CHAPTER 8

PURE COMPETITION
Objectives:

At the end of the chapter the student is expected to:

1. Explain perfect and pure competition

2. Differentiate net income from economic income
3. Determine profit maximization using:
a. Total Revenue minus Total Cost Approach
b. Marginal Revenue Equals Marginal Cost Approach
4. Compute and graph the break-even point, loss, and profit areas
5. Determine long-run price and output under pure competition
6. Evaluate the advantages and shortcomings of pure competition

Terms to Remember:

Competition market- a market with large number of sellers and buyers trading identical
products where buyers and sellers are price takers

Total revenue- price times quantity

Total cost- fixed cost plus variable cost

Marginal revenue- the change in total revenue divided by change in quantity

Economic profit- Total Receipts minus all Cost of Production, explicit and imputed costs,
incurred by the firm

PURE COMPETITION

This chapter shows how the price system operates in a purely conmpetitive
market. Competition has always been part of human motivation and activity.
Competition can make wonders in the economy. The best in human activity like the best
record in the 100-meter dash in the Olympics can be brought out in a spirit of
competition. The best shoes can be produced in the market if there is fair competition
among the shoe producers. Fair competition can make wonders both in human activities
and in the market system. Needless to say, perverted and unbridled competition, can
lead to undesirable ends.
 A market is said to be purely competitive of (1) there is large number of sellers
and buyers of the commodity each too small to affect the price of the commodity; (2) the
outputs of all firms in the market are homogeneous i.e., the product of any seller is
considered as exactly alike in all respects to the other product of any other seller; and
(3) there is perfect mobility of resources, i.e., there is freedom of entry into and exit from
the industry.

Pure and Perfect Competition

Economists make a distinction between pure and perfect competition. We have

already mentioned the characteristics of the market characterized by pure competition.
A market is said to be perfectly competitive if it contains all the characteristics of pure
competition plus an additional characteristics, i.e., consumers, resource owners, and
firms in the market have perfect knowledge of present and future prices and costs.

Perfect knowledge means that a person knows a price of the commodity being
charged in the markets of Cubao or Divisoria, for example. Based on this knowledge, he
can make his decision as whether to buy from one market or the other based on price
differences.

The Demand Curve

When there are large numbers of sellers and buyers of a commodity, each would
be too small a unit to affect the price of the commodity. Consider a typical rice farmer,
for example. Since he is only one of millions of farmers in the Philippines, his individual
decision regarding the pricing of his product would not significantly affect the price of the
rice in the market. This means that both the producers and the sellers are price takers,
i.e., they take whatever price dictated by the market. Given this condition, the demand
curve under a purely competitive market is given, thus,

Price FIRM

P Demand

Output

Firm Demand Curve

 As can be seen from the graph below, the firm faces an infinite elastic demand
curve. The firm can sell any amount it can produce at that price.

However, while each individual firm faces a horizontal demand curve, the
industry demand curve is still downward sloping. The demand and supply curves in the
industry are subject to various influences which generally make the demand curve
downward sloping and the supply curve positively sloped. The market price is then
determined by the interaction of demand on one side, and the supply on the other. The
equilibrium price is therefore shown thus,

Price

INDUSTRY S

P________________

|
|
|
|
| D
| Output
Q

Indusry Demand Curve

The Short Run

when we say short-run we are referring to a time period in which a firm can vary
its output but does not have time to change its plant size. During this period, the firm, for
example, can alter the amount of some factors such as raw materials or labor but does
not have time to change the number of machines or the sizes of the plant which is
considered fixed.

During the short time period, the number of firms in an industry is fixed because
new firms do not have time to leave. Any change in the production of the industry must
come from the fixed plant capacity of existing firms. One assumption of pure
competition is that each firm is too small relative to the price of the product. The
problem facing the firm is that determining what output to produce and cell.
A Note on Profits

The term “profit” can sometimes be ambiguous. To avoid this, let us make some
explicit definition on profit. Economic profitsare a pure surplus or an excess of total
reciepts over all cost of production incured by the firm. Included as cost are obligations
incurred for all resources used which include the opportunity costs. These cost include
returns to the owners of capital used equivalent to what they could get had they
invested in capital elsewhere in the economy. They include implicit returns to labor
owned by the operator of the business.

Let us look how an accountant would look at a corporation’s net income or profits
compare with an economist’s view of economic profits. Assuming that corporate income
taxes are ignored, corporate profits are determined by the accountant as follows:

Gross Income

-Expense (includes interest payments on bonds, amortization expenses,

depreciation expenses, and others
= Net Income or “profits”

The economist would view profit from a slightly different light. Obligations
incurred to the owners of the corpora tions capital (its stockholders) are as much as cost
of production as are those incurred for labor or for raw materials. This means that a
company has to make payments to capital owners in the form of divedents from the
corporation’s “profits”. To arrive at economis profits, divedent payments equal to what
investors could earn had they invested else where in the economy should be subtracted
from the corporation’s net income as follows:

Gross income

-Expenses

=Net income or “profit”

-Average Divident

=Economic profit
Short-run Equilibrium of the Firm: Total Revenue – Total Cost Approach

Given the market price of a product, the producer in a competitive market is

faced with the following questions: (1) Should I produce? (2) If so, what will I produce
and how much? (3) Will profit be realized (or loss)? (4) If so, how much profit (or loss)?

One of the approaches at answering these questions and arriving at the

breakeven point and maximum profit is through the total revenue minus total cost
approach. The break-even point is arrived at when total revenue just equals total cost.
This is a very important concept in economics. Even before thinking of maximum profit
or even any positive profit for that matter, the producer has to break-even first. Once
this is achieved, any point after the break-even point so long as revenues are greater
than cost, will give the producer positive profit.

Total profits equal total revenue minus total cost. So long as revenues are
greater than cost, the firm receives profits; if cost are greater than revenues, the firm is
operating at a loss. Total profits are maximized when the positive difference between
total revenue and total costs is at its greatest. The equilibrium output of the firm is the
output at which total profits and maximizes.

We can see from Table 21 some cost which have been discussed in the previous
chapters.

Total Revenue (TR), for example, is derived by multiplying Price by Quantity

(TR= P X Q). Assuming a market price of ₱131, the Total Revenue curve (column 2) is
obtained by multiplying the values under Quantity (column 1) by Price.

Total Cost (TC) os obtained by adding Fixed Cost (column 3) and Variable cost
(column 4). Thus we have the equation: (Total Cost (TC)= Fixed Cost (FC) + Variable
Cost (VC)

At what output would the firm maximize profits? From the table, we can see that
profit is maximized at output 18. The size of profit at this point is P598, the highest profit
can possibly be obtained as also shown in figure 76 on the succeeding page.

Profit is obtained by subtracting Total Cost (column 5) from Total Revenue

(column 2). Thus, we have the equation, Profit= Total Revenue- Total Cost.

BEP: TR = TC

We note that the break-even point occurs at about output 5.

From the relationships we can see that the firm would achieve positive profits so
long as revenues exceed costs; it will incur losses if costs exceed revenues. Obviously,
if revenues just equal costs, the firm is just breaking even.
Short-run Equilibrium: Marginal Approach

Another way of determining profits in a competitive firm is through the Marginal

Revenue (MR)= Marginal Cost (MC) approach.

TABLE 21

Profit Maximizing Output: Pure Competition

Total Revenue – Total Cost Approach

Quantity Total Fixed Cost Variable Total Cost Profit

Revenue Cost

0 ₱0 ₱200 ₱0 ₱200 -₱200

2 262 200 180 380 -118

4 524 200 340 540 -18

6 786 200 480 680 106

8 1048 200 600 800 148

10 1310 200 740 940 370

12 1572 200 900 1100 472

14 1834 200 1080 1280 554

16 2096 200 1300 1500 596

18 2358 200 1560 1760 598

20 2620 200 1860 2060 560

Marginal Revenue is the additional revenue obtained by putting additional units

of output in the market. This is obtained by the equation:
MR= TR

Marginal Cost is the additional cost incurred when additional units of products are
produced. It is computed as the change in total cost divided by the change in units
produced. Thus, we have the equation:

MC= TC

FIGURE 76
Profit Maximizing Output
Pure Competition
Total Revenue - Total Cost Approach
Through this approach, we can see that if the additional cost of producing of a
unit is greater than the additional revenue obtained, the firm would be losing. The firm
would only gain profit so long as the additional revenue derived by the firm by producing
an additional unit exceeds the additional cost that goes in the production of the
community. This means that profit is obtained where MR exceeds MC.

