Question

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

Short answer

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.

Key concepts

Demand Elasticity

Demand elasticity is all about how much the quantity demanded of a product changes when its price changes. In simpler terms, it's like seeing how much a rubber band stretches when you pull on it. For products with elastic demand, a small tweak in price leads to a large change in the quantity purchased. These can often be non-essential items or goods with lots of substitutes.
On the flip side, if something is inelastic, price changes don’t affect purchasing as much. Things like gasoline or medications that don't have close substitutes tend to have inelastic demand.
Understanding demand elasticity helps businesses decide how much they can change prices without losing customers, and it's crucial in different market structures, like monopolistic competition.

Market Structure

Market structure refers to how a market is organized, mainly based on the number of firms, the type of products they sell, and how easy or difficult it is for new firms to enter the market. In monopolistic competition, many companies sell products that are similar but not identical.
This structure balances competition and a bit of monopoly behavior since every firm sells slightly different products and can set their own prices. However, due to the presence of many rivals with similar goods, firms can't freely hike prices without risking a loss of customers.

• Many sellers: No single firm controls the market.
• Differentiated products: Each seller offers something slightly different.
• Easy entry and exit: New firms can enter the market without much hassle.

Through this, each firm faces a downward-sloping demand curve, meaning they can sell more by lowering the price and vice versa.

Differentiated Products

In monopolistic competition, products are differentiated, meaning they are distinct but still serve a similar purpose. Differentiation can be based on a variety of factors like brand, quality, features, or even customer service, making each product unique in some way.
This uniqueness allows firms to have some control over their prices. A consumer might prefer one toothpaste brand due to flavor or whitening capability, even if another cheaper option exists. However, because the differences aren't enormous, these products also act as close substitutes for each other.
Thus, if one producer raises prices too high, consumers might switch to another brand. This ability to switch easily is what contributes to the elastic demand characteristic of monopolistic competition.