COMMERCE PAPER No. 2 : MANAGERIAL ECONOMICS
MODULE No. 18 : PRICING UNDER MONOPOLISTIC COMPETITION
Subject COMMERCE
Paper No and Title 2: Managerial economics
Module No and Title 18: Pricing under Monopolistic competition
Module Tag COM_P2_M18
COMMERCE PAPER No. 2 : MANAGERIAL ECONOMICS
MODULE No. 18 : PRICING UNDER MONOPOLISTIC COMPETITION
TABLE OF CONTENTS 1. Learning Outcomes 2. Introduction
3. Understand the assumption of Monopolistic competition 4. Product differentiation and Demand curve
5. The concept of the ‘Industry’ and ‘Product group’
6. Derive long-run equilibrium
6.1 Short run equilibrium under monopolistic competition 6.2 Long run equilibrium under monopolistic competition 7. Summary
COMMERCE PAPER No. 2 : MANAGERIAL ECONOMICS
MODULE No. 18 : PRICING UNDER MONOPOLISTIC COMPETITION
1. Learning Outcomes
On studying this module, you would be able to
Understand the assumption of Monopolistic competition.
Know about the importance of product differentiation and demand curve faced by Monopolistic firm.
Understand the notion of ‘Industry’ and ‘Product group’
Learn about the short run and long run equilibrium of a firm in monopolistic competition.
2. Introduction
Perfect competition and monopoly are extreme cases that do not involve active competition at all. In the former, firms have no influence over the market price, while in the latter there is only one producer. Most real firms operate under intermediate market structures. To begin with, they are not monopolies because their industries contain several firms, which often compete actively against each other. On the other hand, these firms do not operate in perfectly competitive markets because the number of competing firms is often small and, even when the number is large; the firms are not price taker.
As in real world, most of the firm operate in intermediate market forms, where they do have some market power but also have competition. Therefore, there is need to study the firm behaviour in intermediate market structures. They are also called imperfectly competitive. The word competitive emphasizes that we are not dealing with monopoly and the word imperfect emphasizes that we are not dealing with perfect competition. In this module, we are focusing on one of the prominently prevailing intermediate market structure that is monopolistic competition. This form of market is close to perfect competition with one important difference. Firm do not sell a homogenous product.
3. Understand the assumption of Monopolistic competition
One of the simple models of imperfect competition is known as monopolistic competition. Tractability of this model is achieved by limiting the form of the interdependence between producers. Monopolistic competition refers to a market in which there are many firms and each sells a single differentiate product. Since each firm’s is somewhat different from those of competitor, each faces a negatively sloped demand curve for its product.
The theory based on four key assumption
COMMERCE PAPER No. 2 : MANAGERIAL ECONOMICS
MODULE No. 18 : PRICING UNDER MONOPOLISTIC COMPETITION
1. Each firm produces one specific variety, or brand, of the industry’s generic product. Each firm thus faces a demand curve that is negatively sloped, yet is elastic, because many close substitutes are sold by other firms.
2. Within the industry there are a number of firms each one ignores the possible outcome of its competing firm when it decides its own price and output decisions.
Each firm’s decision making is based on its own demand and cost conditions and does not take any account for the potential reaction by other firms.
3. Free Entry and Exit Exists. If existing firms are earning profits, new firms have an incentive to enter. When they do, the demand must be shared among more brands.
4. There is symmetry. When a new firm enters selling a new differentiated version of the generic product, it takes customers equally from all the existing firms. For example, a new entrant that captured 5 percent of the existing market would do so by capturing 5 percent of the sale each existing firm.
4. Product differentiation and the Demand curve
Product differentiation is intended to distinguish the product of the one producer from that of the other producers in the industry. The products is not homogenous of the
products are while the basic features may be the same, yet the consumer is persuaded, via advertising or the other selling activities, that the products are different. Product
differentiation exists when differences in the factor inputs, or the location of the firm, which determines the convenience with which the product is accessible to the consumer, or service offered by the producer. Fancied differentiation happens due to by advertising, difference in packaging, difference in design, or simply by brand name. Whatever the case, the aim of the product differentiation is to make the product unique in the mind of the cunsumer. Yet differentiated products are closely related if they are included in the same ‘Product Group’: the products should be close substitutes with high prices and cross- elasticities.
