Question

Suppose that, due to a successful advertising campaign, a monopolistic competitor experiences an increase in demand for its product. How will that affect the price it charges and the quantity it supplies?

Short answer

A successful advertising campaign for a monopolistic competitor will lead to an increase in demand, causing the demand curve to shift to the right. Consequently, the firm will produce a higher level of output, where the new marginal revenue curve intersects the marginal cost curve. Referring to the higher demand curve, the monopolistic competitor will set a higher price corresponding to the new equilibrium output. In conclusion, both the price and the quantity supplied will increase due to the increased demand.

Step-by-step solution

Understand the nature of a monopolistic competitor

A monopolistic competitor is a firm that operates in a market with many firms, each offering a similar but not identical product. This means that each firm has some market power, as buyers perceive their products to be somewhat unique. Monopolistic competitors face downward-sloping demand curves, meaning that they can raise their prices and still maintain some sales, but the higher the price, the fewer units they will sell.

The initial equilibrium of the monopolistic competitor

Before analyzing the effects of the successful advertising campaign, it's important to understand the initial equilibrium of the monopolistic competitor. In the short run, a monopolistic competitor will maximize its profits (or minimize losses) by producing the quantity of output where its marginal cost (MC) equals its marginal revenue (MR). At this point, the firm will set the price by referring to the demand curve for its product.

Analyze the effect of the successful advertising campaign on demand

A successful advertising campaign will increase the demand for the firm's product. This means that, at each price level, there will be more consumers willing to buy the product. In other words, the demand curve for the monopolistic competitor's product will shift to the right.

Determine the new equilibrium

After the demand curve has shifted to the right, the monopolistic competitor will have to reassess its profit-maximizing price and output level. Due to the increase in demand, the firm will now face a higher level of marginal revenue at each quantity produced. As a result, the firm will now produce a higher level of output where the new marginal revenue curve (MR') intersects the marginal cost curve (MC). By referring to the new, higher demand curve, the monopolistic competitor will set the price at a level that corresponds to the new equilibrium output.

Analyze the effect on price and quantity supplied

As a result of the successful advertising campaign, the monopolistic competitor has experienced an increase in demand. This leads the firm to produce a higher level of output and raise the price to maximize its profit. In conclusion, the price of the product will increase, and the quantity supplied will increase as well.

Key concepts

Demand Curve Shift

In a monopolistically competitive market, a firm's demand curve represents the relationship between the price of its product and the quantity of that product consumers are willing to purchase. When a demand curve shifts to the right, as in the exercise scenario involving a successful advertising campaign, it indicates that, at every price point, more consumers are interested in buying the product.

A rightward shift can result from various factors such as an increase in consumer income, changes in tastes or preferences towards the product, a decrease in the price of complementary goods, or successful marketing strategies like advertising. The impact of this shift is pivotal as it alters the market dynamics, leading to changes in the firm’s pricing strategies and the quantity of goods supplied to meet the new consumer demand levels.

Market Equilibrium

Market equilibrium in monopolistic competition occurs where the quantity of goods supplied equals the quantity demanded. This is not just a single point but can be a range of equilibrium points due to product differentiation.

One of the key determinants of this balance is the intersection of the marginal cost curve (MC) and the marginal revenue curve (MR), which indicates the most profitable output level for the firm. An equilibrium is disrupted when an external change, such as a successful advertising campaign, shifts the demand curve. The firm will then adjust its output to reach a new equilibrium where MC equals MR’, with MR’ being the new marginal revenue post-shift. These adjustments lead to changes in the equilibrium price and quantity, showcasing how firms in such markets are responsive to changes in consumer preferences.

Marginal Cost and Marginal Revenue

Understanding the concepts of marginal cost (MC) and marginal revenue (MR) is key to determining how a monopolistic competitor operates. Marginal cost is the additional cost incurred by producing one more unit of a product, while marginal revenue is the additional income from selling one more unit.

In monopolistic competition, firms seek to maximize profits by setting their output where MC equals MR. This crucial decision point reflects the most efficient use of resources from the firm's perspective. If MR exceeds MC, it makes sense to increase production, as each unit sold will add to overall profit. In contrast, if MC exceeds MR, producing additional units results in losses on those units. Thus, the equilibrium output is always at a point where MR is equal to MC, and any factor that alters these margins, like a shift in the demand curve, leads to a reassessment of the output level to maintain profit maximization.

Price and Output Determination

In a monopolistically competitive market, the price and output levels are determined by where the firm’s demand curve intersects with its MR and MC curves. Initially, the firm will seek to price its product and choose an output where its MC curve crosses the MR curve coming down from the demand curve.

With the introduction of an effective advertising campaign, the rightward shift in demand increases marginal revenue at each quantity level. This prompts the firm to re-evaluate its output decision and move to a new profit-maximizing quantity where the MR' curve (reflecting the new, higher level of demand) intersects the MC curve. Subsequently, the firm will set a new higher price that corresponds with this output on the shifted demand curve. The final result is an increase in both the price charged and the quantity supplied, which stems from the firm's objective to maximize profits in light of the new market conditions.