The theory of monopolistic competition was devised by Edward Chamberlain, writing in the US in the 1930s, and his name is often attached to the model, although Joan Robinson published her book in the UK at the same time. The motivation for the analysis was to explain how markets operated when they were operating neither as monopolies nor under perfect competition.
The model describes a marker in which there are many firms producing similar, but ot identical, products, e.g. travel agents, hairdressers, or fast food outlets. In the case of fast-food outlets, the high streets of many cities are characterised by large numbers of different types of takeaway – burgers, fish and chips, Indian, Chinese, fried chicken and so on.
There important characteristics of the model of imperfect competition distinguish this sort of market from others.
First, firms produce differentiated products, and face downward sloping demand curves. In other words, each firm competes with others by making its product slightly different. This allows the firms to build up brand loyalty among regular customers, which gives them some influence over price. It is likely that firms will engage in advertising in order to maintain such brand loyalty, and heavy advertising is a common characteristic of a market operating under monopolistic competition.
Because other firms are producing similar goods, there are substitutes for each firms products, which means that the demand curves is not perfectly price elastic, as was the case with perfect competition. These features – that the product is not homogeneous and demand is not perfectly price elastic – represent significant differences from the model of perfect competition.
Freedom of entry
Second, there are no barriers of entry into the market. Firms are able to join the market if the observe that existing firms are making supernormal profits. New entrants in the market will be looking for some way to differentiate themselves slightly from the others – perhaps the next fast food restaurant will be Nepalese, or Peruvian.
This characteristic distinguishes itself from the monopoly model, as does the existence of fairly close substitutes.
Third, the concentration ratio in the market tends to be relatively low, as there are many firms operating in the market, For this reason, a price change by one of the firms will have negligible effects on the demand for its rivals products.
This characteristic distinguishes the market from the oligopoly market, where there are a few firms that interact strategically with each other.
Taking these three characteristics together, it can be seen that a market of monopolistic competition has some of the characteristics of perfect competition and some of the features of a monopoly market – hence the name.
Short run equilibrium
This diagram represents short run equilibrium under monopolistic competition. AR is the demand curve, and MR is the corresponding marginal revenue curve. AC and MC are the average and marginal cost curves for a representative firm in the industry. If the firm is aiming to maximise profits, it will choose the level of output such that MC = MR. This occurs at output Qs, and the firm will then choose the price that clears the market at price Ps.
This closely resembles the standard monopoly diagram that was introduced earlier. As with monopoly, a firm under monopolistic competition faces a downward sloping demand curve, as previously noted. The difference is that now it is assumed that there is free entry into the market under monopolistic competition, so that the diagram only represents equilibrium in the short run. This is because the firm shown in the figure is making supernormal profits, shown by the shaded area (which is AR – AC multiplied by output).
The importance of free entry
This is where the assumption of free entry into the market becomes important. In the above diagram, the supernormal profits being made by the representative firm will attract other firms into the market. The new firms will produce differentiated products, and this will have two important effects on the demand for the representative firms product. First, the new firms will attract some customers away from this firm, causing the demand curve to shift to the left. Second, as there are now more substitutes for the original product, the demand curve becomes more elastic – remember that the availability of substitutes is an important influence on the price elasticity of demand for a product.
Long run equilibrium
This process will continue as long as firms in the market continue to make profits and attract new firms into the market. It may be accelerated if firms are persuaded to spend money on advertising in an effort to defend their market shares. The advertising may help keep the demand curve downward sloping, but it will also affect the position of the cost curve, by pushing up the average cost at all levels of output.
The diagram above shows the final position for the market. The typical firm is now operating in such a way that it maximises profits, by setting output such that MC = MR); at the same time the average cost curve (AC) at this level of output is tangential to the demand curve. This means that AC = AR, and the form is just making normal profit (i.e. is just covering opportunity cost). There is thus no further incentive for firms to join the market. This occurs when output is set to Ql and price is set to Pl.
