Equilibrium Price and Output Determination under Monopolistic Competition

Short-Run Equilibrium

In short period equilibrium, the firm produces a differentiated product and attains some degree of monopoly power. In a short period, the firm does not have time to change its scale of the plant (or capacity) and no new firms will enter the product group. Now in order to maximize its profits, the monopolistically competitive firm will produce that level of output at which the marginal cost equals marginal revenue.

A monopolist determines the level of output at the point where the two conditions for profit maximization are fulfilled: a) MC = MR and b) the slope of MC > the slope of MR. Being a sole seller, the monopolist determines the price of his product on the basis of the law of demand. Thus, the demand curve (AR) of a firm slopes downwards. In perfect competition the firm is a price-taker, so only decision is a determination of output. The monopolist has to make two decisions: setting the price and his output. However, considering the downward-sloping demand curve, the two decisions are dependent on each other. The core of monopoly power is the capability to change the price of a product.

The short period equilibrium does not mean that all the firms charge the same price. Each firm seeks its own profit-maximizing position. It is not necessary that under monopolistic competition all the firms will attain abnormal profits in the short period. It is possible that some firms may take abnormal profit while at the same time others may incur losses or make normal profits only. Like other market situation, the firm under monopolistic competition has to incur certain fixed costs in the short run which are not related to the volume of the output.

A monopolist firm has to realize three possibilities when it produces any level of output at a point where two conditions are satisfied. They are:

1. If AR > AC, firm obtains excess profit.
2. If AR = AC, firm obtains normal profit.
3. If AR < AC, firm bears the loss.

Excess Profit (AR > AC)
According to the figure, the firm is in equilibrium at point E because the firm satisfies two firm equilibrium conditions (i.e. MC = MR and MC cuts MR from below, at E point).

Normal Profit (AR = AC)
According to the figure, the firm is in equilibrium at point E where two conditions are satisfied, i.e. MC = MR and MC cuts MR from below.

Thus,
Level of output (Q) = OQ
Per unit price (P) = OP = aQ
Per unit cost (C) = OC = bQ
Total Revenue (TR) = PQ = OP × OQ = Area of OPaQ
Total Cost (TC) = Area of OPaQ
Here, Area of TR = Area of TC. Thus, the firm obtains normal profit.

Losses (AR < AC)
In the figure, the firm is in equilibrium at point E, where MC = MR and MC cuts MR from below. Thus,

Here,
Level of output (Q) = OQ
Per unit price (P) = OP = aQ
Per unit cost (C) = OC = bQ
Total Revenue (TR) = PQ = OP × OQ = Area of OPaQ
Total Cost (TC) = CQ = OC × OQ = Area of OCbQ
Here, Area of TC > Area of TR. Thus, firm incurs losses shown by the area Pabc. Loss bearing firm exists in market when it recovers variable costs at prevailing price (i.e. P = AVC). Hence, point ‘a’ is shut-down point.

Long Run Equilibrium

In a long run, the monopolist has sufficient time to expand its plant size or to use its existing plant at any level, which will maximize profit. In other words, due to the availability of sufficient time, market supply can be adjusted according to change in market demand. There is a possibility for the firm earning an excess profit in the long run because entry of new firms is blocked. However, the size of his plant and the degree of utilization of any given plant size depend entirely on the market demand cost condition and market size. Long-run average cost curve and its corresponding long-run marginal cost curves present the alternative plants including various plant sizes from which the firm is to choose for operation in the long run. If the market demand for the product is enough to meet the output produced at optimal capacity by the monopolist, he obtains rational excess profit.

But if the market demand is less or if the market size is small, he operates his plant only on a sub-optimal scale and obtains less excess profit. Similarly, if the market demand is more or its size of the market is large, he operates his plant at more than optimal capacity and obtains more excess profit. In addition, the firm will function at a point on the long- run average cost curve at which the short-run average cost is tangent to it. However, the monopolist operates its plant at sub-optimal scale due to market imperfection. In this way, monopolist earns the excess profit in the long run if he satisfies the following conditions:
i) MC = MR ii) MC cuts MR from below

In the given figure, the firm is in equilibrium at point E where i) MC = MR ii) MC cuts MR from below.

Here, the area of TR (area of OPaQ) = area of TC (area of OPaQ). Thus, the firm maximizes his profit by producing the OQ level of output and will obtain normal profit. The firm operates his plant at a sub-optimal capacity. It is shown by point a where the falling part of AC cuts the Qa vertical line. Thus, the aQ position of the plant is unused capacity.

Reference

Koutosoyianis, A (1979), Modern Microeconomics, London Macmillan