Question

Exercise Problem 1 :

1. How can the firm in monopolistic market be as a price setter?
2. “The monopolistic market is a market in between monopoly and perfect competition”. What does the statement mean?
3. How to set the Price and Quantity that maximize the profit in every type of market? Compare how to set them by using graph under monopoly and perfect competition!

Answer 1

a) Under a monopolistic competition, firms are price makers because they exercise product differentiation. The product that each firm sells have more or less the same usage but they are differentiated by :

· Physical features, such as shape, size, color, design.

· Marketing techniques in the form of different advertising, branding and packaging

· Technological Advancement where some firms may use better technology or highly skilled labor to producer their goods as compared to the other firms.

· Mode of Selling where in some firms sell products through online channels and some sell in their physical retail stores.

Thus each firm under a monopolistic competition produces a unique product and charges a price as per their own benefit, i.e. they can charge a higher or a lower price than its rival firms based upon the above differentiation factors. For E.g. one firm might sacrifice its higher profit margins by charging a lower price but would gain in terms of higher sales revenue. Whereas another firm would decide to raise its price of product by spending more on its advertising and branding, that would induce higher sales. So we can say that under monopolistic competition firms are price makers or price setters.

b) Perfect competition and monopoly are two extreme branches of any market structure. A monopolistic competition has a mix of features from both the perfect competition and from monopoly structure.

· As explained above, all firms under monopolistic competition can differentiate their products and charge different prices (other than its rival firms). Here each firm acts as mini-monopoly and faces a down-ward sloping demand curve. This implies that just as in monopoly, here too firms have market power and they can increase their price without losing all business. Thus just like a monopoly, here too markets are inefficient because the price charged is higher than the marginal cost that decreases the consumer surplus in the short run and crates deadweight loss.

· Just like in perfect competition, under monopolistic completion too there are large number of buyers and sellers who compete with each other, but majorly on non-pricing factors. There is no barrier to entry and exit. This is because the more differentiated the products are the more consumers find them to be unique, which gives a competitive advantage to each firm in their products. Thus, competition highly depends upon factors which differentiate the product and not on price. So firms can easily move in and out of the market. Just like in perfect competition, firms here earn supernormal profits or incur losses in the short-run, but in the long run each firm only earns normal or breakeven profits.

Thus we can say, the monopolistic market is a market in between monopoly and perfect competition.

c) In every market structure, any firm can earn a profit as long as its marginal revenue from producing an additional unit of output is higher than the marginal cost of producing that additional unit. Thus a firm maximizes its profit by producing up till that point where its Marginal revenue is exactly equal to its marginal cost. If a firm tries to produce more or charge a price where the marginal cost of production is higher than the marginal revenue, it starts incurring losses.

Thus profit maximizing condition is given by: MR = MC

Under Perfect Competition: Refer to Figure (a) – Here X-axis shows the quantity and Y-axis shows the price and costs. A perfectly competitive firm is a price takers which set the price determine by the market. Thus the market demand is perfectly elastic such that, the demand curve is horizontally flat where Price = AR = MR = Demand. Since the price remains constant, all of these curve i.e. MR, AR and Demand curve remains the same. As far as the marginal cost is concerned, it is a typical U-shaped curve which exhibits diminishing returns to input. Given the profit maximizing condition, the MC curve cuts MR curve at point Ec, where equilibrium or the profit maximizing level of quantity is Qc and prices are Pc. If any price higher than Pc is charged, it would make the quantity demand for this firm equal to zero. Also, if any quantity higher than Qc is produced, the firm would incur losses because there MC>MR. The profits earned by the competitive firm is given by the shaded area ABCEc, here total revenue (TR = Pc X Qc) is greater than total cost (TC = ATC X Qc).

Under Monopoly: Refer to Figure (b) – Here X-axis shows the quantity and Y-axis shows the price and costs. For a monopolist, the market demand curve is its own demand curve which is downward sloping. It indicates, in order to sell more a monopolist not have to lower the price of additnal unit produced but have to lower the price of all units of goods produced. Due this, the marginal revenue is less than the demand and MR curve fall below the demand curve. The monopolist too faces a typical U-shaped curve which exhibits diminishing returns to input. Given the profit maximizing condition, the MC curve cuts MR curve at point Em, where equilibrium or the profit maximizing level of quantity is Qm and prices are Pm (on the demand curve). If any price higher than Pm is charged, it would lose business by selling lower quantity. Also, if any quantity higher than Qc is produced, the firm would incur losses because there MC>MR. The profits earned by the competitive firm is given by the shaded area PQRS, here total revenue (TR = Pm X Qm) is greater than total cost (TC = ATC X Qm).