Monopolistic Competition and Price Taker Demand - Case Study Example

Monopolistic Competition Before 1933, the price analysis was studied under two market models Perfect Competition and (2) Monopoly. In perfect competition model, it was assumed that there was large number of firms producing homogenous product. In the case of monopoly, there was only one seller of a product. Both these models were thus polar extremes and were considered satisfactory for the market price analysis in economic theory. In the year 1933, Mrs. Joan Robinson of Cambridge University in England and Edward Chamberlin of Harvard University in America introduced a third market model. It was called Imperfect Competition by Mrs. J. Robinson and Monopolistic Competition by Chamberlin. The third market model called monopolistic competition or imperfect competition contains larger elements “of competitive model and a fewer elements of monopoly model. It is thus a hybrid of monopoly and competition. Monopolistic Competition Monopolistic competition as the name signifies is a blend of monopoly and competition. It is systematic and realistic theory of price analysis in this imperfectly competitive world (Begg). Monopolistic competition is a market situation in which there are relatively large numbers of small firms which produce or sell similar but not identical commodities to the customers. For example, a firm supplies branded good ‘Lux Soap’ in the market. There are many other firms in the market which sell similar soaps (not identical) with different brand names like Rexona, Palm Rose, etc. the firm supplying ‘Lux Soap’ enjoys a monopoly position over the sales of its own product. It also faces competition from the firms selling similar products. Same is the case with many other firms in the market like plywood manufacturing, Jewellery making, wood furniture. Book stores, departmental stores, repair services of all kinds, professional services of doctors, technologies, etc. these firms and others which have an element of monopoly power and also face competition over the sale of product or service in the market and called monopolistically competitive firms. According to Leftwitch, “Monopolistic competition is a market situation in which there are many sellers of a particular product, but the product of each seller is in some way differentiated in the minds of consumers from the product of every other seller”. In the words of J.S. Bain, “Monopolistic competition is found in the industry where there is large number of small sellers selling differentiated but close substitute products.” (Begg) In case the number of firms is small and the action taken by one firm is followed by rival firms in the market, it is then to be studied within a separate framework of monopolistic competition called Oligopoly. According to Chamberlin, if all the firms produce identical goods, they can be easily categorized and called an industry. In case, the number of firms is fairly large say 20, 40, 60 and they produce some what similar goods, it is then useful to group these firms together and call them a product group of industry. Characteristics of Monopolistic Competition The main characteristics or features of Monopolistic competition are as under:- 1. A fairly large number of sellers The number of firms in Monopolistic competition is fairly large. Each firm produces or sells a close substitute for the product of other firms in the product group or industry. Product differentiation is thus the hallmark of the Monopolistic competition (Graham). 2. Differentiation in products Under the Monopolistic competition, the firms sell differentiated products. Product differentiation may be real or imaginary. Real differentiation is done through differences in the materials used, design, color etc. Imaginary differences may be created through advertisement, brand name, trade marks etc. The firms producing similar products in this imperfectly competitive world cannot raise the price of product much higher than their rivals. If they do so, they will lose much of their sale, but not all the sale. In case, they lower the price, the total sale can be increased to certain extent. How much will the sale increase or decrease by lowering or raising the price will depend upon the product differentiation of the different firms. (Graham) If the product of various firms are very close substitutes of one another and no imaginary or real difference exists in the mind of the buyers, then a slight rise or fall in the price of the product of one firm will appreciably decrease of increase the demand for the product. If the product of one firm differs from that of other firm, (though the difference may be an imaginary one) a slight rise in the price of the product of one firm will not drive away all its customers. A few faithless buyers may be attracted by the low price of the other rival product but not all the buyers. 3. Advertisement and propaganda Another very important characteristic of the Monopolistic competition is that each firm tries to create difference in its product from the other by advertising, propaganda, attractive packing, nice smile, etc. When it succeeds in its object, the firm occupies almost the position of a monopolist. It is, thus, in a position to raise the price of the product without losing its customers. 4. Nature of demand curve Since the existence of close substitutes limits the monopoly power, the demand curve faced by a monopolistically competitive firm is fairly elastic. The precise degree of elasticity will however, depend upon the number of firms in the group product or industry. If the number of firms is fairly large and the product of each firm is not very similar, the demand curve of a firm will be quite elastic. In case, there is close competition among the rival firms for the sale of similar products, the demand curve of a firm will be less elastic. 