undefined | unit 5 monopolistic competition

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UNIT 5

Monopolistic Competition

Q1) Explain monopolies meaning and characteristics

A1) 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

The firm offer highly differentiated product

Free entry and exit in the market ie no barriers

Firm can make decision independently

Customers have the preference of choosing products

Seller becomes price setter

Seller can charge marginally high price to enjoy some degree of market power

Characteristics

Product differentiation – monopolistic competition includes firms that offer similar product but are not identical. The products are differentiated not on the basis of price, but the difference includes physical aspects of the product, location from where it sells and intangible aspects of the product. The product and services perform the basic function but have difference ion quality such as type, colour, appearance, reputation, location that distinguish the product from each other. For ex, motor vehicles are same to move people from one point to another. But there are many types of motor vehicles such as car, bike, scooter.

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 customer 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.

Q2) Explain Price and output Determination under monopolistic competition

A2) 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.

Q3 )Explain product differentiation

A3) Product differentiation is the process of distinguishing a product or service from others to make it more attractive to a target market. It involves making unique position in the market by offering unique benefit to the target group. This is referred as unique selling position that makes the product stand out from the crowd.

Differentiation does not mean changing the product, but it implies creating a new advertising campaign or by changing its packaging.

Importance of product differentiation

With the increase in competition the demand is divided among the different firm in the market. Thus, it is important to make the customer understand what different the firm is offering.

The product attributes are translated into benefits

It gives the reason to the customers to purchase the products and repeat the purchase.

It increases the value of the product

It builds the brand and increase customer loyalty

To defend their price attribute-based differentiation is important for the brand

Product Differentiation Types & Factors

There are three types of product differentiation as follows

Horizontal differentiation – the products that cannot be differentiated in terms of quality refers to horizontal differentiation

For ex – mineral water brands

2. Vertical differentiation – the products are differentiated in terms of quality refers to vertical differentiation. Here it is possible to say which product is better than the other. Comparison can be easily done.

For ex – Duracell batteries are chosen by the customers because they feel it last long

3. Mixed differentiation – the products are differentiated based on numerous characteristics is known as mixed differentiation.

For ex – choosing the product from Amazon than visiting a store, because customer doesn’t want to leave the house

A product can be differentiated based on:

Price – price is the most common factor of differentiation which attracts the target group towards the products. It separates the economical product from premium product.

Features – products are differentiated based on the features like size, shape, ingredients, origin, etc. Features help the firm to make high pricing decision for the brand.

Performance and quality – a good quality product stand out from the standard quality product. Customers are ready to high price if the quality is good.

Reliability – some products are more reliable than others and they are known for their reliability. Reliability means less probability of failing within a given period of time

Looks – looks plays an important role in differentiating the product. Especially in case of luxury goods.

Channels of distribution – channel of distribution plays an important role in differentiating the product from the competition. Selective distribution strategies are used by firm to position itself as a quality brand.

Complexity – especially in technology industry, level of complexity of usage the product plays a differentiating factor for the firm.

Location – manufacturers’ location, retailer location, brands home country plays an vital role in differentiating a product from its competitors.

Marketing efforts – marketing efforts differentiate the product and give rise to the brand image. Advertising, promotion act as an add on in differentiating the products from its competitors.

After sales service – good after sales service makes the customer satisfied and have faith in the brand. It increases customer loyalty. Good after sales service differentiate the products from the others.

Advantages

Product differentiation gives a reason to the customer to choose the product over the competitors product

Product differentiation gives a reason to the company to charge high price

It allows the firm to compete in other areas other than price

It creates brand loyalty among the customers

It creates a perception in the mind of customers that there isn’t any substitute available in the market.

Q4) Explain selling cost

A4) Selling cost plays a key role in monopolistic competition and oligopoly. To promote sales the firm has to spend on advertising and publicity under these market forms. The producer not only decides about price and output, it also keeps in mind how to maximize profit.

The expenditure which is done by the company refers to selling cost. Selling cost includes salary, rent, advertisements, etc.

Definition

According to Edward H. Chamberlin, “Those costs which are made to adopt the product to the demand are costs of production; those made to adopt the demand to product are costs of selling.”

Selling costs are costs incurred in order to alter the position or shape of the demand curve for the product.” E.H. Chamberlin “Selling costs may be defined as costs necessary to persuade a buyer to buy one product rather than another or to pay from one seller rather than another.” Meyers Assumption

Selling cost is based on two assumptions

The buyer do not have much knowledge about different types of product

The taste and demand of the buyer can be changed.

