BBA I Semester Managerial Economics Pricing Under Monopolistic Competition study Material Notes
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BBA I Semester Managerial Economics Pricing Under Monopolistic Competition study Material Notes: Meaning Price Determination of a firm under monopolistic competition Explanation Normal Profit Minimum Loss Super Normal Profit Short Run Equilibrium Long-run Equilibrium Selling costs Difference Between production costs and selling costs Differences Between monopoly and Monopolistic competition Exercises :
MCom I Semester Managerial Economics National Income Study Material Notes
PRICING UNDER MONOPOLISTIC COMPETITION
MEANING
Monopolistic competition refers to a market situation where there are many firms selling differentiated product. “There is competition which is keen, though not perfect, among many firms making very similar products.” No firm can have any perceptible influence on the price-output policies of the other sellers nor can it be influenced much by their actions. Thus monopolistic competition refers to competition among many firms selling closely related but not identical products.
Products are close substitutes with a high cross-elasticity and not perfect substitutes. Tata, Lipton tea; Dove, Lux soap; Pepsi, Coca Cola cold drinks are examples of product differentiation. Under monopolistic competition, no single firm controls more than a small portion of the total output of a product. As the products are close substitutes, a reduction in the price of a product will increase the sales of the firm but it will have little effect on the price-output conditions of other firms, each will lose only a few of its customers. Likewise, an increase in its price will reduce its demand substantially but each of its rivals will attract only a few of its customers. Therefore, the demand curve (average revenue curve) of a firm under monopolistic competition slopes downward to the right. It is elastic but not perfectly elastic within a relevant range of price at which he can sell any amount. It means that it has some control over price due to product differentiation and there are price differentials between firms. Despite this, the slope of the demand curve is determined by the general level of the market price for the differentiated product. In so far as it exercises some control over price, it resembles monopoly and since its demand curve is affected by market conditions it resembles pure competition. Such a situation is, therefore, characterised as monopolistic competition.
PRICE DETERMINATION OF A FIRM UNDER MONOPOLISTIC COMPETITION
The equilibrium of the firm under monopolistic competition follows the usual analysis in the short-run and long-run.
(a) Short-run Equilibrium
Assumptions
The short-run analysis of the firm under monopolistic competition is based on the following assumptions:
(1) that the number of sellers is large and they act independently of each other. Each is a monopolist in his own sphere;
(2) that the product of each seller is differentiated from the other products;
(3) that the firm has a determinate demand curve (AR) which is elastic;
(4) that the factor-services are in perfectly elastic supply for the production of the product in question;
(5) that the short-run cost curves of each firm differ from each other, and
(6) no new firms enter the industry.
Explanation
Given these assumptions, each firm fixes such price and output which maximizes its profits. The equilibrium price and output is determined at a point where the short-run marginal cost (SMC) equals marginal revenue (MR).
Since costs differ in the short-run, a firm with lower unit costs will be earning only normal profits. In case, it is able to cover just the average variable cost, it incurs losses.
Super-normal Profit
In Figure I the short-run marginal cost curve (SMC) cuts the MR curve at E. This equilibrium point establishes the price QA (-OP) and output OQ. As a result, the firm earns supernormal profit represented by the area PABC.
Normal Profit
Figure 2 indicates the same equilibrium points of price and output. But in this case, the firm just covers the short-run average unit cost as represented by the tangency of demand curve D and the short-run average unit cost curve SAC at A. It earns normal profit.