When will the firm maximize profit? To maximize profits or minimize losses, the
competitive firm should produce at the point where MR = MC.

Table 22 and Figure 77 will illustrate this principle.

In the early stages of production where output is relatively low, marginal revenue
will usually exceed marginal cost. It is, therefore, profitable to produce through this
range of output. So long as marginal revenue exceeds cost, in our case in output 6
onward, the firm will realize profit.

At what output will the firm maximize profit? Profit is maximized where MR = MC.

This is obtained at output 18. At this point, total profit is ₱598, the highest in all profit
column. Total profit is obtained by multiplying profits per unit by Quantity. Any point
outside of output 18 will give the firm lesser profit.

Usually in the early stages of production, the firm would be incurring some
losses. This can be seen from table 22 which shows that negative profit can only be
realized up to output 4. After output 4, the firm realizes profit and as can be seen, profit
is maximized at output 18.where marginal revenue just equal marginal cost. We can,
thus, say that under purely competitive conditions, the competitive firm should produce
at that point where price equals marginal revenue and marginal cost to maximize profits.

Loss-Minimizing Case

In our previous discussion, we saw that the firm accumulates profits because the
market price is greater than the cost of production. So long as the cost of production is
less than the market price, the firm attains profit.

What happens if the firm experiences a situation where the cost of production is
higher than the market price? Obviously, the firm would be incurring losses. In situation
like these, the most important consideration is to determine at what point the firm would
minimize losses.
 TABLE 22

Profit Maximizing Output: Pure Competition

Marginal Revenue Equals Marginal Cost Approach

Quantity ₱ = MR MC AC Profit / Unit Total Profit

2 ₱131 ₱90 ₱190.00 ₱-59.00 ₱-118

4 131 80 135.00 -4.00 -16

6 131 70 113.33 17.67 106

8 131 60 100.00 31.00 248

10 131 70 94.00 37.00 370

12 131 80 91.67 39.33 472

14 131 90 91.43 39.57 554

16 131 110 93.75 37.25 596

18 131 130 97.78 33.22 598

20 131 150 103.00 28.00 560

 FIGURE 77
Short-run Profit Maximizing Position
MR = MC Approach
The marginal revenue equals marginal cost principle would still be relevant in this
case. Any point before or after MR = MC would mean more losses for the firm. Let us
illustrate this through the following graph

FIGURE 78
Short-run Loss-Minimizing Position of a Purely Competitive Firm
 As can be seen from Figure 78, the firm would minimize its losses if it produces
at output 5. The firm would incur higher losses at output other than output 5.

The shaded area, cdep, signifies the amount of losses the firm incurs. This is
obtained by measuring the distance, cp. Multiply by the output which is 5.

The Break-even Price

We already mentioned that the firm would be breaking even if its revenues just
equal its costs. In economics, when we talk of costs we are referring here to both
imputed and explicit costs. In other words, included under costs are all expenses that
can be incurred plus the average dividends paid to investors had they invested
elsewhere in the economy. Economic profits would be achieved if all expenses and
average dividends would be subtracted from gross sales or gross income and a
differential still remains. Zero profit is achieved if costs (which include all expenses +
average dividends) just equal revenues. When the firm has zero profit, the firm is just
breaking even.

Using the per unit analysis, the firm is just breaking even if the market price is
just equal to the lowest point of short-run average cost (SAC). In our graph the short-run
marginal cost intersects the short-run average cost at its lowest point. In this graph P is
the break-even price and Q is the break-even output.

FIGURE 79
Break-even Price and Output
The Shutdown Price

When we talk of shutdown price, we are referring here to the price that would
force the producer to stop production because of losses. In economics, this would
happen if the market price is less than minimum average variable costs. In this case,
the firm would minimize losses by discontinuing production.

Given this situation, the loss will equal total fixed cost when the firm produces
nothing. If the firm should produce at a priceless P average variable costs would be
greater than price and total variable cost would be greater than total receipts. Losses
would equal total fixed costs plus the part of total variable costs not covered by total
receipts. In our case the price P is called the shutdown price where P = AVC.

Let us say that the firm under consideration is a rice farmer who has a farm and a
hand-tractor is not yet paid for.

Given this situation, we can identify which costs would be considered fixed ones
would be called variable. In this case, mortgage and machinery payments constitute
fixed cost and must be met whether or not the farmer produces or not.

FIGURE 80

Break-even and Shutdown Price

 On the other hand, expenses for gasoline, seed varieties, fertilizers, irrigations
and labor expenses represents variable costs. If our farmer produces nothing, there are
no outlays on variable resources.

Given these circumstances, when should the farmer produce nothing at all and
would be wiser merely to hire his labor out to someone else? If expected receipts from
the rice crops are not sufficient to cover the cost of gasoline, seeds, fertilizers, irrigation
and labor costs, he should not produce at all. If he produces under these
circumstances, his losses will equal mortgage and hand-tractor payments plus that part
of his variable costs not covered by his receipts. If he does not produce, his losses will
equal mortgage and hand-tractor payments only. Thus, in a shutdown situation, he
should not produce.

Price and Output in the Long-run

When we talk of long- run equilibrium price and output, we are referring to the
situation toward which the market price and output and the short-run equilibrium price
and output tend in a period of time long enough to allow the following things:

1. the completing by firms of all desired adjustments;

2. the entry of new firms; and
3. the departure of old ones.

At any one time, adjustment in price and output with existing plant tend to bring the
market price and output to the short-run equilibrium figure. But over a longer period, the
various adjustments will bring market price and output and the short-run equilibrium
figure to the long-run equilibrium level. If all long-run adjustments are completed, the
short-run and long-run equilibrium levels will be the same. In addition, the market price
and output will be equal to them.

Long-run Adjustment by Existing Firms

While price in the short-run period need cover only the average variable cost
(AVC) to ensure that firms continue production, over the long-run period price must
cover all costs. This means that price at least equal the average cost (AC), or the
owners would incur loss and, thus, liquidate the business and reinvest in other fields.

In a long-term period, output adjustments of existing firms will differ from those
made in the short-run. The ability to adjust the quantities of all factors employed alters
the cost which affects output. In addition, changes may occur in the number of firms in
the industry and alter quantities supplied at various prices.
 Initially, a firm in a purely competitive model would enjoy economic profits. This is
the case because there are only few firms in the industry and cost of production is lower
than the market price, thus, economic profits are achieved.

But the aforementioned condition cannot stay long. We know that under a purely
competitive model, there is freedom of entry by new firms. So long as there is economic
profit in a business endeavor, firms would be attracted to it and would, thus, venture into
the business. The entry of new firms would be illustrated by the shift of the supply curve
to the right as the following graph would show.

We can see from the graph the effect on consumer’s welfare for markets
characterized by pure competition. Consumer’s welfare is affected through the
following:

1. Increase in output for the economy as is shown by increases in the supply curve,
thus, benefitting the consumers in the choice of greater output.
2. Lower prices as is shown from the downward shift of prices from P1 to P3. Lower
prices are brought about because of the entry of more producers in the industry,
thus promoting healthy competition among themselves and effectively lowering
prices in the process.

However, prices cannot be further lowered below P3. Prices below P3 as shown by
P4 would mean losses for some of the firms. Firms cannot continue losing indefinitely.
After sometime, some of the less efficient producers would have to close shop. If this
happens, prices would go up again to P3. Thus, we see that in the long run prices
would settle at P3. At this point, the MC intersects the lowest point of AC and price is
just equal D = MR. Graphically, the long-run equilibrium under pure competition is
shown in the following:
 FIGURE 81
Long-run Equilibrium
Long-run Equilibrium

We say that a firm is a long-run equilibrium when it has either no incentive or no

opportunity to change what it is doing. This means that price is equal to the long-run
marginal cost and marginal revenue, (P = LMC = MC), so that there is no incentive to
change the size of its plant.

