Price Determination under Monopolistic Competition – Explained!

Each firm under imperfect competition or monopolistic competition produces different commodities which are close substitutes.

This makes the output and price policies of an individual firm’s product partially dependent on the output and price policies of its rivals.

In other words, the average revenue curve and the average cost curve of each firm will be partially affected by the price and output policies of its rivals.

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Since each firm can also increase or decrease the price of its commodity by its own action, the average revenue curve of each firm slopes downwards.

It should be remembered that under perfect competition the average revenue curve of each firm is a horizontal straight line. It is so because no firm by its individual action increases or decreases the price of its commodity.

Further in the case of perfect competition and monopoly a firm under imperfect competition will come to equilibrium where its marginal revenue equals its marginal cost or where

Marginal Revenue = Marginal Cost

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Thus a firm will go on producing so long as its marginal revenue is higher than its marginal cost. It will stop increasing the scale at the point where marginal revenue and marginal costs are equal.

Short period equilibrium (or price determination):

Let us first study determination in short period. In short period there is only partial equilibrium as out of the two conditions for full equilibrium only one is possible, viz : the individual firm will be producing equilibrium output or an output where marginal cost equals marginal revenue.

The other condition viz., the existing firms will have no tendency to change their output in the short period.

Thus in short period conditions, a firm may earn abnormal profits or suffer losses. It will earn abnormal profits because in the short period, the rival firms cannot cut the prices.

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Even price cutting by rival firms does not remove their abnormal profits. Even price cutting by rival firms does not remove their abnormal profits.

As a matter of fact, nor firm would like to practise price cut method to attract the customers of the other firms. It is possible that through price-cut method, a firm might immediately attract some customers of other firms but there is the fear of retaliation.

The other firms might have to lose some of its own customers. Thus each firm hesitates to adopt price-cut method and this enables each firm to earn some abnormal profits in the short period. We illustrate a firm earning abnormal profits.

Along OX output is taken and along OY cost and revenue per unit is measured. AR and MR are short period average and marginal revenue curves of this firm AC and MC are its average cost and marginal cost curves.

This firm will come to equilibrium at point K where MR = MC (i.e. marginal revenue is equal to marginal cost).

PM is the per unit sales price of the commodity. QM is the cost of production per unit. OS is the sale price of the commodity.

PQ is the abnormal profit per unit to the firm. The total abnormal profit of the firm is illustrated by the shaded area PQRS.

Similarly in the short period, any one firm might suffer losses also. This would happen when this particular firm is having so little a share of the total demand (i.e. a very small number of customers) that its average revenue will be less than its average cost.

Thus the average cost AC will be to the left of the average revenue curve AR as illustrated in by the shaded area PQRS.

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Long period equilibrium or price determination:

In the long period there will be full equilibrium i.e. each firm will be producing equilibrium output and that there will be no tendency for the new firms to enter the industry or old ones to leave the industry.

Monopolistic competition resembles perfect competition since there is also free entry and exit of the firm from the industry.

In the long period each firm will have plenty of time to make efforts to attract the customers of its rivals. Publicity and advertisement, salesmanship are the usual devices used by each firm to attract the customers of the rival firms.

There will be an intense competition among rival firms. It is possible that any one firm has introduced some new design or packing for its commodity and has attracted some of the customers of the rival firms.

The rival firms will also copy such practices. This would increase the competition further. This competition among rival firms would increase their output and as a result of this average cost will increase and the average cost will go to the higher position (or will shift to the right).

If there are any abnormal profits, new firms will be attracted and they would share some demand with the firms already in existence.

This will shift demand curves (or average revenue curves) facing the existing firms to lower (or shift them to the left) thereby reducing their profits.

Free exit of firms from the industry signifies that no firms will earn profits less than normal profits. If any firm is earning less than normal profit, it cannot stay in the long period. Either it must improve or commit suicide.

Thus the point of full equilibrium will be reached where every firm is producing optimum output (i.e., where its MR = MC) and-earning just the normal profit.

Since each firm is earning normal profit, the competition among the firms will come to an end. The long period equilibrium is illustrated.

Along OX output is shown and along OY price and cost per unit is taken. This firm will come to equilibrium at point K and produce OM output.

It will sell it at price PM per unit and here the marginal cost is equal to its marginal revenue. The average revenue curve AR just touches the average cost curve AC at P.

This firm is now making only normal gain. The same will be the position of every other firm. This should be remembered that though different firms may be producing different amounts and charging different prices and earning different normal profits but each will have its marginal cost equal to its marginal revenue and its average revenue curve just touching the average cost curve.

Thus each firm will earn normal profit because for each firm the price is equal to its average cost.