Minimum Loss
Figure 3 shows a situation where the firm is not able to cover its short run average unit cost and therefore incurs losses. Price set by the equal Minimum ity of SMC and MR curves at point E is QA which SMC errs only the average variable cost. The tangency of the demand curve D and the average variable cost curve at A makes it a shut-down point. If the firm lowers the price below Q4, it will have to stop further production. However, at this price the firm will incur losses equal to the area CBAP during the short-run in the hope of lowering its costs in the long-run. It is not essential that during the short-run all firms charge identical prices and produce the same quant Output tity as shown above. This is to simplify our geometrical
There being product differentiation, identity of prices and quantities cannot be expected. Each firm acts in accordance with its own short-run costs and equates its SMC curve with the MR curve. However, this does not mean that the firm fixes a very different price from the other producers. Since its product has close substitutes, its price will have to approximate to the prices of the other firms producing a similar product.
Pricing Under Monopolistic Competition
(B) Long-Run Equilibrium
In the long run, there is entry and exit of firms in a monopolistic competitive industry and the adjustment process will ultimately lead to the existence of only normal profits. This is a realistic assumption for in the long-run no firm can earn either super-normal profits or incur losses because each produces a similar product.
If firms in the monopolistic competitive industry are earning super-normal profits, new firms will be attracted into the group. With the entry of new firms, the existing market is divided among more sellers so that each firm will sell lesser quantities of the product than before. As a result, the demand curves faced by individual firms shift down to the left. At the same time, the entry of new firms will increase the demand and hence the price of factorservices which will shift the cost curves of individual firms upward. This two-way adjustment process of lowering the demand curve and raising the cost curves will squeeze out supernormal profits. Thus, each firm will be earning only normal profits in the long-run as shown in Fig. 4. In the figure, all firms are in long-run equilibrium at point E where (1) LMC = MR, and (2) LMC cuts MR from below and the LAC curve is tangent to the DIAR curve at point A. Since price QA = LAC at point A, each firm is earning normal profits and no firm has the tendency to enter or leave the industry. This long-run equilibrium analysis under monopod competition reveals that each firm and the entire industry will not produce optimum output. There will always be excess capacity. For the firms are not in a
MR position to operate their plants to the maximum capacity Output and thus enjoy the economies of large scale production fully. It is evident from Figure 4 where the point of tan gency between the demand curve DIAR and the LAC curve is not at the lowest level L. Rather L is to the right of the point of tangency A. This is because the demand curve DIAR is not horizontal but slopes downward to the right. Thus each firm under monopolistic competition has 2-9, unutilized or excess capacity even in the long-run.
SELLING COSTS
Selling costs are the expenses on advertisement, salesmanship, free sampling, free service, door-to-door canvassing, and so on. Under monopolistic competition where the product is differentiated, selling costs are essential to push up the sales. They are incurred to persuade a buyer to purchase one product in preference to another. Chamberlin defines them “as costs incurred in order to alter the position or shape of the demand curve for a product.” He regards advertisement of all types as synonymous with selling costs. But in the present day business nomenclature, the term selling costs is wider than advertising and it includes besides advertising, expenses on salesmen, allowances to sellers for window displays, free service, free sampling, premium coupons and gifts, etc.
Difference between Production Costs and Selling Costs
Since each firm has to incur selling costs under monopolistic competition, its total costs include production costs and selling costs. Production costs include all expenses incurred in making a particular product, and transporting it to its destination for consumers. They are the outlays on the services of all factor-services—land, labor, capital and organization-engaged in the manufacture of the product and also include packaging, transport and service charges. Selling costs are costs incurred to change consumer’s preferences for a particular product. They are intended to raise the demand for one product rather than another at any given price. Prof. Chamberlin distinguishes between the two in these words: “The former (production) costs create utilities in order that demands may be satisfied, the latter create and shift the demand curves themselves”. To be precise, “those which alter the demand curve for a product are selling costs and those which do not, are production costs”. In other words, those made to adapt the product to the demand are production costs and those made to adapt the demand to the product are selling costs.”
However, no clear-cut distinction can be made between production costs and selling costs. But Prof. Chamberlin himself finds a way out by confining selling costs to only advertising expenses.
