9.3 The Meaning of Monopolistic Competition

Leo manages the Wonderful Wok stand in the food court of a big shopping mall. He offers the only Chinese food there, but there are more than a dozen alternatives, from Bodacious Burgers to Pizza Paradise. When deciding what to charge for a meal, Leo knows that he must take those alternatives into account: even people who normally prefer stir-fry won’t order a $15 lunch from Leo when they can get a burger, fries, and drink for $4.

But Leo also knows that he won’t lose all his business even if his lunches cost a bit more than the alternatives. Chinese food isn’t the same thing as burgers or pizza. Some people will really be in the mood for Chinese that day, and they will buy from Leo even if they could dine more cheaply on burgers. Of course, the reverse is also true: even if Chinese is a bit cheaper, some people will choose burgers instead. In other words, Leo does have some market power: he has some ability to set his own price.

So how would you describe Leo’s situation? He definitely isn’t a price-taker, so he isn’t in a situation of perfect competition. But you wouldn’t exactly call him a monopolist, either. Although he’s the only seller of Chinese food in that food court, he does face competition from other food vendors.

Yet it would also be wrong to call him an oligopolist. Oligopoly, remember, involves competition among a small number of interdependent firms in an industry protected by some—albeit limited—barriers to entry and whose profits are highly interdependent. Because their profits are highly interdependent, oligopolists have an incentive to collude, tacitly or explicitly. But in Leo’s case there are lots of vendors in the shopping mall, too many to make tacit collusion feasible.

Monopolistic competition is a market structure in which there are many competing producers in an industry, each producer sells a differentiated product, and there is free entry into and exit from the industry in the long run.

Economists describe Leo’s situation as one of monopolistic competition. Monopolistic competition is particularly common in service industries like restaurants and gas stations, but it also exists in some manufacturing industries. It involves three conditions: large numbers of competing producers, differentiated products, and free entry into and exit from the industry in the long run.

In a monopolistically competitive industry, each producer has some ability to set the price of her differentiated product. But exactly how high she can set it is limited by the competition she faces from other existing and potential producers that produce close, but not identical, products.

Large Numbers

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In a monopolistically competitive industry, there are many producers. Such an industry does not look either like a monopoly, where the firm faces no competition, or an oligopoly, where each firm has only a few rivals. Instead, each seller has many competitors. For example, there are many vendors in a big food court, many gas stations along a major highway, and many hotels at a popular beach resort.

Free Entry and Exit in the Long Run

In monopolistically competitive industries, new producers, with their own distinct products, can enter the industry freely in the long run. For example, other food vendors would open outlets in the food court if they thought it would be profitable to do so. In addition, firms will exit the industry if they find they are not covering their costs in the long run.

Differentiated Products

In a monopolistically competitive industry, each producer has a product that consumers view as somewhat distinct from the products of competing firms; at the same time, though, consumers see these competing products as close substitutes. If Leo’s food court contained 15 vendors selling exactly the same kind and quality of food, there would be perfect competition: any seller who tried to charge a higher price would have no customers. But suppose that Wonderful Wok is the only Chinese food vendor, Bodacious Burgers is the only hamburger stand, and so on. The result of this differentiation is that each seller has some ability to set his own price: each producer has some—albeit limited—market power.

Product differentiation is an attempt by a firm to convince buyers that its product is different from the products of other firms in the industry.

Product differentiation—an attempt by a firm to create the perception that its product is different—is the only way that monopolistically competitive firms can acquire some market power. How do firms in the same industry—such as fast-food vendors, gas stations, or chocolate makers—differentiate their products? Sometimes the difference is mainly in the minds of consumers rather than in the products themselves. In general, however, firms differentiate their products by—surprise!—actually making them different.

The key to product differentiation is that consumers have different preferences and are willing to pay somewhat more to satisfy those preferences. Each producer can carve out a market niche by producing something that caters to the particular preferences of some group of consumers better than the products of other firms.

We’ll now look at the three forms of product differentiation: differentiation by style or type, by location, and by quality.

Differentiation by Style or Type The sellers in Leo’s food court offer different types of fast food: hamburgers, pizza, Chinese food, Mexican food, and so on. Each consumer arrives at the food court with some preference for one or another of these offerings. This preference may depend on the consumer’s mood, her diet, or what she has already eaten that day. These preferences will not make consumers indifferent to price: if Wonderful Wok were to charge $15 for an egg roll, everybody would go to Bodacious Burgers or Pizza Paradise instead. But some people will choose a more expensive meal if that type of food is closer to their preference. So the products of the different vendors are substitutes, but they aren’t perfect substitutes—they are imperfect substitutes.

Vendors in a food court aren’t the only sellers that differentiate their offerings by type. Clothing stores concentrate on women’s or men’s clothes, on business or casual clothes, on trendy or classic styles. Auto manufacturers offer sedans, minivans, sport-utility vehicles, and sports cars, each type aimed at drivers with different needs and tastes.

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Books offer yet another example of differentiation by type and style. Mysteries are differentiated from romances; among mysteries, we can differentiate among hard-boiled detective stories, whodunits, and police procedurals.

In fact, product differentiation is characteristic of most consumer goods. As long as people differ in their tastes, producers find it possible and profitable to produce a range of varieties.

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For industries that differentiate by location, proximity is everything.
Buddy Mays/Alamy

Differentiation by Location Gas stations along a road offer differentiated products. True, the gas may be exactly the same. But the location of the stations is different, and location matters to consumers: it’s more convenient to stop for gas near your home, near your workplace, or near wherever you are when the gas gauge gets low.

