If many good substitutes exist for a competitive firm’s product, what type of demand curve does it face?
Select one:
a. unit elastic
b. perfectly inelastic
c. perfectly elastic
d. inelastic only over a certain region
The correct answer and explanation is:
The correct answer is c. perfectly elastic.
When many good substitutes exist for a competitive firm’s product, the demand curve the firm faces is perfectly elastic. This means that the firm’s product is viewed as identical to the substitutes in the market. Consumers can easily switch from the firm’s product to another without any change in their utility, making the price the only factor that influences demand.
In perfect competition, firms produce identical or nearly identical products. If a firm raises its price even slightly above the market equilibrium, consumers will immediately shift to other firms offering the same product at the lower price. As a result, the firm cannot sell any of its product at a higher price. On the other hand, if the firm lowers its price, it can sell as much as it wants, but this doesn’t give it a competitive advantage because other firms can also lower their prices in response.
The perfectly elastic demand curve is a horizontal line at the market price, indicating that the firm is a “price taker” and must accept the going market price. Any deviation from this price results in a loss of all customers, as they would simply switch to a competitor.
This situation is characteristic of perfectly competitive markets, where there are many firms producing identical goods, and no single firm has the power to influence market prices. The key feature of this market structure is that the products are homogeneous, meaning consumers see them as perfect substitutes for one another. Therefore, the firm has no room to raise its prices without losing its entire customer base.