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Price Elasticity of Demand and Monopolistic Competition

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Published: Thu, 18 Jan 2018

The Price Elasticity of demand is inversely related to excess capacity in the monopolistic competitive market – Discuss

Before we even dwell and discuss on the abovementioned topic, it would vital for us to understand and define what Price Elasticity of Demand, Excess Capacity and Monopolistic Competitive Market are all about from the economic perspective. By understanding the aforementioned than only we would be able to discuss and deliberate the abovementioned topic in detail.

Elasticity

From the economics perspective based on journal and article in Wikipedia, elasticity can be defined as the measurement of how receptive or responsive an economic variable is, to a change of the other. For example:

  • “If we lower or reduce the price of our product, how much more will it be sold?”
  • “If we raise or increase the price of one product, how will that affect sales of the other product?”
  • “If we learn that a resource is becoming infrequent or limited, will people rush to acquire it?”

We can further elaborate that an elastic variable (or elasticity value greater than 1) is one which responds more than proportionately to changes in other variables. On the other hand, an inelastic variable (or elasticity value less than 1) is one which changes less than proportionately in response to changes in other variables.

Elasticity can be measured as the ratio of the percentage change in one variable to the percentage change in another variable, when the latter variable has a fundamental influence on the former. It is a tool for measuring the responsiveness of a variable, or of the function that determines it, to changes in contributory variables. Frequently used elasticities include price elasticity of demand, price elasticity of supply, income elasticity of demand, elasticity of substitution between factors of production and elasticity of substitution.

Elasticity is one of the most vital concepts in a traditional economic theory. It is valuable in understanding the rate of indirect taxation, marginal concepts as they relate to the company, and distribution of wealth and different types of goods as they relate to the theory of consumer choice. Elasticity is also crucially imperative in any discussion of welfare distribution, in particular consumer surplus, producer surplus, or government surplus.

In a pragmatic work environment, an elasticity is the estimated coefficient in a linear regression equation where both the dependent variable and the independent variable are in natural logs. Elasticity is a common tool amongst observers because it is independent of units and thus simplifies data analysis.

Price Elasticity of Demand

On the other hand, according to Alfred Marshall, Price elasticity of demand (PED or Ed) is a measurement used in economics to illustrate the responsiveness or elasticity, of the quantity demanded of a good or service to a change in its price. More accurately, it gives the percentage change in quantity demanded in response to a one percent change in price (ceteris paribus, i.e. holding constant all the other determinants of demand, such as income).

Price elasticities are almost always negative, although analysts tend to ignore the sign even though this can lead to uncertainty. Only goods which do not conform to the law of demand, have a positive PED. Generally, the demand for a good is said to be inelastic (or relatively inelastic) when the PED is less than one (in absolute value): that is, changes in price have a relatively small effect on the quantity of the good demanded. The demand for a good is said to be elastic (or relatively elastic) when its PED is greater than one (in absolute value): that is, changes in price have a relatively large effect on the quantity of a good demanded. Revenue is maximized when price is determined so that the PED is exactly one. The PED of a good can also be used to predict the rate of a tax on that good. Various research approaches are used to determine price elasticity, including test markets, analysis of historical sales data and conjoint analysis.

Nevertheless, according to Professor Dominick Salvatore in its book, Managerial Economics – Principle and Worldwide Application, mentioned that “Sometimes, lowering the price of the commodity or products increases sales sufficiently to increase total revenues. At other times, lowering the commodity or products prices reduces the firm’s total revenues”. Thus, lowering the price of a particular products will not necessarily increase the total profitability of a company. This is due to the fact that it also have an impact on the production cost.

Therefore, we can also say that the higher the price elasticity, the more sensitive consumers are to price changes. A very high price elasticity indicates that when the price of a good increase, consumers will buy less of the items and when the price of that good falls, consumers will buy more. A very low price elasticity suggests the opposite, that changes in price have slight influence on demand.

As such, it is imperative for a company to really understand the economics and the concept of PED before any decision is made for a price review or for a pricing strategy.

Excess Capacity

Meanwhile, Excess Capacity, based on our reading, as defined in Wikipedia is a situation in which actual production is less than what is achievable or optimal for a company. This often means that the demand in the market for the product is below what the firm could potentially supply to the market.

The amount of excess capacity within an industry is a signal of both the performance of that industry and the demand for the products it produces. Excess capacity is also seen as a good thing for consumers, as it is not likely to lead to the price inflation that would be seen in periods of near-full capacity. A company with sizable excess capacity can often lose a considerable amount of money if it is not able to meet the high fixed costs that are associated with producers.

In other words, it could also be the case that in the long run, the production is operating not at the lowest of its long run average cost curve. Instead, it is operating on a gauge that is smaller and less efficient which the company has, in fact, a capacity to produce more at a lower average cost. , each firm is serving a market that is too small, and there are too many firms, so that the product group as a whole has the capacity to serve more customers than there are. Excess capacity exists when marginal cost is less than average cost and it is still possible to decrease average (unit) cost by producing more goods and services. Excess capacity may be measured as the increase in the current level of output that is required to reduce unit costs of production to a minimum.

Excess capacity may also arise because as demand increases, firms have to invest and expand capacity in uneven or inseparable portions. Company may also choose to maintain excess capacity as a part of a deliberate strategy to deter or prevent entry of new firms.

