Monopolistic Competition and Product Differentiation

The number of doctoral dissertations that profoundly altered economic theory can be counted on the fingers of one hand. Edward Hastings Chamberlin’s Harvard Ph.D. dissertation, The Theory of Monopolistic Competition, (revised and published in 1933) is among the rare exceptions. Prior to the almost simultaneous publication of the works of Chamberlin and Joan Robinson (The Economics of Imperfect Competition, 1933), mainstream economists (with the exception Cournot and very few others) had largely ignored the vast middle ground between the polar extremes of pure competition and pure monopoly, instead focusing on refining the theory of pure competition, which assumes many sellers of homogeneous products.

Chamberlin perceived that few markets are purely competitive, instead seeing close competitors in nearly every market trying to gain market power by differentiating their products, often by advertising the alleged superiority of their products over those of their rivals. Chamberlin attempted to fill this hole in economic theory by blending the theories of monopoly and competition. The central feature of his analysis is that it depicts the demand curves facing firms with differentiated products as being negatively sloped. Firms that compete on the basis of product differences could raise prices without losing all their customers, but they would sell less output. This fact mirrors elements of monopoly. However, as other firms enter a profitable monopolistically competitive market (as they will), competition tends to lower this negatively sloped demand curve to a point of tangency with the firm's average total cost curve, causing monopoly profits to evaporate in the long run, as is also true of pure competition.

Chamberlin's theory combined with the analysis of Joan Robinson to underpin numerous studies of industrial markets from the 1940s into the 1960s, and provided a theoretical foundation for many public policies towards business, especially in the area of antitrust. Their analyses sparked a school of thought called the Structure-Conduct-Performance (SCP) approach. According to the S-C-P line of reasoning, the structure of an industry (e.g., the number of competitors) is assumed to determine conduct (the behavior of the industry’s firms) in a fairly mechanistic fashion, and the conduct of these firms yields efficient or inefficient performance from the vantage of the rest of society.

The Structureà Conduct à Performance Paradigm

Chamberlin’s theory of monopolistic competition is a great example of how powerful new theories become widely adopted, sometimes go out of fashion, and then are resurrected. The “new industrial organization [NIO]”, which relies heavily on elements of game theory, information economics, and analyses of strategic behavior to examine decisionmaking by firms and within a firm, began to emerge in the 1960s. For example, the principal-agent problem that emerges from asymmetric information permits such fiascos as the implosions of Enron, Worldcom, and Tyco in the early 2000s. Corporate managers are now often assumed to have a goal of maximizing their personal self interest instead of the profits and share-values of stockholders assumed in the S-C-P approach.

Advocates of the NIO increasingly dismissed the S-C-P paradigm as unable to provide insight into important issues about how firms compete domestically. However, after roughly 1980, the theory of monopolistic competition was reborn as a cornerstone of the new trade theory, which perceives globalization as increasingly causing once-profitable firms with market power to watch their market power being eroded by foreign competitors. Thus, the analytical insights pioneered by Chamberlin and Robinson continue to provide useful insights into myriad market structures, especially those markets that are increasingly globalized. In Robinson's phrase, she and Chamberlin introduced a “box of tools” sharper and more generally applicable than those that preceded their works..