Question

Explain based on product differentiation that firms face a downward sloping demand curve in monopolistic competition.

Answer 1

Product differentiation is a distinct feature of monopolistic competition. It implies that the rival firms are selling products which are not perfect substitutes but close substitutes of each other. Product differentiation has the following implications: It allows a firm partial control over price of its product which leads to partial monopoly power, elasticity of demand for the firm's product tends to be high because availability of close substitutes and demand curve shows high elasticity of demand, because of availability of close substitutes the consumer's choice also increases which in turn increases their welfare. Partial control over price is the reason behind the downward sloping demand curve under monopolistic competition and this partial control is due to product differentiation. Difference in design, color and packaging attracts the buyer to buy a particular product even at a higher price. Accordingly, due to high elasticity of demand, quantity sold increases when price is reduced and it tends to reduce when price is raised.