Like the adjustments of price and product, a seller under monopolistic competition will so adjust the amount of his selling outlays as to make his total profits maximum.
This problem of adjusting his selling outlays is unique to monopolistic competition, for the firm under perfect competition has not to incur any expenditure on advertisement.
The advertisement expenditure by a purely competitive firm will be without any purpose since it can sell any amount at the prevailing market price without any advertisement expenditure.
The rival firms under monopolistic competition compete with each other through advertisement by which they alter the consumers’ preference for their products and attract more buyers.
Thus a full explanation of the equilibrium under monopolistic competition must also involve equilibrium as to the amount of selling outlays.
Let us illustrate the equilibrium of a firm under monopolistic competition with the help of diagrams.
The demand curve is also the average revenue curve of the firm. AC curve is the average cost while MC curve is the marginal cost curve of the firm.
In the short run, profit maximisation occurs when the firm produces that amount of output and charges that price where MR equals MC.
The firm is in short run equilibrium and is able to make abnormal profits because there are not enough closely competitive substitutes made by other firms to compete away these profits. In the short run, the firm in equilibrium may make not only supernormal profits but also may make losses too.
Because of the relatively free entry and exit in the long run, average costs will be driven towards tangency with the demand curve at point.
In the long run, the firm is only earning normal profits. Competitors are producing similar products and the firm’s excessive profits have been competed away.
This situation is very similar to that of long-run equilibrium under perfect competition. The main difference is that whereas in perfect competition the AR curve of the firm is a horizontal straight line, under monopolistic competition it slopes downwards.
It follows therefore, that so long as cost curves are U-shaped, the long-run equilibrium of a firm producing in monopolistic competition must inevitably occur at a smaller output than in perfect competition.
Because it is impossible for a downward sloping AR revenue curve to be tangent to a given U-shaped cost curve at the minimum point.
This amounts to saying that in the long-run equilibrium under monopolistic competition, output must always be smaller than the optimum output under perfect competition.
The positive difference between the optimum output and the equilibrium output is called “excess capacity” and so there exists excess capacity under monopolistic competition. Firm and industry or groups are in equilibrium when demand curves are tangent to cost curves.
It is quite possible that the demand curve of a firm producing under monopolistic competition will be more elastic in the long run than in the short run.
A short run AR curve which is less elastic than its long run AR curve. It is realistic to think that in the long run AR curve in monopolistically competitive firms will be more elastic as in Fig. 16B, than in the short run for all product.
The concept of monopolistic competition has come under increasing attack with the passage of time. Kalmen Cohen and Richard Cyert (Theory of the Firm) criticised the empirical void created by the model of monopolistic competition.
They concluded that those markets which contain a large number of small firms are nearly always markets selling standardised products such as wheat and lumber.
Even a moderate degree of product differentiation would be likely to leave demand curves for the firm so nearly horizontal that the purely competitive model is an adequate approximation.
They further argue that markets where customers have strong brand preferences are typically markets better classified as oligopolies where the number of sellers is few. For markets in which firms sell a product for which there are no close substitutes, the monopoly model provides a superior basis for analysis.
The retail sector in the urban areas (for example, grocery stores, shoe stores, clothing stores) is the most frequently cited example of monopolistically competitive markets.
But Chamberlin assumes that any price adjustment by one firm will spread its influence over so many firms that there will be no perceptible impact on any of the other firms and hence no readjustment by them. This assumption is unrealistic.
The effects of price changes by one firm will not be spread evenly over all other retailers but will be concentrated on retailers in close proximity to the initiating firm.
The impact on these firms is likely to be felt and evoke a response. In these circumstances the oligopoly model provides a better basis for analysis.