Until the 1920s, competition and monopoly were the only models of market structure that economists had in their toolbox. As consumerism expanded and more varieties of goods and services became available, economists found that these two models were inadequate to explain the vast markets for many goods. In other words, some markets were considered imperfect, or not fitting the mold of the traditional competitive structure. This led to the study of imperfect markets, which included monopolistic competition and oligopoly.

Monopolistic competition is nearer to the competitive end of the spectrum and is defined by the following characteristics:

Most firms sell products that are in some way differentiated from their competitors. For example, this differentiation can take the form of a superior location. Your local dry cleaner, restaurant, grocery, and gas station can have slightly higher prices, but you will not abandon them altogether. Other companies have branded products that give them some ability to increase price without losing all of their customers, as would happen under perfect competition.

Product differentiation gives the firm some (however modest) control over price (market power). This is illustrated in Figure 1. Curve d_c is the competitive demand curve, and d_mc is the demand curve faced by a monopolistic competitor. This is similar to the monopolist’s demand, but the demand curve is considerably more elastic. Because a monopolistic competitor is small relative to the market, there are still a lot of substitutes. Thus, any increase in price is accompanied by a substantial decrease in output demanded. But unlike the perfectly competitive firm that faces a horizontal demand curve with no power to raise price, a monopolistically competitive firm has some market power with its slightly less elastic demand curve.

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Like a monopolist, the monopolistically competitive firm faces a downward-sloping marginal revenue curve, shown in Figure 1 as MR_mc.

Product differentiation can be the result of a superior product, a better location, superior service, clever packaging, or advertising. All of these factors are intended to increase demand or reduce the elasticity of demand and generate loyalty to the product or service. Therefore, the demand curve for monopolistically competitive firms can vary. Although demand curves tend to be elastic (flat), firms that are able to successfully differentiate their products can achieve greater market power, which makes their demand curves steeper, allowing them to charge higher prices.

The Role of Advertising An important way to differentiate products is through advertising. Economists generally classify advertising in two ways: informational and persuasive. The informational aspects of advertising let consumers know about products and reduce search costs. Advertising is a relatively inexpensive way to let customers know about the quality and price of a company’s products. It can also enhance competition by making consumers aware of substitute products. Advertising also has the potential to reduce average costs by increasing sales, bringing about economies of scale.

But advertising does have a negative side as well. Because so much of advertising is persuasive (ads containing little informational content, but designed to shift buyers to competitors producing similar products), the result is that the cost of advertising drives up the price of many products. With all the advertising we see, a significant portion probably cancels each other out.

Advertising is another area in which technology has transformed the medium: Digital video recorders permit ad-skipping and have significantly reduced the impact of TV ads. A lot of advertising dollars are shifting away from conventional media (newspapers, magazines, and television) and moving to the Internet, where consumers can be targeted more inexpensively and efficiently.

All of these ways to differentiate their products give monopolistically competitive firms some control over price. This market power means that their profit-maximizing decisions will be a little different from those of perfectly competitive firms.

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Profit maximization in the short run for the monopolistically competitive firm is a lot like that for a monopolist, but given the competition against firms with similar products, profit will tend to be less. Short-run profit-maximizing behavior is shown in Figure 2. The firm maximizes profit where MR = MC (point c) by selling output q₀ at a price of P₀. Total profit is the shaded area C₀P₀ab. All of this should look very familiar from the last chapter (review the five-step approach to maximizing profit). The difference is that the monopolistically competitive demand curve is quite elastic, and economic profits are diminished. The level of profit is dependent on the strength of demand, but in any event will be considerably lower than that of a monopolist.

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This does not mean that profits are trivial. Many huge global firms sell their products in even larger global markets, and their profits are significant. They are large firms, but do not have significant market power. Many companies—such as Gap, Nike, and Samsung—are all quite large, but relative to their markets face daunting competition.

If firms in the industry are earning economic profits like those of the firm shown in Figure 2, new firms will want to enter. Since there are no restrictions to entry or exit, new firms will enter, soaking up some industry demand and reducing the demand to each firm in the market. Demand will continue to decline as long as economic profits exist. At equilibrium in the long run, the typical firm in the industry will look like the one shown in Figure 3.

Notice that the demand curve is just tangent to the long-run average total cost (LRATC) curve, resulting in the firm earning normal profits in the long run. The firm produces and sells q_L output at a price of P_L (point a). Note that price P_L is not at the minimum point of the LRATC, which shows that prices in monopolistically competitive markets are higher than prices in perfectly competitive markets. Once the typical firm reaches this point, there is no longer any incentive for other firms to enter the industry. Like perfectly competitive firms, monopolistically competitive firms earn normal profits in the long run.

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Are firms in monopolistically competitive industries as efficient as those in perfectly competitive industries? Because firms in both earn normal profits, one might think that both market structures are equally efficient. But they are not. Differentiated products create minimarkets within each industry. For example, Wrangler and True Religion are both brands of blue jeans, but each caters to a different set of customers, allowing True Religion to charge almost 10 times more per pair. And because differentiating products reduces economies of scale, the prices will be slightly higher.

The relatively small differences in price and output represent the cost we pay for greater variety and innovation. For example, dozens of flavors of sodas exist so that we need not drink the same brand every time. And watches offer everything from basic time and date to GPS capabilities and Internet service to cater to each customer’s intended use of the product. Product differentiation is important and for most of us valuable, but not free.

From this discussion, you might get some sense of the pressures firms face to differentiate their products. The more they can move away from the competitive model, the better chance they have of using their market power to make more profit. But because market power evaporates over the long run for monopolistically competitive firms, these firms have to try to sustain the value in the differentiated product. This is hard to do. The price premium charged by Hollister will not be paid when the Hollister brand is no longer as popular, or becomes more like everyone else. Yet, it is in the firm’s interest to product differentiate as long as it can. When you see firms trying to differentiate their products, ask yourself if the products are really so different after all.

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