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Under monopolistic competition, firms compete largely through non-price methods. The main reason firms avoid aggressive price cuts is that:
AProducts are homogeneous so price has no effect on sales
BEach firm faces a perfectly elastic demand and cannot change price
CPrice competition can trigger price wars that erode profit margins
DA regulator fixes the price of every firm in the industry
Answer & Solution
Correct answer: C. Price competition can trigger price wars that erode profit margins
1. Products are close substitutes, so a price cut by one firm invites others to follow.
2. Mutual undercutting can develop into a price war.
3. Price wars push some firms out and shrink everyone's margins.
4. To avoid this, firms rely on advertising and product differentiation instead.
_Source: ICAI BoS CA Foundation Paper 4 Business Economics, Ch 4 Unit III "Price-Output Determination under Different Market Forms", p.21_
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