Q. Describe monopolistic and oligopoly competition. Explain the concept of the pricing decisions under monopolistic competition in short run as well as long run.
Monopolistic
competition and oligopoly are two important market structures in economics.
They fall between perfect competition and monopoly, each having distinct
characteristics that influence the behavior of firms operating within them,
particularly regarding pricing decisions.
Monopolistic Competition
Monopolistic competition is a market structure characterized
by many firms selling differentiated products. While these products are similar
to one another, they are not identical, which allows firms to have some degree
of market power. This product differentiation could be based on quality,
branding, customer service, or other factors that make the product distinct in
the eyes of consumers. Examples of monopolistic competition can be seen in
industries such as fast food, clothing, and consumer electronics.
In monopolistic competition, firms have some control over the prices they charge because their products are not perfect substitutes. However, this control is limited by the availability of close substitutes. The key features of monopolistic competition include:
- Many Sellers: There are
numerous firms in the market, each offering slightly different products.
- Product Differentiation: Firms offer
products that are differentiated in some way, whether through quality,
design, branding, or other attributes.
- Free Entry and Exit: New firms
can enter the market freely if they see potential for profit, and firms
can exit if they are making losses.
- Imperfect Information: Consumers
may not have complete information about all the available products,
leading to variations in consumer preferences.
Oligopoly
An oligopoly is a market structure dominated by a few
large firms, each of which has significant control over the market. These firms
sell either differentiated or homogeneous products. Oligopolies arise when
there are significant barriers to entry, such as high startup costs, economies
of scale, or strong brand loyalty, which prevent new competitors from entering
the market. Examples of oligopolistic markets include the automobile industry,
telecommunications, and airline industries.
The characteristics of an oligopoly include:
- Few Sellers: The market
is dominated by a small number of firms that control a large portion of
the market share.
- Interdependence: Firms in an
oligopoly are highly interdependent, meaning that the actions of one firm
can directly affect the decisions of others. This is especially important
when it comes to pricing strategies and marketing.
- Barriers to Entry: High
barriers to entry prevent new firms from entering the market easily. These
could be due to economies of scale, patents, or significant capital
investment required to start a business.
- Non-Price Competition: Firms in an
oligopoly often compete through advertising, product differentiation, and
other forms of marketing, rather than competing solely on price.
Pricing Decisions Under Monopolistic Competition in the Short Run
In the short run, firms operating under monopolistic
competition make pricing decisions based on the interaction of their marginal
cost (MC) and marginal revenue (MR), which is similar to the behavior of firms
in perfect competition or monopoly. However, because there are many competitors
offering similar products, firms in monopolistic competition face a
downward-sloping demand curve, which indicates that they can charge a higher
price than the marginal cost, but not excessively high.
Profit Maximization
In the short run, a firm in monopolistic competition
maximizes its profit by setting its output level where marginal cost (MC)
equals marginal revenue (MR). The firm will then charge the price that
corresponds to this output level on its demand curve. If the firm is able to
set a price above its average total cost (ATC) at the profit-maximizing output,
it will earn a short-run economic profit.
- Price above Average Total
Cost:
In the short run, the firm may make positive economic profits if the price
charged is above its average total cost at the profit-maximizing output
level.
- Price equals Average Total
Cost:
The firm could also break even if the price equals its average total cost,
in which case, there is no economic profit, but the firm still covers all
of its costs.
If the firm is experiencing positive economic profits
in the short run, other firms may be attracted to the market, leading to an
increase in competition and a potential decrease in the individual firm's
market share.
Pricing Decisions Under Monopolistic Competition in the Long Run
In the long run, the entry and exit of firms into the
market eliminate any short-run economic profits. The assumption in monopolistic
competition is that there are no significant barriers to entry or exit, so new
firms will enter the market if they observe existing firms earning economic
profits. This increase in the number of firms leads to a decrease in the market
share of each individual firm, which in turn affects the demand curve that each
firm faces.
Entry of New Firms
As firms in monopolistic competition earn economic
profits in the short run, the entry of new firms increases the supply of
similar products in the market. This causes the demand curve faced by each
existing firm to shift leftward, meaning that each firm's ability to charge a
higher price decreases. The increased competition results in a situation where
the price charged by each firm gets closer to the average total cost, and
economic profits are eroded over time.
Long-Run Equilibrium
In the long run, the price that each firm charges will
settle at a level where:
- Price equals Average Total
Cost (ATC):
Firms in monopolistic competition do not earn any economic profit in the
long run. The price will be equal to the average total cost at the output
level where the firm is maximizing its profit. This is a key
characteristic of long-run equilibrium in monopolistic competition.
- Productive Efficiency is Not
Achieved:
Unlike perfect competition, firms in monopolistic competition do not
operate at the minimum point of their average total cost curve. Therefore,
they do not achieve productive efficiency in the long run.
- Allocative Efficiency is Not
Achieved:
Monopolistically competitive firms do not produce at the point where price
equals marginal cost (P = MC), which is the condition for allocative
efficiency. Instead, they charge a price higher than marginal cost.
Thus, while monopolistic competition results in some
consumer choice due to differentiated products, the lack of efficiency in the
long run means that resources are not allocated optimally, and there is
deadweight loss in the market.
Conclusion
In conclusion, monopolistic
competition and oligopoly represent two different market structures that offer
insights into how firms make pricing decisions and how those decisions affect
market outcomes. Monopolistic competition is characterized by many firms offering
differentiated products, with pricing decisions influenced by both market power
and competition. In the short run, firms in monopolistic competition may earn
economic profits, but in the long run, the entry of new firms erodes these
profits, leading to a situation where firms earn zero economic profit. While
the pricing decisions under monopolistic competition reflect some degree of
market power, the market does not achieve either productive or allocative
efficiency.
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