Monopolistically competitive industries are made up of a large number of firms, each small relative to the size of the total market. Thus, no one firm can affect market price by virtue of its size alone. But firms differentiate their products, and by so doing gain some control over price.
Product Differentiation and Demand Elasticity
Perfectly competitive firms face a perfectly elastic demand curve for their product because all firms in their industry produce the exact same product. A monopolistic competitor faces a downward-sloping firm demand curve. This type of curve is based on the notion that the firm can change its price without losing all of its business because buyers do not see any perfect substitute. The fewer the substitutes (i.e., the more product differentiation), the less elastic the demand curve will be. The difference is illustrated in the figure below:
A monopolistic competitor, in the short run, is like a monopolist because it is the only producer of its unique product. But unlike a monopoly, the monopolistically competitive firm faces competition from other firms producing good substitutes for its product.
Price/Output Determination in the Short Run
Since the firm has a downward-sloping demand curve, it will also have a downward-sloping marginal revenue (MR) curve. A profit-maximizing firm produces where marginal cost (MC) equals marginal revenue (q0 in the graph below) and charges the price determined by demand (P0).
In panel (a) of the figure, the monopolistic competitor will make a profit. However, like a monopoly, a monopolistic competitor is not guaranteed to make a profit in the short run. The firm may make a loss in the short run; its profitability will depend on the demand. This is shown in panel (b).
To more fully understand price and output determination in monopolistic competition, try the following Active Graph exercise: