5.1 Monopolistic Competition and Oligopoly: Monopolistic competition price and output decision- equilibrium. Monopolistic competition and economic efficiency oligopoly and interdependence

Monopolistic competition

In Monopolistic competition there are large numbers of buyers and sellers which do not sell homogenous product unlike perfect competition. This is more realistic in the real world. Monopolistic competition occurs when an industry in which many firms selling products that are similar but not identical.

Monopolistic competitions try to differentiate its product. Thus it is closely related to business strategy of brand differentiation. In monopolistic competition heavy advertising and marketing is common among firms.

Monopolistic competition combines element of both monopoly and perfect competition. All firms in monopolistic competition relatively have low market power and they are all market makers.

Monopolistic competitive market

Characteristics

2.   Many firms – there are many firms in each product group. A product group is a "collection of similar products". Under monopolistic market, each firms has a small market share.  This gives each firm a freedom to set price and each firm action have negligible impact on the market. A firm can cut the price to increase sale without any fear. As its action will not prompt retaliatory responses from competitors.

3.   Freedom of entry and exit - Like perfect competition, under monopolistic competition the firms can freely enter or exit. When the existing firms makes super-normal profits, then new firms will enter. The entry of new firms leads to increase the supply of goods and services and this would reduce the price and thus the existing firms will be left only with normal profits. Similarly, if the existing firms are incurring losses, some of the firms will exit. This will reduce the supply which result decrease in price and the existing firms will be left only with normal profit.

4.   Independent decision making – under monopolistic market, each firm can independently sets the terms and conditions of exchange for its product. The firm does not consider how their decision will have impact on competitors. In other words, each firm feels free to set prices and prompting heightened competition.

5.   Market power – under monopolistic competition, the firms have low degree of market power. Market power means that the firm has control over the terms and conditions of exchange for its product. All firms under monopolistic competition are price makers. A firm can raise the prices of products and services without losing all its customers base. The firm can also lower prices without any effect on the competitors. Since the firm have relatively low market power, there is no barrier to entry.

Price and output determination under monopolistic competition

Under monopolistic competition a firm can some extent independently control the supply and price of the product. The demand curve is stable and slightly downward slope

A monopolistic competitor creates output at which the marginal cost is equal to marginal revenue. The price is greater than marginal cost.

Short run

In short run, the firm attains its equilibrium where marginal revenue equals marginal cost and the price is set according to its demand curve. Thus when MR=MC, profits are maximized

In the above fig,

AR is the average revenue curve,

MR represents the marginal revenue curve,

SAC curve represents the short run average cost curve,

SMC signifies the short run marginal cost.

In the above figure we can see that at output OM, MR intersects SMC. Here  price is OP’ (which is equal to MP). Thus P is the point on AR curve, which is price. PT is the supper normal profit per unit output, is the difference between the average revenue and average cost.

Long run

In the long run due to the possibility of new firms entering the industry the price under monopolistic competition becomes equal to long-run average cost giving only normal profits. So, no firm under monopolistic competition can make excess profit or loss in the long run.

When the new firm start supplying , the price would fall. Thus the AR curve shifts from right to left and supernormal profits are replaced with normal profits. The long run equilibrium is achieved when average revenue is equal to average cost.

In the above fig we can see that, at pointP, AR curve touches the average cost curve (LAC) as a tangent. P is the equilibrium at price MP and output OM.

At MP average cost is equal to average revenue. Therefore, in long run, the profit is normal. The conditions (MR=MC and AR=AC) result in attaining equilibrium in long run.

Monopolistic competition and economic efficiency:

Product differentiations

Chamberlin has defined product differentiation in the following words: “A general class of product is differentiated if any significant basis exists for distinguishing the goods (or services) of one seller from those of others. Such a basis may be real or fancied, so long as it is of any importance whatever to buyers, and leads to a preference for one variety of the product over another.... Differentiation may be based upon certain characteristics of the product itself, such as exclusive patented features, trademarks, trade names, peculiarities of the package or container, if any, or singularity in quality, design, colour or style. It may also exist with respect to the conditions surrounding its sales. In retail trade, these conditions include such factors as the convenience of the seller’s location, the general tone or character of his establishment, his way of doing business, his reputation for fair dealing, courtesy, efficiency, and all the personal links which attach his customers either to himself or to those employed by him.” So far as these and other tangible and intangible factors create consumers’ preference for one product over the others, the products are virtually differentiated.

