Price determination under monopolistic competition

Price Determination under Monopolistic Competition

Imperfectcompetition covers all situations where there is neither purecompetition nor pure monopoly. Both perfect competition and puremonopoly are very unlikely to be found in the real world. In the realworld, it is the imperfect competition lying between perfect competitionand pure monopoly. The fundamental distinguishing characteristic ofimperfect competition is that average revenue curve slopes downwardsthroughout its length, but it slopes downwards at different rates indifferent categories of imperfect competition. The monopolisticcompetition is one form of imperfect competition.

Features of Monopolistic Competition:

Monopolisticcompetition refers to the market situation in which many producersproduce goods which are close substitutes of one another. Two importantdistinguishing features of monopolistic competition are:

Product differentiation, and

Existence of many firms supplying the market.

Product Differentiation:In contrary to perfect competition where there is only one homogeneouscommodity, in monopolistic competition there is differentiation ofproducts. In monopolistic competition, products are not homogenous norare they only remote substitutes. These are the products produced bycompeting monopolists that have separate identity, brand, logos,patents, quality and such other product features. Productdifferentiation does not mean that goods are completely different.Rather it means that products are different in some ways, but notaltogether so. These imaginary differences are created throughadvertising, marketing, packaging and the use of trademarks and brandnames.

Existence of Many Firms:Under monopolistic competition, there is fairly large number ofsellers, let say 25 to 70. Each individual firm has relatively smallpart of the total market so that each has a very limited control overthe price of the product. And each firm determines its own price-outputpolicy without considering the reactions of rival firms.

In monopolistic competition, in the long run, there isfreedom of entry and exit.

Thecommodity sold in a monopolistic competitive market is not astandardised product but a differentiated product. Hence competition isno longer exclusive on price basis. Buyers are buying acombination of physical product and the serviceswhich go with it.

Because of consumers’ attachment to a particular brand, the seller acquires a monopolistic influence on the market. Thus, thedemand curvefacing a firm under monopolistic competition is a downward slopingcurve, i.e., if he wants to sell more, he has to lower his price. Thedemand curve or AR curve under monopoly also slopes downwards, but thereis a difference between demand curves facing under monopolisticcompetition and pure monopoly. The demand curve faced by a ‘competing monopolist’ ismore elasticthan the demand curve faced by the ‘monopolist’, because there are no close substitutes available for the monopolist commodity.

Price Determination under Monopolistic Competition:

Undermonopolistic competition, the firm will be in equilibrium position whenmarginal revenue is equal to marginal cost. So long the marginalrevenue is greater than marginal cost, the seller will find itprofitable to expand his output, and if the MR is less than MC, it isobvious he will reduce his output where the MR is equal to MC. In shortrun, therefore, the firm will be in equilibrium when it is maximisingprofits, i.e., when MR = MC.

(a) Short Run Equilibrium:Short run equilibrium is illustrated in the following diagram:

In the above diagram, the short run average cost is MT and short run average revenue is MP. Since the AR curve is above the AC curve, therefore, the profit is shown as PT. PT is the supernormal profit per unit of output. Totalsupernormal profit will be measured by multiplying the supernormalprofit to the total output, i.e. PT × OM or PTT’P’ as shown in figure(a). The firm may also incur losses in the short run if it is facing AR curve below the AC curve. In figure (b) MP is less than MT and TP is the loss per unit of output. Total loss will be measured by multiplying loss per unit of output to the total output, i.e., TP × OM or TPP’T’.

(b) LongRun Equilibrium:Under monopolistic competition, the supernormal profit in the long runis disappeared as new firms are entered into the industry. Asthe new firms are entered into the industry, the demand curve or ARcurve will shift to the left, and therefore, the supernormal profit willbe competed away and the firms will be earning normal profits. Ifin the short run firms are suffering from losses, then in the long runsome firms will leave the industry so that remaining firms are earningnormal profits.

The AR curve in the long run will be more elastic, since a large number of substitutes will be available in the long run. Therefore, in the long run, equilibrium is established when firms are earning only normal profits. Now profits are normal only when AR = AC. It is further illustrated in the following diagram: