Pricing under different market structures: Monopolistic completion ***

Pricing under Monopolistic Competition

Monopolistic competition is a market structure that combines elements of both perfect competition and monopoly. It is characterized by many firms selling differentiated products. Let’s delve into its features, price-output determination, and conditions for equilibrium.

Features of Monopolistic Competition

• Large Number of Sellers:
  • The market consists of many sellers, each holding a small market share.
  • No single firm can influence the entire market price.
• Product Differentiation:
  • Firms differentiate their products through branding, quality, features, and other attributes.
  • Each product is unique but has close substitutes, allowing firms to have some degree of pricing power.
• Freedom of Entry and Exit:
  • Firms can freely enter or exit the market.
  • This leads to zero economic profits in the long run as new firms enter when existing firms earn super-normal profits, driving profits down.
• Non-Price Competition:
  • Firms compete on factors other than price, such as advertising, product quality, customer service, and distribution.
  • This helps avoid price wars, which could be detrimental to all firms in the market.

Price-Output Determination under Monopolistic Competition: Equilibrium of a Firm

In monopolistic competition, firms face a downward-sloping demand curve due to product differentiation. Each firm sets the price for its product, leading to the following conditions for equilibrium:

• Short-Run Equilibrium:
  • Price and Output Determination:
    • Each firm determines its output where marginal cost (MC) equals marginal revenue (MR).
    • The equilibrium price is set based on the demand curve at this output level.
    • The firm’s demand curve is downward sloping but flatter than a monopolist’s demand curve, reflecting some degree of price elasticity.
  • Super-Normal Profits:
    • If the price (P) exceeds average total cost (ATC), the firm earns super-normal profits.
  • Diagram Explanation:
  • The MC curve cuts the MR curve from below at point E.
  • The equilibrium price is OP, and the equilibrium output is OQ.
  • Super-normal profit per unit is the vertical distance between the price (P) and ATC at output level OQ.
  • Total super-normal profit is the area between the price line and ATC curve from OQ to Q.
• Short-Run Losses:
  • If the price is below ATC, the firm incurs losses.
• Diagram Explanation:
• The firm’s cost exceeds the price at equilibrium output.
• The loss per unit is the vertical distance between ATC and the price line.
• Long-Run Equilibrium:
  • In the long run, super-normal profits attract new firms, increasing market competition and reducing individual firm demand.
  • Firms adjust until they earn only normal profits, where AR equals ATC.
• Diagram Explanation:
• The average revenue curve (AR) touches the average cost curve (ATC) at the equilibrium quantity.
• At this point, the firm’s price equals its average cost, resulting in zero economic profit.
• Excess Capacity:
  • Firms do not operate at full capacity in the long run.
  • They produce less than the quantity that minimizes average costs, leading to excess capacity.
• Diagram Explanation:
• The equilibrium output (Q1) is less than the output at minimum ATC (Q2).
• Firms prefer to stay at Q1 as increasing output reduces AR more than it reduces ATC.

Conclusion

Monopolistic competition blends elements of both perfect competition and monopoly. Firms differentiate their products, leading to some pricing power, and compete on non-price factors. In the short run, firms can earn super-normal profits or incur losses, but in the long run, entry and exit of firms ensure that only normal profits are earned. This market structure results in firms having excess capacity and not operating at optimal efficiency. Understanding these dynamics helps in analyzing the behavior and performance of firms in monopolistic competition.