CA Foundation Business Economics Study Material Chapter 4 Price Determination in Different Markets – Imperfect Competition : Monopolistic Competition

IMPERFECT COMPETITION : MONOPOLISTIC COMPETITION

Introduction

  • We have studied two models that represent the two extremes of market structures namely perfect competition and monopoly.
  • The two extremes of market structures are not seen in real world.
  • In reality we find only imperfect competition which fall between the two extremes of perfect competition and monopoly.
  • The two main forms of imperfect competition are —
    – Monopolistic Competition and
    – Oligopoly

Meaning and features of Monopolistic Competition

  • As the name implies, monopolistic competition is a blend of competitive market and monopoly elements.
  • There is competition because of large number of firms with easy entry into the industry selling similar product.
  • The monopoly element is due to the fact that firms produce differentiated products. The products are similar but not identical.
  • This gives an individual firm some degree of monopoly of its own differentiated product.
  • E.g. MIT and APTECH supply similar products, but not identical.
  • Similarly, bathing soaps, detergents, shoes, shampoos, tooth pastes, mineral water, fitness and health centers, readymade garments, etc. all operate in a monopolistic competitive market.

The characteristics of monopolistic competitive market can be summed up as follows:

  1. Large number of buyers and sellers
    • There are large number of firms.
      – So each individual firms can not influence the market.
      – Each individual firm share relatively small fraction of the total market.
    • The number of buyers is also very large and so single buyer cannot influence the market by demanding more or less.
  2. Product Differentiation
    • The product produced by various firms are not identical but are somewhat different from each other but are close substitutes of each other.
    • Therefore, the products are differentiated by brand names. E.g. – Colgate, Close-Up, Pepsodent, etc.
    • Brand loyalty of customers gives rise to an element of monopoly to the firm.
  3. Freedom of entry and exit
    • New firms are free to enter into the market and existing firms are free to quit the market.
  4. Non-Price Competition
    • Firms under monopolistic competitive market do not compete with each other on the basis of price of product.
    • They compete with each other through advertisements, better product development, better after sales services, etc.
    • Thus, firms incur heavy expenditure on publicity advertisement, etc.

Short Run Equilibrium of a Firm in Monopolistic Competition. (Price-Output Equilibrium)

  • Each firm in a monopolistic competitive market is a price maker and determines the price of its own product.
  • As many close substitutes for the product are available in the market, the demand curve (average revenue curve) for the product of individual firm is relatively more elastic.

The conditions of equilibrium of a firm are same as they are in perfect competition and monopoly i.e.

  1. MR = MC, and
  2. MC curve cuts the MR curve from below.

The following figures show the equilibrium conditions and price-output determination of a firm under monopolistic competition.

When a firm in a monopolistic competition is in the short run equilibrium, it may find itself in the following situations —

  1. Firm will earn SUPER NORMAL PROFITS if its AR > AC;
  2. Firm will earn NORMAL PROFITS if its AR = AC; and
  3. Firm will suffer LOSSES if its AR < AC

1. Super Normal Profits (AR > AC):
CA Foundation Business Economics Study Material Imperfect Competition Monopolistic Competition 1
CA Foundation Business Economics Study Material Imperfect Competition Monopolistic Competition 2
The firm will earn NORMAL PROFITS if AC curve is tangent to AR curve i.e. when AR=AC

2. Losses (AR < AC):
CA Foundation Business Economics Study Material Imperfect Competition Monopolistic Competition 3
The firm may continue to produce even if incurring losses if its AR ≥ AVC.

Long Run Equilibrium of a Firm in Monopolistic Competition

  • If the firms in a monopolistic competitive market earn super normal profits, it attracts new firms to enter the industry.
  • With the entry of new firms market will be shared by more firms.
  • As a result, profits per firm will go on falling.
  • This will go on till super normal profits are wiped out and all the firms earn only normal profits.

CA Foundation Business Economics Study Material Imperfect Competition Monopolistic Competition 4

  • In the long run firms in a monopolistic competitive market just earn NORMAL PROFITS.
  • Firms operate at sub-optimal level as shown by point ‘R’ where the falling portion AC curve is tangent to AR curve.
  • In other words firms do not operate at the minimum point of LAC curve ‘L’.
  • Therefore, production capacity equal to QQ, remains idle or unused called excess capacity.
  • This implies that in monopolistic competitive market —
  • Firms are not of optimum size and each firm has excess production capacity
  • The firm can expand its output from Q to Q, and reduce its average cost.
  • But it will not do so because to sell more it will have to reduce its average revenue even more than average costs.
  • Hence, firms will operate at sub-optimal level only in the long run.