Price Output Determination under Monopolistic Competition: features, short run, Long run Equilibrium
Price
and Output Determination
Under Monopolistic Competition
The concept of monopolistic
competition put forth by Chamberlin is a true revolutionary as well as more
realistic than either perfect competition or pure monopoly.
Monopolistic competition is
characterized by a large number of firms making slightly different products, in
contrast with perfect competition in which all firms make the same good and
perfect monopoly in which the firm makes a unique good. As monopolistically
competitive firms differentiate their products, some consumers like certain
brands more than others, which in turn provides a firm a bit of consumer
loyalty. If a firm increase the price of its product, it does not lose all of
its consumers. This is called market power and implies that the demand for a monopolistically
competitive firm is downward sloping (much like a monopolist’s but at a smaller
scale).
According to Chamberlin “With differentiation appears monopoly and as it proceeds further, the element of monopoly becomes greater. Where there is any degree of differentiation whatever, each seller has an absolute monopoly of his own product, but is subject to the competition of more or less imperfect substitutes. Since each is a monopolist and yet has competitors, we may speak of them as ‘competing monopolists’ and with peculiar appropriateness, of the forces at work as those of monopolistic competition.”
For instance, in India there are
various manufacturers of tea which produce different brands such as Taj mahal
tea, Tata tea, Brooke bond red level, Litton tea, etc. Thus, the manufacturer
of Taj mahal tea has a monopoly of producing it (nobody else can produce and
sell the tea with the name ‘Taj mahal’) but he faces competition from the
manufacturers of Tata tea, Brooke bond red level, Litton tea, etc. which are
close substitutes of Taj mahal. The manufacturer of Taj mahal tea cannot
therefore decide about his price-output policies without considering the
possible reactions of rival firms producing close substitutes.
Assumptions of monopolistic
competition:
1-Products are differentiated.
2-There are several firms.
3-There are no barriers to entry or
exit.
4- Individual Pricing by a Firm.
The first implication of these
assumptions is that firms have downward sloping demand curves. In this sense,
monopolistic competition differs from perfect competition and seems more akin
to perfect monopoly. However, the freedom of entry assumption
implies that if firm make a positive
profit, new firm will enter and new products will be introduced to the market.
The demand for all firms’ products will decline and entry will stop when firms
make zero economic profit. In this sense, monopolistic competition is similar
to perfect competition.
Thus, monopolistic competition refers
to competition among a large number of sellers producing close but not perfect
substitute products.
IMPORTANT FEATURES OF MONOPOLISTIC
COMPETITION
1. A large number of firms.:
As there is a large number of firms
under monopolistic competition, there exists stiff competition between them. Size
of each firm will be relatively small. This is unlike oligopoly where there are
a few firms of big size.
2. Product differentiation. The
products produced by various firms are not identical but are slightly different
from each other and remain close substitutes of each other.
3. Some influence over the price. Each firm under monopolistic competition produces close substitute of others. Therefore, their prices cannot be very much different from each other. If a firm lowers the price of its product, some customers of other product varieties will switch over to it, and quantity demanded of it will increase. On the other hand, if it raises the price of its product, some of its customers will leave it and buy the similar products from its competing firms. This implies that demand curve facing a firm working under monopolistic competition slopes downward and marginal revenue curve lies below it.
This means that under monopolistic
competition an individual firm is not a price taker but will have some
influence over the price of its product.
Thus, under monopolistic competition,
a firm has to choose a price-output combination
which will maximize its profits.
4. Non-price competition: Expenditure
on advertisement and other selling costs.
Promoting sales of their products
through advertisement is an important example of non-price competition.
The advertisement and other selling outlays by a firm change the demand for its product as well as its costs. Like the adjustments of price and product, a seller under monopolistic competition will also adjust the amount of his advertisement expenditure so as to maximize his profits.
The rival firms under monopolistic competition keenly compete with each other through advertisement by which they change the consumers’ preference for their products and attract more customers.
