Developed by American economist Edward Chamberlin (1899-1967) and English economist Joan Robinson (1903-1983), monopolistic competition refers to competition between several firms producing an almost identical product in a market.
The demand for each good is not perfectly elastic. Monopolistic firms command brand loyalty and therefore are not price-takers. Under this form of competition, total product equals the sum of marginal cost and marginal revenue.
E H Chamberlin, A Theory of Monopolistic Competition (Cambridge, Mass., 1933)
Monopolistic competition is a type of imperfect competition such that there are many producers competing against each other, but selling products that are differentiated from one another (e.g. by branding or quality) and hence are not perfect substitutes. In monopolistic competition, a firm takes the prices charged by its rivals as given and ignores the impact of its own prices on the prices of other firms. In the presence of coercive government, monopolistic competition will fall into government-granted monopoly. Unlike perfect competition, the firm maintains spare capacity. Models of monopolistic competition are often used to model industries. Textbook examples of industries with market structures similar to monopolistic competition include restaurants, cereal, clothing, shoes, and service industries in large cities. The “founding father” of the theory of monopolistic competition is Edward Hastings Chamberlin, who wrote a pioneering book on the subject, Theory of Monopolistic Competition (1933). Joan Robinson published a book The Economics of Imperfect Competition with a comparable theme of distinguishing perfect from imperfect competition. Further work on monopolistic competition was undertaken by Dixit and Stiglitz who created the Dixit-Stiglitz model which has proved applicable used in the sub fields of international trade theory, macroeconomics and economic geography.
Monopolistically competitive markets have the following characteristics:
- There are many producers and many consumers in the market, and no business has total control over the market price.
- Consumers perceive that there are non-price differences among the competitors’ products.
- Firms operate with the knowledge that their actions will not affect other firms’ actions.
- There are few barriers to entry and exit.
- Producers have a degree of control over price.
- The principal goal of the firm is to maximize its profits.
- Factor prices and technology are given.
- A firm is assumed to behave as if it knew its demand and cost curves with certainty.
- The decision regarding price and output of any firm does not affect the behavior of other firms in a group, i.e., impact of the decision made by a single firm is spread sufficiently evenly across the entire group. Thus, there is no conscious rivalry among the firms.
- Each firm earns only normal profit in the long run.
- Each firm spends substantial amount on advertisement. The publicity and advertisement costs are known as selling costs.
The long-run characteristics of a monopolistically competitive market are almost the same as a perfectly competitive market. Two differences between the two are that monopolistic competition produces heterogeneous products and that monopolistic competition involves a great deal of non-price competition, which is based on subtle product differentiation. A firm making profits in the short run will nonetheless only break even in the long run because demand will decrease and average total cost will increase. This means in the long run, a monopolistically competitive firm will make zero economic profit. This illustrates the amount of influence the firm has over the market; because of brand loyalty, it can raise its prices without losing all of its customers. This means that an individual firm’s demand curve is downward sloping, in contrast to perfect competition, which has a perfectly elastic demand schedule.