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6.4 Monopolistic Competition

Learning Objective

  1. Identify the basic features of a monopolistic competition model.

Monopolistic competitionA market structure that is a cross between the two extremes of perfect competition and monopoly. refers to a market structure that is a cross between the two extremes of perfect competition and monopoly. The model allows for the presence of increasing returns to scale in production and for differentiated (rather than homogeneous or identical) products. However, the model retains many features of perfect competition, such as the presence of many, many firms in the industry and the idea that free entry and exit of firms in response to profit would eliminate economic profit among the firms. As a result, the model offers a somewhat more realistic depiction of many common economic markets. The model best describes markets in which numerous firms supply products that are each slightly different from that supplied by its competitors. Examples include automobiles, toothpaste, furnaces, restaurant meals, motion pictures, romance novels, wine, beer, cheese, shaving cream, and much more.

The model is especially useful in explaining the motivation for intraindustry tradeTrade between countries that occurs within the same industry; for example, when a country exports and imports automobiles.—that is, trade between countries that occurs within an industry rather than across industries. In other words, the model can explain why some countries export and import automobiles simultaneously. This type of trade, although frequently measured, is not readily explained in the context of the Ricardian or Heckscher-Ohlin models of trade. In those models, a country might export wine and import cheese, but it would never export and import wine at the same time.

The model demonstrates not only that intraindustry trade may arise but also that national welfare can be improved as a result of international trade. One reason for the improvement in welfare is that individual firms produce larger quantities, which, because of economies of scale in production, leads to a reduction in unit production costs. This means there is an improvement in productive efficiency. The second reason welfare improves is that consumers are able to choose from a greater variety of available products with trade as opposed to autarky.

Key Takeaways

  • A monopolistic competition market represents a cross between a monopoly market and a perfectly competitive market.
  • Intraindustry trade refers to trade within a particular industry. An example is a country that both exports and imports cars.
  • A monopolistic competition model can explain why intraindustry trade may occur between countries.

Exercise

  1. Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”

    1. The type of market structure that mixes assumptions from perfect competition with assumptions from monopoly models.
    2. The term used to describe two-way trade in identical or similar products.
    3. The term used to describe nonhomogeneous goods produced by different firms within the same industry.