How do firms in monopolistic competition determine profitability?

There are six characteristics of monopolistic competition (MC):Product differentiationEditMC firms sell products that have real or perceived non-price differences. Examples of thes

How do firms in monopolistic competition determine profitability?

There are six characteristics of monopolistic competition (MC):

Product differentiationEdit

MC firms sell products that have real or perceived non-price differences. Examples of these differences could include physical aspects of the product, location from which it sells the product or intangible aspects of the product, among others.[7] However, the differences are not so great as to eliminate other goods as substitutes. Technically, the cross price elasticity of demand between goods in such a market is positive. In fact, the XED would be high.[8] MC goods are best described as close but imperfect substitutes.[8] The goods perform the same basic functions but have differences in qualities such as type, style, quality, reputation, appearance, and location that tend to distinguish them from each other. For example, the basic function of motor vehicles is the sameto move people and objects from point to point in reasonable comfort and safety. Yet there are many different types of motor vehicles such as motor scooters, motor cycles, trucks and cars, and many variations even within these categories.

Many firmsEdit

There are many firms in each MC product group and many firms on the side lines prepared to enter the market. A product group is a "collection of similar products".[9] The fact that there are "many firms" means that each firm has a small market share.[10] This gives each MC firm the freedom to set prices without engaging in strategic decision making regarding the prices of other firms (no mutual independence) and each firm's actions have a negligible impact on the market. For example, a firm could cut prices and increase sales without fear that its actions will prompt retaliatory responses from competitors.

How many firms will an MC market structure support at market equilibrium? The answer depends on factors such as fixed costs, economies of scale and the degree of product differentiation. For example, the higher the fixed costs, the fewer firms the market will support.[11]

Freedom of entry and exitEdit

Like perfect competition, under monopolistic competition also, the firms can enter or exit freely. The firms will enter when the existing firms are making super-normal profits. With the entry of new firms, the supply would increase which would reduce the price and hence the existing firms will be left only with normal profits. Similarly, if the existing firms are sustaining losses, some of the marginal firms will exit. It will reduce the supply due to which price would rise and the existing firms will be left only with normal profit.

Independent decision makingEdit

Each MC firm independently sets the terms of exchange for its product.[12] The firm gives no consideration to what effect its decision may have on competitors.[12] The theory is that any action will have such a negligible effect on the overall market demand that an MC firm can act without fear of prompting heightened competition. In other words, each firm feels free to set prices as if it were a monopoly rather than an oligopoly.

Market powerEdit

MC firms have some degree of market power, although relatively low. Market power means that the firm has control over the terms and conditions of exchange. All MC firms are price makers. An MC firm can raise its prices without losing all its customers. The firm can also lower prices without triggering a potentially ruinous price war with competitors. The source of an MC firm's market power is not barriers to entry since they are low. Rather, an MC firm has market power because it has relatively few competitors, those competitors do not engage in strategic decision making and the firms sells differentiated product.[13] Market power also means that an MC firm faces a downward sloping demand curve. In the long run, the demand curve is highly elastic, meaning that it is sensitive to price changes although it is not completely "flat". In the short run, economic profit is positive, but it approaches zero in the long run.[14]

Imperfect informationEdit

No other sellers or buyers have complete market information, like market demand or market supply.[15]Market structure comparisonMarket StructureNumber of firmsMarket powerElasticity of demandProduct differentiationExcess profitsEfficiencyProfit maximization conditionPricing powerPerfect competitionInfiniteNonePerfectly elasticNoneYes/No (Short/Long)Yes[16]P=MR=MC[17]Price taker[17]Monopolistic competitionManyLowHighly elastic (long run)[18]High[19]Yes/No (Short/Long)[20]No[21]MR=MC[17]Price setter[17]MonopolyOneHighRelatively inelasticAbsolute (across industries)YesNoMR=MC[17]Price setter[17]

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