Major components of selling cost

Salary and wages - salary and wages are the first component of selling cost which is paid to the workers and labourers. This is very important as there will be no product without these essential people. The payout depends on how much the firm is making profit and how much hour the workers need to put in to produce the final outcome.

2. Commission - commission are paid out of profit to the middleman. The middleman helps in marketing and promotion of the product. For example, it can be advertising agency who advertise and promote the product.

3. Rent - Another component of the selling cost is rent. It means high expenditure if the venue is located in the central location than any other location. Central location is assumed to pull more customers.

4. Advertising and promotion - advertisement is one of the big expenditure of any company. Advertising can be done through newspaper, radio, magazine, billboards, celebrity endorsements, etc. Promotions refer to the publicity that is done through pamphlets, offers, discounts, collaborations, etc.

Average selling cost-

Average selling cost is the cost per unit of a product. The curve of selling cost is U shape. The average selling cost initially falls and later it start rising. It means proportionate increase in sale is more than the increase in selling costs in the beginning. But after a point proportionate increase in sale is less than the selling cost. ASC curve will never touch X axis or it will never be zero.

Q5) Explain difference between perfect and monopolistic competition

A5)

Perfect competition – in perfect competition, there are large number of buyers and sellers, where large number of small sellers competes against each other. A single firm cannot influence the market price. So, all the firms in perfect completion are price takers.

Features

All firm only have the motive of maximize profits

All firm sell homogenous goods

No customer preferences

Free exit and entry in the market

All firms are price takers. Therefore, the firms demand curves perfectly elastic

All firm have perfect information and knowledge

2. 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.

Features

All firms maximize profit

Free entry and exit in the market ie no barriers

Firm sell differentiated products

Customers have the preference of choosing products

Seller becomes price setter

Seller can charge marginally high price to enjoy market power

Key differences between Perfect Competition vs Monopolistic Competition

A market structure where there are large number of sellers selling similar products and services to the buyers refers to perfect competition. Whereas, a market structure where there are many sellers selling close substitute of products and services to the buyer is monopolistic competition.

2. Standardised product offered in perfect competition. On the other hand, in monopolistic competition product differentiation is there.

3. In perfect competition, the price for the whole industry is determined by the demand and supply forces and every firm sell its product at the price. Whereas in monopolistic competition, every firm offer products at its own price. They are the price setter,

4. In perfect competition, entry and exit are easy as compared to monopolistic competition.

5. In perfect competition, average revenue and marginal revenue coincide with each other. Whereas average revenue is greater than marginal revenue in monopolistic competition. It means to increase sales the firm has to lower down its price

6. Perfect competition does not exist in reality. It is an imaginary situation. While Monopolistic competition exists practically.

	Perfect competition	Monopolistic competition
Number of sellers/ buyers	Many sellers and buyers	Many sellers and buyers
Types of goods and services	Homogeneous	Differentiated
Price	Price taker	Price setter
Is marketing important	Not important	Yes very important
Entry barrier	Zero entry barrier	Low entry barrier
Situation	Unrealistic, imaginary	Real, realistic
Demand curve slope	Horizontal, perfectly elastic	Downward sloping, relatively elastic
A relation between Average Revenue (AR) and Marginal Revenue (MR)	Average Revenue = Marginal Revenue	Average Revenue > Marginal Revenue.

Q6) Explain Excess capacity under monopolistic competition

A6) Excess capacity is also known as unutilised capacity. This occurs when the firm produces output less than the optimum capacity. This happens when the demand falls down. During recession the demand declines and the firm has to reduce the capacity to decrease the cost.

During excess capacity, the firm tend to decline the price of the product to move and cover the fixed cost. Under monopolistic competition, excess capacity is more defined due to the nature of the market structure.

Where:

LAC – Long-run average cost

LMC – Long-run marginal cost

AR – Average revenue

MR – Marginal revenue

OP – Price

OQ – Quantity

E – Equilibrium point

Under monopolistic competition, demand curve slope downwards and it cannot be diverging to the LAC at its minimum point. Equilibrium are reached at E, when LMC = LAC at the minimum point.

Under monopolistic competition, firms face excess capacity, as the firm will not get any incentive to produce optimum output at higher long run marginal cost ie greater than marginal revenue.

