Pricing under Monopolistic Competition
In monopolistic competition, the market has features of both perfect competition and monopoly. A monopolistic competition is more common than pure competition or pure monopoly. In this article, we will understand monopolistic competition and look at the features, price-output determination, and conditions for equilibrium.
In order to understand monopolistic competition, let’s look at the market for soaps and detergents in India. There are many well-known brands like Lux, Rexona, Dettol, Dove, Pears, etc. in this segment.
Since all manufacturers produce soaps, it appears to be an example of perfect competition. However, on close scrutiny, we find that each seller varies the product slightly to make it different from its competitors.
Hence, Lux focuses on making beauty soaps, Liril on freshness, Dettol on antiseptic properties, Dove on smooth skin, etc. This allows each seller to attract buyers to itself based on some factor other than price.
This market has a mix of both perfect competition and monopoly and is a classic example of monopolistic competition.
Features of Monopolistic Competition
(i) Large number of sellers
In a market with monopolistic competition, there are a large number of sellers who have a small share of the market.
(ii) Product differentiation
In monopolistic competition, all brands try to create product differentiation to add an element of monopoly over the competing products. This ensures that the product offered by the brand does not have a perfect substitute. Therefore, the manufacturer can raise the price of the product without having to worry about losing all its customers to other brands. However, in such a market, while all brands are not perfect substitutes, they are close substitutes for each other. Hence, the seller might lose at least some customers to his competitors.
(iii) Freedom of entry or exit
Like in perfect competition, firms can enter and exit the market freely.
(iv) Non-price competition
In monopolistic competition, sellers compete on factors other than price. These factors include aggressive advertising, product development, better distribution, after sale services, etc. Sellers don’t cut the price of their products but incur high costs for the promotion of their goods. If the firms indulge in price-wars, which is the possibility under perfect competition, some firms might get thrown out of the market.
Price-output determination under Monopolistic Competition: Equilibrium of a firm
In monopolistic competition, since the product is differentiated between firms, each firm does not have a perfectly elastic demand for its products. In such a market, all firms determine the price of their own products. Therefore, it faces a downward sloping demand curve. Overall, we can say that the elasticity of demand increases as the differentiation between products decreases.
Fig. above depicts a firm facing a downward sloping, but flat demand curve. It also has a U-shaped short-run cost curve.
Conditions for the Equilibrium of an individual firm
The conditions for price-output determination and equilibrium of an individual firm are as follows:
(a) MC = MR
(b) The MC curve cuts the MR curve from below.
In Fig., we can see that the MC curve cuts the MR curve at point E. At this point,
- Equilibrium price = OP and
- Equilibrium output = OQ
Now, since the per unit cost is BQ, we have
- Per unit super-normal profit (price-cost) = AB or PC.
- Total super-normal profit = APCB
The following figure depicts a firm earning losses in the short-run.
From Fig., we can see that the per unit cost is higher than the price of the firm. Therefore,
- AQ > OP (or BQ)
- Loss per unit = AQ – BQ = AB
- Total losses = ACPB
If firms in a monopolistic competition earn super-normal profits in the short-run, then new firms will have an incentive to enter the industry. As these firms enter, the profits per firm decrease as the total demand gets shared between a larger number of firms. This continues until all firms earn only normal profits. Therefore, in the long-run, firms, in such a market, earn only normal profits.
As we can see in Fig. above, the average revenue (AR) curve touches the average cost (ATC) curve at point X. This corresponds to quantity Q1 and price P1. Now, at equilibrium (MC = MR), all super-normal profits are zero since the average revenue = average costs. Therefore, all firms earn zero super-normal profits or earn only normal profits.
It is important to note that in the long-run, a firm is in an equilibrium position having excess capacity. In simple words, it produces a lower quantity than its full capacity. From Fig. above, we can see that the firm can increase its output from Q1 to Q2 and reduce average costs. However, it does not do so because it reduces the average revenue more than the average costs. Hence, we can conclude that in monopolistic competition, firms do not operate optimally. There always exists an excess capacity of production with each firm.
In case of losses in the short-run, the firms making a loss will exit from the market. This continues until the remaining firms make normal profits only.