Model Answer
0 min readIntroduction
Monopolistic competition, a market structure characterized by numerous firms offering differentiated products, results in unique demand conditions for each firm. Unlike perfect competition, firms possess some degree of market power. This power is reflected in the shape of their demand curves. Two key concepts in understanding these demand curves are the ‘perceived demand curve’ and the ‘proportional demand curve’. The perceived demand curve represents the demand as seen by the firm, while the proportional demand curve is a transformation used for cost analysis. Understanding their differences and the reasons for the steeper slope of the proportional demand curve is crucial for analyzing firm behavior in monopolistically competitive markets.
Perceived Demand Curve
The perceived demand curve (D) represents the demand for a firm’s product as it is perceived by the firm itself. It is downward sloping, reflecting the law of demand – as price decreases, quantity demanded increases. However, it is relatively elastic (flatter) compared to the demand curve faced by a monopolist. This is because of the presence of many close substitutes. Consumers can easily switch to competing products if the firm raises its price significantly. The elasticity of the perceived demand curve is influenced by the degree of product differentiation. Greater differentiation leads to a less elastic demand curve.
Proportional Demand Curve
The proportional demand curve (D’) is a transformation of the perceived demand curve. It is derived by dividing the price (P) by the firm’s total revenue (TR). Mathematically, D’ = P/TR. This transformation is used to simplify cost and revenue analysis, particularly when dealing with firms that operate at less than optimal capacity. The proportional demand curve is also downward sloping, but its slope is different from the perceived demand curve.
Comparing Perceived and Proportional Demand Curves
| Feature | Perceived Demand Curve (D) | Proportional Demand Curve (D’) |
|---|---|---|
| Definition | Demand as seen by the firm | Transformation of perceived demand: P/TR |
| Slope | Relatively elastic (flatter) | Relatively inelastic (steeper) |
| Use | Analyzing market demand and price elasticity | Simplifying cost and revenue analysis, especially at suboptimal capacity |
| Relationship to TR | Directly reflects quantity demanded at a given price | Inversely related to TR; reflects the proportion of price to total revenue |
Why is the Proportional Demand Curve Steeper?
The proportional demand curve is steeper than the perceived demand curve due to the way it is constructed. When a firm lowers its price, its quantity demanded increases, but the increase in quantity demanded is not proportional to the decrease in price. The proportional demand curve focuses on the change in the proportion of price to total revenue.
- Market Power: Firms in monopolistic competition have some degree of market power. This means they can influence prices to some extent. The proportional demand curve reflects this power by showing a larger change in quantity demanded for a given change in price compared to a perfectly competitive firm.
- Revenue Considerations: At lower price levels, the firm needs to sell a significantly larger quantity to maintain the same level of total revenue. The proportional demand curve captures this relationship, making it steeper.
- Mathematical Transformation: The division by total revenue (P/TR) amplifies the effect of price changes, especially at lower price levels, leading to a steeper curve.
Essentially, the proportional demand curve highlights the firm’s ability to increase revenue by increasing quantity sold, even if the price is reduced. This ability is greater than in a perfectly competitive market, resulting in a steeper demand curve.
Conclusion
In conclusion, both the perceived and proportional demand curves are essential for understanding firm behavior in monopolistic competition. While the perceived demand curve reflects the basic relationship between price and quantity, the proportional demand curve provides a more nuanced view, particularly regarding revenue and market power. The steeper slope of the proportional demand curve is a direct consequence of the firm’s ability to influence prices and the mathematical transformation used in its construction, offering valuable insights for cost and revenue analysis.
Answer Length
This is a comprehensive model answer for learning purposes and may exceed the word limit. In the exam, always adhere to the prescribed word count.