On the Nature of Equilibrium in Monopolistic Competition

This paper shows that product differentiation is compatible with perfect competition under free entry and exit and small firm size relative to size of market. Thus, monopolistic competition is a form of perfect competition. Although no product sold under monopolistic competition has a perfect substitute, each product has many close, albeit imperfect, substitutes, which have a cumulative effect on own-price elasticity of demand. With infinitely elastic demand, excess capacity and sub-optimal firm size disappear from monopolistic competition in equilibrium. The number of basic industrial structures is reduced to three—monopoly or single seller, oligopoly or competition among the few, and perfect competition or competition among the many. Perfect competition can be divided into perfect competition with homogeneous products and perfect competition with differentiated products. Advertising can pay off under the latter, since products have separate identities and price depends on quality, even though firms are price takers for any given quality. Under oligopoly, firms will behave like Chamberlin’s monopolistic competitors when certain conditions are met, but there is no guarantee that these conditions ever will prevail. Finally, I ask how small a firm’s share of industry output value must be if it is to be a de facto price taker.