Price Determination Under Monopolistic Competition

            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 or 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. 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 unlike 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

Thus a firm will go on producing 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.

 

Let us first study price 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 firm 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. Even price-cutting by rival firms does not remove their abnormal profits. As a matter of fact, no firm would like to practice price cut method to attract the customers of the other firms. It is possible that through price-cut method, 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 it’s 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 in Fig.

  1. In Fig.  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 profits per unit to the firm. The total abnormal profit of the firm is illustrated in Fig. (1) 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 Fig. (2) The total loss of the firm is represented in fig. (2) by the shaded area PQRS.

5 thoughts on “Price Determination Under Monopolistic Competition”

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