The effect of differentiated products is that the producer has some discretion in the determination of the price. Here the producer is a price- taker to some extent, but has some degree of monopoly power . However, he faces the keen competition of the close substitutes offered by the other firms. Hence the discretion over the price is limited.
Product differentiation creates brand loyalty of the consumer and this is responsible for a negatively sloping demand curve. Product differentiation finally, provides rationale for selling price. Perfectly competitive firms face a perfectly elastic demand curve for their product because all firms in their industry produce the exact same product. A
monopolistic firm faces a downward-sloping firm demand curve. This type of curve happens due to notion that the firm can change its price without losing all of its business because buyers do not see any perfect substitute. The fewer the substitutes (i.e., the more product differentiation), the less elastic the demand curve will be.
COMMERCE PAPER No. 2 : MANAGERIAL ECONOMICS
MODULE No. 18 : PRICING UNDER MONOPOLISTIC COMPETITION
5. The concept of Industry group and Product group
Product differentiation creates difficulties in the analytical treatment of the industry.
Heterogeneous products cannot be added to form the market demand and supply
schedules as in the case of homogeneous products. Therefore the concept of the industry needs redefinition. Chamberlin uses the concept of ‘Product Group’, which includes products which are ‘Closely Related’. The products should be close technological and economical substitutes. Technological substitute are products which can technically cover the same want. For example, all motor cars are technological substitute in the sense they provide transport. Economic substitute are products which cover the same want and have similar prices. For example, a Hillman Avenger and a Morris 1300 can be considered as economic substitutes. An operational definition of the ‘product group’ is that the demand of each single product is highly elastic and that it shifts appreciably when the price of other products in the group changes. In the other word, product forming the ‘group’ or
‘industry’ should have high price and cross-elasticites.
Summation of the individual demand and cost curves to form the ‘industry’ demand and supply requires the use of common denominators. Even so, with the product
differentiation there is no such unique price except under Chamberlin’s Heroic
assumption. As per Chamberlin ‘Heroic assumption’, is that cost and demand functioning is common throughout the group. This requires that consumers’ preferences be evenly distributed among seller, and that differences between the products be such as not give rise in differences in cost. Simultaneously as product differentiation allow each firm to charge a different price. There will be no unique equilibrium price, but an equilibrium cluster of prices, reflecting the preferences of consumers for the product of the various
COMMERCE PAPER No. 2 : MANAGERIAL ECONOMICS
MODULE No. 18 : PRICING UNDER MONOPOLISTIC COMPETITION
firms in the group. When the market demand shifts or cost condition change in a way all firms, then the entire cluster of prices will rise or fall simultaneously.
6. Equilibrium of the Firm
Monopolistic competition refers to the market with a fairly large number of firms which sell differentiated products. A single firm in the product group (industry) hardly any impact on the market price. However, if it reduces price, it can expect a considerable increase in its sales. Each firm is capable of drawing consumers from other firms by conjuring make belief differences or real difference with the help of a range of non price competition like advertisement and sales promotion. Under these circumstances the firm can raise the price and yet not lose out on customer demand. This is because of the fact that the product is differentiated from competing firms due to price and non-price factors.
The demand curve (AR curve) of the monopolistic firm is therefore, highly elastic and is downward sloping. The marginal revenue curve, also slopes downward and lies below the demand curve because there is a fixed relationship between AR and MR.
6.1 Short Run Equilibrium under Monopolistic/Imperfect Competition:
During the short period , the number of firms in the ‘group’ remains the constant. The size of the plant of each firm remains constant. As the firm whether operating under perfect competition, or monopoly wants to maximize profits. In order to achieve this objective, it goes on producing a commodity so long as the MR is greater than MC. When MR = MC, equilibrium is established and produces the best level of output. If a firm produces less than or more than the MR = MC output, it will then not be making maximum of profits.In the short-run, a monopolistically competitive firm may be realizing abnormal profits or suffering losses. If it is earning profits, no new firms can enter the industry in the short-run. In case, it is suffering, losses but covering full variable cost, the firm will continue operating so that the losses are minimized. If the full variable cost is not met, the firm will close down in the short-run. The short-run equilibrium with profits and short run equilibrium with losses of a monopolistically competitive firm are explained with the help of two separate diagrams as under.
