Price and Output Decisions for Firms Under Conditions of Perfect Competition, Monopolistic Competition, and Oligopoly

The price and output decisions for profit-maximizing firms under conditions of perfect competition, monopolistic competition, and oligopoly vary according to each market structure. All firms maximize profits at the price and output level where marginal revenue (MR) = marginal cost (MC), but under different market structures, firms have different demand curves and therefore different revenue structures. Depending on the market structure, profit-maximizing firms make different price and output decisions, and these decisions have different social implications.


Perfectly Competitive Market Structure:

In a perfectly competitive market, firms can't control prices because goods have perfect substitutes, there are a very large number of sellers (and buyers), and firms can easily enter and exit the market. Instead, prices are determined collectively by market supply and demand. The demand curve, then, is perfectly elastic and average revenue (AR) = MR = price (P). Although firms in perfectly competitive markets can’t control prices, they can control their level of output, which they set at the profit-maximizing level of MR = MC. Because P is equal to MR, P is also equal to MC at the profit-maximizing level. As a result, perfectly competitive markets are characterized by pure allocative efficiency – the cost to society for producing another unit is exactly equal to what society pays for that unit. Resources are allocated to allow the maximum possible net benefit, and consumers can get more goods at lower prices than under any other market structure.


Monopolistically Competitive Market Structure:


In monopolistic competition, firms’ still maximize profits where MR = MC. Unlike a perfectly competitive market, however, firms can control prices under conditions of monopolistic competition because of product differentiation. The amount that consumers are willing to pay depends on their degree of preference for different products. These preferences are rarely totally influential – if the price of one producer’s good rises high enough, consumers will switch to a cheaper alternative because of the substitution effect and the income effect. As a result, the demand curve is downward sloping. P > MR, because in order to sell additional units, firm owners must lower the prices of every single unit they sell. If MR = MC and P > MR at the profit-maximizing level, then P > MC. In other words, society has to pay more for goods than goods cost firms to produce. Still, this does not necessarily mean that imperfectly competitive markets are inefficient. After all, if society did not value product differentiation, it wouldn’t pay higher prices for goods with cheaper substitutes.


Oligopoly Market Structure:

Oligopolies are comprised of a few firms, each with a very large share of the market. Cost structures are still the same and firms still maximize profits where MR = MC, but because there are fewer competitors, firms in oligopolies can set P even higher above MC at the profit-maximizing level. Output is lower and market prices are higher than in monopolistic competition and perfect competition. What is unique about firms in oligopolies is that they tend not to raise or lower prices, because at higher prices demand is elastic and at lower prices demand is inelastic – raising or lowering prices would result in revenue losses. As a result, MC can increase or decrease without affecting the profit-maximizing price and output level, and smaller cost savings and increases are not passed to consumers. There are still costs to society, but the market price does not reflect the relative scarcity or abundance of input resources.

Oligopolies and the Kinked Demand Curve Theory

Demand curves in oligopolies are kinked because of price “stickiness” – the phenomenon of prices staying the same – in oligopolistic markets. An oligopoly is comprised of a few mutually interdependent firms, each with a very large share of the market. If a firm raised its prices, all of its customers would turn to its competitors. If a firm lowered its prices, other firms would be forced to follow suit, and all firms would lose revenue. Even when production costs increase, firms in oligopolies resist raising prices. The social implications of price “stickiness” as explained by the kinked demand curve theory are that small cost savings and increases are not passed on to consumers.

Firms in an oligopoly tend to not raise prices because they face a very elastic demand curve above the market price. If a firm were to even slightly increase its prices, it would lose a huge portion of the market to its competitors. Below the market price, demand is inelastic. If a firm lowered its prices, it would not pick up a significant portion of the market because the firms’ mutually interdependent competitors would also have to lower their prices. Firms could gain a small amount in market share initially, but any market gains would be more than offset by what firms would lose in revenue per unit sold. The “kink” in the demand curve is formed by the elastic portion of the demand curve above the market price and the inelastic portion of the demand curve below the market price.

To understand the rationale of the kinked demand curve, it helps to think about its graph. A firm’s demand curve is also its average revenue (AR) curve. Each AR curve has its own marginal revenue (MR) curve, which falls in twice as steep as the AR curve. The “kinked” demand curve for firms in an oligopoly can be looked at as two different demand curves – the elastic demand curve above the kink and the inelastic demand curve below the kink – each with its own MR curve. The different MR curves create a discontinuity, the effect being a vertical portion of the MR curve at the profit-maximizing price and output level. As a result, the MR/marginal cost (MC) relationship is not defined at one specific point, instead, the MC cost curve can fall anywhere in between the vertical gap between the first MR curve and the second MR curve. Smaller increases and decreases in production costs do not change the market price, output level, or the MR/MC relationship. In any other market structure, a change in MC would move along a non-vertical MR curve, which would change the profit-maximizing price/quantity relationship.

Because MC can increase or decrease without altering the profit-maximizing price and output level, smaller cost savings and increases are not passed on to the consumer. There are still costs to society, but the market price does not reflect the relative scarcity or abundance of input resources. When prices in oligopolies do increase, it is because production costs keep rising and firms can no longer afford to keep prices the same forever – and all firms dramatically increase prices at once. At that point, the quantity demanded decreases, output falls, and the demand curve forms a kink around the new profit-maximizing price and output level. Much larger costs (and savings), then, are passed to consumers.