In fact, many monopolistically competitive industries supply goods differentiated by location. This is especially true in service industries, from dry cleaners to hairdressers, where customers often choose the seller who is closest rather than cheapest.

Differentiation by Quality Do you have a craving for chocolate? How much are you willing to spend on it? You see, there’s chocolate and then there’s chocolate: although ordinary chocolate may not be very expensive, gourmet chocolate can cost several dollars per bite.

With chocolate, as with many goods, there is a range of possible qualities. You can get a usable bicycle for less than $100; you can get a much fancier bicycle for 10 times as much. It all depends on how much the additional quality matters to you and how much you will miss the other things you could have purchased with that money.

Because consumers vary in what they are willing to pay for higher quality, producers can differentiate their products by quality—some offering lower-quality, inexpensive products and others offering higher-quality products at a higher price.

Product differentiation, then, can take several forms. Whatever form it takes, however, there are two important features of industries with differentiated products: competition among sellers and value in diversity.

  1. Competition among sellers means that even though sellers of differentiated products are not offering identical goods, they are to some extent competing for a limited market. If more businesses enter the market, each will find that it sells less quantity at any given price. For example, if a new gas station opens along a road, each of the existing gas stations will sell a bit less.

  2. Value in diversity is the gain to consumers from the proliferation of differentiated products. A food court with eight vendors makes consumers happier than one with only six vendors, even if the prices are the same, because some customers will get a meal that is closer to what they had in mind. A road on which there is a gas station every two miles is more convenient for motorists than a road where gas stations are five miles apart.

When a product is available in many different qualities, fewer people are forced to pay for more quality than they need or to settle for lower quality than they want. There are, in other words, benefits to consumers from a greater diversity of available products.

Monopolistic competition differs from the three market structures we have examined so far. It’s not the same as perfect competition: firms have some power to set prices. It’s not pure monopoly: firms face some competition. And it’s not the same as oligopoly: because there are many firms and free entry, the potential for collusion so important in oligopoly no longer exists.

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ECONOMICS in Action

Any Color, So Long as It’s Black

image | interactive activity

The early history of the auto industry offers a classic illustration of the power of product differentiation.

The modern automobile industry was created by Henry Ford, who first introduced assembly-line production. This technique made it possible for him to offer the famous Model T at a far lower price than anyone else was charging for a car; by 1920, Ford dominated the automobile business.

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Ford’s Model T in basic black.
Science and Society/Superstock

Ford’s strategy was to offer just one style of car, which maximized his economies of scale in production but made no concessions to differences in consumers’ tastes. He supposedly declared that customers could get the Model T in “any color, so long as it’s black.”

This strategy was challenged by Alfred P. Sloan, who had merged a number of smaller automobile companies into General Motors. Sloan’s strategy was to offer a range of car types, differentiated by quality and price. Chevrolets were basic cars that directly challenged the Model T, Buicks were bigger and more expensive, and so on up to Cadillacs. And you could get each model in several different colors.

By the 1930s the verdict was clear: customers preferred a range of styles, and General Motors, not Ford, became the dominant auto manufacturer for the rest of the twentieth century.

Quick Review

  • In monopolistic competition there are many competing producers, each with a differentiated product, and free entry and exit in the long run.

  • Product differentiation takes three main forms: by style or type, by location, or by quality. The products of competing sellers are considered imperfect substitutes.

  • Producers compete for the same market, so entry by more producers reduces the quantity each existing producer sells at any given price. In addition, consumers gain from the increased diversity of products.

Check Your Understanding 9-3

Question 9.6

1. Each of the following goods and services is a differentiated product. Which are differentiated as a result of monopolistic competition and which are not? Explain your answers.

  1. Ladders

    Ladders are not differentiated as a result of monopolistic competition. A ladder producer makes different ladders (tall ladders versus short ladders) to satisfy different consumer needs, not to avoid competition with rivals. So two tall ladders made by two different producers will be indistinguishable by consumers.

  2. Soft drinks

    Soft drinks are an example of product differentiation as a result of monopolistic competition. For example, several producers make colas; each is differentiated in terms of taste, which fast-food chains sell it, and so on.

  3. Department stores

    Department stores are an example of product differentiation as a result of monopolistic competition. They serve different clienteles that have different price sensitivities and different tastes. They also offer different levels of customer service and are situated in different locations.

  4. Steel

    Steel is not differentiated as a result of monopolistic competition. Different types of steel (beams versus sheets) are made for different purposes, not to distinguish one steel manufacturer’s products from another’s.

Question 9.7

2. You must determine which of two types of market structure better describes an industry, but you are allowed to ask only one question about the industry. What question should you ask to determine if an industry is:

  1. Perfectly competitive or monopolistically competitive?

    Perfectly competitive industries and monopolistically competitive industries both have many sellers. So it may be hard to distinguish between them solely in terms of number of firms. And in both market structures, there is free entry into and exit from the industry in the long run. But in a perfectly competitive industry, one standardized product is sold; in a monopolistically competitive industry, products are differentiated. So you should ask whether products are differentiated in the industry.

  2. A monopoly or monopolistically competitive?

    In a monopoly there is only one firm, but a monopolistically competitive industry contains many firms. So you should ask whether or not there is a single firm in the industry.

Solutions appear at back of book.