PRICE DETERMINATION UNDER PERFECT COMPETITION

NORMAL PRICE:

According to Professor Marshall, Normal or Natural Price of a commodity is that which

economic forces would tend to bring about in the long run. Professor Marshall referred
the short-period normal price as Sub-Normal Price. Therefore, the normal price has been
bifurcated into:

(a) Short-Period Normal Price

(b) Long-Period Normal Price

a) Short-Period Normal Price: Short period of time refers to the time which is not
sufficient for supply to adjust itself to demand completely. Supply can be adjusted
completely if there is enough time for the factors of production to vary in accordance
with the increase or decrease in demand.

In short run, a firm is in equilibrium at the output at which price equals marginal
costs. In short run, the fixed cost is not considered for decision-making. It is the average
variable cost which is considered for determining whether to produce or not. If the price
falls below the maximum average variable cost, then even in the short run, all the firms in
the industry will shut down to minimise loses. Thus the minimum average variable cost
is the minimum limit to the price. The short-run supply curve of the industry is the lateral
summation of the all the marginal cost curves of the firms. The short-run supply curve of
the industry slopes upward from left to right.
In the above diagram, the short period supply curve is divided into two: short-run supply
curve (SRS) and market period supply curve (MPS). In the above diagram, it is depicted
that in the market period, if the demand increases from DD to D’D’, the market price will
rise sharply from OP to OK, while the supply will remain unchanged at OM or MPS.
However, in the short-run, the increased demand will also increase the production by
making intensive use of the fixed capital equipment and increasing the amount of
variable factors. It should be remembered that in the short-run the fixed capital or the
fixed costs couldn’t be increased or decreased. While in the market period, neither fixed
costs nor variable costs can be varied. The market period is referred to a very short
period. Therefore, the supply curve of the market period is a straight vertical line and the
supply curve of a short period is upward sloping curve from left to right. If the demand
increases from DD to D’D’, the price will decrease from OK to OR and the supply will
increase from OM to OM’ in the short period.

Now if there is a decrease in demand from DD to D”D”, the market price will fall sharply
from OP to OL, the supply of commodity remaining the same. But in the short run, firms
will contract output by diminishing the variable factors and as a result the quantity
supplied will fall. The short-run normal price will be OT. At price OT firms would be
incurring losses. Price cannot fall below OD, since at price below D, firms would not
produce any amount of the commodity and the quantity supplied will be zero.

b) Long-Period Normal Price: In the long run, every cost is variable cost. In this
period, all costs ever incurred by the firm must be recovered. Price, in the long run, or
normal price under perfect competition, therefore, must be equal to the minimum long-
run average cost. A firm under perfect competition is in long-run equilibrium at the
output where price = MC = minimum LAC.

If the price is above the minimum long-run average cost (LAC), the firms will be making
‘super-normal profits’. Therefore, new firms will enter the industry to compete away
these extra profits and the price will fall to the level where it is equal to the minimum
LAC, where the firms are making ‘normal profits’. If the price is below the minimum
long-run average cost (LAC), the firms will be making ‘losses’. Therefore, some of the
existing firms will exit from the industry to avoid losses and the price will rise to the
level where it is equal to the minimum LAC or at the normal price.
Price Determination under Monopolistic Competition

Imperfect competition covers all situations where there is neither pure competition nor
pure monopoly. Both perfect competition and pure monopoly are very unlikely to be
found in the real world. In the real world, it is the imperfect competition lying between
perfect competition and pure monopoly. The fundamental distinguishing characteristic of
imperfect competition is that average revenue curve slopes downwards throughout its
length, but it slopes downwards at different rates in different categories of imperfect
competition. The monopolistic competition is one form of imperfect competition.

FEATURES OF MONOPOLISTIC COMPETITION:

Monopolistic competition refers to the market situation in which many producers produce
goods which are close substitutes of one another. Two important distinguishing features
of monopolistic competition are:

Product differentiation, and

Existence of many firms supplying the market.

Product Differentiation: In contrary to perfect competition where there is only one

homogeneous commodity, in monopolistic competition there is differentiation of
products. In monopolistic competition, products are not homogenous nor are they
only remote substitutes. These are the products produced by competing monopolists
that have separate identity, brand, logos, patents, quality and such other product
features. Product differentiation does not mean that goods are completely different.
Rather it means that products are different in some ways, but not altogether so. These
imaginary differences are created through advertising, marketing, packaging and the
use of trademarks and brand names.
 Existence of Many Firms: Under monopolistic competition, there is fairly large
number of sellers, let say 25 to 70. Each individual firm has relatively small part of
the total market so that each has a very limited control over the price of the product.
And each firm determines its own price-output policy without considering the
reactions of rival firms.

In monopolistic competition, in the long run, there is freedom of entry and exit.

The commodity sold in a monopolistic competitive market is not a standardised

product but a differentiated product. Hence competition is no longer exclusive on
price basis. Buyers are buying a combination of physical product and the
service Because of consumers’ attachment to a particular brand, the seller acquires a
monopolistic influence on the market. Thus, the demand curve facing a firm under
monopolistic competition is a downward sloping curve, i.e., if he wants to sell more,
he has to lower his price. The demand curve or AR curve under monopoly also slopes
downwards, but there is a difference between demand curves facing under
monopolistic competition and pure monopoly. The demand curve faced by a
‘competing monopolist’ is more elastic than the demand curve faced by the
‘monopolist’, because there are no close substitutes available for the monopolist
commodity.

RICE DETERMINATION UNDER MONOPOLISTIC COMPETITION:

Under monopolistic competition, the firm will be in equilibrium position when marginal
revenue is equal to marginal cost. So long the marginal revenue is greater than marginal
cost, the seller will find it profitable to expand his output, and if the MR is less than MC,
it is obvious he will reduce his output where the MR is equal to MC. In short run,
therefore, the firm will be in equilibrium when it is maximizing profits, i.e., when MR =
MC.
b) Long Run Equilibrium: Under monopolistic competition, the supernormal profit in
the long run is disappeared as new firms are entered into the industry. As the new firms
are entered into the industry, the demand curve or AR curve will shift to the left, and
therefore, the supernormal profit will be competed away and the firms will be earning
normal profits. If in the short run firms are suffering from losses, then in the long run
some firms will leave the industry so that remaining firms are earning normal profits.

The AR curve in the long run will be more elastic, since a large number of substitutes
will be available in the long run. Therefore, in the long run, equilibrium is established
when firms are earning only normal profits. Now profits are normal only when AR =
AC. It is further illustrated in the following diagram: