The first model of an imperfectly competitive industry that we shall investigate has conditions quite similar to those of perfect competition. The model of monopolistic competition assumes a large number of firms. It also assumes easy entry and exit. This model differs from the model of perfect competition in one key respect: it assumes that the goods and services produced by firms are differentiated. This differentiation may occur by virtue of advertising, convenience of location, product quality, reputation of the seller, or other factors. Product differentiation gives firms producing a particular product some degree of price-setting or monopoly power. However, because of the availability of close substitutes, the price-setting power of monopolistically competitive firms is quite limited. Monopolistic competition is a model characterized by many firms producing similar but differentiated products in a market with easy entry and exit.
Restaurants are a monopolistically competitive sector; in most areas there are many firms, each is different, and entry and exit are very easy. Each restaurant has many close substitutes—these may include other restaurants, fast-food outlets, and the deli and frozen-food sections at local supermarkets. Other industries that engage in monopolistic competition include retail stores, barber and beauty shops, auto-repair shops, service stations, banks, and law and accounting firms.
Profit Maximization
Suppose a restaurant raises its prices slightly above those of similar restaurants with which it competes. Will it have any customers? Probably. Because the restaurant is different from other restaurants, some people will continue to patronize it. Within limits, then, the restaurant can set its own prices; it does not take the market prices as given. In fact, differentiated markets imply that the notion of a single “market price” is meaningless.
Because products in a monopolistically competitive industry are differentiated, firms face downward-sloping demand curves. Whenever a firm faces a downward-sloping demand curve, the graphical framework for monopoly can be used. In the short run, the model of monopolistic competition looks exactly like the model of monopoly. An important distinction between monopoly and monopolistic competition, however, emerges from the assumption of easy entry and exit. In monopolistic competition, entry will eliminate any economic profits in the long run. We begin with an analysis of the short run.
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