Price Determination Under Monopolistic Competition

Contents .

Meaning and Characteristic Demand and Cost Curves Product differentiation Price determination (short and long periods) Group Equilibrium Selling Costs Comparisons between different areas of

competition

What is Monopolistic Competition ?

Simple meaning (for students):- It is competition faced by different firms

trading in the same range of product , with the product differentiating in minor terms with each other

Definitions :- Monopolistic Competition is a market

situation where there are many producers but each offers a slightly differentiated product

Assumptions .. Large no. of firms and buyers : Like perfect competition there are large no.

of sellers BUT the firm size is small unlike perfect competition

Each firm can decide its own price as they have limited control over the market UNLIKE perfect competition

Product differentiation : It is the situation wherein the buyers can distinguish one product from the other

Why does it arise ? It arises due to the differentiation of the products e.g. shape, durability, color, size etc.

Examples : Colgate, Pepsodent, Prudent, Sensodyne

Freedom of Entry and Exit : There is freedom of entry and exit BUT its

not absolute . There are many difficulties

Price Policy : Each firm has its own price policy . It means

that if a firm wants to sell more units of its product it will have to lower the per unit price .

Less Mobility : Neither factors of production nor goods and

services are mobile .

Imperfect Knowledge : Buyers and sellers are ignorant about

the price . It is so because due to the firms product differentiation .

Non-Price Competition : Different firms compete without

changing the price of the product. Hence, sellers attract customers by offering free gifts .

Demand and Cost Under Monopolistic Competition

Demand Curve Because of product differentiation, demand

curve(AR curve) of a firm under monopolistic competition is downward sloping. Marginal revenue curve is also downward sloping. Demand curve under monopolistic competition is more elastic than under monopoly. It is because if a producer raises the price of his product, then some of the customers stop buying from him and shift their clientele to other producers who have not raised the price and vice-versa.

Cost Curve

Average cost curve, average variable cost curve and marginal cost curve are U-shaped even under monopolistic competition. Special feature of imperfect competition is selling cost, incurred on the advertisement of the product. According to Chamberlin, selling cost curve is also U-shaped. On account of product-differentiation, supply curve of the industry cannot be drawn under monopolistic competition.

Product Differentiation

According to Chamberlin, “A general class of product is differentiated if only sufficient basis exists for distinguishing the goods of one dealer from those of another. Such a basis may be real or fancied, so long as it is of any importance whatever to buyers and leads to a preference for any variety of the product over another.”

Main Peculiarities of Product Differentiation are:

Goods are not homogeneous as in perfect competition.

The goods are close substitutes. Product differentiation may both real and artificial. Producer gets the name or brand legally patented. Aim of product differentiation is to control price

and increase profit. It may increase average cost. Satisfies people’s urge for variety. Hence, it

becomes necessary to pay a little higher price.

Product Differentiation and Demand Curve

The main objective of product differentiation is to increase the influence of the producer in the determination of price. The producer is no longer a price-taker but a price maker. Consequently, demand curve assumes negative slope, signifying more demand when price falls and less demand when it rises. It is because of product differentiation that selling costs have great influence over demand curve.

Price and Equilibrium Under Monopolistic Competition

A producer aims to get the maximum profit even under monopolistic competition. We have seen that profit is maximum when MR=MC. In case of monopolistic competition MR is not equal to AR. If a firm wants to sell more units it has to lower the price per unit due to which AR and MR are downward sloping curves from left to right. A firm produces up to that limit where its MC=MR, and MC curve cuts MR curve from below.

Equilibrium of the Firm

Short Period Equilibrium in Monopolistic Competition:

It refers to the period in which production can be increased, only up to existing production capacity in response to increase in demand. A firm will be in equilibrium when its MC=MR, MC curve cuts MR from below. The firm may face 3 situations: (1) Super Normal Profits, (2) Normal Profits (3) Loss.

Super Normal Profits:

Figure shows that firm is in equilibrium at point E, because at this point MC=MR. It indicates that the firms equilibrium output is OM. Price equilibrium output is OP(=BM). BM is greater than average cost AM(BM>AM). Hence, the firm earns super normal profit equivalent to BA per unit. Total super normal profits

of firm in equilibrium is ABPC.

Normal Profits: Figure shows that firm is in equilibrium at point E where MC=MR and OM will be the equilibrium output. Price of the equilibrium output. Price of the equilibrium output is OP(=AM) and average cost is also OP(=AM). This is because, AR curve is touching AC curve at point A. Hence, in the position of equilibrium AR=AC and the firm earns normal profits.

Minimum Loss: Figure shows that firm will be in equilibrium at point E. At this point MC=MR. In equilibrium position, the firm will produce OM units of output. Price of equilibrium output OM is OP1(=AM) and average cost OP(=BM). Average cost of the firm is more than the price.

Long period equilibrium in monopolist :

It is that time in which the firm can change the production capacity in response to change in demand . New firms can enter the industry .

Firms can run normal profit only .

Group Equilibrium

There are a number of firms producing products . These collectively act as a group and are called an Industry .

The achievement of equilibrium and attainment of optimum point is known as Group Equilibrium .

Example : Group of firms producing Toothpastes .

Excess Capacity

Excess capacity is the difference between optimum output and actual output in the long run equilibrium .

It is said to be when the Average Cost is minimum .

Is excess capacity wasteful ?

There are mixed viewpoints regarding excess capacity about different authors .

However, The correct policy is to reduce the

number of differentiated products until each remaining product can be produced at its least cost output .

Thus we conclude it is not necessary wasteful .