No Such Thing as a Free Lunch: Principles of Economics (Part 66)

“The curious mind embraces science; the gifted and sensitive, the arts; the practical, business; the leftover becomes an economist”

― Nassim Nicholas Taleb, The Bed of Procrustes: Philosophical and Practical Aphorisms

Monopolistic Competition and Oligopoly

(Part A)

by

Charles Lamson

We have now examined two "pure" market structures. At one extreme is perfect competition, a market structure in which many firms, each small relative to the size of the market, produce undifferentiated products and have no market power at all. Each competitive firm takes price as given and faces a perfectly inelastic demand for its product. At the other extreme is pure monopoly, a market structure in which only one firm is the industry. The monopoly holds the power to set price and is protected against competition by barriers to entry. Its market power would be complete if it did not face the discipline of the market demand curve. Even a monopoly, however, must produce a product that people want and are willing to pay for.

Most industries in the United States fall somewhere between these two extremes. In the next several posts, we focus on two types of industries in which firms exercise some market power but at the same time face competition. One type, monopolistic competition, differs from perfect competition only in that firms can differentiate their products. Entry to a monopolistically competitive industry is easy, and each industry is made up of many firms.

The other type, oligopoly, is a broad category that covers many kinds of firm behavior and industry structure. An oligopoly is an industry comprising a small number of competitors; each firm in an oligopoly is large enough to have some control over market price, but beyond that the character of competition varies greatly from industry to industry. An oligopoly may have two firms or 20, and those firms may produce differentiated or undifferentiated products.

Thus far we have to find four types of market or industry structure. These are important because how firms within any industry behave depends upon how that industry is organized---whether there are many firms or a few, whether they are large firms or small, whether the products of one firm are good substitutes for the products of others in the industry, and whether entry is easy or difficult. Figure 1 summarizes the four main types of market organization: perfect competition, monopolistic competition, and oligopoly. While not every industry fits near neatly into one of these categories, the categories do provide a useful and convenient framework for thinking about industry structure and behavior.

FIGURE 1 Characteristics of Different Market Organizations

Monopolistic Competition

A monopolistic competitive industry has the following characteristics:

1. A large number of firms

2. No barriers to entry

3. Product differentiation

While pure monopoly and perfect competition are rare, monopolistic competition is common in the United States, for example, in the restaurant business. Each produces a slightly different product and attempts to distinguish itself in consumers' minds. Entry to the market is certainly not blocked. Although many restaurants fail, small ones can compete and survive because there are no economies of scale in the restaurant business.

The feature that distinguishes monopolistic competition from monopoly and oligopoly is that firms that are monopolistic competitors cannot influence market price by virtue of their size. No one restaurant is big enough to at affect the market price of a prime rib dinner, even though all restaurants can control their own prices. Instead, firms gain control over price in monopolistic competition by differentiating their products. You make it in the restaurant business by producing a product that people want that others are not producing or by establishing a reputation for good food and good service. By producing a unique product or establishing a particular reputation, a firm becomes, in a sense, a "monopolist" that is, no one else can produce the exact same good.

The feature that distinguishes monopolistic competition from pure monopoly is that good substitutes are available in a monopolistically competitive industry. In any given heavily-populated, American metropolis, there are dozens of good Chinese restaurants; oftentimes, with over a dozen packed on a single street. The menus are nearly identical, and they all charge virtually the same prices. At the other end of the spectrum are restaurants, with established names and prices far above the cost of production, which are always booked. That is the goal of every restaurateur whoever put a stock pot on the range.

Firms in a monopolistically competitive industry are small relative to the total market. New firms can enter the industry in pursuit of profit, and relatively good substitutes for the firm's products are available. Firms in monopolistically competitive industries try to achieve a degree of market power by differentiating their products by producing something new, different, or better, or by creating a unique identity in the minds of consumers.

To discuss the behavior of such firms, in the next post, we begin with a few words about advertising and product differentiation. 

*CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 281-283*

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