Equilibrium under Monopolistic Competition

Before determining a firm’s equilibrium under Monopolistic Competition, it is important to note that there are two possible demand curves – both sloping downwards. In this article, we will look at a firm’s short-run and long-run equilibrium under Monopolistic Competition.

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Equilibrium under Monopolistic Competition

The two types of demand curves of a firm under monopolistic competition are due to the following reasons:

• When a firm revises the price of its product, the rival firms don’t always increase the prices of their products too. Therefore, the demand curve has a smaller slope and the demand for the product is more elastic.
• If the rival firms follow the price revision by the first firm, then the demand for its product becomes less elastic. In such cases, the firm needs to slash its prices further to achieve an increase in demand. In this case, the demand curve has a steeper slope.

A Firm’s Short-Run Equilibrium under Monopolistic Competition

Under Monopolistic Competition, the revenue curves are downward sloping (like under Monopoly). This is because, in order to sell more, the firm has to decrease the price.

A firm under Monopolistic Competition can either earn normal profits, super-normal profits, or incur losses. Also, like under Monopoly, a firm earns super-normal profits if the demand for its product is very high.

Also, in the short-run, new firms cannot enter the group and enhance the supply of the product group. Therefore, they cannot compete away the super-normal profits of the firm. Also, in the short-run, a firm faces certain fixed costs. These can include production as well as selling costs.

In the figure above, you can see that the AR and MR curves of the firm have negative slopes. Further, the AVC curve includes the production costs as well as the variable components of selling expenses. Furthermore.

The MC curve cuts the AVC curve at its lowest point. Also, the ATC curve represents the average of the total cost of the firm including the fixed selling expenses.

The MC curve intersects the MR curve from below at point I. Hence, the firm decides to produce a quantity of OM and charge a price of EM per unit.

By doing so, the firm earns a profit of EK per unit and the entry of rival firms do not compete it out. However, based on the relative location of the cost and revenue curves, it is possible that the firm is in equilibrium with:

• Only normal profit
• Covering a part of fixed costs. Therefore, incurring a loss less than its fixed costs
• Loss equal to the fixed costs (where AR is tangent to the AVC curve)

Group Equilibrium

Group equilibrium is the simultaneous equilibrium of all the firms in the group. We know that the cost and demand conditions of individual firms differ from each other.

Further, they produce differentiated products making it impossible to derive demand and supply curves for the group as a whole.

Chamberlin assumed that all firms in the group have identical demand and cost conditions. Therefore, when in equilibrium, all firms produce the same quantities of their respective products and sell them at the same prices.

This, however, is a little unrealistic assumption. For all practical purposes, it is important to determine a firm’s equilibrium under Monopolistic Competiton individually.

A Firm’s Long-Run Equilibrium under Monopolistic Competition

To discuss a firm’s long-run equilibrium under Monopolistic Competition, it is important to remember the following points:

• There are no fixed costs in the long-run. The firm can vary its inputs as well as its selling costs. Further, the firm can choose between various product qualities.
• There is no compulsion on a firm to operate at a loss. It can leave the industry whenever it wants. When a firm leaves the industry, the absolute market shares of the remaining firms, increase. Further, their demand curve shifts right and upwards. This continues until other firms can produce without incurring a loss.
• On the other hand, if the demand is so strong that the existing firms make super-normal profits, then new firms can enter the group.
• They produce close substitutes of the existing products and increase the total product supply. Therefore, the demand shares of the existing firms reduce. Hence, the demand curve of a firm cannot stay above its long-run average cost curve.
• All firms operating under Monopolistic Competition can make a choice between combinations of:
  • Product quality
  • Product Differentiation
  • Selling costs
• A firm must consider the fact that any variation of price on its part can attract a reaction from its rivals. Therefore, it faces a much steeper demand curve.

Therefore, under Monopolistic Competition, a firm is exposed to constant interaction with the rest of the firms in the group. Its decisions are not independent of the decisions of the other firms.

Further, the firm’s demand curve depends on its actions AS WELL AS on the actions of its rivals. Therefore, it must consider different combinations of its cost components pertaining to the product quality and its selling expenses, etc. This helps the firm estimate the slope and position of the demand curve.

Graphical Representation

Let’s say that the LAC curve in Fig. I represent the product quality and selling expenses that a firm selects. This has a corresponding long-term MC curve (LMC) which intersects the MR curve from below at point I.

Therefore, the firm decides to produce a quantity of OM and sell it a per unit price of EM. This gets a profit of EK per unit. However, soon new firms enter the market and start offering close substitutes and bring the profit down.

Therefore, there is a reduction in the market shares of the existing firms. The firm’s AR curve shifts left until it becomes tangent to the LAC curve at point E as shown in Fig. ii. This ensures that the firm earns only normal profit. Once this stage is reached, there is no incentive for new firms to enter the market.

This results in the firm’s long-term equilibrium under Monopolistic Competition. The equilibrium is given by the point of tangency between the firm’s AR curve and LAC curve, which is at point E in Fig. ii. Therefore, in the long-run, under monopolistic competition, firms earn only normal profits.

Solved Question – Equilibrium under Monopolistic Competition

Q1. Why does a firm have two types of demand curves under Monopolistic Competition?

Answer: Under Monopolistic Competition, a firm has two types of demand curves due to the following reasons:

• When a firm revises the price of its product, the rival firms don’t always increase the prices of their products too. Therefore, the demand curve has a smaller slope and the demand for the product is more elastic.
• If the rival firms follow the price revision by the first firm, then the demand for its product becomes less elastic. In such cases, the firm needs to slash its prices further to achieve an increase in demand. In this case, the demand curve has a steeper slope.