Thus, product differentiation is primarily intended to make consumers distinguish the product of one producer from that of the other producers in the industry. When the consumers are able to distinguish one product from the others, they may develop a preference or brand loyalty for one product over the others. Once preference for a product is created, it alters the course of demand curve for the product. In the ultimate analysis, product differentiation leads to a change in demand curve for the product from a horizontal demand line (as under pure competition) to a downward sloping demand curve. The downward sloping demand curve enables the sellers to exercise some discretion in determining the price of his product.

Oligopoly and interdependence

The term oligopoly has been derived from Greek words, ‘oligoi’ means few and ‘poly’ means control. Oligopoly refers to a market structure in which few sellers control the market. These sellers deal with either homogenous or differentiated products.

Oligopoly is also called ‘competition among the few’. Under oligopoly, the industry are dominated by few sellers in the market, every seller influence the behavior of other firm.

In oligopoly there are small numbers of firms in the market. As per the norms, oligopoly consist of 3 -5 dominant firms. The firms can compete with each other or collaborate to earn more profits. Here the buyers are more than the sellers. Some of the examples are automobiles, cement, steel, aluminum, etc.

Characteristics

The main reasons for indeterminate price and output under oligopoly are as follows:

2.   Intermediate demand curve - due to different behaviour patterns of organizations, the demand curve is unknown under oligopoly. Every firm observe the action of the rivals and make strategies accordingly. Under oligopoly, the demand curve is not stable and changes as per the action of rivals. According to Baumol, “the firm’s attempts to outguess one another are then likely to lead to interplay of anticipated strategies and counter strategies which is tangled beyond hope of direct analysis.”

3.   Non profit motive – non profit motive implies, organisation not only aims at maximising profit, it also competes for non profit motive. Under oligopoly, these motives lead to indeterminate price and output. For ex, to promote sales firm uses advertisement and other tools.

Kinked demand model

In oligopolistic market, the competitors change the prices/quantity of output and thus firm cannot have a fixed demand curve. The price remain inflexible for a long time. American economist Sweezy  in 1939 came up with the kinked demand curve to explain the behaviour of oligopolistic organizations.

A kinked demand curve occurs when the demand curve is not a straight line but due to higher and lower prices, it has a different elasticity ie elastic and inelastic.

Assumption of kinked demand curve model

The following figure shows a kinked demand curve dD with a kink at point P.

From the above fig, we can see that at price P, the firm produces and sell output at OM. The upper segment dP of the demand curve dD is elastic as the price rises the demand falls. The lower segment PD of the demand curve dD is relatively inelastic as the price falls, demand for the product increases.

This model suggest that price are rigid and with the increase or decrease in price the firm will face different affects. The kink in the demand curve is due to the behaviour of rival firms to the increase or decrease in price

Impact of price rise

Impact of price cut

Example of kinked demand curve

The market of petrol is homogenous and consumers are price sensitive. If one petrol pump increases the price, consumer will shift to other petrol station. If one petrol station will cut the price, the other station will also follow and cut the price.

Collusive oligopoly

Collusion occurs when the rival firms agree to work together. They together set high price in order to make greater profits. Collusion refers to making higher profit in the expense of the consumer and reduces the competition in the market. Collusion is an agreement to seek higher price.

Definition

According to Samuelson, “Collusion denotes a situation in which two or more firms jointly set that prices or output, divide the market among them, or make other business decisions.”

In the words of Thomas J. Webster, “Collusion represents a formal agreement among firms in an oligopolistic industry to restrict competition to increase industry profits.”

In the above figure we can see that when the industry is competitive quantity Q is given at price P1. As the firm collude, the price increase to P2 and quantity reduced to Q2. Thus the firm earns super normal profit.

Types of collusion

2.   Tacit collusion – it is also referred as implicit collusion. This happens when two or more firms within the same industry informally agree to control the market.

3.   Price leadership - Price leadership occurs when a firm leading in a given industry and can effectively determines the price of goods and services for the entire market. This type of firm is referred as price leaders. Price leadership is “situation in which a market leader sets the price of a product or services and competitors feel compelled to match that price”

Problems of collusion

Collusion is regulated by the government as it is seen bad for consumers and economic welfare. Collusion can lead to

Price leadership

Price leadership occurs when a firm leading in a given industry and can effectively determines the price of goods and services for the entire market. This type of firm is referred as price leaders.

Price leadership is “situation in which a market leader sets the price of a product or services and competitors feel compelled to match that price”

A dominant company sets the price and other firms with little choice have to follow its leads and adjust the price to match the price of the leading firm to hold their market share. Large firms commonly use price leadership as a strategy.

Effective leadership works under following conditions

Types of price leadership

There are three types of price leadership which includes barometric, collusive, and dominant.

2.   Barometric –

3.   Collusive

Advantages

Disadvantages

Key takeaways –

Sources