This chapter introduces and analyzes monopolistic
competition. A monopolistically competitive market lies in between perfectly
competitive and monopolistic markets. This type of market is characterized by
three attributes: many firms, differentiated products, and free entry. A
monopolistically competitive firm shares similarities with competitive and
monopolistic firms. It is a price maker and not a price taker, however it can not earn economic profits in the
long run. Like a monopoly, monopolistically competitive firms charge a price
above marginal cost. Monopolistically competitive firms also do not produce at
the efficient scale. They operate on the downward sloping portion of the demand
curve, and therefore are producing less than the optimal quantity. The number
of firms in a monopolistically competitive market can be either too large or
too small. When it is too small, firms enter the market, driving already
established firms to zero economic profit, conveying a positive externality on
consumers due to greater variety of products and conveying a negative
externality on existing firms due to loss of customers. Due to product variety
in a monopolistically competitive market, many firms advertise their product. There
is a debate over whether advertisement is good practice. Critics argue
advertisements take advantage of consumers and reduce competition while
defenders argue that advertisements inform consumers and increase competition.
