Monopolistic Competition

What It Means

Monopolistic competition describes a market structure (a market is any place or system in which buyers and sellers of products come together) composed of numerous relatively small businesses, each of which sells similar but not identical products. Each firm has some amount of control over prices and market conditions even though there is a high level of competition among them. Common examples of U.S. businesses subject to conditions of monopolistic competition are clothing stores, restaurants, wine merchants, convenience stores, and other retailers in large cities.

Monopolistic competition combines the features of two opposing theoretical concepts: monopoly and perfect competition. A monopoly exists when a single company is the only seller of a good or service and therefore has the power to raise prices, cut production, or otherwise shape the market for its own benefit. Perfect competition describes a market composed of numerous sellers all offering an identical product, so that none of the sellers has the ability to control prices.

In the real world monopolies are rare, and perfect competition is probably nonexistent. Most industries have the characteristics of monopolistic competition or oligopoly, a market type in which a few large companies dominate and therefore have greater power to control prices and market conditions. There is no precise dividing line between these two most common market structures, but monopolistic competition is closer to perfect competition, and oligopoly is closer to monopoly.

When Did It Begin

Competition has always been the engine of any market system. The most prominent early economists, Adam Smith and David Ricardo, recognized this fact and made it the foundation of their theories. But Smith, Ricardo, and other so-called classical economists believed that, in the absence of government intervention, an economy would naturally gravitate toward conditions of perfect competition.

It had become obvious by the late nineteenth century that this was not necessarily true. Large companies dominated many industries in Europe and the United States, and governments began intervening to regulate and break up monopolies, with the intent of promoting increased competition.

The first theoretical analysis of monopolistic competition was simultaneously developed by two economists working independently of one another: the British economist Joan Robinson (who introduced the concept in her 1933 book Economics of Imperfect Competition) and the American economist Edward Hastings Chamberlin (whose ideas on the subject were published in his Theory of Monopolistic Competition, published that same year). While economists recognized that most businesses in the developed world functioned under conditions of monopolistic competition or oligopoly, the concepts were, because of their complexity, difficult to integrate into the framework of existing economic ideas, whereas theories based on perfect competition remained useful despite their limitations. It was not until the 1970s that mainstream economists commonly began addressing markets characterized by monopolistic competition.

More Detailed Information

A market subject to conditions of monopolistic competition has a number of defining characteristics. First, each firm in a monopolistically competitive market is small relative to the overall size of the market. In Chicago, for example, there are thousands of restaurants, each of which has only a small share of the total market. This means that there is a high degree of competition among individual restaurants. No single restaurant has much power to set prices or reduce the number of meals it will serve, since each must be mindful of the other restaurants’ prices and production if it wants to remain profitable. By contrast, a firm with a monopoly has complete power to set prices, whereas firms in a perfectly competitive market have no power to set prices.

Additionally, the products in a monopolistically competitive market are close substitutes for one another, rather than identical. This means that each firm has the equivalent of a narrow monopoly. For example, there may be only one restaurant in Chicago that offers meat bought from a specific specialty farm. This restaurant therefore has more ability to charge a higher price for its steaks than it would have if all restaurants got their meat from the same supplier. The restaurant’s pricing freedom is, nevertheless, restricted by the likelihood that customers will go to another restaurant and eat similar, cheaper meat if the price of specialty-farm meat rises too high. Product differentiation in monopolistically competitive industries may be a matter of quality (for example, a higher grade of meat), of perception (one restaurant’s reputation for high-quality meat), or of subtle differences (one restaurant specializes in skirt steaks, another in filets mignons). In any case, the key factor is that consumers believe products to be different but similar enough to serve as substitutes for one another.

Another characteristic of monopolistically competitive markets is the relative freedom of firms to enter the market. In monopolies there are significant barriers to market entry, such as high start-up costs and government regulations. In perfect competition, on the other hand, there are no barriers to entry; firms can easily enter the market and compete on an equal footing with established companies. In the Chicago restaurant industry, there may not be any significant government barriers to entry, and start-up costs may not be so high as to keep independent businesses out of the market (as would be the case in a monopoly), but some barriers, such as high rent costs and the cost of hiring a chef experienced enough to compete with the many other established restaurants, may exist.

Finally, monopolistic competition requires that buyers have a significant amount of information about all the product and pricing options available to them, and that sellers have a similar amount of information about the production methods and prices of other sellers. The Chicago restaurant customer must be relatively well-informed about what she can get for her money and where, and the restaurant owner must be relatively well-informed about the options potential customers have. A lack of knowledgeable customers gives companies the ability to pursue a monopoly, since they can increase their profits by raising prices. Similarly, ill-informed restaurant owners will not be able to remain competitive, since they are always at risk of being undercut by the pricing of competitors’ food or by cost-cutting innovations being used by rival restaurants. Consumers and sellers under conditions of monopolistic competition, however, do not have the perfect knowledge of the market that they would in a perfectly competitive industry.

Recent Trends

Though Joan Robinson and Edward Hastings Chamberlin introduced theories of monopolistic competition in the 1930s, economists did not immediately integrate these theories into the existing body of economic thought. Instead, mainstream economists continued to build models of the economy (simplified explanations of how the economy works) based on the assumption of perfect competition. These economists persisted with the traditional approach not only because of the difficulty in theorizing about the messier, more complex phenomenon of monopolistic competition but also because the assumption of perfect competition allows them to make a wide range of useful, if limited, predictions. Economics has always required the elimination of certain real-world variables in the interest of crafting useful theories, and this was simply not possible for monopolistically competitive markets.

In the 1970s numerous economists began addressing monopolistic competition in a new way. Rather than try to build universal, simple theories that took into account the many ways in which competition could be imperfect, a new generation of economists satisfied themselves with various useful illustrations of how imperfectly competitive markets worked and with theories about how they might work in various important contexts. New theories of monopolistic competition were applied to international trade (business activity between people and companies in different nations) and economic growth (increases in an economy’s productivity), among other economics subfields. This trend continued until the early 1990s, when there was a shift away from speculative theories about monopolistic competition and toward thorough data collection and mathematical analysis of markets.