COMMERCE PAPER No. 2 : MANAGERIAL ECONOMICS
MODULE No. 18 : PRICING UNDER MONOPOLISTIC COMPETITION
Since the firm has a downward-sloping demand curve, it will also have a downward- sloping marginal revenue (MR) curve. A profit-maximizing firm produces where marginal cost (MC) equals marginal revenue (q0 in the above graph) and charges the price determined by demand (P0). In panel (a) of the figure, the monopolistic competitor will make a profit. However, like a monopoly, a monopolistic competitor is not
guaranteed to make a profit in the short run. The firm may make a loss in the short run;
its profitability will depend on the demand. This is shown in panel (b).
6.2 Determination of long-run price and output in Monopolistic firm
COMMERCE PAPER No. 2 : MANAGERIAL ECONOMICS
MODULE No. 18 : PRICING UNDER MONOPOLISTIC COMPETITION
In the long run, the firms are able to alter the scale of plant according to the changed conditions of demand for a product in the market. They can also leave or enter the industry. If the firms reap subnormal profits in the short run, then new firm would enter the ‘product group‘(industry). The tendency of the new firms to enter the industry continues till the abnormal profits are competed away and the firms economic profits are zero. Monopolistically competitive firms realize losses in the short-run, then some of the firms will leave the industry. The exit of the firm continues till zero economic profits are restored with the operating firms.
In the long-run, there are no entry barriers for the new firms. The incoming try to differentiate their products . The old firms operating with .the used machinery try to match up with the new entrants by improved variety of products in their group. They incur expenditure on advertisement and on sales promotional . They employ better quality staff for making technical improvement in their products. All firms incur
additional expenditure on account of the quality improvements, the cost curves of all the firms move up. Due to entry of new firms in the industry and higher costs of production, the output of each competing firm is reduced. Monopolistic competition leads to, a waste in the economic resources of the country. Long run equilibrium of the monopolistic firm is now explained with the help of Figure. In this figure the long run marginal cost curve (LMC) cuts the marginal revenue curve at point M. The demand curve is tangential to the ATC curve at point T. The equilibrium firm produces OK output and sells it at OE price.
a) Since price equals LAC at point T, no firm is making positive profit. There is no incentive for the new firms to enter the industry nor for the existing firms to leave it. All firms are Fig.making normal profit, so the industry too is in the long run equilibrium each existing firm.
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MODULE No. 18 : PRICING UNDER MONOPOLISTIC COMPETITION
Unlike a perfectly competitive firm, a monopolistically competitive firm ends up choosing a level of output that is below its minimum efficient scale. When the firm produces below its minimum efficient scale, it is under‐utilizing its available resources.
In this situation, the firm is said to have excess capacity because it can easily
accommodate an increase in production. This excess capacity is the major social cost of a monopolistically competitive market structure.
Price taker assumption has certain advantage because a competitive producer can produce as much as the market produces.. One of the advantage is that atomistic producer does not bothered about product. Under monopolistic competition, when entry take place and competition intensify then every producer has to devise their own method to deal with competition. Some of them used advertising where as other use product differentiation and sales promotion technique because of which firstly, AC goes on increasing and secondly as entry took place demand curve become elastic. When demand curve become elastic then producer cannot change price so much.
On the one hand price cannot increase and other hand cost increases. So those producers who succeeded in product differentiation, branding and sales promotion etc are benefited because all these additional cost are effective in generating more demand. Therefore their demand curve expands. As their demand curve expands there is greater possibility of production and profit increases but at the same time there is inefficient producer who does not cope with increases in cost and competition. So in long run there is influx of producer those who can make profit and out flux of those who have burned their finger.
Since entry and exist condition make this possible. So in monopolistic competition in the long run, market is not in a state of stable equilibrium.
