Monopolistic competition

10 November 2008

1 Number of brands
• Our previous analysis on product differentiation is based on the assumption that
the number of brands is fixed at two. Then we ask how what forces would drive
firms to locate their brands close together, and what forces would drive firms
to locate their brands apart from each other along the product characteristic
spectrum.

• The analysis misses an important dimension to product differentiation, namely,

how the number of brands get determined in the first place.

• When there are more brands available, there will be more product varieties,
other things equal. The number of brands that get introduced is an equally
important determinant of the extent of product differentiation as how firms
choose to differentiate their brands from each others’

2 The basic theory of monopolistic competition

• The issue is best analyzed with the model of monopolistic competition developed
by Avinsh Dixit of Princeton University and Nobel Prize winner Joseph Stiglitz
of Columbia University.

• There are n firms, each producing a distinct brand, which we index by i =

1, 2, 3, ..., n.

• Previously in the locational models, we assume consumers’ tastes are hetero-

geneous, and that each consumer will only purchase one brand among possibly
many. The Dixit-Stiglitz model, on the other hand, assumes that consumers’
tastes are homogeneous, and that each consumer will purchase all possible
brands available for sale.

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 Figure 1: A love—for—variety preference

• The reason that they do demand all possible brands is that the preference of the
consumer is assumed to exhibit a love for variety. That is, a given consumer
would prefer to allocate her budget between two brands over allocating the
budget over just one brand, and then prefer three brands over two brands, so
on and so forth. For example, she would choose spending her clothing budget
on a red T-shirt, a pink dress, a blue jean, and a purple shirt over spending the
entire budget on four purple shirts.

• The assumption is arguably not too far off from actual observed behaviours.
After all, variety is the spice of life. Indeed, the love—for—variety assumption is
basic in the indifference curve analysis we were taught in microeconomic theory
class.

• In figure 1, the consumer always attains a higher level of utility by spreading

her budget over both X1 and X2 than spending the entire budget on either X1
or X2 . It is easy to see that the conclusion follows so long as the indifference
curves are convex, as is customarily assumed.

• Specifically, Dixit and Stiglitz assume that the utility function of the consumer
is given by u (x1 , x2 , ..., xn ) , where xi is the quantity of brand i the consumer
purchases. Each consumer has an income equal to y to allocate among the
consumption of the n brands. The budget constraint is

p1 x1 + p2 x2 + ... + pn xn = y.

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 The consumer chooses {x1 , x2 , ..., xn } to maximize utility u (x1 , x2 , ..., xn ) sub-
ject to the above budget constraint.

• The utility maximization yields the usual (Marshallian) demand curves of each
brand:

x1 = D1 (p1 ; p2 , p3 , p4 , ..., pn , y) ,
x2 = D2 (p2 ; p1 , p3 , p4, ..., pn , y) ,
. (1)
.
.
xn = Dn (pn, p1 , p2 , ..., pn−1 , pn , y)

• We assume that

1. The demand curves are downward sloping, i.e. as pi increases, Di declines,

i = 1, ..., n.
2. The brands are substitutes, i.e. for j 6= i, as pj increases, Di goes up.1

• The market is monopolistic in the sense that each firm faces a downward sloping
demand curve. That is, a firm will not lose all sales when charging a price
higher than the price charged by others. The worse that can happen is that
the quantity demand will go down. If the brands are not differentiated and in
a world of perfect information, the demand curve facing any single firm would
be perfectly elastic in that a firm will lose all sales when it attempts to charge
a price above that charged by others. Now that the brands are differentiated
and are only imperfect substitutes of each other, consumers will not give up on
the given brand altogether even if it costs more than other brands.

• The market, however, is not pure monopoly since, though imperfect, there are
substitution possibilities. Each brand is supposedly competing with a large
number of brands, which limits the firm’s ability to charge high prices.

