Theory of Equilibrium Determination in Monopolistic Competitive Market

Updated on June 8, 2015

IRSHAD CV has been a student in Economics. Now he is doing Masters in Economics. He completed B.A. Economics from the University of Calicut.

Introduction

Monopolistic competitive market is one where large number of firms supplies the commodities to a large number of customers. Now, there are many examples existed for the monopolistic competitive market like pastes, shampoo, shaving cream etc.

Even though all the firms are supplying substitutable commodities with different brands, each firm are like monopoly in their product. At the same time all the commodities are substitutable and so they face stiff competition from their rival firms. So, the analysis of equilibrium determination is very vital because of the varieties features in the monopolistic competitive market. This hub very briefly highlights the equilibrium determination both in short run and long run with the help of diagrams.

Short Run Equilibrium

Short run is a period, where the producer can change only variable inputs like labor, fuel, power etc. to increase or decrease production. Since the products of each firms are somewhat differentiated, each firm can fix their own price for their product. At the same time all the products are substitutable for uses, the firm should either increase sales or reduce costs to get more profits. Normally when a firm reduce price, he may got more customers. That is so; Average Cost (AC) will be a decreasing curve. Short runs equilibrium of monopolistic competitive firm with super normal profits can be represented diagrammatically as shown in the Figure I below.

Two conditions for equilibrium

1) Marginal Cost (MC) cut Marginal Revenue (MR) from below

2) Marginal Cost (MC) equals Marginal Revenue (MR)

In the Figure I Average Revenue Curve is the demand which slopes downward (because the opposite relationship between price and quantity). Marginal Revenue (MR) curve also slopes downward which lies below Average Revenue (AR) curve. Marginal Cost curve cut Marginal Revenue from below through the point ‘E’, where the equilibrium is determined. At point ‘E’, demand is ‘Q’ and X1 is the commodity exchanged. Price is determined at point ‘P’. At equilibrium, ‘S’ is the cost and ‘P’ is the price. So, the profit will be equal to the area ‘PQRS’. In the case of short run the firms are earning super normal profit.

Long run equilibrium

Long run refers to a period in which the producer can change both variable inputs like labor and fixed inputs like land to increase or decrease the output of the firm.

Since the long run period allows the firms to change both their fixed and variable inputs, the firm can only make normal profit. Because when the market earns super normal profits, new firm may enter to the industry. Similarly, when the industry making losses, some of the existing firms may leave. That is why, Chamberlain's theory based on the concept that, all firms in the monopolistic market earn equal market share and so all the firms make normal profits.

Here in the long run also, the Average Revenue (AR) curve is elastic one, because each firm can sell more at lower price. In the long run, two conditions have to satisfy at the equilibrium point. They are

1) Marginal Revenue (MR) equal to Marginal Cost (MC) and

2) Average Revenue (AR) equal to Average Cost (AC)

The long run equilibrium of monopolistic competitive market can be represented as showing in Figure II.

In the Figure II, equilibrium is determined at point ‘E’. Marginal Cost (MC) cut Marginal Revenue (MR) from below through the point ‘F’. And tangent to the Average Revenue curve (demand) at point ‘E’, where price is determined ‘P’ and quantity is determined at ‘Q’.

Concept of excess capacity in the long run

In the long run, Chamberlain's theory is based on the excess capacity. That is the firms never utilizes their optimum capacity or never produce with less cost. In the Figure II at equilibrium point, the Long run Average Cost (LAC) curve tangent in the falling part (at point ‘E’). That is cost is not minimum. The cost becomes minimum at the minimum point of Long run Average Cost (LAC). So, the firm never uses their optimum capacity and they leave the excess capacity equal to the area ‘Q’ to ‘Q1’.

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