Long-run equilibrium for the industry means that the firms in the industry are in
long-run equilibrium. It also means that there is no incentive for new firms to enter the
industry or for existing firms to leave. In other words, economic profits no longer exist to
induce the entry of new firms, nor can there be by the pain of losses to induce present
firms to leave.

Economic profits can be obtained by firms in the industry only if the market price
is greater than the short-run average cost (SAC). However, in the long-run, the entry of
new firms will force to Pe where price just equals average cost. At this point, zero profit
(which includes all expenses + average dividends) is achieved. It is also at this point
where individuals firms will have cut their plants back to the most efficient sizes as
shown by the short-run average cost (SAC). This means that the firms will operate at
the most efficient rate of output.

In the long-run, economic profits have been eliminated by the entry of new firms,
and there is no incentive for more firms to enter. No losses are being incurred, thus,
there is no incentive for firms to leave. The firms in the industry are doing well; and they
are earning returns which they could have obtained in alternative employment of
business opportunities.

An Evaluation of a Competitive Market

As we have seen, the final long run equilibrium position for each firm under a
purely competitive situation implies some basic characteristics. As shown in our
previous examples, pricing will settle at the level where they are equal to minimum
average cost.

We also saw that the marginal cost curve intersects, and is therefore equal to,
average cost at the point of minimum average cost. In the long-run equilibrium position,
“everything being equal”, equilibrium point is reached where MR(P) = AC = MC. This
tripe equality implies that, although a competitive firm may realize economic profits or
losses in the short-run, it will just break-even by producing in accordance with the
principle MR(P) = MC = AC. This triple equality suggests some highly desirable features
and shortcomings of the competitive price system.

Efficient Allocation of Resources

Subject to certain limitations, most economists agree that a purely competitive

economy will lead to the most efficient allocation of resources. A competitive price
economy will tend to allocate the fixed supplies of resources available to society in such
a way as to maximize consumer satisfaction.

First, because of the presence of the competition, firms would be forced to

produce those goods which consumers want most. In addition, prices charged by firms
under pure competition would be reasonable to both the producers and especially to the
consumers.

Second, the presence of competition forces firms to use the most efficient, or
least-cost methods in the production of these goods. Firms under pure competition
cannot afford to produce goods of inferior quality. Consumers will shift to producers who
will produce better quality goods or services assuming the presence of competitive
pricing. These two important conclusions can be explained by going back to some
principles we have taken up before.

1. The first principle implies the effect of P = MC. This principle implies that
production must not only be technically efficient but it must also entail the
production of the “right goods” consumers need and want. The competitive price
system sees to it that resources are allocated so that they best fit the preferences
of the consumers.

The profit seeking competitor realizes that maximum possible profit is

attained only by equating price and marginal cost. To produce short of P(MR) =
MC means less than maximum profits attainable. It also implies underutilization
of resources.

For the same reason, the production of the good should not go beyond the
output at which price equals marginal cost. To do so would mean less than the
maximum profits attainable by the producer. This means that the producer is
spending more than what is necessary to produce a good desired by consumers.
It also implies an over allocation of resources to produce a good or a service.

To summarize, under pure competition, producers will produce each

commodity up to that precise point at which price an marginal cost are equal.
Resources are efficiently allocated given this situation.
 2. The second implies the workings of P = AC principle. We discussed that in the
long-run, the presence of the competition forces firms to produce at the minimum
point of average cost of production and to charge prices consistent with these
costs.

This situation is obviously highly desirable from the consumers’ point of

view. It means that firms must use the best available technology in order to
survive. It also implies that producers cannot afford to produce inferior quality
goods or their competitors will grab the market from them by producing better
quality products at competitive prices.

This principle also means that consumers benefit from the highest volume
of production and the lowest product price which are possible under a
competitive market. It also implies that the cost involve in each instance is only
the cost essential in the production of a product. This would mean that the lowest
possible price would only be charged to consumers because producers can only
get normal profits from their ventures.

A final appealing feature of a purely competitive economy is that the highly

efficient allocation of resources which it fosters comes about because businesses
and resource suppliers freely seek to further their own self-interests. This means
that the “invisible hands” theory is at work in a competitive market system. In a
competitive economy, businesses employ resources until the extra, or marginal,
costs of production equal the price of the production. this is not only maximizes
the profits of the individual producers but simultaneously results in a pattern of
resource allocation which maximizes the satisfaction of the consumers. The
competitive price system organizes the private interests of producers along lines
which are fully in accord with the interests of society as a whole.

Shortcomings of the Competitive Price System

We just finished discussing the desirable aspects of markets characterized by

pure competition. This time we will discuss some of the shortcomings of this same
system.

1. The Income Distribution Problem

We mentioned in our previous discussion that competitive price system

will allocate resources efficiently, i.e., will produce goods and services which
maximizes the consumers’ wants. This contention, however, is predicated upon
 some given distribution of money income or the amount of pesos (peso votes) a
consumer possesses.

As long as the amount of pesos or the peso votes of consumers are more
or less distributed equitably, the price system will allocate resources efficiently. In
cases, however, where there are high degrees of income inequality, allocation of
resources would inevitably be titled in favor of those who possess the necessary
peso votes.

Competitive price system under this situation would lead to the production
of luxuries for the rich while denying the basic needs of the poor. Consider, for
example, the housing problems in the Philippines. There is a great housing
shortage in the cities, especially in the Metro Manila areas. Only a small
percentage of families in Metro Manila have detached housing units. The greater
portion live in overcrowded apartments. Now, those who do not have necessary
peso votes have to make do with the construction of flimsy houses in unoccupied
lot areas, thus, creating the phenomenon called the “squatters’ area.”

Given this shortcoming, many economists believe that the distribution of

income which pure competition provides should be modified by fiscal or
governmental action. With the housing problem, for example, the government
should provide low-cost housing to the low-income groups of similar plans to
those who are at a disadvantage because of income inequality.

2. Market Failure: External Costs and Public Goods

The competitive price system does not accurately measure costs and
benefits where spillover costs and benefits are significant. Under a competitive
situation, each producer will assume only those costs which it must pay. This
correctly implies that in some lines of production, there are significant costs
which producers scan and do avoid. This avoided costs accrue to society and are
aptly called spillover or external costs.

Firms may avoid the cost of properly disposing the waste materials or of
buying pollution-treated equipment similar to what the Magnolia Plant of San
Miguel Corporation has at its aurora Blvd. Plant in Quezon City. The result in
significant spillover cost in the form of polluted rivers, smog, and a generally
debased community.

Similarly, unbridled competition may cause profit-seeking firms to brutally

exploit farmlands, forests, and mineral deposits through the use of cheapest
 production methods. The results, would, of course, be unproductive lands,
denuded forests, and polluted mineral camps. The cost to society is the
permanent loss of irreproducible natural resources.

On the other hand, the production and consumption of certain goods and
services such as anti-TB or polio shots, yields wide-spread satisfactions or
benefits to society as a whole. These satisfactions are called external or spillover
benefits.

The market system does not provide for social or public goods. The
construction of maintenance of public schools, public hospitals, parks,
infrastructure and similar projects are done outside the market system. Despite
its over virtues, the competitive price system ignores an important class of goods
and services national defense, flood control programs and so forth, which can
and do yield satisfaction to consumers but which cannot be priced and sold
through the market system.

REVIEW EXERCISES

Pure Competition

Name:____________________________ Professor:__________________________

Year and Section:___________________ Rating:____________________________

Exercise 1

Match Column A with Column B.