• We shall analyze a NE in prices. Consider the pricing decision of firm 1. Holding

a fixed belief on the pricing decisions of all others at some {p∗2 , p∗3 , ..., p∗n }, firm
1 chooses the price to charge to maximize profit:

max {p1 − c} D1 (p1 ; p∗2 , p∗3 , ..., p∗n , y) .

Call the profit-maximizing price p∗1 . Figure 2 illustrates that p∗1 is determined
in the usual procedure of setting the marginal revenue equal to the marginal
cost.
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If the brands are complements, Di declines as pj increases.

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 Figure 2: Profit maximization

• In equilibrium, the n prices {p∗1 , p∗2 , ..., p∗n } maximize the profit of each firm
i = 1, ..., n, i.e. for any other pi :
³ ´
(p∗i − c) Di p∗i ; p∗1 , p∗2 , ..., p∗i−1 , p∗i+1 , ..., p∗n ≥
³ ´
(pi − c) Di pi ; p∗1 , p∗2 , ..., p∗i−1 , p∗i+1 , ..., p∗n .

• In equilibrium, each firm earns a gross profit

π gross (n) = (p∗ − c) q ∗ .

• We write the gross profit as a function of the number of brands. Why should
there exist such a dependence? When there are more brands competing for the
fixed budget of the consumers, the consumers may then only allocate a smaller
fraction of their fixed budgets on the purchase of each good. Specifically, the
demand curve of each brand should shift in as the number of brands goes up,
resulting in lower prices, sales, and profits.
• If there is some fixed cost of entry equal to F , the net profit is
π net (n) = π gross (n) − F,

which will be driven down to zero in equilibrium if there is free entry. The next
diagram shows that equilibrium entry ne occurs at the intersection of the firm’s
gross profit and the fixed cost of entry.

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Figure 3: Falling demand when n increases

Figure 4: Free—entry equilibrium

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 Figure 5: Profit and surplus

3 Efficient product variety

• Is the equilibrium product variety, as given by ne in fig.4, efficient? In other
words, are there too many or too few brands get introduced in the free market?
To answer the question, we ask whether the private benefit the firm enjoys from
introducing a new brand is below, above, or just equal to the social benefit —
the benefits that accrue to firms and consumers altogether.
• In fig.5, we assume that the monopolistically competitive firm’s profit maxi-
mization occurs at some (pm , Qm ) pair, where the firm’s marginal revenue is
equal to the constant marginal cost c.

• The firm’s gross profit is equal to the area B. As we argued in the previous
section, when more brands get introduced, the demand curve of each shifts in
due to the greater competition for the consumers’ fixed budgets. The firm’s
profit-maximizing price, as well as the gross profit, is lowered in the process.
Entry would continue until the firm’s gross profit is no greater than the fixed
cost of entry F that may be thought of as the investment necessary to introduce
the new brand, as shown in fig.4. In terms of fig.5, we have in equilibrium:

B = F.

• Should the introduction of new brands stop at this point for efficiency?

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 Figure 6: Efficient entry?

• The consumer surplus that is made available due to the introduction of this
brand is equal to the area A. The firm’s gross profit is equal to the area B. The
total gross surplus is thus the sum of A and B. The cost to society of introducing
the new brand is equal to the fixed cost F. Apparently, from a efficiency point
of view, the introduction of new brands should continue until the total surplus
is no greater than the fixed cost of entry

A+B =F (2)

Figure 6 shows how entry is determined if instead it is governed by the above

criteria.
• The comparison suggests that the number of brands introduced in equilibrium
ne falls below the level governed by the criteria in (2) . When a firm introduces
a new brand, it also confers positive benefits to consumers, the size of which is
equal to area A in figure 5. This externality is of course not taken into account
in the firm’s decision whether to introduce the brand. The firm’s only concern is
its profit — area B in figure 5, notwithstanding society as a whole enjoys a surplus
that is equal to area A + B. We may call this the imperfect appropriability of
the returns to new product introduction. The firm is responsible for the entire
cost of introducing a new brand that is equal to F but is only able to reap part
of the returns, with the other part accruing to consumers.
• Actually the maximum surplus that could be available due to the introduction

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 of the new brand is equal to sum of areas A, B and C if the firm can be made to
price at marginal cost and produce at the Pareto optimal output level Q∗ . But
then the firm may only earn a zero gross profit and could not hope to recover
any of the investment at all. Any regulations that restrict the monopolistically
competitive firm to price at marginal cost would only suffocate any new product
introduction. The firm earns the greatest returns to introducing a new brand
when it is made the monopolist of the new brand. Even then the returns fall
below the returns to society as a whole.