Pricing Under Monopolistic Competition
Firm’s Equilibrium under Selling Costs
It is assumed that when a firm incurs selling costs (1) its demand curve shifts upward to the right; (2) the average total cost curve lies above the average production cost curve; and (3) the firm maximizes its net profits.
Since MC and MR curves are not shown in the diagram, the formula for calculating net profits is: Net Profits =(Price x Output)-(Production Costs +Selling Costs), i.e., the difference between the new demand curve and the average total cost curve multiplied by the number of units of the product sold at that price.
Suppose a firm spends Rs 1,000 on advertising its product. Every time it spends this sum of money, the demand curve for its product shifts upward to the right so that it is able to sell more than before and earns larger profits. In Figure 5, APC is the production cost curve and each time when Rs 1,000 are spent on advertising, the average total cost curve becomes AC, and AC, D (AR) is the original demand curve before selling costs are incurred and D, (AR) and D,(AR, are the new demand curves. The original equaled position is when OA product is sold at price. The firm earns TSRP super-normal profits when OA product is sold at OP price. Now, when selling costs are incurred in the first instance, the new equilibrium position brings T.S.R,P, profits by selling OB output at OP, price. Further
Output expenditure of Rs 1,000 on advertising increases
Fig. 5 profits to T,S,R,P,, when OC quantity of the product is sold at OP, price. The firm will, however, continue to spend Rs 1,000 on advertising its product each time so long as it adds more to total revenue than to total costs, till profits are maximised. If the firm spends more on advertisement beyond this level, the addition to revenue will be less than costs. The firm will lose rather than gain by increasing selling costs. In the Figure 11, the firm reaches the position of maximum profits when OC product is sold at OP, price and earns T,S,R,P, super-normal profits. Any further expenditure on an advertisement will lead to a diminution of profits.
Pricing Under Monopolistic Competition
DIFFERENCES BETWEEN PERFECT COMPETITION AND MONOPOLISTIC COMPETITION
Perfect competition and monopolistic competition have certain similarities and dissimilarities.
Similarities. The two market situations have the following points of similarities:
(1) The number of firms is large both under perfect competition and monopolistic competition
(2) In both, firms compete with each other.
(3) In both, there is freedom of entry or exit of firms.
(4) In both, the equilibrium is established at the point of equality of marginal cost and marginal revenue.
(5) In both the market situations, firms can earn super-normal profits to incur losses in the short run. But in the long run, firms earn only normal profits.
Dissimilarities. There are, however, certain points of dissimilarities between perfect competition and monopolistic competition which are discussed as under:
(1) Products. Under perfect competition, each firm produces and sells a homogeneous product so that no buyer has any preference for the product of any individual seller over others. On the other hand, there is product differentiation under monopolistic competition. Products are similar but not identical. They are close substitutes. They differ from each other in design, color, flavor, packing, etc.
(2) Price Policy. Price, under perfect competition, is determined by the forces of demand kingly for the entire industry. Every firm has to sell its product at that price. It has to output to that price. On the other hand, every firm has its own price-policy under lipstick competition. It cannot control more than a small portion of the total output of a product in a group.
(3) Demand Curve. Geometrically, the demand curve (AR) of a firm is perfectly elastic under perfect competition and the marginal revenue (MR) curve coincides with it, shown as AR= MR, in Fig. 6. But the demand curve of a firm is elastic and downward sloping under monopolistic competition, and its corresponding MR curve lies below it.
(4) Equilibrium. There are differences in the equilibrium situations between the two. When under perfect competition MC=MR, price also equals them since price P = ARE MR. This is because the AR curve is horizontal to the X-axis. Since the AR curve slopes downward to the left, the MR curve is below it under monopolistic competition. So price P = AR > MR = MC.
(5) Size. Another difference relates to their size. In the long-run, competitive firms are of the optimum size and produce to their full capacity because at its minimum point E in Figure 6. But under monopolistic competition, the firms are of less than the optimum size and possess excess capacity because the AR curve is downward sloping and cannot be tangent to the LAC curve at its minimum The equilibrium is at point E. The firm sells quantity at Q, A, price and has Q. excess capacity.
