The desirability of perfect competition

Perfect competition is considered desirable for society for at least two reasons. First, the price charged to individuals equals the marginal cost of production to each firm. In other words, one can say sellers charge buyers a reasonable or fair price. Second, in general, output produced under a perfectly competitive market structure is larger than other market organizations. Thus, perfect competition becomes desirable also for the amount of the product supplied to consumers as a whole. These are two reasons why a capitalist society adores the virtues of perfect competition. In fact, to maintain a reasonable amount of competition in a market is generally considered a goal of government regulatory policies. No single firm dominates the market under perfect competition: this parallels the status of an individual citizen in a democracy, a widely practiced form of government in capitalist countries.

VI. MONOPOLISTIC COMPETITION

For years, economic theory told us little about market forms in between the two ex­treme cases: pure monopoly and perfect competition. This gap was partially filled, and the realism of economic theory increased, by the work of Edward Chamberlin of Harvard University and Joan Robinson of Cambridge University during the 1930s. As pointed out above, industries in the real world rarely satisfy the stringent conditions necessary to qualify as perfectly competitive market structures. The world in which we live is invariably characterized by competition of lesser degrees than stipulated by perfect competition. Many industries that we often deal with have market structures that are monopolistic competition or oligopoly. Apparel retail stores (with many stores and differentiated products) provide an example of monopolistic competition.

The market structure they analyzed is called monopolistic competition.

A market is said to operate under conditions of monopolistic competition if it satisfies four conditions, three of which are the same as under perfect competition:

(1) Numerous participants — that is, many buyers and sellers, all of whom are small;

(2) freedom of exit and entry; (3) perfect information; and (4) heterogeneity of
products — as far as the buyer is concerned, each seller's product is at least somewhat
different from every other's.

Notice that monopolistic competition differs from perfect competition in only one respect (item 4 in the definition). While under perfect competition all products must be identical, under monopolistic competition products differ from seller to seller — in quality, in packaging, or in supplementary services offered (such as car window washing by a gas station). The factors that serve to differentiate products need not be "real" in any objective or directly measurable sense. For example, differ­ences in packaging or in associated services can and do distinguish products that are otherwise identical. On the other hand, two products may perform quite differently ' in quality tests, but if consumers know nothing about this difference, it is irrelevant,

In contrast to a perfect competitor, a monopolistic competitor's price will change when its quantity supplied varies. Each seller's product differs from everyone else's. So, in effect, each deals in a market that is slightly separated from the others and caters to a set of customers who vary in their "loyalty" to the particular product. If the firm raises its price somewhat, it will drive some of its customers into the arms of competitors. But those whose tastes make them like this firm's product very much will not switch. If one monopolistic competitor lowers its price. it may expect to attract some trade from rivals. But, since different products are im­perfect substitutes, no one competitor will attract away all the business.

Thus, if Harriet's Hot Dog House reduces its price slightly, it will attract those customers of Sam's Sausage Shop who were nearly indifferent between the two. A bigger price cut by Harriet will bring in some customers who have a slightly greater preference for Sam's product. But even a big cut in Harriet's price will not bring her the hard-core sausage lovers who hate hot dogs. So the monopolistic competitor's demand curve is negatively sloped, like that of a monopolist, rather than horizontal, like that of a perfect competitor.

Since each product is distinguished from all others, a monopolistically..competi­tive firm appears to have something akin to a small monopoly. Can we therefore ex­pect it to earn more than zero economic profit? As with a perfect competitor, perhaps this is possible in the short run. But in the long run, high economic profits j will attract new entrants into a monopolistically competitive market—not entrants with products identical to an existing firm's, but with products sufficiently similar to hurt.

If one ice-cream parlor's location enables it to do a thriving business, it can
confidently expect another, selling a different brand, t6 open nearby. When one
seller adopts a new, attractive package, rivals will soon follow suit, with slightly
different designs and colors of their own. In this way, freedom of entry ensures that
the monopolistically competitive firm earns no higher return on its capital in the
long run than it could earn elsewhere. Just as under perfect competition, price will
be driven to the level of average cost, including the opportunity cost of capital. In
this sense, though its product is somewhat different from that of everyone else, the firm under monopolistic competition has no more monopoly роwег than one..operat­ing under perfect competition.

Let us now examine the process that assures that economic profits will be driven to zero in the long run, even under monopolistic competition, and see to what prices and outputs it leads.

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