Economists describe four primary market structures that cover most industries.  At the poles are Perfect Competition, where many firms compete selling identical products in a nearly frictionless market, and Monopoly, an industry dominated by a single firm that enjoys considerable market power.  But neither of these describe most actual firms.  To find an example of Perfect Competition, one must look to commodities or financial markets.  And Monopoly is increasingly rare due to the easy entry the internet provides new market entrants.  The real world is instead dominated by either firms like the local Tex-Mex restaurant or Target.

Monopolistic Competition describes a highly competitive market, but one where the participants are able to differentiate their offerings from their competitors.  The Tex-Mex restaurant is an example of a Monopolistically Competitive firm.  In almost any community there are many restaurants.  But none of them are exactly identical.  One may be well known for its Guacamole while another is conveniently located near an office park.  This differentiation is what distinguishes a Monopolistically Competitive market from Perfect Competition. 

The most important implication of product differentiation involves pricing.  Perfectly Competitive firms are “price takers” – accepting as given the prevailing market price.  Monopolistically Competitive firms, on the other hand, do set their own price. 

In my community, there are many hair salons.  Modesta is one of them.  Let’s compare the situation facing a typical corn farmer and the one facing Modesta.  If a corn farmer decides to raise price by 20% and so charge more than every other corn farmer, she’ll sell nothing.  There are many other sellers selling the identical product.  And so, if she isn’t willing to sell her corn for the prevailing market price, why would anyone choose to buy from her.  Corn is corn. 

But a hair stylist is not just a hair stylist.  Stylists build relationships with their clients.  They learn the way the client’s hair grows, about their dogs and kids, etc.  And so, when a hair stylist raises her price 20%, she doesn’t lose all of her customers.  She may lose some, but not all of them.  And so, while the farmer is stuck with the market price, the hair salon has some say over the price they’ll charge.

In a sense, Monopolistic Competition looks a lot like Monopoly.  There is only one provider of water in my community and there is only one Modesta.  But while there are no good substitutes for water, there are many decent, though not perfect, substitutes for Modesta.  And so, hair salons are both Monopoly and Perfect Competition at the same time – and thus the name Monopolistic Competition.

What about long-term profitability?  This is where the similarity between Monopolistic Competition and Monopoly ends.  A Monopoly can enjoy extraordinary profits indefinitely because barriers to entry are present.  Monopolistically Competitive industries, by definition, have no barriers to entry.  If barriers were present, we’d relabel it Monopoly or Oligopoly.

And so, if my hair salon/cat shelter is a huge hit and I start making lots and lots of money, somebody’s going to notice.  There’s absolutely nothing to keep others from combining a hair salon and a cat shelter.  Next thing you know every salon and barber shop in town is crawling with cats.  (The next big opportunity then will be a salon with no cats for people with allergies.). Anyway, the absence of barriers means that the extraordinary profits I was earning aren’t sustainable in my Monopolistically Competitive market.  There’s just too much potential competition.

Are Monopolistically Competitive industries allocatively efficient?  To answer this, let’s do a thought experiment.  Let’s say there are five sellers of bicycles in my community.  The bicycles are identical in every way except color.  One shop sells red bikes, another blue, and so on.  Because the colors differ, each shop will cater to a particular market niche.  Those who prefer red bikes will go to the red bike store, even if price is slightly higher than charged by say the yellow bike store. 

Now, let’s say we enact a law that says all bikes must be white.  Our shops can now compete only on price.  We’ve gone from Monopolistic Competition to Perfect Competition. And?  Well first, the price of bikes will fall.  We no longer have a way to differentiate and so must compete on price alone.  Prices will fall until each shop is earning just enough to stay in business (i.e. economic profit equals zero.) 

But the lower price will attract those customers who weren’t quite willing or able to pay the price before.  Eliminating the product differentiation led to some additional transactions.  And so, Monopolistic Competition isn’t quite allocatively efficient.  Product differentiation creates the ability to raise price above cost leading to the exclusion of some buyers.

Monopolies we regulate to avoid this Dead Weight Loss.  But we tolerate it with Monopolistic Competition.  One reason is because the cost of standardizing product features would be crazy excessive.  But also, because we consider product variety to be an offsetting social good.

Most small business and self-employment are Monopolistically Competitive.  Piano tuners, private detectives, restaurants, hair salons, pan handlers, and balloon sculptors.  The absence of barriers to entry is largely responsible.  These firms generally earn enough to compensate their owner for her or his opportunity costs of being in business, but not much more.  There are of course exceptions.  Some don’t stay in business.  And some do pretty well.  But on average, Monopolistic Competition generates only modest (or zero economic) profit.