Competition, Monopolistic

Competition, Monopolistic

BIBLIOGRAPHY

Economists have a spectrum of models with which to analyze how competing firms interact. The simplest of these involve situations in which firms can choose quantities and other variables (product quality, and advertising), without having to consider the reaction their choices might generate from other firms. Obviously, when there is a single firm in a market (a monopolist), this occurs by definition, as there are no other firms to do the reacting. However, it is also the key assumption underlying perfect competition, where firms are assumed to take prevailing prices as given. Specifically, firms believe that if they charge a higher price than the market price, they will lose all of their customers. The problem with perfect competition is that, in reality, competing firms have some discretion over the price, and they can therefore raise them without losing all of their sales. In this situation, however, firms might be “small,” and so it might be reasonable to presume that they can be modeled independently of other firms’ potential reactions.

Monopolistic competition is the term given to this “middle ground.” An industry is defined as monopolistically competitive if: (a) there are many producers and consumers in the industry; (b) consumers have preferences that may cause them to favor one specific firm over another; and (c) there are no barriers to entry or exit. Conditions a and c are also features of perfect competition, so the critical distinction comes from condition b, whereby the products sold by firms are not homogeneous (i.e., perfectly substitutable) in the eyes of consumers. Consumers may favor one firm over another because of location, branding issues, knowledge of quality, advertising and marketing appeal, or individual product characteristics.

In many respects, the outcomes from monopolistic competition are similar to those from perfect competition. First, in long-term equilibrium with identical firms, profits are dissipated by competition, and entry occurs at the point where the marginal firm is earning enough to cover fixed or sunk-market entry costs. Second, prices reflect average production costs. However, because the firms have some pricing discretion, they will charge a mark-up over their marginal costs (even in the long-run) and conceptually will be able to recover fixed costs associated with, say, product development. This also means that, compared with perfect competition, prices will be higher and quantity lower in monopolistic competition, leading to a debate as to whether this sacrifice is made up for by product variety.

It is this latter implication that has perhaps proved most significant in giving monopolistic competition greater prominence in economic analysis. Monopolistic competition was independently developed by Edward Chamberlin and Joan Robinson in the early 1930s. Each was motivated by a problem with perfect competition identified by Piero Sraffa, who noted in 1926 that if firms had fixed production costs and falling average costs (i.e., economies of scale), then perfect competition imposed no limit to firm size. This could not be reconciled with the reality of smaller firms even where economies of scale appeared to be present. Chamberlin and Robinson saw the reconciliation of this problem in the notion that competing firms might have downward sloping individual demand curves. Chamberlin assigned this trend to the existence of product differentiation, while Robinson found that it came about because of an imperfect adjustment response from other firms (today termed “residual demand”). This meant that individual firms would be limited in their ability to realize scale economies because of entry by others who could pick up some consumers by supplying a differentiated product.

The marrying of economies of scale and competitive pressures led to important developments in other areas of economics. In 1977, Avinash Dixit and Joseph Stiglitz developed a tractable model of monopolistic competition that allowed for a convenient analysis of product variety (and showed that too few products would be produced relative to the social optimum). This model formed the basis for new trade theory (Krugman 1979), new growth theory (Romer 1987), and new economic geography (Krugman 1991), each of which required a model that enabled firms to have economies of scale, yet also be limited by competitive pressure.

SEE ALSO Competition; Competition, Imperfect; Discrimination, Price; Monopoly; Price Setting and Price Taking; Robinson, Joan

BIBLIOGRAPHY

Chamberlin, Edward H. 1933. The Theory of Monopolistic Competition. Cambridge, MA: Harvard University Press.

Dixit, Avinash K., and Joseph E. Stiglitz. 1977. Monopolistic Competition and Optimal Product Diversity. American Economic Review 67 (3): 297–308.

Hotelling, H. 1929. Stability in Competition. Economic Journal 39: 41–57.

Krugman, Paul R. 1979. Increasing Returns, Monopolistic Competition, and International Trade. Journal of International Economics. 9 (4): 469–479.

Krugman, Paul R. 1991. Increasing Returns and Economic Geography. Journal of Political Economy 99 (3): 483–499.

Lancaster, Kelvin J. 1979. Variety, Equity, and Efficiency: Product Variety in an Industrial Society. New York: Columbia University Press.

Robinson, Joan. 1933. The Economics of Imperfect Competition. London: Macmillan.

Romer, Paul M. 1987. Growth Based on Increasing Returns Due to Specialization. American Economic Review 77 (2): 56–62.

Sraffa, Piero. 1926. The Law of Returns under Competitive Conditions. Economic Journal 36 (144): 535–560.

Joshua Gans