Module 17: Monopolistic Competition

Policy Example: Should Public Schools Require Students to Wear Uniforms?

Exploring the Policy Question

1. How are fashion and sportswear companies able to charge so much for clothes?
2. Would requiring the use of generic uniform clothes improve welfare?

17.1 What is Monopolistic Competition?

Learning Objective 17.1: Describe the structure of the monopolistically competitive market.

17.2 Equilibrium in Monopolistic Competition

Learning Objective 17.2: Explain how equilibrium is achieved in monopolistically competitive markets.

17.1 What is Monopolistic Competition?

Learning Objective 17.1: Describe the structure of the monopolistically competitive market.

Monopolistically competitive markets are markets in which low fixed costs and free entry and exit of firms make them competitive but firms are able to differentiate their products which causes them to face downward sloping demand curves like imperfectly competitive firms such as monopolists.

As an example, consider the market for athletic shoes. In the United States in 2017, Nike had a 35% share of the athletic shoe market, it’s Jordan brand had an 12% share, Adidas had an 11% share and Sketchers, New Balance, Converse and Under Armour had 6.3%, 3.7%, 3.6%, and 2.4%, respectively. The process of designing and making athletic shoes is not very capital intensive, so there are low fixed costs and there are no barriers to entry – any company who would like to sell shoes in the United States may do so. Athletic shoes are largely similar and, despite high-end shoes that may include special materials or technologies that enjoy patent protection, a regular pair of running shoes are relatively the same: cloth upper, foam padding and a rubber sole. Despite this, Nike is able to charge considerably more for their shoes than a generic equivalent, why? Part of the reason is that through branding and marketing Nike has differentiated its shoes from those of competing companies.

Though athletic shoe companies expend a lot of time and effort into product differentiation, even firms that produce very similar products might be monopolistically competitive with a small amount of differentiation if the market is small enough. In perfectly competitive markets the assumption is that firms are price takers because each individual firm is such a small part of the overall market. But if the market is so small that it only supports a few firms, each firm could have a downward sloping demand curve. For example, in a very small town with only two coffee shops, if the shops are able to attract a particular type of customer, they might be able to charge more because the customers prefer their shop to the rival shop. Perhaps one shop has a décor and music that appeals to a younger customer while the other has décor and music that appeals to older customers.

17.2 Equilibrium in Monopolistic Competition

Learning Objective 17.2: Explain how equilibrium is achieved in monopolistically competitive markets.

To think about equilibrium in monopolistically competitive markets, we begin by assuming firms with identical costs and homogeneous products. Unlike perfectly competitive firms that take the market equilibrium prices as given, monopolistically competitive firms achieve some pricing power through product differentiation. In essence, these firms ‘capture’ part of the market for themselves. This doesn’t mean they can charge any price they like, but that they create for themselves a downward sloping demand curve. In the absence of competition, such a scenario would potentially lead to monopoly rents and economic profits. However, the free entry and exit of firms will guarantee that there will be no economic profits in the long-run because any positive economic profits will induce new firms to enter. The resulting equilibrium looks like the graph in Figure 17.2.1 which shows how one firm can both face a downward sloping demand curve and have zero economic profits.

Figure 17.2.1: Equilibrium in Monopolistically Competitive Markets

In Figure 17.2.1 the red line is the firm’s marginal revenue curve. Since the firm faces a downward sloping demand curve, they have a downward sloping marginal revenue curve similar to a monopolist. The difference is this marginal revenue curve is from their individual demand curve with is only a part of total demand. Monopolistically competitive firms are profit maximizing firms and therefore set their output where marginal revenue equals marginal cost. To find this point we look at the firm’s cost curves, in blue, and find the intersection of marginal revenue and marginal cost. In the figure this occurs at the quantity q*. The maximum price the firm can charge and sell q* is p*. The firm’s average cost at q* is equal to p*, so its total cost is equal to its total revenue and therefore its economic profits are zero.

Figure 17.2.2: Achieving Equilibrium in Monopolistically Competitive Markets