PRICE DETERMINATION UNDER MONOPOLISTIC COMPETITION DEFINITIONS According to

PRICE DETERMINATION UNDER MONOPOLISTIC COMPETITION

DEFINITIONS: � According to J. S. Bains “Monopolistic competition is found in the industry where there is a large number of small seller, selling differentiated but close substitute product. ” � According to Lim Chong Yah “ Monopolistic Competition is a market situation where there are many producers but each offers a slightly differentiated product. ”

ASSUMPTIONS OF MONOPOLISTIC COMPETITION � LARGE NUMBER OF FIRMS AND BUYER: Under monopolistic competition there are large number of buyers and seller. But size of each firm is small. � PRODUCT DIFFERENTIATION : It is a main feature of monopolistic competition. Product differentiation refers to that situation wherein buyer can distinguish one product from another.

� FREEDOM OF ENTRY AND EXIT : Firms under monopolistic competition are free to enter and leave the market. New firms face difficulties to enter the market. � SELLING COST : Each firm spends a lot on publicity of its products. with a view to selling more and more units of the product it give wide publicity of its product. � PRICE POLICY : Each firm has its own price policy. Average and marginal revenue curve of a firm under monopolistic competition slopes downward. It means if firm want to sell more it has to lower its price.

� NON PRICE COMPETITION : Another feature of monopolistic competition is that, different firms compete with one another without changing the price of the product by offering free gift with the product.

DEMAND COST UNDER MONOPOLISTIC COMPETITION � DEMAND CURVE : Demand curve (AR) and marginal revenue curves are downward sloping because of product differentiation. REVENUE Y o MR OUTPUT AR X

� COST CURVE : Average cost curve, average variable cost curve and marginal cost curves are U-shaped under monopolistic competition.

PRODUCT DIFFERENTIATION � DEFINITION : According to Chamberlin “ A general class of product is differentiated if only sufficient basis exists for distinguishing the goods(or services) 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. ”

PRODUCT DIFFERENTIATION AND EQUILIBRIUM � Under monopolistic competition product differentiation has great influence over firm’s equilibrium. It can be clarified with following diagram : REVENUE/COST Y B A E P Q H F G R O N OUTPUT M X

� Supposing price of a product has already determined. It is assumed that producer will de able to sell more if he produce quality product. � It is clear form diagram that A and B represents cost curve of good A and B respectively. OP is the price in the market and at this price level ON quantity of good A and OM quantity of good B. Total profit of good B is SGHP which is more than good A whose profit is RFEP. So firm will prefer to produce good B.

EQUILIBRIUM OF THE FIRM � SHORT TERM EQUILIBRIUM OF THE FIRM : q SUPER NORMAL PROFIT : OUTPUT Y MC P A B C E is the point of equilibrium. Firm earn super normal profit equal to ABCP , here AM>BM. AC E A MR MC=MR R O M OUTPUT X

q NORMAL PROFIT : REVENUE/COST MC P AC E O MR M OUTPUT AR E is the point of equilibrium. Firm earn normal profit as AR curve is equal to AC curve.

q MINIMUM LOSS : MC Y B REVENUE/COST P Q O AV C A E MR=MC M OUTPUT q LONG E is the point of equilibrium. Firm suffer a loss of AB per unit. Total loss of a firm is BAPQ. SAC MR AR X TERM EQUILIBRIUM : In long term equilibrium firm earn only normal profit. At the point of equilibrium AR is tangent to LAC.

REVENUE/COST Y LMC A P E O LAC AR MR M OUTPUT X GROUP EQUILIBRIUM Two assumptions : 1) Demand cost curves of all the firms of the group are the same. 2) Number of firms are so large that no individual firm can affect the price and output.

C COST/REVENUE/PRI CE Y D D 1 A B O R E M 1 C G M D 1 D OUTPUT X Group equilibrium is explained in the figure. DD is a demand curve and CC is a cost curve. At OA price, difference between cost and revenue curve is maximum which will yield super normal profit equal to BARG. This will tempt new firms to join the group and total demand will be distributed among several sellers. The number of firm will increase till DD 1 becomes tangent to CC. OB will be equilibrium price of the group and OM 1 will be equilibrium output.

EXCESS CAPACITY REVENUE/COST “Excess capacity is the difference between optimum output and the actual output in the long run equilibrium. Optimum output of a firm have been regarded to be the output where long run average cost is a minimum. ” Y LM C R M E O LAC MR Q Q 1 OUTPUT AR X

Selling Costs According to Chamberlin , “ Selling costs are costs incurred in order to alter the position or shape of the demand curve for the product. ” According to Meyers , “Selling cost may be defined as costs necessary to persuade a buyer to buy one product rather than another or to buy from one seller rather than another. ”

(2) Assumptions: Selling costs are based on two assumption: (I) Buyers’ demand taste can be changed; (ii) Buyers’ do not have full knowledge about the different types of the product. (iii)Selling costs appraise the buyers of the conditions of the market , superiority of the product and similar other things.

