Monopolistic Competition, there are a large number of firms that produce differentiated products which are close substitutes for each other. In other words, large sellers selling the products that are similar, but not identical and compete with each other on other factors besides price.
Features of Monopolistic Competition
1.Product Differentiation: This is one of the major features of the firms operating under the monopolistic competition, that produces the product which is not identical but is slightly different from each other. The products being slightly different from each other remain close substitutes of each other and hence cannot be priced very differently from each other.
2. Large number of firms: A large number of firms operate under the monopolistic competition, and there is a stiff competition between the existing firms. Unlike the perfect competition, the firms produce the differentiated products which are substitutes for each other, thus make the competition among the firms a real and a tough one.
3. Free Entry and Exit: With an intense competition among the firms, the entity incurring the loss can move out of the industry at any time it wants. Similarly, the new firms can enter into the industry freely, provided it comes up with the unique feature and different variety of products to outstand in the market and meet with the competition already existing in the industry.
4. Some control over price: Since, the products are close substitutes for each other, if a firm lowers the price of its product, then the customers of other products will switch over to it. Conversely, with the increase in the price of the product, it will lose its customers to others. Thus, under the monopolistic competition, an individual firm is not a price taker but has some influence over the price of its product.
5. Heavy expenditure on Advertisement and other Selling Costs : Under the monopolistic competition, the firms incur a huge cost on advertisements and other selling costs to promote the sale of their products. Since the products are different and are close substitutes for each other; the firms need to undertake the promotional activities to capture a larger market share.
6. Product Variation: Under the monopolistic competition, there is a variation in the products offered by several firms. To meet the needs of the customers, each firm tries to adjust its product accordingly. The changes could be in the form of new design, better quality, new packages or container, better materials, etc. Thus, the amount of product a firm is selling in the market depends on the uniqueness of its product and the extent to which it differs from the other products.
The monopolistic competition is also called as imperfect competition because this market structure lies between the pure monopoly and the pure competition.
Restaurants are a monopolistically competitive sector; in most areas there are many firms, each is different, and entry and exit are very easy. Each restaurant has many close substitutes—these may include other restaurants, fast-food outlets, and the deli and frozen-food sections at local supermarkets. Other industries that engage in monopolistic competition include retail stores, barber and beauty shops, auto-repair shops, service stations, banks, and law and accounting firms.
A cartel is defined as a group of firms that gets together to make output and price decisions. The conditions that give rise to an oligopolistic market are also conducive to the formation of a cartel; in particular, cartels tend to arise in markets where there are few firms and each firm has a significant share of the market. In the U.S., cartels are illegal; however, internationally, there are no restrictions on cartel formation. The organization of petroleum?exporting countries (OPEC) is perhaps the best?known example of an international cartel; OPEC members meet regularly to decide how much oil each member of the cartel will be allowed to produce.
Oligopolistic firms join a cartel to increase and improve their market power, and members work together to determine jointly the level of output that each member will produce and/or the price that each member will fix. By working together, the cartel members are able to behave like a monopolist. For example, if each firm in an oligopoly sells an undifferentiated product like oil, the demand curve that each firm faces will be horizontal at the market price. If, however, the oil?producing firms form a cartel like OPEC to determine their output and price, they will jointly face a downward?sloping market demand curve, just like a monopolist. In fact, the cartel’s profit?maximizing decision is the same as that of a monopolist, as Figure reveals. The cartel members choose their combined output at the level where their combined marginal revenue equals their combined marginal cost. The cartel price is determined by market demand curve at the level of output chosen by the cartel. The cartel’s profits are equal to the area of the rectangular box labeled abcd in Figure . Note that a cartel, like a monopolist, will choose to produce less output and charge a higher price than would be found in a perfectly competitive market.
Once established, cartels are difficult to maintain. The problem is that cartel members will be tempted to cheat on their agreement to limit production. By producing more output than it has agreed to produce, a cartel member can increase its share of the cartel’s profits. Hence, there is a built?in incentive for each cartel member to cheat. Of course, if all members cheated, the cartel would cease to earn monopoly profits, and there would no longer be any incentive for firms to remain in the cartel. The cheating problem has plagued the OPEC cartel as well as other cartels and perhaps explains why so few cartels exist
According to the indifference curve approach, it is not possible for the consumer to say how much utility he derives from the consumption of a commodity, because utility is not a measureable magnitude.
