Section 7.5 Monopolistic competition
Monopolistically competitive markets have no barriers to entry and, therefore, many sellers. These markets also feature differentiated products. Think of the market for bread at your local grocery store. There is free entry in the market for bread, since essentially anyone can open a bakery and start baking and selling their bread. This leads to a wide variety of sellers, and many differentiated styles of bread at the store: white bread, whole wheat, 7-grain, 12-grain, 21-grain, oat nut, brioche, baguette, focaccia, and countless more! Moreover, even with the same type of bread, different brands’ products are likely at least a little different from each other. One bakery might sell a baguette that has a slightly flakier crust than the baguette of another bakery. Fast food restaurants, coffee shops, clothing brands, and many other consumer products fit this description of monopolistic competition.
The defining feature of monopolistically competitive markets is the range of differentiated products. Because there are many different sellers with slightly different products, consumers will have a variety of preferences. Some consumers prefer McDonald’s french fries; others prefer Burger King or Wendy’s. If a consumer has a preference for McDonald’s fries, they would have a slightly higher willingness to pay (WTP) for McDonald’s fries over french fries from other restaurants. With enough differentiation in product, and many buyers in the market, there’s gotta be some consumer that has a preference for each different product.
It’s important to note how this differs from perfectly competitive markets. In perfect competition, since the many sellers are selling identical products, consumers have no reason to be willing to pay different price to different firms for the same product. So no firm has market power, since there is no justification for charging a price higher than a competitors’ price.
So, how do monopolistically competitive firms get their market power? In a monopoly, the seller’s market power comes from barriers to entry. Since competitors literally cannot enter the market, the one seller in the market has a massive amount of influence over the market outcome. However, there is free entry in monopolistic competition! These firms cannot prevent competitors from entering. Even if you run a very successful bakery, there is no way to prevent other bakers from entering the market to compete with you.
In monopolistic competition, firms derive their market power from their differentiated products. Each seller can take advantage of consumers’ unique preferences for its product - and their higher willingness to pay for its product - to wield some market power and influence its price. The seller will be able to mark its price up above its marginal cost at least a little bit. Therefore, in the short run, a monopolistically competitive firm behaves like a mini-monopoly: at any moment in time, each firm is the only firm selling its uniquely differentiated product.
The graph below shows how a monopolistically competitive firm chooses output \(q^*\) to maximize its profit. Like any firm, it is optimal to produce where marginal revenue equals marginal cost. If the model looks similar to a standard monopoly, that’s because it’s the same! In the short run, the seller’s market power functions just like a monopoly.
To complete our model of monopolistic competition, we need to discuss how much profit the firm makes in the short run. On our standard graph, it is straightforward to observe the firm’s total revenue. If the firm produces \(q^*\text{,}\) and sells for price \(p^*\text{,}\) total revenue is \(TR = p^*q^*\text{.}\) Graphically, total revenue is the rectangular area under the demand curve at the firm’s price-quantity combination. \(p^*\) is the vertical distance, \(q^*\) is the horizontal distance, and their product is total revenue.
What about the firm’s total cost? To see this, we need to add the firm’s average total cost curve to our graph. As we’ve seen, a firm’s average total cost measures its cost per unit, and is defined as \(ATC = \frac{TC}{q}\text{.}\) Notice, though, that with a quick rearrangement, we can get an expression for total cost:
\begin{equation*}
ATC = \frac{TC}{q} \Longleftrightarrow TC = ATC \times q^*
\end{equation*}
Just as we measured total revenue, we can measure total cost as a rectangular area. The firm’s \(ATC\) at \(q^*\) is the vertical distance up to the \(ATC\) curve, \(q^*\) is the horizontal distance, and their product is total cost.
When combined, we can see a visual representation of the firm’s profit. If the total revenue area is larger than the total cost area, the firm makes positive profit. And the size of that difference between \(TR\) and \(TC\) is exactly the firm’s profit - because this is the definition of profit!
Now we are ready to finish our monopolistic competition story. In the first chapter, we saw that a monopolistically competitive firm behaves like a mini-monopoly in the short run. It is the only producer of a unique product, so it can exert its marker power to increase its profit. But what happens in the long run?
Remember free entry? Monopolistically competitive markets have no barriers to entry. This means if firms are making positive profit in a monopolistically competitive market, new firms will be attracted to enter the market. The more bakers and entrepreneurs hear about profit-making opportunities in the market for baked goods, the greater incentive they have to enter that market and produce their own slightly differentiated product!
New entrants won’t be able to sell a product identical to those of existing firms, but they will probably be able to produce something reasonably similar. Think of the ways a new firm might try to imitate the product of an existing firm, or make something close but with a slightly unique spin on it. The new entrants drawn into the market bring new differentiated products; while not perfect substitutes for existing products, the introduction of even more differentiated products lowers demand for the products of existing firms. In doing so, the entrants erode the market power - and profit (as we will see!) - of existing firms.
This decrease in demand leads to a corresponding drop in the firm’s marginal revenue. Since consumers’ willingness to pay decreases, the additional revenue generated from output increases also decreases. As both curves shift inward, this leads to a lower optimal quantity, a lower price, and smaller profit, as is shown in the graph below.
Over time, we would anticipate entry to continue in the long run until the profit reached zero. As long as there are opportunities for positive profit in a monopolistically competitive market, firms will enter the market and slowly erode the market power of existing firms with the introduction of new differentiated products. If instead, firms were making losses in a monopolistically competitive market, free exit would encourage some firms to leave the market. This would expand the market power of the remaining firms, increase their demand, and increase firm profits until profit was no longer negative.
Just as we saw earlier with dynamic stability and the eventually adjustment of a perfectly competitive market to equilibrium, it is difficult to say just how long the long run is here. It might take months or even years in real time for firm profits to reach zero completely. Additionally, over that time, existing firms will likely do everything they can to continue to differentiate their products from existing and new competitors. If you can imagine your favorite coffee shop or fast food restaurant constantly offering new products, seasonal items, or special promotions, these are all strategies for further differentiation - and strengthening market power 1 .
Therefore, if the first chapter of our monopolistic competition story is the short-run mini-monopoly story, the second chapter is the long-run profit trend story:
- If firms are making positive profit, new competitors will enter the market. This decreases demand for existing firms, erodes market power, and drives profit to approach zero.
- if firms are making negative profit, some firms will leave the market. This will increase demand for existing firms, enhance their market power, and lift profit toward zero.
From this angle, monopolistic competition really is the perfect name for this market structure. The market behaves monopolistically in the short run, and competitively in the long run!
