Based on the difinition of monopolistic competition form Investopedia: Character
ID: 1125622 • Letter: B
Question
Based on the difinition of monopolistic competition form Investopedia:
Characterizes an industry in which many firms offer products or services that are similar, but not perfect substitutes. Barriers to entry and exit in the industry are low, and the decisions of any one firm do not directly affect those of its competitors. All firms have the same, relatively low degree of market power; they are all price makers. In the long run, demand is highly elastic, meaning that it is sensitive to price changes. In the short run, economic profit is positive, but it approaches zero in the long run. Firms in monopolistic competition tend to advertise heavily.
Question : However, the graph shows that in the long run the demand curve is steeper (less elastic), can you explain why it become steeper and why difinition said in the long run the demand is highly elastic.
Explanation / Answer
The graph you have shown in the question is "wrong".
A monopoly always earns a supernormal profit in the short run and in the long run with low barriers to entry, this will attract a lot of other firms and they will make it a monopolistic competition. In case of a monopoly, the demand was inelastic i.e. it didn't change much in relation to the change in price. One reason for this inelasticity was the absence of any substitute.
With new firms attracted by the supernormal profit, there will be a lot of close substitute in the market. So if the monopoly charges a high price (read earns a supernormal profit) the consumers have a choice to shift to any other goods provider.so tho increase its profit the firm will set its price which is very close to the market price. Just like it happened in a perfect market competition. The only difference here the firm has some degree of control in setting its price making its demand curve i.e. AR curve, slope downward.
These substitute goods are responsible for the fairly elastic demand curve (AR curve) in a monopolistic competition
This new firms will keep entering the market and provide a substitute or closely related product unless there is no supernormal profit. And the demand curve is tangent to the Average cost curve and firm stops making any profit. (In the above diagram the average cost curve is really U shaped, to make it tangent the demand curve is made inelastic = steep sloped and because of it, he has also moved MR curve)
The definition is right, the graph is wrong.
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