Question

Discuss both the price elasticity of demand (what type) and the cross-price elasticity of demand (positive or negative) facing a firm in a monopolistically competitive industry. Why is this so? Also include in your reply the effect of advertising on the demand curve.

Answer 1

In a monopolistically competitive industry, there are large number of firms, each having a significant market share, and selling differentiated products that are not perfect substitutes to each other. However consumers are still able to switch between products of different firms whenever there is an entry or exit of firms that changes the market price of products

Demand faced by a monopolistically competitive firm is generally elastic in nature because there are so many other firms in the market that are selling products that are close substitute to each other, increase in the price of product by one firm will encourage consumers to look for other firms that are selling their products at unchanged price which makes the consumers price sensitive.

Cross price elasticity of demand is generally positive because consumers consider the products of different firms as substitutes. When the price of product sold by one firm increases, consumers can purchase the same product although differentiated, from other firms at a relatively unchanged price. This will increase the demand for their products, indicating a positive cross price elasticity

Advertising can increase the demand for the product sold by the firm that is advertising. With the help of promotion and marketing firm is able to encourage consumers to buy its product, which includes consumers who were previously buying from other firms. As the advertising shifts the demand curve to the right, both the price and the quantity are increased for the firm that advertises.