The following article will guide you about how to determine price and output under monopolistic competition.
Price and Output Determination under Short Run:
Under monopolistic competition price and output are determined as under other type of market structure during short period. The point of equilibrium of an individual firm will be at the point where its marginal cost is equal to its marginal revenue (MC=MR).
During short period there may be three situations of the firms under monopolistic competition as given below:
(1) Profit Making Situation:
Profit making situation will be when individual firm’s revenue is greater than its cost (AR>AC). Profit making situation is also called abnormal or super profit situation as given in Diagram 1.
Price, costs and revenues are shown on OY-axis while output on OX-axis. The point of equilibrium is E where marginal cost is equal to marginal revenue (MC=MR) of the firm. The price is OP, output is OQ. The average profit (AR—AC) is TS and total profit is PLST.
(2) Normal Profit:
When the firm’s average revenue is equal to its average cost the situation is called normal profit.
It can be seen from the following diagram:
In the diagram output is shown on OX-axis, price, costs and revenue are shown on OY-axis. The point of equilibrium is E where firm’s marginal cost is equal to its marginal revenue (MC=MR). Price is PQ and output is OQ. At P the average revenue is equal to average cost hence the firm is earning normal profit only.
(3) Loss Making Situation:
Under monopolistic situation during short period a firm will earn loss when its cost is greater than its revenue (AC>AR). It can be explained with the help of the Diagram 3.
Price, cost and revenue are shown on OY-axis while output is shown on OY-axis respectively. The point of equilibrium (MC=MR) is E. Price is OP and output is OQ. Average loss (AC- AR) is ST and total loss is LPTS.
Price and Output Determination during Long Period:
Under monopolistic competition, firms have freedom to enter and exit the industry. In the long run if firms are earning profit new firms are attracted and it will increase the output and consequently prices will fall leading to conversion of profit making situation into normal profit situation.
Contrary to it when firms are incurring losses during long period they will leave the industry. It will reduce the volume of output, prices will increase and the loss making situation will be converted into normal profit. Thus, the firms will earn normal profit only during long period. It can be seen from Diagram 4.
Price, costs and revenue are shown on OY-axis and output on OX-axis. Point of equilibrium (MC=MR) is E. Price is PQ and output is OQ. At P point average cost is equal to average revenue (AC=AR). Hence, the firm is earning normal profit only during long period.