Many of the small, service-based businesses located in your
neighbourhood are monopolistic competitors—dry cleaners, hair stylists,
restaurants, auto mechanics, shoe-repair shops, grass-cutting and snow-
removal services, home-renovation firms, plumbers, electricians, and
painters. In each case, the firm tries to differentiate its product by offering
more convenient hours, better workmanship, guarantees of some kind, or
perhaps just nicer people. And in each case the firm has some ability to
set its own price—but its market power is limited by the nearby presence
of other firms selling similar products.
The Assumptions of Monopolistic
Competition
The theory of monopolistic competition is based on four key simplifying
assumptions:
1. Each firm produces its own version of the industry’s differentiated
product. Each firm thus faces a demand curve that, although
negatively sloped, is highly elastic because competing firms
produce many close substitutes.
2. All firms have access to the same technological knowledge and so
have the same cost curves.
3. The industry contains so many firms that each one ignores the
possible reactions of its many competitors when it makes its own
price and output decisions. In this respect, firms in monopolistic
competition are similar to firms in perfect competition.