11. 2 Monopolistic Competition
The theory of monopolistic competition was originally developed to
deal with the phenomenon of product differentiation. This theory was
first developed by U.S. economist Edward Chamberlin in his pioneering
1933 book The Theory of Monopolistic Competition.
This market structure is similar to perfect competition in that the industry
contains many firms and exhibits freedom of entry and exit. It differs,
however, in one important respect: Whereas firms in perfect competition
sell an identical product and are price takers, firms in monopolistic
competition sell a differentiated product and thus have some power over
setting price.
Product differentiation leads to the establishment of brand names and
advertising, and it gives each firm a degree of market power over its own
product. Each firm can raise its price, even if its competitors do not,
without losing all its sales. This is the monopolistic part of the theory.
However, each firm’s market power is severely restricted in both the short
run and the long run. The short-run restriction comes from the presence
of similar products sold by many competing firms; this causes the
demand curve faced by each firm to be very elastic. The long-run
restriction comes from free entry into the industry, which permits new
firms to compete away the profits being earned by existing firms. These
restrictions comprise the competition part of the theory.
