Question

Explain how the characteristics of a monopolistically competitive market determine the shape of an individual firm’s demand curve.

Answer 1

Monopolistic competition is different to monopoly competition. A monopoly occurs when a individual or organization in a market is the sole provider of a product or a service. Monopolistic competitive markets have widely differentiated products; have several firms supplying the good or service; firms can freely enter and leave in the long run; firms can make independent decisions; there is some degree of market power; and buyers and sellers have imperfect data.

For two reasons, markets which have monopoly competition are inefficient. The first source of inefficiency is because the firm charges a price which exceeds marginal costs at its optimum output. The competitive monopoly firm maximizes profits in which marginal revenue equals marginal costs. The demand curve of a dominant monopoly firm is sloping downward, meaning it can charge a price that exceeds the marginal costs. The market power possessed by a competitive monopoly firm means that a net loss of consumer and producer surplus will occur in its profit maximizing production level.

The second source of inefficiency is the excess capacity of these firms. The profit maximizing output from the firm is less than the output associated with the average minimum cost. All companies, irrespective of the type of market in which they operate, will produce to a point where demand or price equals average costs. This happens in a perfectly competitive market where the perfectly elastic demand curve is equal to the average minimum rate. In a dynamic monopoly market the demand curve is sloping downward. That leads to overcapacity in the long run.

The demand curve of a competitive monopoly market is sloping downward. This means the quantity demanded for that good rises as the price decreases. While this seems relatively straightforward, in a monopolistic competitive market, the shape of the demand curve has several important implications for firms.

In monopolistic competition, the demand curve for an individual firm slopes downward, as opposed to perfect competition where the individual demand curve of the firm is perfectly elastical. This is because firms have market power: they are able to raise prices without losing all of their customers. These companies have a limited ability to dictate the price of their products in this type of market; a company is a price setter not a price taker (at least to some extent). The market power source is that there are relatively fewer rivals than there is in a competitive market, and companies concentrate on product differentiation, or price-free differences.By differentiating its products, companies are ensuring that their products are imperfect substitutes for each other in a monopolistically competitive market. Consequently, a company that works on its branding can raise its prices without risking its consumer base.