5. Product variation.
The amount of the product which a firm
will be able to sell in the market depends in part upon the manner in which its
product differs from others. Where the possibility of product differentiation
exists, sales depend upon the skill with which a product is distinguished from
others and made to appeal to a particular group of buyers.
6. Freedom of entry and exit.
In a monopolistically competitive market,
it is easy for the new firms to enter and the existing firms to leave it. Free
entry means that when in the industry existing firms are making super-normal
profits, the new firms enter the industry which leads to the expansion of output.
As a result, price of product tends to fall in the long run and entry will stop
when firms make zero economic profit.
Price-Output
Equilibrium under Monopolistic Competition:
The equilibrium of the firm under monopolistic
competition follows the usual analysis in the short-run and the long-run.
Short-run Equilibrium: The short-run analysis
of the firm under monopolistic competition is based on the following
assumptions
1- that the number of sellers is large and they act independently of each other. Each is a monopolist in his own sphere;
2- The product of each seller is differentiated from the other products;
3-The firm has a determinate demand curve (AR) which is elastic;
4- The factor-services are in perfectly elastic supply for the production of the product in question;
5- The short-run cost curves of each
firm differ from the others;
Given these assumptions, each firm
fixes such price and output which maximizes its profit. The equilibrium price
and output are determined at a point where the short-run marginal cost equals
marginal revenue [MC=MR].
Since costs differ in the short-run, a
firm with lower unit costs will be earning only normal profits. In case it is
able to cover just the average variable cost, it incurs losses.
1-
Short-run supernormal profit:
A firm in the short run earns Super-normal profits when the market price exceeds the short-run average total cost (SATC) or when AR>AC.
In the above diagram, the output is measured along the OX axis and price,
revenue, and cost on the OY axis. AR is the
demand curve or average revenue curve The MR curve lies below the AR curve. MC
curve cuts the MR curve from below at point C. The firm produces and sells an
output OQ, as at this level of output MR = MC. The firm sells output OQ at
OP/EQ per unit price. The total revenue of the firm is equal to the area OQEP,
whereas the total cost of producing output OQ is OQFP1. The total profits of
the firm are equal to the orange rectangle PP1EF. The per-unit
profit is indicated by the distance PP1 or EF.
2- Short Run Zero Profit:
A firm, in the short run, maybe making zero economic profit or normal economic profit when AR=AC.
In the above diagram, the MR curve
lies below the AR curve. MC curve cuts the MR curve from below at point C. The
firm sells output OQ at OP/EQ per unit price. The total revenue of the firm is
equal to the area OQEP, whereas the total cost of producing output OQ is also
OQEP. Hence, a firm is making a normal profit.
3-Short-run loss:
The firm, in the short run, may be in loss if the market price is lesser than the average total cost [AR<AC]
In the above diagram,
the MR curve lies below the AR curve. MC curve cuts the MR curve from below at
point C. The firm sells output OQ at OP/EQ per unit price. AC is greater than
AR. The total revenue of the firm is equal to the area OQEP, whereas the total
cost of producing output OQ is also OQFP1. Hence, a firm is suffering a net
loss PP1EF.
Price output
determination in the long run: long run is a period of time
where a firm will get adequate time to make any changes in the business. A firm
can initiate several measures to minimize its production costs and enjoy all
the benefits of large production.
The cost conditions, as
a result, differ slightly in the long run. While fixing the price, a firm in
the long run, should consider its AC and AR.
Generally, in the long
run, a firm can earn only normal profits. If AR is greater than AC, there will
be super-normal profits. This leads to entry of new firms- increase in the
total number of firms- total production- fallen prices- decline in profit
ratio. On the other hand, if AC is greater than AR, there will be losses. This
leads to the exit of old firms- decrease in the number of firms- total
production- rise in prices- increase in profit ratio. Thus, the entry and exit
of firm continues till AR becomes equal to AC. In the long run, two conditions
are required for the equilibrium of the firm- (i) MR = MC (ii) AR = AC.
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