5. Freedom of entry and exit of firms The entry of new firms in the monopolistically competition industry is relatively easy. There are no barriers of new firms to enter the product group or leave the industry in the long run. 6. Sales efforts With heterogeneous products, the sale of the products by the firms can no longer be taken for granted. Sale depends upon sale efforts. 7. Non-price competition In Monopolistic competition, the firms make every effort to win over the customers. Other than price cutting, the firms may offer after sales service, a gift scheme, discount not declared in the price list etc. The monopolist’s demand curve Under perfect competition, the demand curve which an individual seller has to face is perfectly elastic, i.e. it runs parallel to the base axis. The competitive seller being unable to affect the market price sells its output at the prevailing market price. Hence marginal revenue equals the price of the product. The average-revenue is identical to its marginal revenue. Thus under perfect competition MR=AR=Price and the three curves coincide and are perfectly elastic. This is, however, not the case under monopoly. The monopolist is the sole supplier of a product in the market. He has full powers to make decisions about the pricing of his product. He is a price taker. If he lowers the unit price of his product, his’ sale is increased, if he raises the price, he will not lose his entire sale (Lawrence). The demand curve is facing the monopolist thus slope downward from left to right. As the monopolist’s demand curve is negatively sloped, the marginal revenue is here no longer equal to price or average revenue. It is less than the price (AR) at every level of output, except the first. The relation between marginal revenue and average revenue is explained with the help of a schedule and a diagram. Price per meter Quality output Total revenue Marginal Average revenue USD USD USD USD 100 1 100 100 100 80 2 160 60 80 60 3 180 20 60 45 4 180 0 45 35 5 175 -5 35 In the above schedule, it is shown that as the monopolist lowers the price of his product from 100 USD to 80 USD in specified period of time, the sale increase from one unit to two units. The total revenue resulting from the sale of one more unit increases by 50 USD; whereas the additional unit has been sold for 80 USD. The reason for the total revenue not to increase by the same amount is that the price has been reduced for increasing the sale of extra units. The price cut is applied to two units of output sold and not to the additional unit alone. Same is the case with the third, fourth and fifth units sold. The marginal revenue is less than the price (AR) for all the units of commodity disposed off in the market. MR= ▲TR/▲Q 100 80 A 60 C 40 D 20 AR demand 0 1 2 3 4 5 6 As the marginal revenue is always less than the price, the marginal revenue curve, therefore, remains below the average revenue curve or demand curve as is illustrated in the above diagram. The demand curve which also represents the average revenue curve has a downward slope. The demand curve is downward sloping because the monopolist can sell greater output only by reducing the price of units of output. The marginal revenue curve of the monopolist always lies below the demand curve because the marginal revenue from sale of additional unit of output is less than its price (Krugman). A question can be asked; can a Price Taker charge very high price for his product? The answer to this question is not a difficult one; when a Price Taker has to determine the price of his product, he has two options before him. He may either fix the price of the commodity arbitrarily or put it in the market for sale or he may place the output in market and allow the price to be determined by the conditions of demand and supply. The price taker will adopt that course which gives him maximum net profits. If the demand for the product of a price taker is less elastic, then he is in a happy position and can fix a higher price than what he can get in a competitive market. In case, the demand for his product is more elastic, then it is in the interest of price taker to charger lower price and increases his sale. On the side of supply, if the product of a monopolist is subject to law of increasing return, then he can push his sale by lowering the price. If the commodity is subject to law of diminishing return, then he should restrict the output and fix a higher price for his output. The monopolist cannot charge very high price for his product due to the following reasons:- 1. Entry of new firms If a monopolist charges high price for his product, the new firms, lured by higher profits will creep into the field and the very positions of the monopolist will then be in danger. 2. Availability of substitutes There are very few commodities in the world for which substitutes are not available. If the monopolist charges higher price, the consumer will take to its substitutes. The monopolist, being afraid of the use of substitutes fixes a reasonable price of his product. 3. Fear of state intervention The price fixed by the monopolist for the commodities may also be not very high due to the fear of state intervention. The state, in the interest of the consumers, may fix a maximum price for the product of the monopolist or may undertake to supply the commodity itself. The fear of the state intervention forces the monopolist not to charge very high price for the product. Work Cited Begg, David. Economics. London: McGrew-Hill, 1997. Dawson, Graham. Economics and Economic Change. London: FT Prentice Hall, 2006. Gitman, J. Lawrence. Principles of managerial finance. London: McGrew-Hill, 1998. Paul R. Krugman. International Economics: Theory and Policy. New York: Addison Wesley, 2002. Read More