Monopolistic Competition and Economic Efficiency

Perfectly competitive markets are desirable because they are economically efficient-as long as there are no externalities and nothing impedes the workings of the market, the total surplus of consumers and producers is as large as possible. Monopolistic competition is similar to competition in some respects, but is it an efficient market structure? To answer this question, let's compare the long-run equilibrium of a monopolisdcally competitive industry to the long-run equilibrium of a perfectly competitive industry.

Figures 12.2a and 12.2b show that there are two sources of inefficiency in a monopolistically competitive industry. First, unlike in perfect competition/the equilibrium price exceeds marginal cost. This means that the value to consumers of additional units of output exceeds the cost of producing those units. If output were expanded to the point where the demand curve intersects the marginal cost curve, total surplus could be increased by an amount equal to the shaded area in Figure 12.2b. This should not be surprising. We saw in Chapter 10 that monopoly power creates a deadweight loss, and monopoly power exists in monopolistically competitive markets.

Second, note in Figure 12.2 that the monopolistically competitive firm operates with excess capacity; its output is below that which minimizes average cost. Entry of new firms drives profits to zero in both perfectly competitive and monopolistically competitive markets. In a perfectly competitive market, each

FIG U RE 122 Comparison of Monopolistically Competitive Equilibrium and Perfectly Competitive Equilibrium. Under perfect competition, as in (a), price equals marginal cost, but under monopolistic competition, price exceeds marginal cost, so there is a deadweight loss as shown by the shaded area in (b). In both types of markets, entry occurs until profits are driven to zero. Under perfect competition the demand curve facing the firm is horizontal, so the zero-profit point occurs at the point of minimum average cost. Under monopolistic competition the demand curve is downward-sloping, so the zero-profit point is to the left of the point of minimum average cost. In evaluating monopolistic competition, these inefficiencies must be balanced against the gains to consumers from product diversity.

firm faces a horizontal demand curve, so the zero-profit point occurs at minimum average cost, as Figure 12.2a shows. In a monopolistic ally competitive market, however, the demand curve is downward sloping, so the zero-profit point is to the left of minimum average cost. This excess capacity is inefficient because average cost would be lower with fewer firms.

These inefficiencies make consumers worse off. Is monopolistic competition then a socially undesirable market structure that should be regulated? The answer for two reasons is probably not. First, in most monopolistically competitive markets, monopoly power is small. Usually, enough firms compete, with brands that are sufficiently substitutable for one another, so that no single firm will have substantial monopoly power. Any deadweight loss from monopoly power should therefore also be small. And because firms' demand curves will be fairly elastic, the excess capacity will also be small.

Second, whatever inefficiency there is must be balanced against an important benefit that monopolistic competition provides -product diversity. Most consumers value the ability to choose among a wide variety of competing products and brands that differ in various ways. The gains from product diversity can be large and may easily outweigh the inefficiency costs resulting from downward-sloping demand curves.


The markets for soft drinks and coffee illustrate the characteristics of monopolistic competition. Each market has a variety of brands that differ slightly but are close substitutes for one another. Each brand of cola, for example, tastes a little different from the next. (Can you tell the difference between Coke and Pepsi? Between Coke and Royal Crown. Cola?) And each brand of ground coffee has a slightly different flavor, fragrance, and caffeine content. Most consumers develop their own preferences; you might prefer Maxwell House coffee to the other brands and buy it regularly. However, these brand loyalties are usually limited. If the price of Maxwell House were to rise substantially above those of other brands, you and most other consumers who had been buying Maxwell House would probably switch brands.

Just how much monopoly power does General Foods, the producer of Maxwell House, have with this brand? In other words, how elastic is the demand for Maxwell House? Most large companies carefully study the demands for their product as part of their market research. Company estimates are usually proprietary, but a study of the demands for various brands of colas and ground coffee used a simulated shopping experiment to determine how market shares for each brand would change in response to specific changes in price.1

1 The study was by John R. Nevin, "Laboratory Experiments for Estimating Consumer Demand: A Validation Study, " Journal of Marketing Research 11 (Aug. 1974): 261-268. In simulated shopping trips, consumers had to choose the brands they preferred from a variety of prepriced brands. The trips were repeated several times,with different prices each time.

table 12.1 Elasticities of í5emand for Brands of Colas ánd


Elasticity of Demand


Royal Crown Coke

HillsBrothers Maxwell House Chase & Sanborn

Ground Coffee:

Table 12.1 summarizes the results by showing the elasticities of demand for several brands.

First, note that among the colas. Royal Crown is much less price elastic than Coke. Although it has a small share of the cola market, its taste is more distinctive than that of Coke, Pepsi, and other brands, so consumers who buy it have stronger brand loyalty. But because Royal Crown has more monopoly power than Coke does not mean that it is more profitable. Profits depend on fixed costs and volume, as well as price. Even if its average profit is smaller. Coke will generate more profit because it has a much larger share of the market.

Second, note that coffees as a group are more price elastic than colas. There is less brand loyalty among coffees than among colas because the differences among coffees are less perceptible than the differences among colas. Compared with different brands of colas, fewer consumers notice or care about the differences between Hills Brothers and Maxwell House coffees.

With the exception of Royal Crown, all the colas and coffees are very price elastic. With elasticities on the order of -5 to -9, each brand has only limited monopoly power. This is typical of monopolistic competition.

In an oligopolistic market, the product may or may not be differentiated. What matters is that only a few firms account for most or all of total production. In some oligopolistic markets, some or all of the firms earn substantial profits over the long run because barriers to entry make it difficult or impossible for new firms to enter the market. Oligopoly is a prevalent form of market structure. Examples of oligopolistic industries include automobiles, steel, aluminum, petrochemicals, electrical equipment, and computers.

Why might barriers to entry arise? We discussed some of the reasons in Chapter 10. Scale economies-may make it unprofitable for more than a few

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