But a consumer can compare two or more combi¬nations of goods and say which of them he likes best or whether he likes them all equally well. The Laws of Consumer Demand can be deduced from these preferences.
Suppose a consumer is asked to choose between the following two combinations:
a. 4 apples and 2 oranges
b. 2 apples and 3 oranges
He may prefer a to b or b to a or he may like both combinations equally well. In the last case we say that he is indifferent between them. It is not necessary at this stage to know how much utility is obtained from an apple or an orange. The consumer can compare the relative desirability of, or indifference between, two combinations of goods without knowing the exact amount of “utility” and “satis¬faction” obtained from each combination.
To show how Indifference Curves are constructed let us take the example of a consumer purchasing two goods only, apple and orange. He may prefer apple to orange but if orange becomes relatively cheap he may be induced to eat a few more units of it. If the price of apple becomes much cheaper he may give up orange altogether.
On the other hand, if the price of apple becomes very high he may be forced by lack of means to give up apple. Between these two extremes he will purchase both apple and orange, but will vary the proportions according to relative prices so that he obtains the advantages of small price changes of either commodity. It follows, therefore, that there are more than one combinations of apple and orange which are equally satisfactory to him.
Suppose the following combinations are equivalent:
(a) 1 unit of apple and 4 units of orange
(b) 2 units of apple and 3 units of orange
(c) 3 units of apple and 2 units of orange
(d) 4 units of apple and 1 unit of orange
An Indifference Curve:
These combinations are represented by small circles in Fig. 4.7 where apple is measured on the horizontal axis and orange on the vertical axis. There may be many other such combinations. Let I be a continuous line joining the small circles and other similar points. The curve I1 is called an indifference curve.
Thus an indifference curve may be defined as a curve which shows combinations of goods which are equivalent to one another. It is a locus of points sharing alternative combinations of apple and orange which give the same satisfaction to the consumer. The consumer has no reason to prefer any of the combinations on the curve to any other on the same curve. He is indifferent as to which of these combinations he uses. Each indifference curve is an equal-utility curve.
The indifference curve approach is based upon the following assumptions:
A rational person will prefer a larger quantity of a good than a smaller amount of it.
The consumer is supposed to be consistent about his tastes and pre¬ference.
3. Diminishing Marginal Substitutability:
Suppose a consumer buys orange and apple. It can be assumed that as more and more of units of apple are substituted for orange, the consumer will be willing to give up fewer and fewer units of orange for additional units of apple. As the quantity of orange consumed increases, more of it will be required to compensate for loss of apple. This follows from the principle that as the consumption of orange increases the desire for it will fall and as the consumption of apple decreases the desire for it will increase.
Therefore, the marginal rate of substitution of orange for apple increases as the quantity of orange increases relatively to apple. Alternatively we can say that the marginal rate of substitution of orange for apple diminishes as the supply of apple diminishes. This is called the Principle of Diminishing Marginal Substitutability. It is assumed that the two goods are not perfect substitutes for one another and that want for the goods are not satiable.
Properties (Characteristics) of Indiffe¬rence Curves:
Indifference curves have the following four properties:
1. An indifference curve which lies above and to the right of another shows preferred combinations of the two commodities.
2. Indifference Curves Have a Negative Slope:
when the quantity of one commodity (A) in a combination of two goods increase, the quantity of the other commodity (O) must decline. Therefore, an indifference curve must slope downwards from left to right.
The Marginal Rate of Substitution:
The slope of the indifference curve is called the MRS which is the ratio of the marginal utilities of the two commodities. This is expressed as
MRS x,y = – ?Y /?X = MUx/MUy
3. An Indifference Curve cannot Intersect or Touch Another Indifference Curve:
This can be proved by showing that if two indifference curves on the same indifference map intersect, there is logical contradiction (or inconsis¬tency). Suppose I1, and I2 intersect as in Fig 4.8, then from I1.
