A market structure characterized by a large number of small firms, similar but not identical products sold by all firms, relative freedom of entry into and exit out of the industry, and extensive knowledge of prices and technology. This is one of four basic market structures. The other three are perfect competition, monopoly, and oligopoly. Monopolistic competition approximates most of the characteristics of perfect competition, but falls short of reaching the ideal benchmark that IS perfect competition. It is the best approximation of perfect competition that the real world offers.

Monopolistic competition is a market structure characterized by a large number of relatively small firms. While the goods produced by the firms in the industry are similar, slight differences often exist. As such, firms operating in monopolistic competition are extremely competitive but each has a small degree of market control.

In effect, monopolistic competition is something of a hybrid between perfect competition and monopoly. Comparable to perfect competition, monopolistic competition contains a large number of extremely competitive firms. However, comparable to monopoly, each firm has market control and faces a negatively-sloped demand curve',500,400)">demand curve.

The real world is widely populated by monopolistic competition. Perhaps half of the economy's total production comes from monopolistically competitive firms. The best examples of monopolistic competition come from retail trade, including restaurants, clothing stores, and convenience stores.

Characteristics

The four characteristics of monopolistic competition are: (1) large number of small firms, (2) similar, but not identical products, (3) relatively good, but not perfect resource mobility, and (4) extensive, but not perfect knowledge.

Large Number of Small Firms: A monopolistically competitive industry contains a large number of small firms, each of which is relatively small compared to the overall size of the market. This ensures that all firms are relatively competitive with very little market control over price or quantity. In particular, each firm has hundreds or even thousands of potential competitors.

Similar Products: Each firm in a monopolistically competitive market sells a similar, but not absolutely identical, product. The goods sold by the firms are close substitutes for one another, just not perfect substitutes. Most important, each good satisfies the same basic want or need. The goods might have subtle but actual physical differences or they might only be perceived different by the buyers. Whatever the reason, buyers treat the goods as similar, but different.

Relative Resource Mobility: Monopolistically competitive firms are relatively free to enter and exit an industry. There might be a few restrictions, but not many. These firms are not "perfectly" mobile as with perfect competition, but they are largely unrestricted by government rules and regulations, start-up cost, or other substantial barriers to entry.

Extensive Knowledge: In monopolistic competition, buyers do not know everything, but they have relatively complete information about alternative prices. They also have relatively complete information about product differences, brand names, etc. Each seller also has relatively complete information about production techniques and the prices charged by their competitors.

Product Differentiation

The goods produced by firms operating in a monopolistically competitive market are subject to product differentiation. The goods are essentially the same, but they have slight differences.

Product differentiation is usually achieved in one of three ways: (1) physical differences, (2) perceived differences, and (3) support services.

Physical Differences: In some cases the product of one firm is physically different form the product of other firms. One good is chocolate, the other is vanilla. One good uses plastic, the other aluminum.

Perceived Differences: In other cases goods are only perceived to be different by the buyers, even though no physical differences exist. Such differences are often created by brand names, where the only difference is the packaging.

Support Services: In still other cases, products that are physically identical and perceived to be identical are differentiated by support services. Even though the products purchased are identical, one retail store might offer "service with a smile," while another provides express checkout.

Product differentiation is the primary reason that each firm operating in a monopolistically competitive market is able to create a little monopoly all to itself.

Demand and Revenue

The four characteristics of monopolistic competition mean that a monopolistically competitive firm faces a

Demand Curve,Monopolistic Competition

relatively elastic, but not perfectly elastic, demand curve, such as the one displayed in the exhibit to the right. Each firm in a monopolistically competitive market can sell a wide range of output within a relatively narrow range of prices.

Demand is relatively elastic in monopolistic competition because each firm faces competition from a large number of very, very close substitutes. However, demand is not perfectly elastic (as in perfect competition) because the output of each firm is slightly different from that of other firms. Monopolistically competitive goods are close substitutes, but not perfect substitutes.

In the exhibit to the right, the monopolistically competitive firm can sell up to 10 units of output within the range of $5.50 to $6.50. Should the price go higher than $6.50, the quantity demanded drops to zero.

A monopolistically competitive firm is a price maker, with some degree of control over price. Once again, unlike perfect competition, a monopolistically competitive firm has the ability to raise or lower the price a little, not much, but a little. And like monopoly, the price received by a monopolistically competitive firm (which is also the firm's average revenue) is greater than its marginal revenue.

In the exhibit to the right, the marginal revenue curve (MR) lies below the demand/average revenue curve (D = AR). While marginal revenue is less than price, because demand is relatively elastic, the difference tends to be relatively small. For example, 5 units of output correspond to a $5 price. The marginal revenue for the fifth unit is $4.80, less than price, but not by much.

Short-Run Production

The analysis of short-run production by a monopolistically competitive firm provides insight into market supply. The key assumption is that a monopolistically competitive firm, like any other firm, is motivated by profit maximization. The firm chooses to produce the quantity of output that generates the highest possible level of profit, given price, market demand, cost conditions, production technology, etc.

