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The Theory of Monopolistic Competition: E.H. Chamberlin's Influence on Industrial Organisation Theory over Sixty Years

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Abstract

In 1933, Edward H. Chamberlin published the Theory of Monopolistic Competition (1962). The work, based upon a dissertation submitted for a PhD degree in Harvard University in 1927 and awarded the David A. Wells prize for 1927–28, has since become a milestone in the development of economic thought. Its impact on industrial organisation theory, general equilibrium and welfare economics, international trade theory and, to a greater or lesser degree, all other branches of economic analysis, has been pervasive and enduring. The ideas set out in the book have been developed, expanded and refined in ways too numerous to be identified precisely, and the books and articles which take Chamberlin's contribution as a starting point arguably exceed in number those on any other single subject in the lexicon of economics.
34
The Theory of Monopolistic Competition:
E.H. Chamberlin's Influence on Industrial
Organisation Theory over Sixty Years
by R. Rothschild*
University of Lancaster, Lancaster, UK
Introduction
In 1933, Edward H. Chamberlin published the Theory of Monopolistic Competition
(1962).
The work, based upon a dissertation submitted for a PhD degree in Harvard
University in
1927
and awarded the David A. Wells prize for
1927-28,
has since become
a milestone in the development of economic thought. Its impact on industrial
organisation theory, general equilibrium and welfare economics, international trade
theory and, to a greater or lesser degree, all other branches of economic analysis, has
been pervasive and enduring. The ideas set out in the book have been developed,
expanded and refined in ways too numerous to be identified precisely, and the books
and articles which take Chamberlin's contribution as a starting point arguably exceed
in number those on any other single subject in the lexicon of economics[l].
Its status in the history of economic thought notwithstanding, the Theory of
Monopolistic Competition is in many ways a rather unsatisfactory work. It rests upon
assumptions which describe a world for which there is no empirical analogue: it seems,
in its original form at least, to be a solution in search of a problem. Indeed, from
a modern perspective, it would appear that the impact of the "Chamberlinian"
contribution is due less to the insights contained in the Theory than to the efforts
of those whose work has made up the research progamme which
was
set in train in 1927.
The purpose of this paper is to consider some of the links between Chamberlin's
ideas and the developments to which these ideas gave rise. In doing so, we shall hope
to place in perspective his early contribution to what is now known as "Industrial
Organisation" theory, and thereby to demonstrate the power and enduring influence
of his role in the evolution of economic thought.
Chamberlin's Contribution
The Theory of Monopolistic Competition deals with two types of market. The first,
to which Chamberlin gave relatively little attention in the book
itself,
involves a small
number of firms (oligopolists) who face a choice between myopic competition of the
kind first discussed by Cournot (1838), and joint-profit maximisation. Chamberlin's
* This paper was written in large part while the author was Visiting Fellow at the Australian Graduate
School of Management, University of New South Wales, Sydney.
Chamberlin and Industrial Organisation Theory 38
particular contribution was to show that the recognition of mutual interdependence
on the part of firms in the small numbers case is a necessary, if not sufficient[2]
condition for the attainment of a Pareto optimal outcome[3]. Although he chose to
relegate the discussion of the oligopoly case to a few pages, Chamberlin was in later
years to regard this market form as being of central importance in economic analysis
(see Chamberlin, 1957, 1961; Kuenne, 1967; and Skinner, 1983).
The second type of market which Chamberlin considered and upon which we
shall focus in this discussion is the "large group". It was in this context that he
sought to identify the key features of monopolistic competition. For the purposes of
his model Chamberlin regarded industries as being made up of "groups" of products,
each in turn being made up of
close,
but less than perfect substitutes. Groups could
themselves be distinguished from one another by the degree of substitutability of their
respective products, in this case taken to be smaller than that between varieties within
a given group. The classification of industries on this basis was not universally
accepted[4],
in part because of the marked pervasiveness and complexity of product
differentiation in practice. Even after six decades, the problems of definition and the
need to find a satisfactory basis for classification remain[5]. However, Bain (1967,
p.
153)
has observed that, despite its shortcomings, Chamberlin's conceptualisation has:
proved formally satisfactory, tractable and productive of meaningful hypotheses...by
assuming explicitly that the enterprise economy
is
made up of industries that
are
identified
and separated by the cross-elasticities of demand among products, and by then classifying
such industries according to their market structures
The elements of the large group model can be described with the aid of Figures 1
and 2. Let the industry initially comprise N firms, each producing a single variety
of the differentiated product. For the sake of simplicity, suppose that at any price
p the amount sold by any individual firm is 1/Nth of the total market demand. Let
costs be the same for all firms (in this case, the traditional U-shaped average total
cost curve is appropriate) and suppose that the prevailing price yields a surplus over
costs.
Suppose further that, initially, entry into the group is blocked. Under
Chamberlin's assumptions, each firm will perceive an opportunity to increase its profits
by lowering its price, provided that none of its competitors does the same. On the
basis of this
belief,
each firm will expect to increase its sales by moving down its
(relatively elastic)
ceteris
paribus demand curve
(dd);
but if all firms were to behave
in similar fashion, then each would find that its sales are given by the (more inelastic)
"share-of-the market" demand curve (DD). Chamberlin argues that the conjecture
of each firm to the effect that it can gain at the expense of its rivals will be rendered
invalid by the fact that all behave in this manner, each motivated by the belief that
its price reduction will have negligible (and equal) impact upon the sales of
all
others.
The result is that all firms find themselves on their respective DD curves. Yet none
is encouraged to revise its expectations: each reduces price still further, until ultimately
only normal profits are obtained.
