Question

For the following questions assume a market that operates under monopolistic competition. a) Explain how the characteristics of a monopolistically competitive market determine the shape of an individual firm’s demand curve. b) Suppose firms producing running shoes are experiencing short run losses. Draw a fully labelled diagram to illustrate this situation for a representative firm. c) Nike researchers have developed a new type of running shoe that provides more support for peoples’ ankles and knees while running. Draw a diagram to show what happens to the market for Nike’s running shoes, assuming the Nike was initially making a normal profit. d) Explain, with the aid of a diagram, what would happen to Nike’s market share in the long run following the events in part (c) above.

Answer 1

a. i. In a monopolistic competitive market, there are many sellers and many buyers.

ii. The products the firms are selling are close subsititutes of each other.

iii. Products are differentiated on the basis of packaging, quantity etc.

iv. Firms have partial control over the price due to product differentiation.

iv. The demand curve of a monopolistic competition firm is always a downward sloping curve from left to right. This is because firms can sell more only if they lower their prices.

Also, the demand curve faced by the monopolistic competition firms is more elastic than the demand curve faced by monopoly. This is because of availablity of substitutes in the market.

b. Equilibrium quantity is attained by the firm where its marginal cost intersects the marginal revenue of the firm.

The equilibrium price is attained on the corresponding point on the demand curve.

Losses are represented by the shaded area.

c. The demand for Nike shoes will rise because of this development. People will want to buy more at the existing prices because of this favorable development.

d. In the long run, the other firms will also develop the same technology from which Nike is profitting. Due to this supply will rise in the market. Prices will go down due to this. Due to this, firms will again start earning normal profits in the long run.