Price & Output determination : Monopolistic Competition

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    As we know, under Monopolistic competition MR is not equal to AR as in case of perfect competition. So, if a firm wants to sell more units of output, it will have to lower its price per unit. That is the reason why under monopolistic competition AR and MR curves are sloping downward from left to right.

    A firm , under monopolistic competition reaches its equilibrium when produces up to that limit where its

    • Marginal cost (MC) is equal to Marginal revenue (MR) and
    • MC cuts MR from below.


    Firm’s equilibrium under monopolistic competition is studied under two different time periods:(i) Short period and (ii) Long period

    # Short period equilibrium in monopolistic competition :

    Under short run, with increase in demand ;production can be increased up to existing production capacity. There is no time to increase the fixed factors of production like machinery, building etc. The quantum of profit available to a firm in short period depends upon the demand for goods and efficiency of firm and the firm faces three situations:

    • figure_17.1Super normal profits : The fig. shows that a firm is in equilibrium at point Z and firm’s equilibrium output is OK. Price of equilibrium output is OE (=MK). The equilibrium price MK is greater than average cost LK. Hence the firm earns super normal profits i.e (MK-LK) = ML. Total super normal profits is denoted by shaded region EFML.
    • Normal profits : Here the equilibrium price OE is equal to average cost i.e OE. In this position AR curve is touching SAC at point M. Hence AR =AC and the firm earns normal profits.
    • figure_17.2Minimum loss : It is evident from the fig. that firm is in equilibrium at point Z. In equilibrium position, firm will produce OK units of output. Equilibrium price is OF and the average cost is OE (=MK). Average cost of firm is more than its price hence a firm suffers loss equivalent to MK-YK=MT. The total loss of firm is EFMT.


    # Long Period Equilibrium in Monopolistic Competition :

    Long period is a time period in which firm can change its production capacity in response to demand. A firm can change its plant and machinery  and also a new firm can enter the industry. Each firm will produce upto that limit where its MR marginal revenue is equal to its long run marginal cost. A firm under long run always earn normal profits. No firm can earn super normal profits because:

    1. If a firm earn super normal profits, new firms will be attracted and entered the industry due to free entry and exit. As a result the total supply will increase and they will be deprived of super normal profits.
    2. To create more demand new firms will lower the price of product. In order to exist in market, old firms will also lower the prices and hence both will be deprived of super normal profits.
    3. Low installation cost and free entry will attract new firms to enter the industry. Hence the increase in demand of factors will also increase its price. Thus, high average cost will cause the super normal profits to disappear.

    No firm can either incur loss in the long run because :

    1. If a firm earns losses in long run, it is better for him to shut down the business and exit the industry. Hence the total suppky of industry will fall short of total demand causing the price to rise and the firm will continue to earn normal profits.

    figure_17.3In this fig. LAC is long run average cost whereas LMC is long run marginal cost. The point of equilibrium occurs at point M. OK is the equilibrium output and OE is the equilibrium price (=TK). At equilibrium output OK, Average revenue curve is tangent to LAC at point T which means at long run, price and LAC is equal. Hence, the firm only earns NORMAL PROFITS.


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