When the possibility of free entry and exit is considered explicitly, the process,
starting at an arbitrary price above average total costs, is similar, except that now the
location of the DD curve is determined by the size of N. Super-normal profits attract
new entrants, and the DD curve shifts leftward at the same time as the individual
36 Journal of Economic Studies 14,1
firms undertake their myopic price reductions. The shift is halted when the prevailing
market price equals average total costs, but if at this point firms continue to perceive
opportunities for profitable price reductions, then these will take place. Eventually,
a point is reached at which all firms make losses, yet each conjectures that, provided
that none of its rivals behaves as it does, profitability will be restored through one
final price reduction. Since all firms entertain this naive expectation the result is that
losses are increased for
all.
The difficulties are resolved through the exit of
some
firms,
an action which has the effect of shifting the DD curve to the right. Eventually, a
Cournot equilibrium is attained where the dd curve is tangent to the average total
cost curve. At this point, no firm has an incentive to change its price, and neither
entry nor exit will take place. Here, a uniform
price,
equal to average costs, obtains for
all firms, but each produces an output smaller than that which would be produced if
Chamberlin and Industrial Organisation Theory 37
the dd curve were horizontal, as it is under conditions of perfect competition. This
phenomenon encouraged Chamberlin to the view that monopolistic competition would
give rise to a "waste" of
resources:
too many varieties will be produced, each on too
small a scale.
The
Theory
of
Monopolistic Competition
contains a substantial discussion of selling
costs.
The ideas put forward by Chamberlin are discussed in some detail in Abbott
(1955),
but much recent work in this area has departed from Chamberlin's original
treatment. For this reason, we shall omit from our review this aspect of the "large
group" case. However, it would be inappropriate to accord similar treatment to the
question of product variation as a competitive device, and much of the following
discussion will address this key issue.
For the purposes of this survey, we identify four aspects of the Chamberlin model
as it has been set out here:
38 Journal of Economic Studies 14,1
(3) the assumptions on the nature and consequences of "entry" (and "exit"); and
(4) the question of the "optimality" of product variety.
Symmetry and Myopia
Chamberlin's analysis rests heavily upon two interrelated assumptions. The first is
that any firm contemplating a price reduction expects to attract a very small proportion
of custom from each of
its
competitors; the second is that this proportion is the same
for all of those competitors. Consequently, every prospective price-cutter believes that
other firms will lose so small a proportion of their customers that none will respond
by cutting its own price. According to Chamberlin, this belief
is
correct, but because
each acts on this basis market price must fall. These two assumptions are themselves
closely linked with, and indeed provide the rationale for, Chamberlin's implicit
assumptions about the price cross-elasticities of demand for all pairs of products,
and their apparent insensitivity to changes in the number of varieties in the product
group.
There are two separate issues involved here. The first concerns Chamberlin's
assertions about symmetry and the negligible effect of firms' price reductions on the
sales made by their
rivals.
The second concerns the myopia to which these perceptions,
when shared by the agents themselves, give
rise.
These issues are of central importance,
because the assumption that firms are myopic in their pursuit of profits is justified
only if they consider that their actions have negligible impact upon each and every
one of their competitors. Any other conjecture raises the question of structural
interdependence, and the notion of comparative anonymity of the individual firm in
the large group is replaced by a more complex and less tractable set of relationships.
Dixit and Stiglitz (1977) have shown formally that the consumer-theoretic basis of
the Chamberlin model requires that demands be generated by an aggregate utility
function characterised by a constant elasticity of substitution between any pair of
varieties. As Nicols (1947) noted, this may be an unduly restrictive requirement. His
alternative is a formulation based on the assumption that customers have scales of
preferences, in terms of which they prefer one variety but are indifferent amongst all
others. In this case, the
ceteris
paribus demand curve for each firm can be shown
to have an obtuse kink at the going output, and Chamberlin's price cross-elasticity
assumptions, yielding as they do a continuous dd
curve,
turn out to imply a complex
and rather special combination of preferences on the part of customers.
An extension of the Nicols' model would be one in which the desire for variety
on the part of a customer is assumed to diminish continuously with the "distance"
of any given variety from his most preferred choice. The idea of distance as a proxy
for product differentiation has provided the basis for a substantial body of literature
on the subject of spatial competition. Since the appearance of the pioneering work
of Hotelling (1929)[6], theorists have recognised that a spatial representation is a
tractable and useful way of analysing aspects of the Chamberlin model. Chamberlin
himself recognised the potential of the spatial approach in his celebrated "Appendix
C" (1962), and also in his discussion of the general applicability of considerations
relevant to competition between small numbers
(1962,
pp. 103, 104). Because differences
in "location" may be considered a proxy for product differentiation in general,
Chamberlin and Industrial Organisation Theory 39
location patterns are analogous to configurations of "variety" in monopolistically
competitive markets. Consequently, if the distance between every pair of firms in the
spatial market were the same then, in Chamberlin's sense, all products in the group
would be equally substitutable for one another. The particular advantage of the spatial
representation is that it makes it possible to show the special circumstances under which
this will not be so, and the variety of configurations which may arise when different
assumptions are made. One of the crucial differences between the Chamberlin and
the Hotelling representations of a differentiated market has been identified by
Archibald and Rosenbluth (1975), and must be borne in mind. If
the
distances between
all pairs of varieties are not the same, then the impact of both price changes and entry
will be asymmetric and dependent upon the "proximity" of
given
varieties to the source
of the perturbation. We shall return to this point below, but it is worth noting here
that in this sense, the Chamberlin-Dixit-Stiglitz formulation of the underlying utility
function is less useful than that implied by Nicols.
In setting out some of the features of models of spatial competition which inform
and extend the Chamberlin analysis, we shall assume initially that the number of
varieties, N, is fixed. The most appropriate point of departure for those wishing to
link the work of Chamberlin with the literature of spatial competition is the "zero
variations" conjecture (ZCV). Under ZCV, each firm expects that its rival(s) will not
respond to any action on its part. In this sense, ZCV is the natural counterpart of
Chamberlin's assumption of myopia. Hotelling assumes a uniform distribution of
consumers' preferences over a line of finite length (a "one dimensional market")[7],
[8].