Productive efficiency occurs when a firm is operating at the bottom of their long run average cost curve. Allocative efficiency occurs when price is set to marginal cost. It is clear that neither of these conditions will be met. The representative firm does not reach the minimum point in the long run average cost curve in the above diagram, and does not attain productive efficiency; furthermore, the price charged is above marginal cot so allocative efficiency is also not achieved.
If a typical firm in the market is not fully exploiting the possible economies of scale that exist, could be argued that product differentiation is damaging the society’s total welfare, in the sense that it is the product differentiation that allows them to keep their demand curves downward sloping. In other words, too many different products are being consumed. However, this argument can be countered by pointing out that consumers have more freedom of choice. The very fact that they are prepared to pay a premium price for their chosen brand indicates that they have some preference for it.
Another crucial difference between monopolistic competition and perfect competition is that under monopolistic competition firms would like to sell more of their product at the going price, whereas under perfect competition they can sell as much as they like that the going price. This is because price under monopolistic competition is set above marginal cost. The use of advertising to attract more customers and to maintain customer perception of the product differences may be considered a problem with this market. It could be argued that excessive use of advertising to maintain product differentiations is wasteful, as it leads to higher average cost curves than needed. On the other hand, the need to compete in this way may result in less X-inefficiency than could arise under a complacent monopolist.
Examples of monopolistic competition
The theory of monopolistic competition describes a market with some features of a monopoly and some of perfect competition. Entry barriers are low, so the market has many firms. However, firms in the market use product differentiation to influence customers, and thus face downward sloping demand curves. What sorts of market in the real world might typify this structure?
Take a drive along a motorway or trunk road in the UK, and observe the heavy goods vehicles and smaller vans that you pass. You will see HGVs and vans in a wide variety of liveries, from a wide range of countries, and carrying a wide diversity of loads.
This is a market that is characterised by many competing firms, many of which operate in niche markets. Firms try to differentiate their offerings by carrying particular categories of goods – building materials, perhaps, or electronic goods. Some may trade between certain destinations. They advertise by broadcasting their specialism on their vehicles, in the Yellow Pages, or on the internet.
Another part of the road transport market that may typify monopolistic competition is local taxi markets. Count the local taxi companies in your Yellow Pages. Again, firms seeking to differentiate their products through having a fleet livery, by advertising pre-booking only, or by offering a limousine service. There may also be firms that specialise in long distance trips, say to airports.
Another example is food outlets. The number of restaurants and fast-food outlets has mushroomed in recent decades, and on many high streets in UK towns there is proliferation of eating places and takeaways.One of the characteristics of a market under perfect competition is the product differentiation that takes place. Each individual seller sets out to be different from its competitors. This is certainly a characteristic of the fast-food sector, where outlets offer different styles of cuisine – burgers, Indian, Chinese, Thai, Mexican and so on. Before condemning such a marker as being damaging to consumers because of the effect on productive and allocative efficiency, it is worth being aware that this market offers consumers a wide range of choice for fast food. If they value this choice, then this could be seen as a benefit that arises because of the market structure.
- The theory of monopolistic competition has its origins in the 1930s, when economists such as Edward Chamberlin and Joan Robinson were writing about markets that did not conform to the models of perfect competition and monopoly
- The model describes a market where there are many firms producing similar, but not identical, products
- By differentiating their product from those of other firms, it is possible for firms to maintain some influence over price
- To do this, firms engage in advertising to build up brand loyalty
- There are no barriers to entry in the market, and concentration ratios are low
- Firms in the short run make supernormal profits
- In response, new entrants join the market, shifting the demand curves of existing firms and affecting their elasticity
- The process continues until supernormal profits have been competed away, and the typical firm has its average cost curve at a tangent to its demand curve (AR)
- Neither productive nor allocative efficiency is achieved in the long run equilibrium
- Consumers may benefit from the increased range of choice on offer in the market.