In this series of posts covering market structures, today we will talk about perfect and monopolistic competition which is quite different from monopoly. Over this series of posts we will see how they are different.
Perfect competition – Price, MR, MC:
In a perfect competition, average revenue and marginal revenue are equal to the price of the product. Marginal cost is the increase in the total costs from the production of one more additional unit of output. Marginal cost can therefore be calculated as the difference between the current total cost and the total cost after producing one more unit divided by the difference between the current output and the output including the additional unit.
In a perfect competition, a firm maximises its profit at the point where marginal revenue is equal to marginal cost. It means that a firm should go on producing as long as its marginal revenue for every additional unit produced and sold is greater than its marginal cost. Beyond, MR = MC, the total cost increases more than the total revenue by producing an additional unit of output and profit is reduced.
However in case of a firm whose MR = MC but it is selling at less than the AVC (average variable cost) shutting down production would be a profit maximising decision.
Short run is the period over which some costs are fixed. For example, plant and machinery. In the long run all costs are variable. Plant and machinery can be sold or added to in the long run.
In a perfect competition, in the short run, as long as the average revenue is greater than the variable cost the firm should continue to operate even though it is not covering all its fixed costs as shutting down would cause more losses as the fixed costs have to be paid regardless of production. In the long run, if the average revenue is less than the average total cost (as all costs are variable in the long run), the firm should shut down and minimise its losses as it is not able to sell above its cost. If the average revenue is just equal to the average total cost the firm will break even.
Monopolistic competition in detail:
To recap, in a monopolistic competition there is large number of firms producing a product so that no one firm can dictate the price. The products are close substitutes of each other. The firms differentiate their products based on quality, features and marketing. Better quality products command a higher price than a competitor. Therefore firms have elastic curves but not perfectly elastic curves. In a monopolistic competition too firms will go on producing until MC = MR. At that point however price is higher than ATC and therefore the firms are earning economic profits. As more firms enter the market chasing these economic profits, supply increases pushing the price downwards so that the firms are still producing at MC=MR, but are no longer earning any economic profits.
Therefore in a monopolistic competition, it is extremely important for firms to keep innovating and enhancing their products further so that they may have less elastic demand curves and therefore they are in a position to charge higher prices. Towards the same end, it is also important to advertise and market their products differently in order to position their products differently in the market.
That’s all in this post about perfect competition and monopolistic competition …..Thanks for reading….watch out for the next post where we would learn about the four different types of oligopoly market structures and thereafter we will cover monopoly … so stay tuned..
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For solved examples please refer to the CFA Institute Books or any other study notes that provide them and you may want to use. The problems can be easily solved using the CFA institute approved financial calculators. Please refer to the CFA exam policy and CFA calculator guide.