There are two firms, both identical in all respects but for their locations on the
line.
Letting both production costs and elasticity of consumers' demands be zero, he
assumes that each buyer purchases from the firm whose price plus transport cost is
the lowest. Hotelling allows the firms infinite mobility, so that each is able to adjust
its location until no further gain is possible given the choice made by its rival. The
equilibrium condition is thus identical to that of the Cournot model. On this basis,
he establishes some useful results for the two-seller case. The first is that the
introduction of
"space"
removes some of the discontinuities associated with traditional
non-spatial models of interdependence: if one firm undercuts its rival, then the latter
will not lose all of its custom. This perception conforms with Chamberlin's model.
The second result of interest is that, given identical prices for both firms, there can
be found a spatial equilibrium in which the two firms emerge adjacent to each other
in the middle of the market.
Recent work on the Hotelling model by D'Aspremont et
al.
(1979) has attempted
to show that under ZCV, too great a proximity between the two firms may prevent
a simultaneous equilibrium in both price and location from occuring. This result
contrasts with those obtained by Neven (1985, 1986) who demonstrates that a pure
strategy price equilibrium can be found for this case, and also for the case in which
the density of consumer demand is not uniform across the line. In the latter
formulation, the tendency of the two firms is however towards dispersion rather than
concentration at the midpoint. The two-firm model has also been considered by
Smithies
(1941).
In his framework, elasticity of demand is finite. His results show the
crucial role played by the elasticity assumption, and in particular the fact that in this
40 Journal of Economic Studies 14,1
case the tendency will be towards dispersion. In this sense, his result appears to offer
some support for Chamberlin's implicit assumption that, in differentiated markets,
varieties will be symmetrically dispersed[9].
Unfortunately, however, the introduction of larger numbers of varieties makes
matters very much more complex. Chamberlin (1962) has shown that there is no stable
(pure strategy) equilibrium in locations (given identical prices) when N =
3.
A similar
result has been proved by Shaked (1975) and Graitson
(1979),
although Shaked (1982)
has shown that, for this
case,
there does exist an equilibrium in mixed strategies. Lerner
and Singer (1937) and Eaton and Lipsey (1975) have shown that a purely locational
equilibrium can, however, be found for any
A7
greater than 3. The results confirm a
tendency towards dispersion, but in general the distance between adjacent firms is
not uniform. Other formulations of the N-firm problems under ZCV include
Carruthers (1981), who models a case in which each firm assumes that its rivals'
locations are fixed, but that they will adjust their prices to his choice of price and
location. This has the effect of bringing the firms located towards the end of the line
somewhat closer to the interior than is the case in the models of Lerner and Singer
and Eaton and Lipsey[10].
The analyses presented above are based upon a somewhat restrictive assumption.
Novshek (1980), for example, has observed that in spatial markets where marginal
costs are constant, ZCV may be an inappropriate concept: the fact that firms whose
markets overlap must always affect each other means that no equilibrium of interest
can occur. According to Novshek it is, not surprisingly, only monopolies (whose
markets are, by their nature, distinct from others) for whom ZCV is a legitimate
operational assumption, and for these firms it
is
largely irrelevant in any
case.
A similar
conclusion can be found in Kohlberg and Novshek
(1982),
who show that the existence
of equilibrium depends in a crucial way upon the length of the market relative to the
number of firms. Quite apart, however, from the restrictions necessary to secure
equilibria of interest, there is the objection raised by Kamien and Schwartz (1983),
who point out that the logic of ZCV is itself suspect: if each firm conjectures that
rivals will not respond to its actions, how does the firm justify its own response to
theirs? A wide variety of possibilities arises once the ZCV assumption is relaxed.
Gannon (1972) has argued that equilibrium in the two-firm case may be anywhere
in the market, depending upon the conjectures of the firms. His general principle is
that firms will emerge closer to each other if each believes that the other will respond
"weakly" (ie. to a smaller extent) to any change in its own location, and vice-versa
for "strong" expected reactions. D'Aspremont et
al.
(1979) and Graitson (1980) have
proposed a modified concept, the "maximim" conjecture, for which an equilibrium
in both prices and locations (each firm at the midpoint of its respective market) may
be found. Rothschild (1976, 1979) has investigated the application of the maximin
concept to the case where N
is
fixed and greater than 2, and demonstrates a general
tendency towards dispersion[ll].
Perhaps the most important, yet least developed, of the analytical issues arising
from an explicitly spatial representation of the work of Chamberlin is the problem
of "chain-linked" markets. A market may be said to be chain-linked if a cut in price
by one firm affects more strongly its proximate rivals, leaving relatively unaffected
those further away. Here, proximity encompasses both physical proximity (as in the
Chamberlin and Industrial Organisation Theory 41
case of gasoline filling stations) and similarity in characteristics (as in the case of
varieties of
cider).
Either
way,
the argument that proximate competitors will be more
affected by a price reduction, and hence will be more likely than others to respond,
is an intuitively and empirically appealing one. Kaldor (1935) was the first to raise
the objection that markets are typically chain-linked rather than symmetrical in
Chamberlin's sense. Chamberlin's symmetry assumption makes it unnecessary for him
to consider this important question, but he
shows
himself
to
be aware of
it
(Chamberlin,
1962,
pp. 103, 104). A brief discussion of chain-linking can be found in Copeland
(1940) and Henderson (1954), but the idea
is
not developed. Lancaster (1966) has dealt
with the concept in the course of setting out his "characteristics" approach to the
theory of demand. This framework, which Lancaster (1966), Baumol (1967), Salop
(1979) and Archibald, et
al.
(1986) have shown to be similar to the one-dimensional
spatial models, rests upon the assumption that consumers typically demand
characteristics of products rather than products themselves. Competition between firms
is thus seen to be competition between "bundles" of
characteristics.