The short-run production decision for monopolistic competition can be illustrated using the exhibit to the right. The top panel indicates the two sides of the profit decision--revenue and cost. The slightly curved green line is total revenue. Because price depends on quantity, the total revenue curve is not a straight line. The curved red line is total cost. The difference between total revenue and total cost is profit, which is illustrated in the lower panel as the brown line.

Short-Run Production,Monopolistic Competition

A firm maximizes profit by selecting the quantity of output that generates the greatest gap between the total revenue line and the total cost line in the upper panel, or at the peak of the profit curve in the lower panel. In this example, the profit maximizing output quantity is 6. Any other level of production generates less profit.

Long-Run Production

In the long run, with all inputs variable, a monopolistically competitive industry reaches equilibrium at an output that generates economies of scale or increasing returns to scale. At this level of output, the negatively-sloped demand curve is tangent to the negatively-sloped segment of the long run-average cost curve.

This is achieved through a two-fold adjustment process.

The first of the folds is entry and exit of firms into and out of the industry. This ensures that firms earn zero economic profit and that price is equal to average cost.

The second of the folds is the pursuit of profit maximization by each firm in the industry. This ensures that firms produce the quantity of output that equates marginal revenue with short-run and long-run marginal cost.

Because a monopolistically competitive firm has some market control and faces a negatively-sloped demand curve, the end result of this long-run adjustment is two equilibrium conditions:MR = MC = LRMC P = AR = ATC = LRAC With marginal revenue equal to marginal cost, each firm is maximizing profit and has no reason to adjust the quantity of output or factory size. With price equal to average cost, each firm in the industry is earning only a normal profit. Economic profit is zero and there are no economic losses, meaning no firm is inclined to enter or exit the industry.

These conditions are satisfied separately. However, because price is not equal to marginal revenue, the two equations are not equal (unlike perfect competition). This further means that monopolistic competition does NOT achieve long-run equilibrium at the minimum efficient scale of production.

Real World (In)Efficiency

A monopolistically competitive firm generally produces less output and charges a higher price than would be the case for a perfectly competitive industry. In particular, the price charged by a monopolistically competitive firm is greater than its marginal cost.

The inequality of price and marginal cost violates the key condition for efficiency. Resources are NOT being used to generate the highest possible level of satisfaction.

The reason for this inefficiency is found with market control. Because a monopolistically competitive firm has control over a small slice of the market, it faces a negatively-sloped demand curve and price is greater than marginal revenue, which is set equal to marginal cost when maximizing profit.

While monopolistic competition is technically inefficient, it tends to be less inefficient than other market structures, especially monopoly. Even though price is greater than marginal revenue (and thus marginal cost), because the demand curve is relatively elastic, the difference is often relatively small.

For example, a monopoly that charges a $100 price while incurring a marginal cost of $20 creates a serious inefficiency problem. In contrast, the inefficiency created by a monopolistically competitive firm that charges a $50 price while incurring a marginal cost of $49.95 is substantially less.

The closer marginal revenue is to price, the closer a monopolistically competitive firm comes to allocating resources according to the efficiency benchmark established by perfect competition.

In the grand scheme of economic problems, the inefficiency created by monopolistic competition seldom warrants much attention... and deservedly so.

The Other Three Market Structures

Monopolistic competition is one of four common market structures. The other three are: perfect competition, monopoly, and oligopoly. The exhibit to the right illustrates how these four market structures form a continuum based on the relative degree of market control and the number of competitors in the market. In the middle of the market structure continuum, near the left end, is monopolistic competition, characterized by numerous competitors and limited market control.

Perfect Competition: To the far left of the market structure continuum is perfect competition, characterized by a large number of relatively small competitors, each with no market control. Perfect competition is an idealized market structure that provides a benchmark for efficiency.

Monopoly: To the far right of the market structure continuum is monopoly, characterized by a single competitor and extensive market control. Monopoly contains a single seller of a unique product with no close substitutes. The demand for monopoly output is THE market demand.

Market Structure Continuum

Oligopoly: In the middle of the market structure continuum, residing closer to monopoly, is oligopoly, characterized by a small number of relatively large competitors, each with substantial market control. A substantial number of real world markets fit the characteristics of oligopoly.

On the surface, oligopoly and monopolistic competition seem quite different. Oligopoly contains a few large firms that dominate a market. Monopolistic competition contains a large number of small firms, each with some, but not a lot of market control. However, monopolistic competition and oligopoly are actually the heart and soul of the market structure continuum.

There is no clear-cut, obvious dividing line between monopolistic competition and oligopoly. While a three-firm industry is most assuredly an oligopoly and a 3,000 firm industry is most likely monopolistic competition, an industry with 30 firms could be considered either oligopoly or monopolistic competition. For example, convenience stores in a large city are undoubtedly monopolistically competitive. However, convenience stores in a smaller town might very well be oligopoly.

LONG-RUN PRODUCTION ANALYSIS:

An analysis of the production decision made by a firm in the long run. The central characteristic of long-run production analysis is that all inputs under the control of the firm are variable. The central principle guiding production in the long run is returns to scale, which indicates how production responds to proportional changes in all inputs. A contrasting analysis is short-run production analysis.

