product itself.

Examples: advertising, sales promotion, window displays, free samples, discounts, salesmen’s salaries, publicity campaigns, sponsorships, etc.
Selling costs are particularly important under monopolistic competition because firms must persuade consumers to buy their differentiated brand rather than rival brands.

Production costs are incurred to make the goods; selling costs are incurred to make the goods sold.

2. Types of Selling Costs

Informative advertising: Provides factual information about price, features, uses, etc.
Persuasive advertising: Attempts to change consumer preferences and create brand loyalty, often by emotional appeal, prestige and image.

In monopolistic competition, persuasive advertising is more common and has a stronger effect on equilibrium, as it shifts the demand curve and alters its elasticity.

3. Selling Costs and Cost Curves

Selling costs have their own behaviour in relation to output:

The total selling cost curve is generally rising; more advertising and promotion are required to push sales to higher levels.
The average selling cost (ASC) curve is typically U-shaped:
- At low levels of advertising, an increase in selling costs may spread over many units, reducing ASC.
- Beyond a point, further advertising yields diminishing returns and ASC rises.
When selling costs are combined with production costs, we get average total cost (ATC):
ATC = Average Production Cost + Average Selling Cost.

4. Effect of Selling Costs on Demand and Equilibrium

Selling costs affect equilibrium in two opposite ways:

Demand-increasing effect:
Effective advertising and sales promotion can:
- Shift the firm’s AR curve to the right, increasing demand for its brand.
- Make the demand curve less elastic by strengthening brand loyalty.
Cost-increasing effect:
At the same time, selling costs:
- Raise the firm’s costs, shifting the AC curve upwards.
- Hence the firm’s profit depends on whether the demand-raising effect is stronger than the cost-raising effect.

Fig. 2 — Effect of selling costs: successful advertising shifts the demand curve upward (AR) while also raising cost (ATC). Equilibrium is still determined by MR = MC, with new price P′ and output Q′. Profit increases only if the demand-raising effect exceeds the cost-raising effect.

The firm will choose that level of selling costs at which the extra revenue from additional sales just equals the extra selling cost — i.e. where marginal selling cost = marginal revenue from selling activity (a deeper point often mentioned in advanced treatment and consistent with the reasoning in your prescribed text).

5. Long-run Effect of Selling Costs on Group Equilibrium

In the long run:

If selling costs enable some firms to earn supernormal profits, these profits will attract new firms and new brands into the group.
Entry of new firms again splits the market demand, shifting each firm’s AR curve leftwards and reducing profitability.
In long-run group equilibrium, each firm chooses that combination of product features and selling costs where it earns only normal profit (AR tangent to LAC including selling costs).
Selling costs are then regarded partly as the cost of maintaining brand loyalty and competitive position rather than as a source of continued supernormal profit.

III. Combined Effect on Equilibrium under Monopolistic Competition

We can now integrate the role of product differentiation and selling costs in determining equilibrium under monopolistic competition:

Product differentiation and selling costs together shape the position and elasticity of the firm’s demand curve (AR).
In the short run, successful differentiation and selling efforts may:
- Shift the AR curve to the right and make it less elastic,
- Allow the firm to charge a higher price and sell more,
- Generate supernormal profits despite higher costs.
In the long run, free entry of new firms shifts individual demand curves leftwards until:
- AR is tangent to LAC (including selling costs),
- Firms earn only normal profit, and
- Each firm operates with excess capacity, producing less than minimum LAC output.
At the group level, equilibrium involves many brands, each with its own small loyal following, significant selling costs and normal profits in the long run.

Key Examination Points to Highlight

Product differentiation → downward sloping, relatively elastic AR curve for each firm.
Selling costs → shift AR upward (favourable) but also shift AC/ATC upward (unfavourable).
Short run: MR = MC; firms may earn supernormal profits due to brand loyalty and advertising.
Long run: entry of new firms → AR shifts left; AR is tangent to LAC; only normal profit remains.
Excess capacity in long-run equilibrium due to downward sloping AR under product differentiation.

Exam Tip (Panjab University — 15 marks type): To write a scoring answer, follow this structure: (i) brief introduction of monopolistic competition; (ii) clear meaning of product differentiation and how it shapes AR and MR, with Fig. showing shift in AR and MR; (iii) short-run and long-run effect of product differentiation on equilibrium (supernormal profits → normal profits, excess capacity); (iv) definition and types of selling costs; their effect on demand and cost (AR and AC/ATC) with a neat diagram; and (v) combined conclusion on how both product differentiation and selling costs determine equilibrium of the firm and the group under monopolistic competition, strictly following the logic of T.R. Jain & V.K. Ohri. Underline key terms like “brand loyalty”, “AR tangent to LAC”, “excess capacity” and “selling costs” to catch the examiner’s eye.

Conclusion

To conclude, under monopolistic competition the equilibrium position of the firm and the group is fundamentally shaped by product differentiation and selling costs. Product differentiation gives each firm a downward sloping demand curve and some monopoly power, while selling costs are used to strengthen this position by shifting the demand curve in the firm’s favour. In the short run, these factors may generate supernormal profits and enable the firm to charge a higher price and expand output. In the long run, however, free entry of new firms erodes these supernormal profits, so that each firm ends up in equilibrium where MR = MC and AR is tangent to LAC (including selling costs), with only normal profit and excess capacity. This is precisely the Chamberlinian equilibrium framework presented in your prescribed textbook and is of high examination importance in Panjab University B.Com (Semester I) papers.

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.