The analogy with
spatial representations of horizontally differentiated products is readily apparent, and
writers in this area have emphasised the localised (non-symmetrical) nature of
competition in markets defined in this way,
Archibald and Rosenbluth (1975) have integrated Lancaster's approach to demand
with Chamberlin's large group model, and show that the latter's ceteris
paribus
demand
curve (dd) is an absurd construct if the products in question have fewer than four
distinguishing characteristics. The principal reason is that, in Lancaster's formulation,
such a situation would give rise to a series of chain-linked markets. However, if the
number of characteristics identifying each product exceeds four, then although the
likelihood of discontinuities in competitors' reactions is increased, the possibility that
these might be small or mutually offsetting is sufficient to provide a rationale for
Chamberlin's implicit assumptions. In similar vein, Capozza and van Order (1982)
suggest that, even when competitors are few, price reductions may not be followed.
In this sense, the effect of chain-linking may be less serious than might be expected.
The problem of chain-linking nevertheless remains one of quite crucial importance
in industrial organisation theory. As Friedman (1977, 1983) has argued, the concept
provides a sensible view of monopolistically competitive markets, and one which is
in many ways superior to that commonly found in the literature. However, although
the question is addressed in Friedman (1983), he offers few results apart from a
formalisation of some of the relationships. Perhaps the most detailed analysis of the
phenomenon to date can be found in Rothschild
(1982,
1986),
who shows, on the basis
of
a
particular set of
expectations,
how an equilibrium in prices may emerge in a chain-
market in which all adjacent firms are equidistant.
The natural extension of the analysis of chain-markets is to the question of the
effect of changes in N. In Chamberlin's formulation, the cross price-elasticity of
demand for each existing variety remains unchanged in the face of entry and exit.
The spatial analogy, and in particular the phenomenon of chain-linking suggests that
changes in the number of firms must be expected to change the relative proximities
of the available varieties. If this occurs, then individual price cross-elasticities must
also
change.
The problem remains an important and potentially fruitful one for further
research.
42 Journal of Economic Studies 14,1
Uniformity and Excess Capacity
Chamberlin's assumptions of uniformity in demand and costs have also received a
great deal of critical attention. Stigler (1950), for example, noted that product
differentiation and uniformity of cost and demand curves across all firms are mutually
exclusive concepts: differentiation, by its very nature, serves to make firms dissimilar,
and dissimilarities manifest themselves most commonly in non-uniform costs. The
point was not lost on Chamberlin, who made a number of attempts[12] to modify
the assumption. A recent contribution may have provided a basis for countering
Stigler's objection. Sher and Pinola (1981) have argued that a sufficient condition for
the existence of both of Chamberlin's demand curves (dd and DD) is that the prices
of products stand always in the same proportional relation to one another. Extending
this argument to cases in which the respective cost curves of the producers stand in
the same
proportional
relation to one another as do their
prices,
would make it possible
to identify an equilibrium for the group at some configuration of these prices.
This modification of the Chamberlin uniformity assumption, valuable though it
is,
does not take account of the effect of entry and exit. Irrespective of whether costs
and demands are identical or merely in
fixed
proportions to one another, the important
questions in this context are firstly whether group equilibrium will be characterised
by excess capacity in Chamberlin's sense and secondly whether the process will lead
to the zero-profit outcome predicted for the large group case.
We
turn first to the question of
excess
capacity. In a series of
papers,
Demsetz (1959,
1964,
1968, 1972) addressed Chamberlin's assertion that, in equilibrium, firms would
produce a smaller output than that necessary to minimise average total costs. The
essence of
Demsetz'
argument is that when a profit-maximising firm changes its output,
it will also attempt to shift its demand curve through increased selling expenditure.
When this occurs, the demand curve ceases to be fixed in the sense assumed by
Chamberlin. As an alternative to Chamberlin's demand curve, Demsetz introduces
the concept of a mutatis mutandis average revenue curve which depicts the optimum
price for each quantity sold. On the assumption that returns to selling expenditure
initially increase and subsequently decrease, the Demsetz curve acquires an inverted
U-shape. On the further assumption that firms will always wish (or be forced by
competition) to choose the most efficient available process, the tangency of
the
mutatis
mutandis curve with the average total cost curve ensures that the locus of market
equilibria will be horizontal, thus permitting the attainment of
a
zero-profit equilibrium
at the level of minimum average cots.
Although the Demsetz contribution has been extensively criticised (see for example
Archibald, 1961; Barzel, 1970, Perkins, 1972; Schmalensee, 1972; Ohta, 1977 and
Murphy, 1978) it has, together with the work of Dewey (1958) and Fama and Laffer
(1972),
formed the foundation for the development of a new and potentially exciting
research area known as the Theory of Contestable Markets. Dewey argued that
Chamberlin's tangency position would be inherently unstable. If competition is
imperfect, then rationalisation of the industry must be expected to lead ultimately
to production at minimum average costs. A necessary condition here, as Dewey points
out, is that entry into the market must be an instantaneous possibility. The leading
contributors to the contestability literature (Panzar and Willig, 1977; Baumol et al.,
1982 and Baumol, 1982, characterise a contestable market as one which permits
Chamberlin and Industrial Organisation Theory 43
absolutely free (and instantaneous) entry and costless exit. The entrant suffers no
disadvantages relative to incumbents and can, upon leaving the market, recover all
costs incurred on entry, subject, of course, to adjustment for any normal user costs
and depreciation. Since this condition serves to eliminate all risks involved in entry,
markets defined in this way are vulnerable, irrespective of the time period under
consideration. Because of
the
absence of barriers to entry and
exit,
contestable markets
are characterised by zero economic profits, no matter how many firms operate. In
such markets there exists no inefficiency, however defined, for the reason that
inefficiency constitutes an invitation to entry and will thus be eliminated. Moreover
price can never be less than marginal costs, since potential entrants could, in those
circumstances, obtain higher profits than incumbents by shading price and eliminating
unprofitable units. It follows that, in contestable markets, price must always equal
marginal costs, so that the necessary conditions for Pareto optimality are satisfied.