A B

_____1.Point of profit maximization a. Homogeneity

_____2.Similarity of products b. MR = MC

_____3.No control over the market c. Price taker

_____4.Big number of buyers and sellers d. P=ATC

_____5.Transferability of resources e. Total Cost

_____6.Increase in new investor f. Price-setter

_____7.industry supply g. Aggregate Supplies of firms

_____8.Price in Pure Competition h. Market Price

_____9.Profit i. Free entry

_____10.Break-even j. Highest Price

k. Plurality

l. TR = TC

m. Mobility

n. Average Cost

Exercise 2

Complete the following table:

Price Qd TC TR AC MR MC Profit

₱ 3.00 5 10
3.00 10 25
3.00 15 30
3.00 20 33
3.00 25 45
3.00 30 66

At which quantity above is profit maximized? _________________________________.

Is this extraordinary or normal profit? _______________________________________.

Why? ________________________________________________________________.
Exercise 3

Draw the demand curve of a firm under pure competition.

Draw the demand curve of the industry under pure competition.

Differentiate between the two curves

 CHAPTER 9

Monopoly

Objectives:
At the end of the chapter, the student is expected to:

1. Define monopoly
2. Determine profit maximization using :
a. Total Revenue minus Total Cost Approach
b. Marginal Revenue equals Marginal Cost Approach
3. Point out some misconceptions regarding, pricing and profits under monopoly
4. Explain long-run equilibrium price and output under monopoly
5. Clarify regulation of monopoly by price control
6. Evaluate the welfare effects of monopoly

Terms to Remember

Monopoly – Refers to the form of market organization in which there is a single seller of
product without equals marginal cost.

Profit maximization – A monopolist maximizes profit by choosing a quantity where

marginal revenue equals marginal cost.

Price discrimination – The business practice of selling the same good or service at
different prices to different customers

Pure monopoly exists when a single firm is the sole producer of a product or a
service for which there are no close substitutes. When we talk of close substitutes we
mean there are no other firms producing the same products varying only in minor ways
from that of the monopolist.

Monopoly is virtually non-existent in basic manufacturing industries but was fairly

common in steel aluminum, tobacco and other areas. The tobacco industry and the
steel industries are cases that can be cited. Now, it occurs most commonly in regulated
public utilities and in particular geographical areas where transportation costs allow a
local seller to act as a monopolist within a certain range of prices.

Let us cite some examples. Manila Electric Company (Meralco) monopolizes the
distribution of electricity in the Metro Manila Area. Although candles or kerosene lights
can be used, they are considered imperfect or poor substitutes for electricity. Maynilad
is considered a monopoly. It is the only company that supplies water service for some
parts of Metro Manila Area.
 Pure monopoly, thus, refers to the form of market organization in which there is a
single firm producing a commodity or a service for which there are no close substitutes.
Thus, the firm is the industry and faces a negatively sloped industry demand curve for
the commodity or service.

The Demand Curve

The difference between a pure monopolist and a purely competitive seller lies in
the demands side of the market. In our previous discussions, we recall that the purely
competitive seller faces a perfectly elastic demand schedule. The competitive firm can
sell as much or as little as it wants at the going market price. Thus, we see that the
competitive firm is a “price taker” and therefore, must accept the market determined
price.

The monopolist’s demand curve is different. Because the pure monopolist is the
industry, its demand curve is the industry demand curve. The industry demand curve is
not perfectly elastic, but rather, is negatively sloped. As a result, if the monopolist wants
to sell more of the commodity or vice, he must lower its price. Thus, for the monopolist,
MR> P and his MR curve lies below this demand curve. Table 23 and Figure 82 will
illustrate this point.

Short-run Equilibrium Total Revenue – Total Cost Approach

Given the market price of a product, the monopolist is faced with the following
questions. (1) At the points would I be losing? (2) At what point would I break-even? (3)
At what point would I maximize profit?

One of the approaches at answering these questions would be through the Total
Revenue – Total Cost Approach. The monopolist would be losing so long as his costs
exceed his revenues. The break-even point is arrived at when total revenues just equal
total costs.

Revenue minus cost equal profits. So long as revenues are greater than costs,
the monopolists accrues profits; if costs are greater than revenues, even a monopolist
would be incurring losses. Maximum profit is achieved when the positive difference
between the total revenue and total cost is greatest. The equilibrium output of a
monopolist is the output at which total profits are maximized.
 Given Table 23 below, Let us graph how the equilibrium output of a monopolist is
achieved.

TABLE 23

Revenue and Cost Data of a Pure Monopolist (Hypothetical Data)

Price Quantity Total Marginal Total Marginal Average Profit

cost Revenue Revenue Cost Cost

P80.00 -- - - P60.00 - - (P60.00)

70.00 1 P70.00 P70.00 80.00 P20.00 P80.00 (10.00)
60.00 2 120.00 50.00 90.00 10.00 45.00 30.00
55.00 2.5 147.00 35.00 100.00 20.00 40.00 37.50
50.00 3 150.00 25.00 120.00 40.00 40.00 30.00
40.00 4 160.00 10.00 200.00 80.00 50.00 (40.00)
30.00 5 150.00 (10.00) 350.00 150.00 70.00 (200.00)

Profit Maximization: Total Curve

As in the case of pure competition, the rules for profit maximization are the same
for pure monopoly. When plotted, the total revenue schedule of Table 23 become the
total revenue (TR) curve of Figure 82 as seen on page 185.

As can be seen, the total revenue curve is dome-shaped. The total cost is
constantly rising. The difference between the total revenue and total cost is total profit.
Initially, total profit is negative. As the firm continues to produce, it breaks even. The firm
breaks even when total costs just equal total revenues. In the graph, this is achieved
after output 1.

Total profit becomes positive when total revenue exceeds total cost. When the
firm continues to produce after the break-even point, the firm attains positive profit. In
the graph, maximum profit is achieved at output 2.5. The Monopolist maximizes profit at
this output because the differences between TR and TC is greatest at this point. At this
point the slopes of TR and TC are equal (i.e.,tangents to the curves at this output are
parallel). Since the slope of the TR curve is the marginal revenue, profits are maximized
at the output at which marginal revenue equals marginal cost. This is illustrated in the
following graph.
 FIGURE 82

Short-run Profit Minimization

Total Curves
Some Common Misconceptions

It is commonly believed that because a monopolist can manipulate price and

output, he will, therefore, charge the highest price as he can get. This is not a correct
assumption. As can be seen of Figure 83, a maximum profit is attained at the price of
Php.55 per unit. Any price charged by a monopolist above that price will give him lower
profits. As was discussed earlier, maximum profit is attained at the point where marginal
revenue equal marginal cost. In figure 83, this is attained at the price of Php.55 per unit
and at 2.5 units as output. Any price or output greater or lesser that Php.55 and 2.5
units would give lesser profit monopolist.

FIGURE 83

Short-run Minimization per Unit Curves

 Because the demand curve facing purely competitive firm is perfectly elastic,
there is a temptation to assume that the demand curve faced by a monopolistic is
inelastic. This is not the case in most instances. A monopolist will always want to
produce in the elastic range of its demand curve. If we recall the concept of elasticity,
lowering price within the inelastic range of the curve would result to lower total revenue.
The monopolist will always want to avoid price and output combinations within the
elastic segment of the demand curve. At any point within this range, marginal cost is
positive. At the output at which marginal cost equals marginal revenue, marginal
revenue must also be positive, then the elasticity of demand must be greater than one

We also have to emphasize that monopoly does not guarantee economic profits.
It is true that in all likelihood, economic profits are greater for a monopolist that for
producers in a purely competitive market. In the short-run the monopolist may incur
losses. If this happens, the concern of the monopolist is to minimize losses. Losses are
minimized if the short-run marginal cost equals marginal revenue. This concept is
illustrated in Figure 84 below.

FIGURE 84

Short-run Minimization: Per Unit Curves

The Long-run

As we have taken before, we saw that entry of new firms into an industry
characterized by pure competition is easy in the long-run. Entry into a monopolistic
blocked either by natural or artificial forces.

One of the barriers to entry into a monopolistic industry is the question of size or
economies of scale. Capitalization of monopolistic industries usually run in millions or
billions of pesos. The production and eventual distribution of energy, for example, is a
very expensive proposition. It takes millions of dollars, for example, to operate and
maintain Meralco. It cost us billions of dollars to build our first nuclear plant in Bataan.
Not just anyone can go into this kind of industry

The monopolist may also block entry in several ways. The discovery, production
and control of the sources of raw materials is a case in point. A country or a company
might have control of strategic raw materials like aluminium, bauxite uranium, and would
thus, exercise monopolistic control over these materials.