• Should we then conclude that the free market necessarily introduces too few
new brands?

• The answer is no because there is yet another externality the firm imposes on
others when it makes available a new brand. We have noted previously that
when there are more brands competing in the monopolistically competitive
market, the demand curve of each shifts in, as the fixed budgets of consumers
will have to be allocated among more brands. This is a negative externality a
firm imposes on others when it introduces a new brand. The effect is a variant
of the business stealing effect, which we first saw operative in Cournot oligopoly
of a homogeneous product.

• It is clear from fig.3 that the sum of consumer surplus and the firm’s gross
profit associated with each brand falls when the demand curve shifts in. When
deciding whether or not to introduce a new brand, the firm will not take into
account the fact that it would cause a decline in the consumer surpluses and
profits associated with other brands. Introducing a new brand is privately
profitable as along as the gross profit is above the fixed cost. But from for
efficiency point of view, the reduction in the surpluses associated with all other
brands should also be figured into the decision.

• Now let the reduction in the surpluses associated with all other brands that
is caused by the entry of the nth brand be δ (n) . For efficiency, a new brand
should be
C.S. (n) + Gross Profit (n) − δ (n) = F. (3)
The left hand side, which may be thought of as the social marginal benefit of
introducing a new brand, is the net addition to total surplus brought by the
introduction of the nth brand. Efficienct product variety is at where this is just
equal to the social cost of entry F .

• The private benefit is simply the firm’s gross profit which may either fall below
or rise above the left hand side of (3) . Therefore, equilibrium product variety
may either be greater than or less than the socially optimal product variety.
The ambiguity stems from the opposite tendencies of the two externalities.

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 The imperfect appropriability tends to cause too little product variety, whereas
the business stealing effect tends to cause excessive product variety.

• What is not ambiguous however is that the free market in general cannot be
made to provide us with the socially optimal product variety. When the im-
perfect appropriability is stronger than the business stealing effect, there is
insufficient new product introduction. In this case, the government may correct
the inefficiency by subsidizing firms to introduce new brands. Whereas when
the business stealing effect is stronger, there is a case for the government to tax
the introduction of new brands.

4 General equilibrium
• In the above analysis, we have taken as given the budgets of consumers that
may be spent on the various brands. The very first lesson in macroeconomics
however is that aggregate income is equal to aggregate output. The introduction
of a new brand raises aggregate output and should result in a corresponding
increase in aggregate income. Then the consumers’ budgets that may be spent
on the various brands could rise by as much as the output of the new brand.

• In this case, the budget to be allocated on the existing brands can stay constant
despite the fact that there are now more brands to be purchased. Specifically,
there may not be any leftward shifts in the demand curves of the brands given
rise by the business stealing effect. In large part, the business stealing effect is
an artifact of our assumption that income is fixed in advance, which may not
be a good assumption in the present context.

• There is a well-known proposition in 19th century classical economics called

Say’s law, which states that supply creates its own demand. Indeed, the Say’s
Law is the historical percussor of the aggregate income—aggregate output iden-
tity in modern marcroeconomics. Applying Say’s law to the present analysis,
the business stealing effect may well vanish entirely. In that case, we will be left
with the imperfect inappropriability , which tends to cause insufficient equilib-
rium product variety.

• The policy implication is that the free market should fail to deliver sufficient
product variety in most cases, and the appropriate public policy is that the
introduction of new brands should be subsidized.