(3) Difference between Selling Costs and Production Costs: Selling Costs (1) Those costs which Aim to attract the customers to the products. (2)Selling costs include all kinds of expenses on advertisements in newspaper , magazines etc. (3)The purpose of selling costs is to push the demand for the product. Production costs (1)Those costs which are incurred in order to make the commodity worthy of meeting the requirements of customers. (2)Production costs include such expenditure as production of the product, transportation, storage, delivery to customer etc. (3)The purpose of production costs is to increase the supply of the product.

Y S S SELLING COST Selling costs curves are also Ushaped. In fig. SS is average selling cost curve. Initially it falls and later it rises. It means in the beginning proportionate increase in sales is more than the increase in selling costs. After a point proportionate increase in sales is less than the increase in selling costs. It implies up to a point per unit selling cost go on diminishing but after a point the same tend to increase. O (4)Shape of the Selling Costs: X OUTPU T

(5) Selling Costs and Firm’s Equilibrium: Firm has to decide about the price of commodity and the selling costs to be incurred. It is assumed that demand for the product increases due to increase in selling costs, resulting into extra profits for the producers and demand curve shifts to the right as a result of increase in selling costs.

� Output is shown on OX-axis , and costs on OY -axis. Before incurring selling costs , suppose that price is as shown by AR 1 curve and average cost of production is as shown by ACP. In this , equilibrium output is OQ. It is assumed that the output MC = MR. To avoid the complexity of curves in the dig. , MC & MR curves have not been shown. In this, firm is earning ABCD super normal profits.

Comparison between Monopolistic Competition and Perfect Competition (1)Assumption regarding Product: Under perfect competition it is assumed that all firms produce homogenous products. Under monopolistic competition there is product differentiation. Goods produced by the firms differ in one way or the other because of this difference each firm is a monopolist of its own product.

(2)Assumption regarding number of Buyers and Sellers : Under perfect competition there are large number of sellers of homogenous product. Group of such sellers constitutes industry. No seller by his individual actions can influence other sellers. Under imperfect competition, number of sellers is more than one. Many such sellers are collectively called ‘Group’. In both these market situations there are large number of sellers.

(3)Assumption regarding Degree of Knowledge: Under perfect competition it is assumed that buyers and sellers have perfect knowledge of the market conditions. On the contrary, buyers and sellers under monopolistic competition are not fully aware of the market conditions. (4) Assumption regarding shape of demand curve: Under perfect competition, due to large number of firms and homogenous product , demand curve is perfectly elastic. It means, under perfect competition average revenue curve is parallel to OX-axis. In this situation, average revenue is equal to marginal revenue.

AR=MR P P REVENU E represented by a single curve PP which is parallel to OXaxis. Price of the product is determined by the industry and each firm has got to accept that price. Firm, therefore, is a price-taker. (b)In monopolistic competition, AR curve slopes downward. AR and MR curves are not only separate downward sloping curves but MR curves is below AR curve. So, firm is a price-maker. O Y O X OUTPUT REVENUE (Rs. ) (a) In fig. . , AR and MR are Y AR MR OUTPUT X

(5) Implications regarding decisions: Under perfect competition, a firm can take decision only with regard to the quantity of output to be produced. A firm under perfect competition need not incur any selling costs. On the other hand, a firm under monopolistic competition can determine either the output to be produced or the price to be charged. Selling costs are an important feature of monopolistic competition.

(6) Implication regarding condition of Maximum Profit: According to marginal analysis decision regarding achievement of equilibrium position , both under perfect and monopolistic competitions, can be taken on the basis of the following principle: Equilibrium = MR = MC It proves that under both market conditions , position of equilibrium is achieved when output is produced up to a level where MC = MR.

Comparison between Monopolistic Competition and Monopoly (1)Assumption Regarding Product: Product of a monopolist may or may not be homogenous. However, product differentiation is an important feature of monopolistic competition. (2)Assumptions regarding number of Sellers and Buyers: In case of monopoly, there is only one seller and large number of buyers. Under monopolistic competition there are large number of buyers and sellers producing close – substitutes.

(3) Assumption regarding Entry : Under monopolistic competition there are no restrictions on the new firms to enter into and the old ones to leave the group. It is possible in the long run only. But under monopoly there are restrictions on the entry of new firms. (4) Different Average and Marginal Revenue Curves: Under monopoly, AR and MR curves are two separate curves. AR curve represents price of different units and MR curves represents the MR of different units.

� Under monopolistic competition also, AR and MR curves are two separate curves. They slope downward from left to right. But both these curves are more elastic than curves under monopoly. Y MR o OUTPUT REVENUE(Rs. ) Y AR X AR o MR OUTPUT X

(5) Implications regarding Decisions: A firm, whether operating under monopoly or monopolistic competition , can either fix the price or the output but it cannot fix both. A firm under monopolistic competition has to spend a lot on selling costs but a monopolistic spends very little on selling costs. (6) Comparison regarding profit: In the short-run, the monopolistic and a firm under monopolistic competition, may earn super normal profit, normal profit and even suffer losses; but in the long run whereas a monopolistic earns super normal profit, a firm under monopolistic competition generally earns normal profit only.