Above figure shows different possible equilibrium point for industry operating in
monopolistic competition, due to expansion of demand and supply curve. However due to
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MODULE No. 18 : PRICING UNDER MONOPOLISTIC COMPETITION
different possible equilibrium position, it is quite feasible for a firm to earn super normal profit and incur losses in long run but it can be sustained in longevity.
As, above diagram shows different possible equilibrium point for industry operating in monopolistic competition, due to expansion and contraction of demand curve and supply curve. However due to different possible equilibrium position, it is quite feasible for a firm to earn abnormal profit and incurred losses even in the long run but it cannot sustain in overall long run. In long run, when in initial year some firm earn abnormal profit, it gives incentives to new firm to enter the industry and produce a differential product. This tendency continues until abnormal profit wiped out normal profits. In long run under monopolistic competition there is no stable equilibrium due to influx and out flux of firms.
Initially there are relatively fewer producers in the market. Therefore the supply is less (S1S1). Also, since the producers have not been able to influence demand through
advertisement, selling costs and product differentiation, the demand curve is low (D1D1).
At the equilibrium point ‘1’ sufficient expansion has not taken place in the market and the supply (MC) is high the price is OP1. Some of the producers become capable of exploiting their monopolistic tendency and are not able to raise demand (D2D2). Thus equilibrium in the market happens to be at ‘2’. The prices rise to OP2. So far other
producers from outside the industry have not realized the potential for profit (P2- P2). The moment they do there is a flux into the market, ushering in the outset of long run. Supply curve shifts to the right (S3S3)., but simultaneously since there are many more producers the demand curve also falls. This is because not all producers are equally efficient in selling their product. The new equally efficient in selling their product. The new demand has shifted back to D1D1. Ordinarily equilibrium would take place at ‘3’. Here the normal profits obtain. This ideal situation continues under perfect competition,. But under monopolistic competition each new producer thinks that he is better than the existing ones. So he continues to stick it out. This way there are too many producers. The supply curve slides down to S4S4. The new equilibrium is now at ‘4’. Here the firm make loses (P2’-P2). Finally some producers leave and the supply function rise again to S1S1 and price rise to OP1.
7. Summary
Imperfect competition refers to those market structures that fall between perfect competition and pure monopoly. Markets that have some features of competition and some features of monopoly. One of the intermediate market structures is monopolistic competition.
Monopolistic competition refers to a market in which there are many firms and each sells a single differentiate product. Since each firm’s is somewhat different from those of competitor, each faces a negatively sloped demand curve for its product.
Product Differentiation
COMMERCE PAPER No. 2 : MANAGERIAL ECONOMICS
MODULE No. 18 : PRICING UNDER MONOPOLISTIC COMPETITION
–Each firm produces a product that is at least slightly different from those of other firms.
–Rather than being a price taker, each firm faces a downward-sloping demand curve.
As heterogeneous products cannot be added to form the market demand and supply schedules as in the case of homogeneous products. Therefore the concept of the industry needs redefinition. Chamberlin uses the concept of ‘Product Group’, which includes products which are ‘Closely Related’. The products should be close technological and economical substitutes.
The goal of a monopolistic firm is to maximize profit. Profit maximization occurs at the quantity where marginal revenue equals marginal cost. In the short run, an individual firm may either earn super normal profit or normal profit or incur losses. This depends on position of short run cost curves.
In the long run perfect competitive firm only earn normal profit. This is due to unrestricted entry into and exit of firms from the industry in the long run.
If the firms are earning abnormal profits in the short run, then new firm will enter the ‘product group‘(industry). The tendency of the new firms to enter the industry continues till the abnormal profits are competed away and the firms economic profits are zero. Similarly if monopolistically competitive firms realize losses in the short-run, then some of the firms will leave the industry. The exit of the firm continues till zero economic profits are restored with the operating firms.
Unlike a perfectly competitive firm, a monopolistically competitive firm ends up choosing a level of output that is below its minimum efficient scale. In this situation, the firm is said to have excess capacity. This excess capacity is the major social cost of a monopolistically competitive market structure.
