Oligopoly is closer to monopoly than to pure competition. Ease of entry and exit in monopolistically competitive markets forces firms into a slightly more competitive mode.
Monopolistic competition requires easy entry and exit into industries in which many potential suppliers compete vigorously with makers of close, but not perfect, substitutes for their “brand-name” products.
Monopolistic competitors do not base decisions on the anticipated individual reactions of their many competitors, so they are not mutually interdependent in the way oligopolists are. Product differentiation (e.g., packaging, advertising, or styling), however, gives them some control over prices.
Few models of firm behavior occupied the vast middle ground between pure competition and monopoly until the 1930s, when the works of Joan Robinson and E. H. Chamberlin made it clear that most earlier models left huge gaps. The continuum from competition to monopolistic competition through oligopoly to monopoly is not smooth, and where an industry fits may change over time. For example, 40 years ago automaking was clearly an oligopoly; General Motors, Ford, and Chrysler sold roughly 95 percent of all cars in the United States. Rambler, Jeep, Hudson, Studebaker, and Packard sold the other five percent, but these firms have died or been absorbed into the "Big 3." However, competition from BMW, Fiat, Honda, Hyundai, Nissan, Toyota, Volkswagen, and other foreign carmakers has moved this oligopolistic industry a bit closer to the monopolistically competitive mode.
Monopolistic competition resembles pure competition in allowing easy entry or exit, but differs because each firm produces a differentiated good. Monopolistically competitive industries have:
1. Large numbers of potential buyers and suppliers.
2. Differentiated products that are close substitutes.
3. Easy entry or exit in the long run.
Successful product differentiation creates market power by expanding the demand curve the firm faces and decreasing its price elasticity; this can allow a monopolistic competitor to act a little like a monopolist. Each monopolistic competitor has some control over price. But, as we shall see, like competitors, monopolistic competitors earn only normal profit in the long run because entry by potential competitors is easy.
Short-Run Pricing and Output
A monopolistic competitor's profit-maximizing short-run price and output combination is shown at point a in Figure 2; output q0 is sold at price P0. Regardless of market structure, all firms maximize profit by producing where marginal revenue equals marginal cost. In the short run, this successful firm's economic profit equals the shaded area.
Monopolistic competitors may suffer short-run losses; profits would be impossible if a firm's average cost curve were always above the demand curve. Like all firms, a monopolistic competitor would minimize losses by selling that output where marginal revenue equals marginal cost, as long as the price it could set (average revenue) exceeded average variable costs.
Monopolistic competitors differentiate products to exploit short-run profit opportunities, and would like their profits to persist. These hopes are usually frustrated because typical monopolistic competitors earn only normal profits in the long run; the long-run industry adjustments parallel those for pure competition. Entry of new firms seeking profits cannot be prevented, which may increase production costs. Profits are also dissipated because prices fall when new competitors expand output and take customers from existing firms.
This shrinks the demand for a successful firm's products. When new firms enter the market, the demand curves of established firms shift leftward and become more elastic, ultimately leaving all firms in an equilibrium of the sort shown in Figure 3. Marginal revenue equals marginal cost at point a, and the long-run average total cost (LRATC) curve is just tangent to the demand curve at point b. This tangency allows the firm to sell its output at a price just equal to average cost (Pe = ATCe), yielding only normal profits in the long run. Product differentiation allows the prices of comparable goods to vary in monopolistic competition, but only within a narrow range.
Resource Allocation and Efficiency
Pure competition is allocatively efficient because marginal social benefit equals marginal social cost (P = MSC), and is productively efficient because average costs are minimized. In Figure 3, demand would be dc for a pure competitor; the equilibrium at point c entails more production which is sold at a lower price (Pc= min LRATC= MC) and more output than would be produced by a monopolistic competitor. Note that, even though both perfect and monopolistic competitors only realize normal profit in the long run, the monopolistically competitive price is higher (Pe), and each firm sells less (qe).
The failure of firms that have market power to produce that output which minimizes average costs is known as the excess capacity theorem.
This analysis suggests that monopolistic competition is both allocatively and productively inefficient. Product differentiation often entails little real value. Allocative inefficiency (failure to produce the mix of goods consumers want most) is present if price exceeds marginal social costs (P > MSC). Persuasive advertising (the use of slogans and imagery to stimulate psychological impulses to buy) is frequently the culprit.
Even though monopolistic competitors reap only normal long-run profits, monopolistic competition creates productive inefficiency---costs are not minimized. A pure competitor would produce for Pc per unit; advertising and other costs of artificial differentiation drive up a monopolistic competitor's minimum to Pe, which is above the minimum average total cost in Figure 3. Monopolistic competition misallocates resources because costs, and thus prices, are higher and each firm's output is less.
Some economists contend that any minor inefficiency is more than offset by the greater range of choices available. Is product differentiation desirable because consumers gain a greater range of choice, or is most differentiation an artificial and worthless consequence of misleading advertising? Your answer to this question, which may easily vary from one industry to the next, indicates whether or not you think monopolistic competition provides an offset to its allocative and productive inefficiency. If you view product diversity as worthless and are unwilling to suffer from this type of inefficiency, one solution is to buy generic goods wherever possible.