The firm's demand curve when products are differentiated

Overview

Defining features of monopolistic competition and firms in monopolistic competition advertise.

What you need to know

Answer each one before you reveal it.

Questions from this subtopic

Each one with the model answer underneath.

1. 1

   What are the defining features of monopolistic competition?

   Model answer

   There are many firms, each with a small share of the market, and each acts independently because none is large enough for rivals to react to it. Products are differentiated rather than identical, by brand, quality, design, service or location, so buyers have preferences between sellers. Entry to and exit from the industry are free in the long run. Information is good but not perfect, and firms compete through advertising and product design as well as through price.

2. 2

   Why does a firm in monopolistic competition face a downward-sloping demand curve rather than a horizontal one?

   Model answer

   Because its product is not identical to its rivals'. Some buyers prefer its particular brand, location or service and will stay with it after a small price rise, so it does not lose every customer as a perfectly competitive firm would; it loses only those whose preference was weak. It can therefore choose its price, within limits, and the quantity it sells falls as that price rises. The curve is nonetheless very elastic, because there are many close substitutes and a large price rise would drive most buyers away.

3. 3

   Why is a monopolistically competitive firm's demand curve much more elastic than a monopolist's?

   Model answer

   Elasticity depends on the availability of substitutes. A pure monopolist has none by definition, so buyers who dislike the price have nowhere to go and demand is comparatively inelastic. A monopolistically competitive firm has many rivals selling something very similar, so its differentiation buys only a little loyalty and a modest price rise sends most customers elsewhere. Its demand curve is therefore shallow, and the more alike the products are the flatter it becomes, approaching the horizontal line of perfect competition in the limit.

4. 4

   Where does the marginal revenue curve lie for a monopolistically competitive firm, and why?

   Model answer

   Below the average revenue curve at every positive output, because the firm must lower its price on all units to sell one more, so the revenue gained on the extra unit is partly offset by revenue lost on the rest. For a straight-line demand curve it starts at the same point on the vertical axis and falls at twice the rate. With demand P = 22 − 0.2Q, marginal revenue is 22 − 0.4Q: both begin at £22, demand reaches zero at 110 units and marginal revenue reaches zero at 55 units.

5. 5

   Give three ways firms in a monopolistically competitive market differentiate their products.

   Model answer

   Physical differences in the product itself, such as recipe, ingredients, styling or durability. Differences in the service surrounding it, such as opening hours, delivery, warranties, atmosphere or the skill of staff. Differences in perception created by branding, packaging and advertising, where the product is much the same but buyers believe it is not. Location is a fourth and often decisive form, since a convenient supplier is genuinely a different proposition from a distant one even if what it sells is identical.

6. 6

   Why do firms in monopolistic competition advertise, when firms in perfect competition do not?

   Model answer

   Advertising is worthwhile only if it can change the demand curve the firm faces, and in perfect competition there is nothing to advertise: the product is homogeneous, buyers already know every price, and the firm can sell all it wants at the market price anyway. Under monopolistic competition the product is differentiated and information is imperfect, so advertising can both shift the firm's demand curve to the right and make it steeper by strengthening loyalty. That allows a higher price or a larger volume. The cost of the advertising raises average total cost, so the firm gains only if the revenue effect is the larger.

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