This explains why indifference curves cannot intersect.
… Transitivity implies that if A is preferred to B and B is preferred to C then A is preferred to C.
4. Indifference Curves are Convex to the Origin:
Thus it is concluded that
(i) each indifference curve is a distinct line;
(ii) it slopes downwards from left to right and
(iii) it is convex to the origin.
There are, however, certain exceptions to rule 3. Under certain special circumstances an indifference curve may be a straight line or even concave to the origin.
The term Iso-quant or Iso-product is composed of two words, Iso = equal, quant = quantity or product = output.
Thus it means equal quantity or equal product. Different factors are needed to produce a good. These factors may be substituted for one another.
A given quantity of output may be produced with different combinations of factors. Iso-quant curves are also known as Equal-product or Iso-product or Production Indifference curves. Since it is an extension of Indifference curve analysis from the theory of consumption to the theory of production.
Thus, an Iso-product or Iso-quant curve is that curve which shows the different combinations of two factors yielding the same total product. Like, indifference curves, Iso- quant curves also slope downward from left to right. The slope of an Iso-quant curve expresses the marginal rate of technical substitution (MRTS).
“The Iso-product curves show the different combinations of two resources with which a firm can produce equal amount of product.” Bilas
“Iso-product curve shows the different input combinations that will produce a given output.” Samuelson
“An Iso-quant curve may be defined as a curve showing the possible combinations of two variable factors that can be used to produce the same total product.” Peterson
“An Iso-quant is a curve showing all possible combinations of inputs physically capable of producing a given level of output.” Ferguson
The main assumptions of Iso-quant curves are as follows:
1. Two Factors of Production:
Only two factors are used to produce a commodity.
2. Divisible Factor:
Factors of production can be divided into small parts.
3. Constant Technique:
Technique of production is constant or is known beforehand.
4. Possibility of Technical Substitution:
The substitution between the two factors is technically possible. That is, production function is of ‘variable proportion’ type rather than fixed proportion.
5. Efficient Combinations:
Under the given technique, factors of production can be used with maximum efficiency.
Properties of Iso-Product Curves:
The properties of Iso-product curves are summarized below:
1. Iso-Product Curves Slope Downward from Left to Right:
They slope downward because MTRS of labour for capital diminishes. When we increase labour, we have to decrease capital to produce a given level of output.
2. Isoquants are Convex to the Origin:
Like indifference curves, isoquants are convex to the origin. In order to understand this fact, we have to understand the concept of diminishing marginal rate of technical substitution (MRTS), because convexity of an isoquant implies that the MRTS diminishes along the isoquant. The marginal rate of technical substitution between L and K is defined as the quantity of K which can be given up in exchange for an additional unit of L. It can also be defined as the slope of an isoquant.
It can be expressed as:
MRTSLK = – ?K/?L = dK/ dL
Where ?K is the change in capital and AL is the change in labour.
Equation (1) states that for an increase in the use of labour, fewer units of capital will be used. In other words, a declining MRTS refers to the falling marginal product of labour in relation to capital. To put it differently, as more units of labour are used, and as certain units of capital are given up, the marginal productivity of labour in relation to capital will decline.
Thus it may be observed that due to falling MRTS, the isoquant is always convex to the origin.
3. Two Iso-Product Curves Never Cut Each Other:
As two indifference curves cannot cut each other, two iso-product curves cannot cut each other.. Therefore two curves which represent two levels of output cannot intersect each other.
4. Higher Iso-Product Curves Represent Higher Level of Output:
A higher iso-product curve represents a higher level of output
5. Isoquants Need Not be Parallel to Each Other:
It so happens because the rate of substitution in different isoquant schedules need not be necessarily equal. Usually they are found different and, therefore, isoquants may not be parallel
6. No Isoquant can Touch Either Axis:
If an isoquant touches X-axis, it would mean that the product is being produced with the help of labour alone without using capital at all.