Monopolistic Competitive Market

Monopolistic competition from economic perspective is a category of imperfect competition such that many producers sell products that are different from one another as goods but not perfect substitutes (such as from branding, quality, or price). In monopolistic competition, a firm takes the prices charged by its competitors as given and ignores the impact of its own prices on the prices of other company. In the presence of strong government, monopolistic competition will fall into government-granted monopoly. Unlike perfect competition, the firm maintains spare capacity. Models of monopolistic competition are often used to model industries. Examples of industries with market structures similar to monopolistic competition include restaurants, cereal, clothing, shoes, and service industries in large cities. The “founding father” of the theory of monopolistic competition is Edward Hastings Chamberlin, who wrote a pioneering book on the subject, Theory of Monopolistic Competition. Joan Robinson published a book The Economics of Imperfect Competition with a comparable theme of distinguishing perfect from imperfect competition.

The characteristic of a monopolistic competitive markets are as follow:

  • There are many producers and many consumers in the market, and no business has total control over the market price.
  • Consumers perceive that there are non-price differences among the competitors’ products.
  • There are few barriers to entry and exit.
  • Producers have a degree of control over price.

In the long-run characteristics of a monopolistically competitive market are almost the same as a perfectly competitive market. Two differences between the two are that monopolistic competition produces diverse products and that monopolistic competition involves a great deal of non-price competition, which is based on subtle product differentiation. A firm making profits in the short run will nonetheless only break even in the long run because demand will decrease and average total cost will increase. This means in the long run, a monopolistically competitive firm will make zero economic profit. This illustrates the amount of influence the firm has over the market; because of brand loyalty, it can raise its prices without losing all of its customers. This means that an individual firm’s demand curve is downward sloping, in contrast to perfect competition, which has a perfectly elastic demand schedule.

Differences between Perfect and Monopolistic Competition

To show that the PED is inversely related to excess capacity in the monopolistic competitive market, in this discussion, we will be comparing mostly between perfect competitive market and monopolistic competitive market which is also an imperfect market.

There are two main differences between perfect competition and monopolistic competition. First is excess capacity; in perfect competition, firms usually will produce a product up to the maximum capacity of its production to get the lowest average total cost, ATC. Meanwhile in monopolistic competition, the firms will have an excess capacity if they produce less than the quantity at which average total cost is at minimum; which if they lower the price, they could sell more but they might producing at a point where their cost will exceed their revenue.

The second differences are mark-up. In perfect competition, P=MC, but in monopolistic competition, P > MC because of its marked up. The marked up is because of the price discrimination which use by the firms in monopolistic market.

Price and Output in Monopolistic Competition

First of all, let us look at the factors affecting the PED. As we can see, in monopolistic competition market, there are high numbers of substitutes available for the products that produce by the firms. This is because each of the firms produce similar product but not identical. Because of this, the market has a greater PED. Any changes in price will make a possibility of consumer to change their demand for other substitute products.

This is why, monopolistic market are also called price searcher market, as they are actually looking for the best price for their product. Since the firms produce similar product, they cannot fight their price using the ATC, where they cannot produce more than they can sell. They can only produce the quantity at which the marginal revenue is equal to the marginal cost.

Can we say that monopolistic competition is inefficient? Yes, because in monopolistic competition P > MC, marginal benefits is larger than marginal cost. In order to reach the highest possible profit, firms competing in three important area of product differentiation, which is the quality, price and marketing. The quality of the product is just not only about the reliability of the product, but also about the design and the services, more on the after sales services. Using this quality aspect, firms can do the price discrimination, which differentiated their product with other product. However there is a trade off between prices and quality. The lower the price, the lower the product quality can be. As to further increase the sales, firms have to do a good product packaging and advertising. Since consumer value a variety, and variety is a cost, it is reasonable for the firms to price discriminate other products.

However in monopolistic market, since no barrier to entry and exit from the market, firms have to be careful not to gain high profit in the long run as it can attract new competitors into the market.

Product Development and Marketing

Since monopolistic firms need to maintain their economic profit, in the condition of high ATC, there are needs to keep and sustain a continuous product development. In the market where the competitors are always looking for new innovation, new technology and attractable product, they need to be in line with the up to date trend of consumers. New product development would allow a firm to gain a competitive advantage, even sometimes temporarily before competitors imitate the innovation.

Looking at the scenario where competitors usually keep imitate the new innovation produce, it might cross our mind why firms need to be the innovation leaders since after that the competitors will had it imitate. The innovation cost are high compare to imitate cost, but the benefit as innovation leaders have a value to consumer and also would increases total revenue.

Firms usually will pursue product development until their marginal revenue from innovation equals to the marginal cost of innovation.

As a human, consumer have a natural willing feeling to pay higher for the products that have a high value to them, even sometimes the price is ridiculous. The marginal social benefit of an innovation is the increase of price to the product and also a marginal social cost to the firms for the cost of innovation. Basically, the profit is maximized when MR=MC, but in monopolistic competition P>MR. Because of that, amount of innovation is less than efficient.

Compare to the perfect competition market, monopolistic market have a higher selling cost since they need to spend a lot on promoting the uniqueness of their product compare to other substitutes product. The increase in selling cost will increase ATC at any level of output, but would not affect the MC of production. If their effort in promotion and advertising increases the demand of the product, then they are considered success. This is the cost that the monopolistic firms have to pay, to reduce their excess capacity, by increasing the demand of the products. But advertising is not only use to promote the variety and the uniqueness of the product, but also sometimes use to remind the market of their high quality product.

Conclusion

From the comparison that we highlight between perfect competition market and monopolistic competitive market, we can see the relation between the increasing of selling cost, increase of demand and reduced in excess capacity. When the firm concentrate in having a continuous product development with greater advertising and promotion effort, they can increase the demand of the product which in turn inversely reduce the excess capacity of the firms.


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