The firm under monopolistic competition gets equilibrium at point E1,where quantity produced is OQ1and at point A demand curve is tangent to LAC. OQ is the optimum output produced where LMC curve intercepts the LAC curve at its lowest point as shown in the figure. Beyond OQ1 , the firm start making losses as LMC is greater than MR. Thus, excess capacity is created as represented by Q1Q. In long run under monopolistic competition prices are higher and output is lower.

Causes of excess capacity

Downward-sloping demand curve or average revenue (AR) curve - under monopolistic competition demand curve is sloping downward which is caused due to product differentiation. While under perfect competition there is no excess capacity as the demand is perfectly elastic.

2. Entry of new firms in the industry - In short run firms earn abnormal profit which attract new entrants. As the new firm enter the market, the existing firm reduce to earning normal profits. Due to sharing of market demand, each firm produces less than its optimum capacity.

Benefits of excess capacity

Under monopolistic competition, the excess capacity is caused by product differentiation that leads to product variety and quality. This is beneficial to consumer. Excess capacity increases customer satisfaction as Consumers do not prefer homogenous products

Q7) Explain Oligopoly: Characteristics indeterminate pricing and output

A7) 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

Few firms – under oligopoly, there are few firms and the exact number of firms is not defined. Each firm produces a significant portion of the total output, so there is severe competition.

Barriers to entry – under oligopoly there are barrier to entry and thus the firm can earn super normal profits in the long run. Barriers to entry are patents, licenses, control over crucial raw materials, etc. The entry of new firms is prevented by these barriers.

Non price competition - due to the fear of price wars in Oligopoly, firms try to avoid price competition. They are dependent on non price methods such as advertising, after sales services, warranties, etc.

Interdependence - each firm is affected by the price and output decisions of rival firms since each firms hold a significant share in the total output of the industry. While determining the price and output levels, the firm takes into consideration the action and reaction of its rival firms.

Nature of product – the firm products are homogeneous or differentiated under oligopoly.

Selling cost – for large market share selling costs are highly important for competing against rival firms

No unique pattern of pricing behaviour - The firms can cooperate with each other in setting the pricing policy or they may act as competitors. The pricing behaviour depends on the firm motives. The firms can compete or cooperate with other firm which leads to different pricing situations.

Indeterminateness of the Demand Curve - Unlike other market structures, it is not possible to determine the demand curve of a firm, under Oligopoly. Under oligopoly, the demand curve is not stable and changes as per the action of rivals

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

Different behaviour patterns – the behaviour patterns differ from organisation to organisation under oligopoly. The firms can cooperate with each other in setting the pricing policy or they may act as competitors. According to Baumol, “under the circumstances a very wide variety of behaviour patterns becomes possible. Rivals may decide to get together and co-operate in the pursuit of their objectives so far as the law allows, or at the other extreme they may try to fight each other to the death.” Thus, price and output of an organisation under oligopoly differ in different behaviour patterns.

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.

Q8) Explain classical model of oligopoly

A8)

Cournot’s Duopoly model

a French economist Augustin Cournot was the first to develop a formal duopoly model in 1838.
This model is implied when firm produces homogenous goods, they compete simultaneously on market share and output, they expect any changes the firm make, in response the rivals not to change their output.
Cournot uses the example of mineral spring water. Both the firm operates at zero marginal cost. The demand curve face constant negative slope. Each seller acts on the assumption that his competitor will not react to his decision to change his and price.
The model conclude that each firm supplies one-third of the market and charges the same price. While one-third of the market remains unsupplied.
The model is criticised that the assumption zero cost of production is totally unrealistic

2. Chamberlin’s duopoly model

Chambrilin states that the firm takes into account the reaction of other firms to the firms output and price decision.

His model is based on assumption of homogeneous products, firms of equal size with identical costs, no entry by new firms and full knowledge of demand.

The single oligopolistic takes into account both the direct as well as the indirect effects of his decisions.

Each oligopolist must be aware of the marginal costs of other firms.

According to chamberlin, the recognition of reaction to an oligopolistic firm price and output decision would avert harmful competition and would result in a stable industry equilibrium with the monopoly price and monopoly output.

3. Bertrand’s Duopoly Model

A French Mathematician Bertrand, developed his own model of duopoly in 1883.

On the basis of behavioural assumption Bertrand’s model differs from Cournot’s model

Cournot assumes rival output remains constant. While under Bertrand’s model seller determines his price on the assumption that rivals price remains constant.