7. Each Isoquant is Oval-Shaped.
It means that at some point it begins to recede from each axis. This shape is a consequence of the fact that if a producer uses more of capital or more of labour or more of both than is necessary, the total product will eventually decline. The firm will produce only in those segments of the isoquants which are convex to the origin and lie between the ridge lines. This is the economic region of production.
Difference between Indifference Curve and Iso-Quant Curve:
The main points of difference between indifference curve and Iso-quant curve are explained below:
1. Iso-quant curve expresses the quantity of output. Each curve refers to given quantity of output while an indifference curve to the quantity of satisfaction. It simply tells that the combinations on a given indifference curve yield more satisfaction than the combination on a lower indifference curve of production.
2. Iso-quant curve represents the combinations of the factors whereas indifference curve represents the combinations of the goods.
3. Iso-quant curve gives information regarding the economic and uneconomic region of production. Indifference curve provides no information regarding the economic and uneconomic region of consumption.
4. Slope of an iso-quant curve is influenced by the technical possibility of substitution between factors of production. It depends on marginal rate of technical substitution (MRTS) whereas slope of an indifference curve depends on marginal rate of substitution (MRS) between two commodities consumed by the consumer.
The concept of cross elasticity of demand plays a major role to forecast the effect of changes in the goods price which are in demand and its substitutes including complimentary goods.
The demand for a good is associated with the demand for other good. Hence, change in the price of one good actually makes change in the price of another good. The relationship between two related goods can be measured by cross- elasticity of demand.
As per ferguson saying” the cross elasticity of demand is the proportional change in the quantity demanded of good A divided by the proportional change in the price of the related good B.”
Cross elasticity of demand is a positive when two goods are substitute of each other This is because the increase in the price of one good increases the demand for the other. Where as in complimentary goods case ,the cross-elasticity of demand will be negative as increase in the price of one good decreases the demand for the other.
Measurement of Cross Elasticity of Demand:
Cross-elasticity of demand is the ratio of percentage change in demand of good A produced due to the percentage change in price of related good B.
Hence ,the cross-elasticity formula (ec) of demand is below:
ec = Percentage change in quantity demanded of A/Percentage change in price of B
Percentage change in quantity demanded of A= New demand for A (?QA)/Original demand for A (QA)
Percentage change in price of B= New price for B (?PB/Original price for B(PB)
The symbolic representation of the formula for cross elasticity of demand is as follows:
ec = ?QA/QA: ?PB/PB
ec = ?QA/QA */PB/?PB
ec = ?QA/?PB */PB/QA
?QA can be calculated by subtracting original demand for A(QA) from increase in demand (QA1), which is as follows:
?QA = QA1 – QA
Similarly, PB is the difference between the new price of B (PB1) and original price for B (PB).
It is also calculated by the formula:
?PA = PB1 –PB
There are three types of Cross Elasticity of Demand:
The cross-elasticity numerical value of demand is not same for every goods. It may differs for different types of goods.
The various types of cross-elasticity of demand are as mentioned:
i. Positive Cross Elasticity of Demand:
Implies that the cross elasticity of demand would be positive when increase in the price of one good (A) causes increase in the demand for the other good (B). In short, cross elasticity is positive for substitutes.
The cross elasticity of “demand is positive; therefore, A and B are substitutes.
ii. Negative Cross Elasticity of Demand:
A situation where increase in the price of one good (A) reduces the demand for the other good (B). The cross elasticity of demand will be negative for complementary goods.
The cross elasticity of demand is negative; therefore, A and B are complementary to each other.
iii. Zero Cross Elasticity of Demand:
The cross elasticity of demand will be zero when two goods A and B are not related to each other. Hence , the increase or decrease in the price of one good (A) will not affect the demand of other good (B).
Importance of Cross Elasticity of Demand:
The concept of cross elasticity of demand plays a major role in forecasting the effect of change in the price of a good on the demand of its substitutes and complementary goods. Cross elasticity helps in deciding goods price by analysing the demand change by its substitute and complementary goods.
It also Helps in understanding the nature of relationship between two goods even if they are substitute or complimentary to each other