The results reported here introduce explicitly the question of entry, and the issue
of whether it will give rise to equilibrium. This is itself an important subject and,
despite the vigour with which the contestability argument has been pursued, by no
means a settled one. Even if the symmetry and uniformity assumptions were valid
in general, the likelihood of a zero-profit group equilibrium under free entry and any
imaginable conjectures on the part of firms would remain a separate and controversial
issue Kaldor (1935) argued that zero-profit equilibrium might not occur in the presence
of indivisibilities and economies of
scale.
In this case, entry will not lead ultimately
to a Chamberlinian tangency, but rather, will cease prematurely because of high costs.
Using the spatial analogy, the "interpolation" of a producer "between" any two others
might actually cause profits to become negative, thus deterring entry and yielding
monopoly advantage to pre-existing firms. This argument has found broad acceptance,
although Capozza and van Order (1982) have observed that it is weakened somewhat
if capital is mobile and the market is large relative to the indivisible unit of capital.
However their results also show that if capital is not mobile, then Kaldor's objection
cannot be so easily dismissed. A similar conclusion can be found in Eaton and Lipsey
(1976,
1978). Peles (1974) also concludes that pure profits may exist in equilibrium,
and argues that the presence of untransferable fixed assets allows firms to enjoy
monopoly power. But he shows that the quantity produced by these firms may
correspond to that associated with minimum average costs, so that in this sense
production is efficient.
Similar ideas have been put forward by Tullock
(1965),
Telser
(1969)
and Salop (1979).
With the aid of a spatial analogy, Tullock shows that a Chamberlinian zero-profit
equilibrium is indeed possible, and that it will also be Pareto optimal if consumers'
tastes are taken explicitly into account. In the same vein, Telser distinguishes between
markets of finite and infinite
length.
In the former, entry will lead to a Chamberlinian
equilibrium. In this sense, the restriction imposed by the finite nature of the market
gives rise to inefficiency. However, where the market is infinite, efficiency can in
principle be achieved. Salop investigates the problem using the framework of a
Chamberlinian "group" and an "outside" market. In his formulation, consumers buy
either one unit or none of the differentiated product, and spend the remainder of
their income on the homogeneous outside
good.
The differentiated product
is
produced
44 Journal of Economic Studies 14,1
subject to decreasing costs; the other is produced under competitive conditions. For
this case there can be shown to exist a variety of zero-profit equilibria, two of which
are of particular interest. The first is a confirmation of the existence of the traditional
Chamberlinian equilibrium; the second is an equilibrium in which profits are zero
but the demand curve is kinked because of the conjectures of the firms involved. The
result is similar to that of Sweezy (1939), although the conjectures of the agents are
somewhat different. While Salop does establish conditions under which profits in
equilibrium will be
zero,
he also provides an insight into the circumstances under which
this outcome will not necessarily occur. In particular, he notes that the existence of
indivisible
fixed
costs may require that the number of varieties in the market be integer
valued, thus preventing a zero-profit equilibrium from being attained. In this sense,
his results may be seen as being in the tradition of Kaldor[13].
Some of the problems of indivisibility, monopoly and efficiency which arise in the
context of a partial equilibrium formulation of the Chamberlin model disappear when
the framework is that of a general equilibrium. Hart (1978, 1980, 1982) has argued
that a monopolistically competitive equilibrium can exist given correct conjectures
on the part of firms about the demand for all potential differentiated goods, and that
this equilibrium will be approximately Pareto optimal if the economy is sufficiently
"large".
This result
does,
however, turn crucially upon certain restrictions on consumers'
preferences. Novshek (1980) offers similar results to Hart on the basis of a modified
ZCV assumption. Gabszewicz and Thisse (1980) also address the relationship between
the size of the market and the nature of the resulting equilibrium. They show that
increases in the number of differentiated products ultimately bring about a perfectly
competitive outcome, provided that the firms choose prices non-cooperatively. But
there exists an upper bound to the number of firms which can be active in such a
market.
It will be clear from the foregoing discussion that no unambiguous conclusions
can be drawn as to the existence or otherwise of a zero-profit equilibrium under
monopolistically competitive conditions. The question of whether or not such an
equilibrium would be characterised by the existence of excess capacity merely serves
to complicate the
issue.
The mobility of capital will doubtless
be
a factor of importance
in both respects. But even if
capital is
perfectly
mobile,
the characteristics of equilibrium
prices will depend upon the conjectures of firms, the preferences of consumers and
the size of the economy.
Variety, Market Pre-emption and Welfare
The issues raised in this section relate to the optimal provision of variety from the
perspective of both firms and consumers. As already noted, Chamberlin gives explicit
attention to the question of
entry.
However, in his model firms already in the market
do not anticipate new competition and so make no provision for it when deciding
upon the location of the products in the spectrum of
varieties.
In practice, of course,
existing firms must be expected to devote considerable resources to the matter of
selecting varieties and, in particular, to pre-empting the choices of potential
competitors. The need to do so arises in large part from the commitment which a
particular choice of variety imposes upon firms. In Chamberlin's model the entry
Chamberlin and Industrial Organisation Theory 48
of new firms cannot be prevented and, once it occurs, the market shares of all
incumbents are reduced by equal amounts. Using the analogy of the spatial market,
the implicit assumption in this case
is
that firms are "infinitely
mobile"
in the Hotelling
sense, and can adjust to the new entrant by establishing an accommodating set of
equidistant locations post
entry.
In practice, of course, such possibilities are severely
restricted by the existence of relocation costs[14].
Once the possibility of entry is introduced explicitly, firms face the need to choose
product varieties subject to expectations of
the
behaviour of both existing and potential
rivals.