The analysis of long-run production indicates how a business pursues the production of output given that all inputs under its control is variable. In particular, a firm is able to alter not only the quantity of labor and materials, but also the amount of capital. In the long run, a firm is not constrained by a given factory, building, or plant size.

Long-run production analysis extends and augments short-run production analysis commonly used to explain the law of supply. The critical difference between the long run and the short run is the law of diminishing marginal returns. This law applies to the short run, which has at least one fixed input, but not the long run, which has all inputs variable.

The guiding principle for the long run is returns to scale, which indicates how production changes due to proportional changes in all inputs. Returns to scale can be either increasing, decreasing, or constant.

Two Runs: Short and Long

The first step in the analysis of long-run production is a distinction between the short run and the long run.

Short Run: The short run is a period of time in which at least one input used for production and under the control of the producer is variable and at least one input is fixed.

Long Run: The long run is a period of time in which at all inputs used for production and under the control of the producer are variable.

The difference between short run and long run depends on the particular production activity. For some producers, the short run lasts a few days. For others, the short run can last for decades.

All Inputs: Variable

In the long run, all inputs under the control of the producer are variable. A variable input is an input used in production and under the control of the producer that can be changed during the time period of analysis. While the short-run is characterized by at least one fixed input, usually capital (factory, production facility, building, and/or equipment), in the long run all inputs, including the quantity of capital is variable.

From a practical standpoint, this means that a firm not only has the ability to adjust the number of workers, but also the size of the factory. If the existing production plant is being used beyond capacity, then a bigger one can be constructed in the long run. If the existing office building has unused space, then a firm can move to a smaller one in the long run.

Note that the phrase "under the control of the producer" is included in the specifications of short run, long run, and variable input. The reason is that long-run production analysis is most concerned with how producers adjust the inputs under their control in response to changing prices.

Any production activity invariably includes inputs that are beyond the control of the producer, including government laws and regulations, social customs and institutions, weather, and the forces of nature. These other variables are certainly worthy of consideration, but are not fundamental to explaining and understanding the basic principles of market supply

Three Returns to Scale: Increasing, Decreasing, and Constant

If a firm or producer changes all inputs proportional, the resulting change in production is guided by returns to scale, which come in three varieties. First, production might actually increase proportionally to the increase in inputs. Second, production might increase more than the increase in the inputs. Third, production might increase less than the increase in inputs. These three alternatives are technically termed constant returns to scale, decreasing returns to scale, and increasing returns to scale.

Constant Returns to Scale: This occurs if a proportional increase in all inputs under the control of a firm results in an equal proportional increase in production. In other words, a 10 percent increase in labor, capital, and other inputs, also results in an equal 10 percent increase in production.

Increasing Returns to Scale: This occurs if a proportional increase in all inputs under the control of a firm results in a greater than proportional increase in production. In other words, a 10 percent increase in labor, capital, and other inputs, results in a production increase that is greater than 10 percent.

Decreasing Returns to Scale: This occurs if a proportional increase in all inputs under the control of a firm results in a less than proportional increase in production. In other words, a 10 percent increase in labor, capital, and other inputs, results in a production increase that is less than 10 percent.

Returns to scale sheds a little long-run production analysis light on the positive law of supply relation between price and quantity. In the short run, the law of diminishing marginal returns indicates that a higher production cost, and thus a higher price, corresponds with greater production, which is the law of supply.

However, in the long run, because returns to scale can increase, decrease, or remain constant, production cost can also increase, decrease, or remain constant, which further means price can increase, decrease, or remain constant. As such, there is no reason to expect that the law of supply correspondence between a higher price and a larger quantity holds in the long run.

One Step

This analysis of long-run production is but the first step in a brisk walk toward a better understanding of market supply. Further steps include the cost of long-run production and the market structure in which a firm operates, such as perfect competition or monopoly.

Production Cost: An understanding of market supply builds on the long-run production analysis and the key role played by returns to scale. Because the productivity of the variable input can increase, decrease, or remain constant in the long run, long-run production cost can also increase, decrease, or remain constant. This provides insight into the applicability of the law of supply in the long run.

Market Structure: The market supply also depends on the structure of the market, especially the degree of competition and the resulting market control of each firm. Competitive markets, with limited control over the price, tend to produce output by equating price and marginal cost in the long run. However, less competitive markets, with greater market control by the participating firms, need not equate price and marginal cost.

Two Scale Cost Alternatives

Long-run production analysis provides the foundation for understanding long-run cost. In particular, increasing and decreasing returns to scale are behind two important long-run cost concepts--economies of scale and diseconomies of scale.

Economies of Scale: These occur if a firm experiences a decrease in the long-run average cost due to proportional increases in all inputs. Economies of scale result, in part, from increasing returns to scale. If production increases more than inputs increase, then the average cost of production declines.

Diseconomies of Scale: These occur if a firm experiences an increase in the long-run average cost due to proportional increases in all inputs. Diseconomies of scale result, in part, from decreasing returns to scale. If production increases less than inputs increase, then the average cost of production increases.