Patent ownership and research is another case in point. Patents held by the
monopolist prevent other firms from duplicating the product. For example, in the
manufacture of shoe machinery a single company has held patents simultaneously on
virtually all equipment used in the manufacture of shoes. Instead of selling machinery
outright to the manufacturers, the company leased it to them and collected royalties.
The shoe manufacturer who obtained any equipment from another source would then
find it impossible to obtain key equipment from the company.

Another reason could be that a firm may become a monopolist because it is

awarded a market franchise by the government. The firm is granted the exclusive
privilege to produce a given good or service in a particular area. In exchange for this
right, the firm agrees to allow the government to regulate certain aspects of its
behaviour, pricing, policies and other operational policies. We have several examples to
illustrate this point. In the field of energy, the case of Meralco is a classic example; in
transportation we have the Light Rail Transit (LRT), in trading, we had the National
Sugar Trading Association (Nasutra).

Size of plant Adjustment

As we just discussed, since entry into the industry under monopoly is blocked,
the monopolist adjusts the long-run output by means of size of plant adjustments. We
will just explain two possibilities here. First, the relationship between the monopolist’s
market and long0run average cost of may be such that a plant smaller than the most
efficient size will be built. Second, the relationship may be such that a most efficient size
of plant will be appropriate.
Less than most efficient size of plant

The size of plant is considered less than the most efficient if the monopolist’s
market is so limited that the marginal revenue curve cuts the long-run average cost
curve to the left of its minimum point. Figure 85 illustrates this situation.

FIGURE 85

Long-run Profit Maximization: Less than Most Efficient Plant Size

As can be seen from the graph, long run profits area maximized at the output at
which the long-run marginal cost (LMC) equals marginal revenue (MR). This means that
the output is Qm and the price is P. the monopolist should build the size of plant that will
produce that output. This means the short-run average cost (LAC) at output Qm. If the
short run average cost (SAC) is tangent to long-run average cost (LAC) at output Qm,
the short-run marginal cost is necessarily rqual to the long-run marginal cost at that
output. Profits are equal to PC x Qm. Any change in the size of plant or in the rate of
output of short-run average cost will decrease of profits.

Situations like this happen when the market is not large enough to expand the
plant sufficiently to take advantage of all economies of size. The size of plant used will
have some excess capacity. Medium-sized towns often operate plants smaller than the
most efficient size at less than the most efficient rates of output. In addition to his, the
relatively small local market for electricity limits the generating plant to a size too small
to use the most efficient generating equipment and techniques. This is the reason why
most small-and medium-sized electric plants outside the jurisdiction of the Manila
Electric Company (Meralco) charge higher rates than Meralco. And it is for this reason,
too, why consumers in the outlying areas near the Metro Manila want to be integrated
into the services of Meralco.

Most efficient Size of Plant

The most efficient size of plant is where the monopolist market and cost curves
are such that the marginal revenue curve hits the minimum point of the long-run
average cost (LAC) curve. The long-run profit maximizing output is Qm, at which the
long-run marginal cost equals marginal revenue. At this point, the output will necessarily
be at which the long-run average cost is minimum.

The most efficient size of plant is build where SMC = LMC = MR = SAC = LAC at
output Qm. At this point, cost of production is C, and the price is P. profits are equal to
PC x Qm. The following graph (Figure 86) illustrates this concept.

FIGURE 86

Long-run Profit Maximization: Most Efficient Size of Plant

Price Discrimination

In some cases, a monopolist may find it possible and profitable to separate two
markets and to charge different price for the product in each of the markets. For
example, moviegoers are charged different prices although they see the same movie;
orchestra tickets are paid lower rates compared with lodge tickets. Appliance prices in
Metro Manila are comparatively lower compared with the prices in the provinces for
example.

There are several reasons why price discrimination occurs. First, the monopolist
can keep the markets apart. Secondly, for price discrimination to be effective and
profitable, the elasticities of demand at each price level must differ among the markets.

Figure 87 will help clarify this concept.

FIGURE 87

Price Discrimination

From Figure 87, we can see that there are two markets: Market I and Market II.
There are two corresponding demand curves representing the demand curve for each
market. D1 for Market I and D2 for Market II. We can also see that the demand curve of
the first market is inelastic while that of the second market is elastic.
 As we can see, the price charged for the first market is higher at P1 compared
with a lower price in the second market at P2. The price in the first market is higher
because demand for the product is inelastic while the price in the second market is
lower because demand is elastic.

In addition, the amount of goods bought in the first market at Q1 is comparatively

less than what are bought in the second market at Q2. We can conclude from the graph
that more goods are bought in second market because demand for the product is
elastic. Prices here are lower compared with less goods bought at the second market
where demand is inelastic.

Price discrimination is widely practiced in our economy. The sales representative

who must communicate important information to the company headquarters has to use
the more expensive long-distance telephone service (if it is available from the area he is
calling from). Electric utilities frequently segment their markets by end users. The
industrial users are charged higher rates compared with the ordinary home users.

As we have seen, movie theaters vary their charges on the basic of the location
of the moviegoers. The more numerous orchestra viewers are charged less than the
balcony or lodge viewers. Railroars vary the rate charged per kilometre per ton
according to the market value of the product being shipped. The shipper of 20 tons of
refrigerator sets will be charged more than the shipper of 20 tons of gravel and sand.

Physicians and lawyer frequently set their fees for a given service on the basis of
ability to pay. The more affluent customers can be charged more than the less affluent
ones. Charitable cases or pauper litigants are not charged any fees simply because
they cannot pay any.

Airlines charge higher rates to traveling executives whose demand for travel tend
to be inelastic, and offer lower fares to students, teachers, or families whose demands
are more elastic. An appliance manufacturer that sells its product directly to the public
would charge higher price compared to what is offered to big distributors. Big
distributors order more goods and are, thus, given discounts.

Regulation of Monopoly

As we have learned, there is a tendency for a monopolist to maximize profits and

being the only one in the market, a monopolist normally would not think too much of
consumer’s welfare. If monopolies were not regulated, the cost of energy would be
costing much more now or the cost of dextrose or other medicines would be much more
expensive that their prices now.
 Public welfare dictates that the government should take more active role in the
regulation of monopolies. Monopolies cannot just be left alone by the government in the
same way as other industries in more competitive models are left alone.

There are two parties involved here: the monopolist who tends to maximize profit
and the consumer who must be protected by the government and given a fair deal by
monopolist. Thus, the economic problem involved here is the determination of the rate
that will induce the monopolist to furnish the amount of product consistent with his cost
and with the need and demands of the consumers. This problem can be resolved by
analyzing the graph below.

FIGURE 88

Regulation of Monopoly by Price Control

In the absence of price regulation, the monopolist would maximize profit at P1

and output Q1 where marginal cost equals marginal revenue. Since cost of production
is given as C1 profits would be equal to C1P1 x OQ1.

The government can regulate prices by establishing a price lower than P1 but of
course, greater than the cost of production. Suppose the government establishes price
at P2 would it still be profitable for a monopolist to produce? The answer is affirmative.
 At P2 the marginal cost curve cuts the demand curve. The demand for the
commodity thus, increases as a result of a fall in the price level. Output at P2 would
then placed at Q.

The monopolist can still profit despite a lower price. Profit at P2 would be
equivalent to C2P2 x OQ2. At this price, the monopolist can still attain a reasonable
degree of profit at the same time giving the consumer a break in the form of relatively
lower price and relatively greater output.

The Welfare Effect of Pure Monopoly

We can now compare two markets: a market characterized by pure competition,

and one characterized by pure monopoly. Obviously, from the point of view of
producers, a monopolistic market would be preferred. A monopolist does not have to
contend with any competitor, has considerable control over price decisions, and has,
therefore, more chances of maximizing profit. Given these factors, what welfare
considerations are in store for the consumer? The following discussions will answer this
question.