The anticipation of the choices to be made by subsequent entrants is a necessary
condition for securing optimal provision of variety ex post from the firms' point of
view. The analysis of the problem has proceeded along two distinct lines. The first
assumes that N is determined exogenously and that firms attempt only to ensure their
maximum attainable advantage given the certainty that the industry will contain that
number. The second assumes that N is determined endogenously and that firms deter
entry by means of appropriate choices of location on the variety spectrum.
Perhaps the earliest discussion of the first version of the problem is to be found
in Rothschild (1976, 1979), who considers a case in which N is exogenously determined
but firms enter sequentially. All firms are assumed to sell at the same price, so that
only location is a choice variable. The market is taken to be the circumference of a
circle, with each consumer buying from the nearest seller. Firms choose their locations
on the assumption that succeeding entrants (whose number is known with certainty)
will choose the most unfavourable location from their point of view; each assumes
further that all rivals entertain precisely the same maximin conjecture. The pattern
of locations which results depends upon the elasticity of demand for each variety:
if elasticity is zero, then the first N-l entrants will locate equidistant, while the Nth
will choose a location arbitrarily; if elasticity is finite, then all firms emerge more
or less at the midpoints of their respective markets, but the early entrants obtain larger
markets than those who enter later. In both models there is a tendency towards a
dispersion of varieties over the variety spectrum.
The second of the two lines of analysis has been dealt with by Hay (1976), Prescott
and Visscher
(1977)
and Lane
(1980).
All analyse the strategic aspects of entry deterrence
under sequential entry. In Hay's model, new entry is prevented by a process of brand
proliferation, in which firms leave insufficiently large gaps in the spectrum of product
varieties to support newcomers. In Chamberlinian terms, the profits obtainable by
new firms are less than those at the tangency of average revenue and costs. When
entry is deterred in this
way,
the general tendency
is
for incumbents to disperse rather
than cluster, but in this they are constrained by the need to ensure that the interstitial
market segments are kept sufficiently small. The important insight obtained by Hay
is that it is minimum market size rather than price which constitutes the effective
deterrent to new competition. In his formulation, once entry has been deterred, the
prices of all firms adjust so as to maximise the profits of
each.
He shows that similar
conditions apply, and similar market configurations emerge, when the market is
growing. Moreover, the analysis can be shown to proceed as before even when demand
is not uniformly spaced, except that under these circumstances the spacing of firms
in equilibrium will be irregular.
46 Journal of Economic Studies 14,1
Prescott and Visscher consider a number of different formulations of the sequential
entry problem and show that, for each, the tendency is towards a dispersion of varieties.
When N is
fixed,
a Hotelling-type approach yields a result similar to that of Rothschild
(1976);
when waiting time is introduced explicitly, a Cournot equilibrium in both price
and location is obtained; when there is waiting time and prices can be chosen (and
costlessly varied) after the choices of others have been observed, then there also exists
an equilibrium; finally, when production capacities are chosen sequentially under
conditions of restricted entry and firms are permitted to choose plant in any number
of locations, complete monopoly results. The idea of plant proliferation as a tactical
device is also explored by Peles (1974). Results of the latter type are of some interest
when the social optimality of product variety is being considered. We return to this
topic below.
Lane offers an analysis which draws on elements in the work of both Hay and
Prescott and Visscher. On the assumptions that firstly each consumer has a unique
set of preferences and secondly both prices and locations are endogenously determined,
he sets out a model in which firms enter sequentially and cluster in the centre of the
market. A firm's optimal location will be found at the point where there exists a balance
between the tendency to cluster in this
way,
and the pressure to disperse which results
from competition in
price.
The patterns of location which characterise Lane's sequential
entry equilibrium yield to early entrants higher profits than those obtained by others.
The level of fixed costs for the firm will be a factor in the decision to deter new entry:
if these costs are high, then entry deterrence is possible; if they are
low,
then the profit
maximising strategy for the firm may require that new entrants be accommodated.
A similar result has been obtained by Dixit (1979) in a somewhat different context.
The natural extension of the arguments contained in some of the work outlined
here
is
the use of brand proliferation as an element of strategic behaviour. A discussion
of the issue can be found in Archibald and Rosenbluth
(1975)
and Schmalensee (1978),
who uses the principle in his analysis of entry deterrence in the "ready-to-eat" breakfast
cereal industry. Recent work of a similar kind is to be found in Lyons (1986).
In turning to the question of the optimality of product variety from the point of
view of the consumer, we address the welfare implications of monopolistic competition.
Some early writers, such as Kahn (1935) concerned themselves exclusively with the
relationship between price and marginal costs which characterises the equilibrium of
the large group. Kahn argued that, where price exceeds marginal cost, Pareto optimality
can still be achieved if the ratio of these variables is uniform throughout the economy.
But, as Bishop (1967) has observed, this approach to the question of optimality neglects
the important relationship between variety and welfare, which in his view remains
indeterminate as long as Chamberlin's uniformity assumption is retained, even if other,
more traditional optimality conditions are met. The problem, although partly eased
if the uniformity assumption is abandoned, is never entirely eliminated. In similar
vein, Kaldor (1935) has argued that it is impossible to draw any general conclusions
about the implications of excess capacity for welfare.
Chamberlin's own views on the welfare implications of large group equilibrium are
to be found in a number of
sources.
His exposition in Chamberlin (1950) is perhaps
the best known of
these.
There he observes that the consequences of monopolistically
competitive elements had either been "ignored or seriously misunderstood", and that
Chamberlin and Industrial Organisation Theory 47
the view of perfect competition as an ideal (as, for example, in Kahn, 1935) reflected
an underestimate of the pervasiveness of monopoly in the real world and a consequent
failure to incorporate it into a workable definition of welfare. In essence, whenever
diversity is demanded, marginal cost pricing
ceases
to be a basis for welfare judgements,
and comparisons of the state of affairs in large group equilibrium
which he terms
"a sort of an ideal" with the prescriptions of the perfectly competitive model are
therefore meaningless. Chamberlin is equally clear about the difficulties involved in
establishing the optimality of product variety. In his
view,
no unambiguous statements
are possible a priori.