This model focuses on price competition

The firm thinks by marginally cutting the price with others price remain same, it can capture the entire market

The other firm also respond and price war flares up

The process of cutting the price to capture the market goes on as long as the price exceeds the marginal cost of the firm at its current sales.

4. Stakelberg’s duopoly

Under this model, each seller from his experience becomes aware of this rival reaction to his sales plan

The firm then estimates his rival’s reaction curve and then make his own calculation to choose a profit maximising output.

A firm allows his rival’s reaction in its decision making is called a leader by Stackelberg

5. Sweezy’s Kinked Demand Model:

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.

Q9) Explain kinked demand model

A9) Kinked demand curve

In oligopolistic market, the competitors change the prices/quantity of output and thus firm cannot have a fixed demand curve. The price remains 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

All firms in the industry are quite developed with or without product differentiation

All firms are selling goods on satisfactory prices

If one organisation reduces the price, then other organisation will cut the price means demand is inelastic

If one organisation increase the price and other organisation will not increase the price, then customer will shift to low priced firm . it means demand is elastic

There is always a prevailing price

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

The increase in price by a firm will make the product expensive and consumer will switch to the rivals.

Increase in price will result in fall in demand. Thus it refers to price elastic

The firm will loose revenue with increase in price because the percentage fall in demand is greater than the percentage rise in price.

Impact of price cut

The cut in price by the firm will increase the demand for the goods and would lead to rise in revenue. The firm would gain market share

Other firms will not see fall in their market share. They will also cut the price to follow the first one. Thus the firm will only see small increase in demand.

If demand is inelastic and price falls, then revenue will fall.

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.

Q10) Explain briefly price leadership

A10)

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

When the number of companies are small

Entry to the industry are restricted

Products are homogeneous

Demand is inelastic or less elastic

Types of price leadership

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

2. Dominant –

In dominant price leadership, only one organisation dominates the entire industry

It is also referred as partial monopoly.

Under this the leading firm sets the prices and the smaller firms providing same products and services adjust and match the price of the leading firm

The dominant firm use its monopoly power to maximise the profits

The dominant firm ignores the interest of other organisation

The price leader follows predatory pricing, which refers to lowering prices to levels so that smaller, competing firms find difficulty to remain in business.

3. Barometric –

Under barometric, one organisation at first declares the change in the price and assumes that other organisation will accept it.

The organisation need not to be leader of the firm and does not dominate others.

Barometric leader have less power to impose its decision on the other firms

Organisation which lacks capacity to estimate appropriate supply and demand conditions they follow the price changes made by barometric leaders

Barometric leader is preferred as one organisation is not the only leader.

4. Collusive

Collusive leadership is an agreement between the dominant firms to keep their prices in mutual alignment.

This type of leadership is used in industry where the entry cost is high and cost of production is known.

Smaller firms follow the price change effectively.

It is done to avoid competition

This involves illegal agreement to disrupt the market equilibrium and gain unfair market advantage.

The firm collude to avoid uncertainties and maximise the joint profit.

Advantages

It can secure high profit margin for the company

Pricing strategies improves the market share of the company for a specific products and services

The price leaders control the price of the goods and services, which makes difficult for other rivals to enter the market as disruptors

Leads to price stability avoiding price wars to an extent

Small firms lack sufficient knowledge into the principle of costing. They can utilize the big firm’s costing department by being price followers

Disadvantages

The price leaders find difficulty to assess the reactions of followers.

Leads to malpractices like the rival firm charging lower prices as compared to the price set by the price leaders

Rival firm follow non price competition in the form of aggressive promotion strategies.

Problem arises if there are differences in cost of price leaders and price followers. Price leader will fix lower price if cost of production is less. This will result in loss of price follower if his cost of production is more.

Q11) Explain collusive oligopoly

A11)

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

Formal collusion – A formal agreement made between the firms to stick to high prices. This involves the creation of a cartel. The most famous cartel agreement is OPEC. OPEC control over the world petroleum market. It is also referred as two or more firms within the same industry formally agree to control the market. Such formal agreement is kept highly secret.

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.

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

High price to consumer which result in decline in consumer surplus and allocative inefficiency

It act as a barrier to entry. New firms are discouraged to enter the market.

Collusion leads to easy profit which can make the firm lazy and avoid innovation to increase productivity.

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