Suppose an industry is monopolistically competitive: it consists of many producers, all competing for the same consumers but offering differentiated products. How does such an industry behave?

As the term monopolistic competition suggests, this market structure combines some features typical of monopoly with others typical of perfect competition. Because each firm is offering a distinct product, it is in a way like a monopolist: it faces a downward-sloping demand curve and has some market power—the ability within limits to determine the price of its product. However, unlike a pure monopolist, a monopolistically competitive firm does face competition: the amount of its product it can sell depends on the prices and products offered by other firms in the industry.

The same, of course, is true of an oligopoly. In a monopolistically competitive industry, however, there are many producers, as opposed to the small number that defines an oligopoly. This means that the “puzzle” of oligopoly—will firms collude or will they behave noncooperatively?—does not arise in the case of monopolistically competitive industries. True, if all the gas stations or all the restaurants in a town could agree—explicitly or tacitly—to raise prices, it would be in their mutual interest to do so.

But such collusion is virtually impossible when the number of firms is large and, by implication, there are no barriers to entry. So in situations of monopolistic competition, we can safely assume that firms behave noncooperatively and ignore the potential for collusion.