Short-run Output Restriction

If all industries were initially purely competitive and were in long-run equilibrium,
monopolization of one or more of them would reduce consumer welfare.

As we have seen in our previous discussion on pure competition, equilibrium

price is reached where price equals cost of production or the lowest point of the average
cost curve. In our graph, price and output under pure competition would be placed at P2
and Q2.

In contrast, a monopolist would maximize profit at the point where the marginal
revenue just equals marginal cost. As can be seen from the graph, the monopolist sees
the market demand curve sloping downward to the right and marginal revenue curve
that lies below the demand curve like MR in our graph. To maximize profit, the
monopolist would produce at output Q1 and would peg his price at P1.

As we can see, the price charged by a monopolist would be higher compared

with that charged in a market characterized by pure competition. In addition, the amount
of goods available to the consumer would be less (Q1) compared with more goods (Q2)
that would have been available to the consumer if the market were characterized by
pure competition.
 FIGURE 89

Monopolistic Output Restriction

Inefficiency of the Firm

In addition to the welfare impact output restriction, the monopolistic firm ordinarily
will not use resources at their peak potential efficiency. The purely competitive firm in
long-run equilibrium uses the most efficient size of plant at the most efficient rate of
output. The size of plant and the output that maximize that monopolist’s long-run profits
are not necessarily the most efficient ones. However, if monopoly is to be compared
with pure competition on this point, the comparison is legitimate only for industries in
which pure competition can exist.

In an industry with a limited market relative to the most efficient size of plant,
monopoly may result in lower cost or greater efficiency than would occur if there were
many firms, each with a considerably less than most efficient size of plant.

Sales Promotion

It may be to the advantages of the monopolist to engage in some sales

promotion activities of this kind. The monopolist may use sales promotion to enlarge his
market, that is, to shift his demand curve to the right. Consider, for example, the
advertisement of monopolies like the Manila Electric Company and the Philippine Long
Distance Telephone Company. These monopolies advertise for several seasons: to
enlarge their respective markets, to promote goodwill or good public relation with the
consumer, to make the public aware that their companies exist and is doing good
service to the public.

If a monopolist can convince the public that consumption of his product is highly
desirable or even indispensable, elasticity of demand at various prices may be
decreased. Additionally, such activities may be used to shield him from potential
competition and to protect his monopoly position. His objective in this case will be to get
his firm’s name so closely tied to his product that potential competitors will find it futile to
attempt to enter the market.

All of these sales promotions imply cost to the company. The welfare effect of all
these efforts will inevitable be reflected in additional cost to the company which will
ultimately be passed on to the consumers in the form of higher prices.

Monopolies in the Philippine Setting

From the previous discussions, we have implied the loss of consumers’ welfare
where monopolies exist. Can this situation take place in our country?

We have had unpleasant experiences with monopolies in the Philippines.

Consumers have been complaining about the abuses committed by monopolies in the
Philippines. Pressures have been exerted by concerned citizens and consumers’ union
to make these monopolies conscious not only of monopoly profits but also of public
welfare

We are obviously moving away from centralization, monopolies, and regulations.

We have taken steps to deregulate the coconut industry by allowing, among other
things, all oil millers to export their products to overseas markets.

Our experience under a more centralized economic set-up, which apparently

became expedient under an authoritarian regime while it lasted, has obviously not
worked in our best interest. This is the reason we are falling back to our original position
of promoting free enterprise.

But even in normal times, we had problems with monopolies in areas where they
are deemed necessary and practical or their type of operations can be justified by the
prevailing circumstances or exigencies. There is nothing wrong with monopolies,
especially in public utilities like power, water, telecommunications and the like, provided
management and those who work for such enterprises remember what their real role in
the economy is and why they are granted exclusive franchise in their areas of operation.

Public utilities are, first of all, public service enterprise. The exclusive franchise or
monopoly granted to a company or service establishment is intended to enable the
enterprise to show a profit and therefore, remain in operation.

But precisely because a monopoly in a public utility or service area has actually
the power to deprive a member of the human community one or more of the basic
necessities of everyday living (electricity, water, and others), it should not abuse that
power.

There have been quite a number of instances where a housewife would be

deprived of electricity or water or telephone even if she promised to raise the cash to
make a book back accounts and would plead for just a little more time to produce the
money.

In the final analysis, it is probably management that must be blamed for

perpetuating a policy that forgets and even makes a mockery of public service and puts
more emphasis on profit even if it has to be punitive and thereby creates public distrust
and ill-will

A Study on Monopolies

We have already shown theoretically how monopolies reduced consumer welfare

in the form of higher prices and lesser goods available to the consumers. We also
mentioned that ordinarily a monopolistic firm will not use resources at their peak
potential simply because of absence of competitors. Because of this, a monopolist can
afford to be inefficient and can still rake in higher than average profits.

Are there evidences that these theoretical principles are valued in the real world?
A well-documented study made up by a group of economists at the University of the
Philippines School of Economics came up with the conclusion that the presence of
numerous monopolies in the economy represents an enormous drag on productive
capacity. In the absence of economic competition, many of these entities are allowed to
earn higher than average profits or to fritter away this potential surplus in the form of
waste and inefficiency. Where they dominate production, they are able to charge higher
prices to clients or get away with inefficient service (e.g., the utilities); where they are
exclusive purchaser (i.e., monopsonies) as in the sugar and coconut industries, they
may penalize direct producers by paying a lower price than under a competitive system.

The government has mandated the existence of many private monopolies, and is
itself a monopolist in some sectors of the economy (e.g., through the National Food
Authority). Especially disturbing has been the concentration taking place in the banking
industry and its close relationship to the concentration of ownership in the economy; the
combination of finance and industrial interests has concentrated the most important
decision on the allocation of society’s resources into a few private hands, both local and
foreign. Parallel to his has been the growth of the government’s role. Apart from its
implication for economic efficiency, such a trend has had a severe negative impact on
income distribution.

The study added that except where there are valid economic reasons for
maintaining them (and these must be publicly demonstrable), monopolies are
economically harmful, and the trend towards greater economic concentration should be
discouraged. Existing monopolistic and other privileges, especially those with exist only
by virtue or presidential decrees or letters or instructions, should as a rule be abolished
and re-established, if at all, only after a lengthy public discussions and study. These
include the more important monopolies in agriculture, such as sugar, coconut, and the
NFA’s various trading prerogatives. Government financial institutions should cease
acting as mere conduits for Central Bank credit and should generate their own sources
of funds. (e.g., by attracting deposits). This will force them to become more efficient in
their lending , since they would be held liable by their sources of funds for any bad
credit decisions; competition in the whole financial market would thereby also be
stimulate.

REVIEW EXERCISES

Monopoly

Name:____________________________ Professor:__________________________

Year and Section:__________________ Rating:____________________________

Exercise 1

Indicate if the following characteristics exist in a condition of pure monopoly by

writing a YES in the blank for those that do and a NO for those that do not.

_________1. Freedom of entry into the market

_________2. Consumers enjoy variety of products.

_________3. The seller is a price maker.

_________4. The seller can set price as high as he can without affecting demand.

_________5. The seller’s demand curve is downward sloping.

_________6. The seller’s marginal revenue is lower than price.

_________7. Perfect knowledge of market conditions

_________8. The seller advertises his product.

_________9. Profit is maximized where MR = MC.

_________10. Extraordinary profits are enjoyed when price exceeds the average cost.

Exercise 2

Give the points of differentiation between a pure monopoly and a technical

monopoly.

1.

2.

3.

Exercise 3

Complete the following table:

Quantity Price Total Average Marginal Total Marginal Total

Cost Cost Cost Revenue Revenu Profile
e

0 ₱200 145
1 180 175
2 160 200
3 140 220
4 120 250
5 100 300
6 80 370
7 60 460
8 40 570

1. Compute and graph profit maximization using:

a. TR – TC Approach
 b. MR = MC Approach
2. How much is maximum profit? Why?
3. Graph the profit area.

Exercise 4

Discuss the following:

1. Producers would prefer a market characterized by Monopoly. Explain the

theoretical and practical reasons for your answer.
2. How do you characterize monopolies in the Philippines? Relate your answer to
the study made by a group of UP economists.