(6) Selling Costs. Another difference relates to selling costs. There is no selling problem under perfect competition where the product is homogeneous. So there are no selling costs. But under monopolistic competition where the product is differentiated, selling costs are essential to push up the sales.
(7) Price-Output. The output of the firm under monopolistic competition is smaller and price higher than under perfect competition. This is illustrated in Figure 6 where DIAR. and MR, are the average and marginal revenue curves of the firm under monopolistic competition, and AR= MR of the competitive firm. The LMC and LAC curves are assumed to be the same for both the firms. The equilibrium of the former is established at E, and that of latter at E. The firm under monopolistic competition sells og, output which is less than that of the competitive firm’s output OQ while its price Q,A, is higher than the price QE of the competitive firm.
Pricing Under Monopolistic Competition
DIFFERENCES BETWEEN MONOPOLY AND MONOPOLISTIC COMPETITION
There are certain similarities and dissimilarities between monopoly and monopolistic competition which we discuss below:
Similarities. The following are the points of similarities between the two market situations:
(1) Both in monopoly and monopolistic competition the point of equilibrium is at the equality of MC and MR and the MC curve cuts the MR curve from below.
(2) In both, the demand curve (AR) slopes downward to the right and the corresponding marginal revenue curve is below it.
(3) In both situations the equilibrium point is below the price line (AR).
(4) In both, there is excess capacity. In other words, the demand curve (AR) is not tangent to the long-run average costs curve at its minimum point.
(5) In both market situations, the producer is a price-maker. He can raise or lower the price.
Dissimilarities. There are, however, more dissimilarities than similarities in monopoly and monopolistic competition which are as under:
(1) Number of Producers. There is only one producer of a product under monopoly while there are a number of producers under monopolistic competition.
(2) Firms. There is no difference between firm and industry under monopoly. The monopoly firm is the industry. On the contrary, there are many firms in monopolistic competition and the industry is called a group.
(3) Product. Only a single product is produced under monopoly and there is no product differentiation. Under monopolistic competition every producer produces differentiated products. Products are similar but not identical.
(4) Selling Costs. There are no selling costs in monopoly because the monopolist has no competitor. However, when the monopoly firm is established, the monopolist may spend some money on advertisement to acquaint the consumers about his product. But he will spend on advertisement only once. On the other hand, due to large number of firms and existence of competition among them, expenditure on selling costs is essential under monopolistic competition.
(5) Price Policy. The monopolist can charge different prices from different customers for the same product and can adopt the policy of price discrimination. But price discrimination is not possible under monopolistic competition due to the presence of competitive element in it
(6) Demand Curve. There being no close substitutes of the product under monopoly, the demand for his product is less elastic. Therefore, the demand curve of the monopolist is steep or less elastic. But products are close substitutes under monopolistic competition. As a result, the demand for the product of every firm is more elastic and its demand curve is flat.
(7) Price Level. The monopoly price is higher than the price under monopolistic competition. Moreover, the monopolist has more freedom in fixing the price for his product than the monopolistic competitor.
(8) Entry and Exit. Firms can enter and leave the group’ under monopolistic competition in the long run because the element of competition is present in this market situation. But the monopolist has full control either over the price or the supply, therefore no firm can enter the monopoly industry.
(9) Profits. There being no fear of entry of new firms in monopoly, the monopolist earns super-normal profits even in the long run. But firms earn only normal profits in the long run under monopolistic competition because the firms can enter and leave the ‘group’.
EXERCISES
1 Distinguish between production costs and selling costs. Explain the firm’s equilibrium under selling costs.
2. Discuss and illustrate with diagrams the equilibrium of the firm and industry under monopolistic competition. What are selling costs? How these costs influence the equilibrium of the firm under monopolistic competition?
