Under monopolistic competition, organizations need to make optimum adjustments in the prices and output sold to attain equilibrium.
Apart from this, under monopolistic competition, organizations also need to pay attention toward the design of the product and the way the product is promoted in the market.
Moreover, an organization under monopolistic competition is not only required to study its individual equilibrium, but group equilibrium of all organizations existing in the market. Let us first understand individual equilibrium of an organization under monopolistic competition.
As we know every seller, irrespective of the market structure, is willing to maximize his/her profits. In monopolistic competition, profits are maximized at a point where marginal revenue is equal to marginal cost. The price determined at this point is known as equilibrium price and the output produced at this point is called equilibrium output.
If the marginal revenue of a seller is greater than marginal cost, he/she may plan to expand his/her output. On the other hand, if marginal revenue is lesser than marginal cost, it would be profitable for the seller to reduce his/her output to the level where marginal revenue is equal to marginal cost.
Equilibrium in Short Run:
The short-run equilibrium of a monopolistic competitive organization is the same as that of an organization under monopoly. In the short run, an organization under monopolistic competition attains its equilibrium where marginal revenue equals marginal cost and sets its price according to its demand curve. This implies that in the short run, profits are maximized when MR=MC.
Figure-2 shows the equilibrium in the short run:
In Figure-2, AR is the average revenue curve, MR represents the marginal revenue curve, SAC curve denotes the short run average cost curve, while SMC signifies the short run marginal cost. In Figure-2, it can be seen that MR intersects SMC at output OM where price is OP’ (which is equal to MP). This is because P is the, point on AR curve, which is price.
From Figure-2, it can be interpreted from that the organization is earning supernormal profit. Supernormal profit per unit of output is the difference between the average revenue and average cost. In Figure-2, average revenue at equilibrium point is MP and average cost is MT.
Therefore, PT is the supernormal profit per unit of output. In the present case, supernormal profit would be measured by the area of rectangle P’PTT’ (which is output multiplied by supernormal profit per unit of output).
On the other hand, when marginal cost is greater than marginal revenue, organizations would incur losses, as shown in Figure-3:
Figure-3 shows the condition of losses in the short run under monopolistic competition. Here, OP’ is smaller than MT, which implies that average revenue is smaller than average cost. TP is representing the loss that has incurred per unit of output. Therefore total loss is depicted from rectangle T’TPP’.
Equilibrium in Long Run:
In the preceding sections, we have discussed that in the short run, organizations can earn supernormal profits. However, in the long run, there is a gradual decrease in the profits of organizations. This is because in the long run, several new organizations enter the market due to freedom of entry and exit under monopolistic competition.
When these new organizations start production the supply would increase and the prices would fall. This would automatically increase the level of competition in the market. Consequently, AR curve shifts from right to left and supernormal profits are replaced with normal profits.
In the long run, the AR curve is more elastic than that of in the short run. This is because of an increase in the number of substitute products in the long- run. The long-run equilibrium of monopolistically competitive organizations is achieved when average revenue is equal to average cost. In such a case, organizations receive normal profits.