Exercise 5

Write C for a purely competitive market, M for a monopolist market/industry, or F

if neither one.

_____1. Each seller takes the role of a price taker.

_____2. Shutdown point is when determined selling price is less than a firm’s AVC.

_____3. Firm maximizes profit when determined selling price is equal to average cost.

_____4. In the long-run, all costs become variable.

_____5. No good substitutes are available for the good or service the only firm offers.

_____6. Break-even position is when marginal cost is equal to AVC.

_____7. Only more than normal profits can be earned by the firms.

_____8. A firm’s supply curve is its variable cost curve,

_____9. Profit is maximized at an output level where MR is equal to MC.

_____10. The firm and the industry are one.

CHAPTER 10
 MONOPOLISTIC COMPETITION

Objectives:

At the end of the chapter, the student is expected to:

1. Explain monopolistic competition

2. Cite examples of firms/industries under monopolistic competition
3. Determine short-run and long-run profit maximization under monopolistic
competition
4. Give a comparative analysis between monopoly, monopolistic competition, and
pure competition
5. Evaluate the welfare effects of monopolistic competition

Terms to Remember

Monopolistic competition- a market structure in which many firms sell products that are
similar but not identical

Product differentiation- The practice of making product unique or different from

competition

We have already discussed pure competition and monopoly. In purely

competitive industry, there is the presence of many firms; in contrast, there is only one
firm in a pure monopoly. For many years, economists felt that these two models were
adequate enough to analyze any market. This situation lasted until the late twenties.

As we now know, however, between the extremes of pure competition and

monopoly there exist “intermediate” market structures that can be classified into two
categories: monopolistic competition and oligopoly. These two market structures are
often lumped together into a market characterized by “imperfect competition.”

One of the most notable achievements of economists who examined the middle
ground between pure competition and monopoly was that of an American economist,
Edward H. Chamberlin who developed the theory of monopolistic competition.

E. H. Chamberlin based his theory of monopolistic competition on solid empirical

fact: there are very few honest to goodness monopolies because there are very few
commodities for which close substitute do not exist; similarly, there are very few
commodities that are entirely homogeneous. Instead, there is a wide range of
commodities, some of which have relatively few good substitutes and some of which
have many good, but not perfect, substitutes.

In many cases, the product is heterogeneous rather than homogeneous, thus,

pure competition cannot exist because of its assumption of homogeneity. On the other
hand, although heterogeneous, the products are only slightly differentiated. Competition
exist because each is a close substitute for the other.

Product Differentiation

The basic idea behind monopolistic competition is that most firms face relatively
close substitutes and that most commodities are not completely homogeneous from one
producer to another. This concept is what we call product differentiation.

Firms in a purely competitive market produce a standardized product;

monopolistically competitive producers turn out variations of a given product. A number
of firms produce toothpaste, for example. However, the product of each firm differs from
its rival in various ways.

When a consumer wants to buy toothpaste, he specifies the brand of toothpaste

he wants. He does not go to the store and orders a toothpaste; he goes to the store and
orders “Colgate” or “Close Up” or whatever brand he wants.

Product differentiation has several dimensions. “Real” differences can exist when
functional features, material, design are important aspects of product differentiation.
“Imaginary” differences can exist through effective use of advertising, packaging,
trademarks, and brand names. A smoker, for example, smokes “Marlboro” cigarettes
because of the image projected by this particular brand of cigarette. There are other
conditions where differentiation can exist: the location of the store, the reputation of the
firm marketing the product, the courteousness of the sales staff, the availability of credit,
and others.

Because of product differentiation, the producers would spend significant

amounts for advertising and promotion to increase sales. In a market characterized by a
monopolistic competition, competition centers not only on price but also on product
quality, advertising, and sales promotion.

What is Monopolistic Competition?

Monopolistic competition refers to the market organization in which a relatively

large number of small producers or suppliers are offering similar but identical products.
An example of this is given by the many tablets for headache available in the market
(for example, Biogesic, Medicol, Advil). Another example is given by the many different
brands of bath soap available in the market like Safeguard, Lifebuoy, Palmolive.

Let us compare monopolistic competition with pure competition. Pure competition

requires hundreds, thousands or even millions of producers. The millions of farmer in
the agricultural sector is an example of the number of producers under pure
competition. Monopolistic competition does not require the presence of thousands or
millions of firms or producers but only a fairly large number say 15, 25, 40, 50.

Because of the presence of relatively large number of producers in a

monopolistic competition, several important considerations can be noted. Since each
firm has a comparatively small percentage of the total market, each has a very limited
amount of control over market price. However, the seller has some degree of control
over the price he charges because of product differentiation. Because of this degree of
control, the seller faces a negatively sloped demand curve. However, the existence of
many close substitutes limits his degree of control resulting in a highly elastic demand
curve.

Product differentiation leads some consumers to prefer the products of one

producer in an industry over those of others. Thus, there is some degree of control over
price leading to a negatively sloped demand curve. In the example of pills for headache
or the brands of bath soap, product differentiation makes the products sold by one seller
somewhat different from the product sold by another. No single price prevails for the
differentiated products of the industry, although price differences do not vary much from
the other brands. Producers or sellers charge somewhat different prices depending on
consumers’ acceptance of the differentiated products.

Short-run Equilibrium

Short-run pricing and output determination for monopolistic competition is similar

to that of other market situations we have previously discussed. It is primarily an
analysis of the adjustment of the individual firm to the condition each firm faces. Under a
monopolistic condition, a firm does not have time to change its plant size. Individual
firms can make price and output adjustments. It is possible to bring about small
changes in demand for individual firms through advertising and variations in design and
quality.

Profit maximization with respect to price and output by the individual firm follows
the rules we discussed in previous chapters. The firm’s short-run average cost curve
and the short-run marginal cost curve are shown as SAC and SMC, respectively. Since
the demand curve is less than perfectly elastic, marginal revenue for each possible level
of sales is less than the product price, and the marginal revenue curve lies below the
demand curve. Figure 90 illustrates the short-run equilibrium point under monopolistic
competition.
 FIGURE 90

Short-run Profit Maximization

From the graph, we can see that the firm maximized profit by producing at output
Q at which marginal cost equals marginal revenue. Profits per unit are given as CP.
Total profits can be obtained by multiplying profit per unit (CP) by the number of good
bought (Q). (Total point profit=CPxQ).

Short-run equilibrium does not mean that all the firms in the market charge
identical prices. This is not expected since the firms in the industry do not produce
homogeneous products. However, prices charge by different producers will not be far
apart.

Short-run loss minimization

It is possible that because of unhealthy and cutthroat competition, a less

favorable cost and demand situation may exist putting the monopolistically competitive
firms in the position of incurring losses in the short-run. Given this situation, the same
principle would be used: losses will be minimized at the point where marginal cost
equals marginal revenue. Figure 91 on the next page illustrates this point.

When we talk long-run equilibrium we are referring to two types of adjustments

firms are faced with: the firm can build any desired size of plant; where entry is open
and when profits are being made, it is possible for new firms to enter the market. In
case losses are being incurred, losing firms can make an exit in the industry.

FIGURE 91

Short-run Loss Minimization

Adjustment: Entry Blocked

Blocked entry in an industry characterized by monopolistic competition clearly will

not be the usual case; still it may, and sometimes, does, occur. Where it occurs, it is
usually the result of legislative activity of some kind. Owners or operators of the firms in
a particular industry may belong to a trade association that has some political influence
on a local, foreign or perhaps even a nationwide basis. The industry may be fairly
profitable, and the trade association may foresee the possibility of wholesale entry into
the industry. Therefore, it may use its influence to secure the enactment of legislation
that is rationalized as insuring an adequate supply of the commodity at prices allowing
those in the trade to make fair and reasonable profits. In the service trades in a
particular city or state, one can easily find licensing laws that tend to block entry.
 Given this situation, firms seek to adjust their respective plant sizes to those
required for long-run profit maximization. Thus, the long-run marginal cost, the long-run
average cost, and the marginal revenue curves are the relevant ones for the firm. This
concept is illustrated in figure 92.

From the graph, we can see that profits will be maximum at output Q at which
point the long-run marginal cost equals marginal revenue. Output Q can be sold for
price P per unit. At this price and output, profits are equal to PC x Q.

FIGURE 92

Long-run Profit Maximization: Entry Blocked

Adjustment: Open Entry

A large number of firms existing in the industry suggest that the size of each firm
is not so big and that effective collusion would be extremely difficult. Thus, unless
through government intervention, most of the bars to entry are not effective in markets
of monopolistic competition.

As long as pure profits exist for firms in the industry and potential entrants
believe that they can also make profits, entry will be attempted. As new firms enter, they
compete for the market share of existing firms, causing the demand curve and the
marginal revenue curve faced by each to shift downward. The increase in the number of
suppliers pushes the whole cluster of price ranges for individual firms downward.

The entry of new firm into the industry will affect the production cost of existing
firms. This will shift the demand curves faced by individual firms downward, thus,
decreasing the market share of each firm. In addition, cost curves of the firms would
move upwards not only because of additional costs brought in by the new entrants but
also by sales promotion efforts of each firm in an effort to attract more sales.

As long as profit possibilities remain, new firms will continue to enter the market.
Now, since entry is open, eventually enough firms will have entered into the market just
enough for each firm to get normal profit with pure profits squeezed out. The less
productive firm would incur losses, and thus, must leave the market. Theoretically, this
will be shown with the long-run average cost shifting upwards. Equilibrium point is
reached where price equals LAC and LMC. This means that when enough firms have
entered to cause the demand curve faced by each firm to be just tangent to its long run
average cost curve, firms of the industry will no longer be making pure profits, and entry
will stop. Figure 93 illustrates this point.

FIGURE 93

Long-run Profit Maximization: Open Entry

Monopolistic Competition, Monopoly, and Pure Competition: A Comparison

We have already discussed the characteristics of monopolistic and pure

competition. From this discussions, we can make several comparisons. Among these
are the following:

First, the firm under monopolistic competition is likely to produce less goods and
charge relatively higher prices than under pure competition. There are comparatively
less number of producers existing under monopolistic competition. This would account
for less goods produced as compared with a market characterized by pure competition.
In addition, less number of firms present under monopolistic competition would enable
producers to charge relatively higher prices than under pure competition. The demand
curve facing the monopolistic competitor is not perfectly elastic, as it is pure
competition. Since marginal revenue is less than price in monopolistic competition, the
firm will produced less than the amount at which price equals marginal cost resulting to
less production than under pure competition.

Second, in comparison with monopoly, firms under monopolistic competition are

likely to have greater output, lower prices and thus, lower profits. The firms in a product
group may obtain pure profits if they were to collude, ie., if entry into the industry is
blocked. Producers would prefer a market characterized by pure monopoly because
profits are greater here compare with those prevailing under monopolistic competition.
From the point of view of the consumers, however, they would be worse off because of
higher prices and output restriction.

Third, firms under monopolistic competition may be somewhat inefficient

because they tend to operate with excess capacity. The inefficiency is seldom found
under pure competition which could mean the exit of a firm from the industry.
Inefficiencies may not be very great in the monopolistically competitive firm because the
demand curve is likely to be highly elastic. The more the elastic the demand curve the
less excess capacity the firm will likely have.

WELFARE EFFECTS OF MONOPOLISTIC COMPETITION

Output Restriction

If one of the industries of a purely competitive economy in long-run equilibrium

were to become monopolistically competitive, welfare would tend to be reduced by a
slight increase in the prices charged for the product. In other words, since prices are
relatively higher under a monopolistically competitive firm, consumer would receive less
welfare than under a purely competitive economy.
 The demand curve faced by the monopolistically competitor, though very elastic,
is less than perfectly elastic. Marginal revenue for the individual firm is less than the
price, and the rate of output is stopped short of that at which marginal cost equals the
product price. Thus, comparatively less output is expected under a monopolistic
competition than under pure competition.

In the long-run the price would equal the average cost of production unless entry
into the industry is blocked. When entry is free and easy – as appears to be the usual
case – new firms enter the profit-production of the product. The organization of the
economy’s productive capacity can follow consumers’ tastes and preference with a high
degree of accuracy.

When entry into profit-making industries is blocked, the consequences with

respect to price and average costs are much the same as they are under pure
monopoly. The productive capacity of the economy cannot be organized to conform
accurately to consumers’ taste and preferences. Additional quantities to resources are
prohibited from moving into the profit-making industries where they would be more
productive than they are in alternative employments.

Efficiency of Individual Firms

There will be some inefficiency of individual firms in the long-run when entry into
the industry is easy; that is, the firm will not be induced to build the most efficient size of
plant nor to operate the one it does build at the most efficient rate of output. A most
efficient size of plant would involve the firm in losses since average cost at such an
output would be greater than price. If the long-run average cost curve lies below the
demand curve for any range of output, pure profits can be made by any firm that builds
the correct size of plant for anyone of those outputs. New firms will enter until profits are
eliminated. Profit possibilities are eliminated when individual firm long-run average cost
curve lies above the demand curve for all outputs. Exit of firms from the industry will
continue until the long-run average cost curve for each firm is again tangent to the
demand curve faced by it.

Some overcrowding with regard to the number of firms in the industry and some
excess plant capacity may occur when entry is easy. Since each firm builds a less than
most efficient size of plant, there is room for more firms to exist than there would be if all
were building plants of the most efficient size. In addition, since each firm tends to
operate the plant that it does build at less than the most efficient rate output, it follows
that excess plant capacity may exist.

When entry is restricted, the firm will build the appropriate size of plant to
produce the output at which long-run marginal cost equals marginal revenue. There is
no inducement for the firm to build an optimum size of plant. Pure profits are made by
the firm so long as the average cost curve lies below the market price. The plant will be
optimum only in case the firm’s marginal revenue curve passes through the minimum
point on its long-run average cost curve.

Range of Products Available

Consumers will have a broad range of types, styles, and brands of particular
products from which to choose in market situations of monopolistic competition. The
consumer can choose the style, type shape and color of package that most nearly suits
his wants or fancy depending on the amount of money he has.

The different kinds of a specific product may be so numerous that they can prove
confusing to the consumer, and problems of choice may become complicated. Because
the product differentiations, consumers have to pay higher prices for particular brands
which in reality may not really be superior to lower-priced brands of the same kind.

REVIEW EXERCISES

Monopolistic Competition

Name:___________________________ Professor:__________________________

Year and Section:_________________ Rating:_____________________________

Exercise 1

Indicate if the following characteristics exist in monopolistic competition by

putting a YES before those that are and a NO for those that are not.

________1. Product differentiation

________2. Brand loyalty

________3. Uniform pricing of commodities

________4. Sellers enjoy a certain degree of market control

________5. Perfect knowledge of market conditions

________6. Interdependent action of sellers

________7. Free entry into and exit from the market

________8. Consumers enjoy a variety of goods.

________9. Producers tends to operate at full capacity.

________10. The seller’s marginal revenue is identical to price.

________11. The seller faces a downward sloping demand curve.

________12. The elasticity of demand for the seller’s product is determined by the
buyer’s attachment to the product.

________13. Sellers advertisement their products.

________14. Branding, labeling, packaging, shaping and differentiation in physical

attributes are practiced.

________15. Profit is maximized where MR = MC.

Exercise 2

A. Identify the following curves:

B. In the graph from the previous page, indentify a price where the seller will enjoy
extraordinary profits.
C. Enumerate the different methods use in product differentiation.

Exercise 3

Indicate which type of market can be characterized by the following features.

1. Consumer choice of products

2. Need for advertising
 3. Extraordinary profit
4. Independent producer action
5. Firm determines his own prices
6. Use of non-priced competition
7. Underutilization of facilities
8. Product differentiation
9. Collusion of producer
10. Easy entry into the market

Exercise 4

Given the supply function

QS = 12 – P

Determine the demand TR and MR Schedules

P Q TR MR

0
1
2
3
4
5
6