Chapter 20: Problem 736

Why will firms in monopolistic competition tend to have highly elastic (not quite horizontal) demand schedules?

Short Answer

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Firms in monopolistic competition tend to have highly elastic demand schedules because they sell differentiated products that have close substitutes. A small change in price will lead to a substantial change in quantity demanded as consumers switch between similar goods from competing firms. However, the demand curve is not perfectly elastic or horizontal, as firms still face competition and there is a limit to how much they can sell at a given price.

Step by step solution

Understand Demand Elasticity #

The elasticity of demand refers to the responsiveness of the quantity demanded for a good or service to a change in its price. If the demand for a good or service is highly elastic, then a small change in price will lead to a large change in the quantity demanded. Conversely, if demand is inelastic, then changes in price have a minimal effect on the quantity demanded.#

Monopolistic Competition and Demand Curve #

Monopolistic competition is a market structure where there are many sellers each selling a differentiated product. Due to the product differentiation, each firm in such a market structure faces a downward sloping demand curve, meaning they can sell more at a lower price and less at a higher price.#

Highly Elastic Demand in Monopolistic Competition #

The demand curve for firms in monopolistic competition is elastic (but not perfectly elastic or horizontal) because while they sell differentiated products, these products are not unique and have close substitutes. This means that if a firm in monopolistic competition raises its prices too much, consumers will switch to buying similar goods from other firms, hence, a sizable change in quantity demanded for a small change in price. Similarly, if it lowers its prices, it will attract consumers away from its competitors, again implying a sizable change in quantity demanded for a small change in price - which is the very nature of elastic demand.#

The Lack of Perfectly Elastic Demand #

While the demand curve in monopolistic competition is highly elastic, it is not horizontal or perfectly elastic. A perfectly elastic demand curve would imply that a firm could sell any quantity it wanted at a given price, meaning that it would face no competition. This is not the case in monopolistic competition, where a firm, though selling a differentiated product, faces competition from other firms selling similar (though not identical) products. Hence, there is a limit to how much a firm can sell at a given price, which is often determined by the differentiation of its product and the competition it faces. Hence, the demand curve is not horizontal but slopes downward.

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