Whilst no recent contributions to the subject have developed the issues raised by
Kahn (1935), a number of writers have attempted to show that, in monopolistically
competitive markets, variety will be over-, under-, or optimally-provided[15]. Lewis
(1945),
for example, argues that monopolistic competition may lead to either excess
capacity or optimal provision, depending upon the circumstances surrounding the
particular class of
trade.
Spence (1976a) suggests that product selection failures ("too
many, too few, or the wrong products") may be a significant part of the overall costs
of market imperfection, but concludes that these costs are not currently measurable.
In Spence (1976b) he shows that, given monopolistically competitive pricing, high own
price and price cross-elasticities are likely to lead to the production of too many
products, while the converse is probable when both of these elasticities are low. A
similar result can be found in Dixit and Stiglitz (1977), who distinguish between the
"market" solution and the socially optimal outcome. The basis of their analysis is
the conflict between the objectives of producers (profit maximisation) and those of
the consumer (consumer's surplus), and they demonstrate that under certain conditions
on consumers' utility functions free entry will lead to the provision of a less than
optimal number of varieties[16].
The relationship between economies of
scale
and the extent of product differentiation
has been investigated by Meade
(1974).
He recognises a general need for variety, which
he regards as being greater the smaller the degree of substitutability among products.
But he argues also that the benefits of variety must be set against the opportunity
costs involved in its provision, measured here in terms of
the
economies of
scale
which
derive from concentration on the production of a narrower range of products. He
observes that, as a general
principle,
if costs of production
are
high
while
substitutability
is low, then firms will concentrate upon a smaller number of varieties. In such
circumstances, cost considerations will dominate the need for substitutability even
though the socially optimal solution demands variety. Koenker and Perry (1981)
consider circumstances under which scale economies will give rise to excessive variety.
The problem has been approached from an explicitly spatial perspective by Stern
(1972),
who shows that monopolistic competition may lead to market areas of above
optimal size (too little variety) as well as to market areas of below optimal size (too
much variety) according to circumstances. In similar vein, Heal (1980) has observed
that small markets will be under-served in terms of variety, while the reverse is true
for larger markets. In this sense, the extent to which variety is provided is determined
by the size of the market.
Another approach to the question of optimal variety stresses the importance of
market structure in general. Lovell (1970) argues that both price and variety may be
48 Journal of Economic Studies 14,1
inappropriate in some
sense.
In particular, to the extent that the variety being offered
reflects the dominant market form and also the conjectures of the firms involved,
socially optimal provision
is
unlikely except in unique circumstances. Swan
(1970)
shows
that a monopolist operating under conditions of constant returns to scale will offer
optimal variety. On the same subject, but for a more general case, Lancaster (1975)
has shown that, under imperfect competition and increasing returns to scale,
differentiation will not in general be socially optimal, but the precise direction of bias
depends upon the particular market structure. In his view, if returns to scale are
increasing, then monopolistic competition gives rise to excessive differentiation, and
monopoly to too little. However, if returns to scale are constant, then market
imperfections are not in themselves a cause of sub-optimal provision of
variety.
The
inference for both writers is thus that market conditions do not matter when constant
returns prevail. The point is disputed by White (1977), who shows that a monopolist
working under such conditions will offer optimal variety only if allowed to discriminate
on the basis of
price.
Otherwise, some of the products desired by consumers may not
be offered. Using a similar argument, Gabszewicz (1983) has shown that, even if
overhead costs are excluded, a monopoly may produce less variety than is socially
optimal.
The review of the literature in this section suggests that no firm conclusions should
be drawn as to the optimality or otherwise of product provision in differentiated
markets, from either the producers' or the consumers' points of view. Whether or
not variety will be over- or under-supplied depends upon the technical conditions in
production, the structure of the market, the conjectures and strategic behaviour of
firms,
and the utility functions of the consumers.
Concluding Comments
The nature and significance of the Chamberlinian contribution are best judged in
terms of the literature which his original work has inspired. On this criterion, as our
brief review will have demonstrated, Chamberlin's impact upon the evolution of
economic analysis must be beyond
dispute.
Although his view of
the
world, as expressed
in the Theory of Monopolistic Competition, has been shown by subsequent writers
to have been overly simple and, in places, crucially flawed, the insights upon which
it was based have themselves formed the foundation for much of what is today called
Industrial Organisation theory. Viewed in this light, Chamberlin's contribution must
be regarded as a cornerstone of economic analysis and a guarantee that his name will
enjoy a permanent place on the roll of the great economic theorists.
Notes
1.
Although Joan Robinson's celebrated book, The
Economics
of
Imperfect
Competition (1933),
appeared at the same time
as
the work of Chamberlin, it
is
undoubtedly the latter which
has
received
more attention. In this review we shall address ourselves exclusively to his contribution. For a
discussion of
the
intellectual background to Chamberlin's work see Chamberlin
(1961)
and papers
in Kuenne (1967).
2.
See Fellner (1967) for a discussion of this point.
3.
See Friedman (1977) for an analysis of the conditions under which noncooperative behaviour may
yield outcomes which are Pareto optimal, and Formby and Smith (1979) for an exposition and
critique of Chamberlin's cooperative outcome in the two-firm case.
Chamberlin and Industrial Organisation Theory 49
4.
See Bain (1967).
5.
See Bishop
(1952),
Heiser
(1955),
Bishop
(1955),
Fellner
(1953),
Chamberlin
(1953)
and Bishop (1953).
6. Similar analysis can be found in Launhardt (1885) and Zeuthen (1929).
7.
This particular form has been widely used as an analogue for monopolistic competition, even
though in such a market all firms can never be equidistant from all others. The point, however,
is that the absence of symmetry of this kind from the one-dimensional market must imply its
absence from an N-dimensional one.
