Monopolistic Competition – Managerial Economics Notes – BBA/MBA Notes

Price and Output Decisions in Short Run

The price and output determination models of monopolistic competition was developed by Chamberlin as explained here. Although monopolistic competition is characteristically close to perfect competition, pricing and output decisions under this kind of market are similar to those under monopoly. The reason is that a firm under monopolistic competition faces a downward sloping demand curve. This kind of demand curve is the result of

(i) a strong preference of a section of consumers for the product and

(ii) the quasi-monopoly of the seller over the supply. The strong preference or brand loyalty of the consumers gives the seller an opportunity to raise the price and yet retain some customers. Besides, since each product is a substitute for the other, the firms can attract the consumers of other products by lowering their prices.

The short-term pricing and output determination under monopolistic competition is illustrated in following figure. The AR and MR curves and SMC and SAC curves give short-run revenue and cost curves, respectively, faced by the monopolistic firm. As shown in the figure, firm’s MR intersects its MC at point A. Point A determines the profit maximizing output at OQ. Given the demand curve, this output can be sold at price PQ. So the price is determined at PQ. At this output and price, the firm cams a maximum monopoly or economic profit equal to PM per unit of output and a total monopoly profit shown by the rectangle P1PMP2. The economic profit. PM (per unit) exists in the short-run because there is no or little possibility of new firms entering the industry: But the rate of profit would not be the same for all the firms under monopolistic competition because of difference in the elasticity of demand for their products. Some firms may earn only a normal profit if their costs are higher than those of others. For the same reason, some firms may make even losses in the short-run.

Monopolistic Competition
Source : Managerial Economics by D.N. Dwivedi

Price and Output Determination in the Long Run

The mechanism of price and output determination in the long-run under monopolistic competition is illustrated in the following figure. To begin the analysis, let us suppose that, at some point of time, firm ‘s revenue curves are given as AR1 and MR1 and long-run cost curves as LAC and LMC. As the figure shows, MR1, and LMC intersect at point M determining the equilibrium output at OQ2 and price at P2Q2. At price P2Q2. the firms make a supernormal or economic profit of P2T per unit of output. This situation is similar to short-run equilibrium.

Let us now see what happens in the long run. The supernormal profit brings about two important changes in a monopolistically competitive market in the long run.

Monopolistic competition
Source : Managerial Economics by D.N. Dwivedi

First, the supernormal profit attracts new firms to the industry. As a result, the existing firms lose a part of their market share to new firms. Consequently, their demand curve shifts downward to the left. This kind of change in the demand curve is shown in following Fig.  by the shift in AR curve from AR1 to AR2 and the MR curve from MR1 to MR2.

Second, the increasing number of firms intensifies the price competition between them. Price competition increases because losing firms try to regain or retain their market share by cutting down the price of their product. And new firms in order to penetrate the market set comparatively low prices for their product. The price competition increases the slope of the firms “demand curve” or. in other words, it makes the demand curve more elastic. Note that AR2 has a greater slope than AR1 and MR2, has a greater slope than MR1

The ultimate picture of price and output determination under monopolistic competition is shown at point in Figure shown above. As the figure shows, LMC intersects MR2, at point N where firm s long-run equilibrium output is determined at OQ1 and price at P1Q1. Note that price at equals the LAC at the point of tangency. It means that under monopolistic competition, firms make only normal profit in the long-run. Once all the firms reach this stage, there is no attraction (i.e. super normal profit) for the new firms to enter the industry, nor is there any reason for the existing firms to quit the industry. This signifies the long-run equilibrium of the industry.

 

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