8. The basic Hotelling model has attracted some criticisms which
we
shall not develop
here.
Hartwick
and Hartwick (1971) have shown that the equilibrium price in such a market may not be unique,
but will depend upon the initial price and location choice of the first firm to act. Devletoglou
(1965) bases his characterisation on a slightly different set of
assumptions.
He identifies a "minimum
sensible" constraint of indifference on the part of
buyers.
Given the existence of such a constraint,
it can be shown that firms will be repelled from the centre.
9. Models similar to that of Smithies have been investigated by Lerner and Singer (1937), Webber
(1972),
Eaton and Lipsey
(1975),
Graitson
(1979)
and Economides
(1982),
who assume rectangular
demand functions with the particular property that consumers buy one unit of the product up
to some
price,
and nothing above
it.
In this
case,
depending upon the size and shape of
the
market
area, different equilibria can be found, their number and character depending, in turn, upon the
number of firms in the market. Vickrey (1963) has considered the Hotelling/Smithies problem
in the context of a circular, rather than a linear market, and confirms the tendency to dispersion
when elasticity of demand is finite.
A number of writers have argued that the tendency will be toward agglomeration, rather than
dispersion. Lewis (1945) has suggested that larger retail firms will tend to cluster together. Stahl
and Varaiya (1978) attribute such behaviour to imperfections in information on the side of firms,
while Stuart (1979) argues that clustering is more likely to be due to uncertainty on the part of
consumers. Although we shall not develop these issues here, their importance for the theory of
location, especially retail location, should be noted.
10.
Ali and Greenbaum (1977) consider a similar case involving sequential entry into the market for
banking services.
11.
Teitz (1968)
shows that, if
firms
are permitted to
own
multiple
plants,
then an equilibrium
in
locations
will only be likely to occur if maximin location strategies are adopted. Variations on this game-
theoretic approach include Stevens (1961), who models the Hotelling/Smithies framework as a
zero-sum game, and shows that if the location points are discrete and choices simultaneous, then
their results hold. Gal-or (1982) considers the possibility of mixed strategies, showing that when
firms choose a distribution of
prices
(rather than a single
price),
equilibria may exist where otherwise
none would be possible. Kohlberg (1983) has shown that if the Hotelling problem is modeled as
an N-person game in which strategies are location choices and the payoffs are market shares, then
relocation gives rise to jump discontinuities. But if consumers choose outlets on the basis of travel
time plus waiting time (the latter being a function of the market shares of firms) then market
shares become continuous functions of
the
firms' locations. Unfortunately, no equilibria exist for
the case where N > 2.
12.
See, for example, Chamberlin (1962, p. 82ff).
13.
The work of
Losch (1954) is in
many
ways
a parallel
to
that of Chamberlin.
Using
a spatial framework
(in this case, an areal market), Losch shows that a system of regular hexagonal markets, one for
each firm, yields a unique zero-profit equilibrium under conditions of free entry. In contrast to
these findings, and on the basis of rather different assumptions on costs, Mills and Lav (1964)
have shown that there may be a wide variety of market shapes consistent with free entry, so that
profits in equilibrium may not be
zero.
Extending their analysis to include the question of efficient
allocation, and comparing their
findings
with those of Chamberlin, they conclude that equilibrium
may be characterised by a misallocation of resources especially where de-centralised processes are
involved. (A discussion of this point can be found in Samuelson, 1967; and Grace, 1970). Eaton
(1976) and Eaton and Lipsey (1978) provide a rationalisation and confirmation of the Mills and
Lav "positive profit" argument in the context of a one-dimensional market in which firms entertain
ZCV with respect to rivals' locations and the expectations that their respective mill prices will
not be undercut. Niedercorn (1981) offers a similar result.
30 Journal of Economic Studies 14,1
The
relationship between the monopoly and competitive
prices
posited
by
Losch has itself attracted
considerable attention, and is relevant to the work of Chamberlin. Greenhut et
al.
(1975) have
pointed out that the Loschian equilibrium will be characterised
by
higher prices than would spatial
monopoly, and that the more intuitively plausible outcome associated with traditional (non-spatial)
theory requires the explicit assumption that firms' prices at their respective market boundaries
be
fixed.
The Greenhut-Hwang-Ohta interpretation differs from that of Beckman
(1970),
who argues
that Loschian free entry
will
reduce prices to the minimum
level
consistent with
zero
profits. However,
as Capozza and
van
Order
(1977)
have pointed out, the debate hinges upon different interpretations
of "equilibrium". If
the
equilibrium condition requires profits to be
zero,
then Loschian competition
yields this outcome, but only at a "high" price; alternatively, if the condition requires all firms
to have equal market shares, then the Greenhut-Hwang-Ohta approach yields a more satisfactory
result. Capozza and van Order (1978) employ ZCV to show that Losch's perverse results obtain
only in exceptional cases, and not in the more traditional (Chamberlinian) framework of
monopolistic competition.
14.
The processes involved in product selection by firms have been the subject of study for some time.
Brems
(1951)
addressed the question but found it to be largely intractable. It
is
only since the work
of Baumol (1967) that potentially fruitful analysis has been possible. His model employs the
techniques of integer programming to establish optimal strategies of product design. On the
assumption that no retaliation by rivals is possible, he shows that the optimal strategy of a firm
involves making its product more, rather than
less,
similar to existing varieties. In contrast, Schuster
(1969) has considered a case in which the preferred strategy involves the production of varieties
which are quite distinct from those of rivals. Reichardt (1962) has cast the analysis in explicitly
game-theoretic
terms.
Lancaster
(1966)
has also studied the problem in a "characteristics" framework.
Valuable though these contributions have been, all are restricted to the analysis of product selection
in markets where N is fixed.
15.
For a diagrammatic exposition of some of the models set out here, see de Meza (1983).
16.
But see Pettengill (1979) for a counter argument.
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