19 Monopolistic Competition

The Policy Question
Should Public Schools Require Students to Wear Uniforms?

Exploring the Policy Question

1. How are fashion and sportswear companies able to charge so much for clothes?
2. Would requiring the use of generic uniform clothes improve welfare?

19.1 What Is Monopolistic Competition?

Learning Objective 19.1: Describe the structure of the monopolistically competitive market.

Monopolistically, competitive markets are markets in which low fixed costs and free entry and exit of firms make them competitive but in which firms are able to differentiate their products, which causes them to face downward-sloping demand curves like imperfectly competitive firms, such as monopolists.

As an example, consider the market for athletic shoes. In the United States in 2017, Nike had a 35 percent share of the athletic shoe market; its Jordan brand had a 12 percent share; Adidas had an 11 percent share; and Sketchers, New Balance, Converse, and Under Armour had 6.3 percent, 3.7 percent, 3.6 percent, and 2.4 percent, respectively. The process of designing and making athletic shoes is not very capital intensive, so there are low fixed costs and no barriers to entry—any company that would like to sell shoes in the United States may do so. Athletic shoes are largely similar, and despite high-end shoes that may include special materials or technologies that enjoy patent protection, a regular pair of running shoes are relatively the same: cloth upper, foam padding, and a rubber sole. Despite this, Nike is able to charge considerably more for its shoes than a generic equivalent. Why? Part of the reason is that through branding and marketing, Nike has differentiated its shoes from those of competing companies.

Though athletic shoe companies expend a lot of time and effort on product differentiation, even firms that produce very similar products might be monopolistically competitive with a small amount of differentiation if the market is small enough. In perfectly competitive markets, the assumption is that firms are price takers because each individual firm is such a small part of the overall market. But if the market is so small that it only supports a few firms, each firm could have a downward-sloping demand curve. For example, in a very small town with only two coffee shops, if the shops are able to attract a particular type of customer, they might be able to charge more because the customers prefer their shop to the rival shop. Perhaps one shop has a decor and music that appeal to younger customers, while the other has a decor and music that appeal to older customers.

19.2 Equilibrium in Monopolistic Competition

Learning Objective 19.2: Explain how equilibrium is achieved in monopolistically competitive markets.

To think about equilibrium in monopolistically competitive markets, we begin by assuming firms with identical costs and homogeneous products. Unlike perfectly competitive firms that take the market equilibrium prices as given, monopolistically competitive firms achieve some pricing power through product differentiation. In essence, these firms “capture” part of the market for themselves. This doesn’t mean they can charge any price they like but that they create for themselves a downward-sloping demand curve. In the absence of competition, such a scenario would potentially lead to monopoly rents and economic profits. However, the free entry and exit of firms will guarantee that there will be no economic profits in the long run because any positive economic profits will induce new firms to enter. The resulting equilibrium looks like the graph in figure 19.1, which shows how one firm can both face a downward-sloping demand curve and have zero economic profits.

In figure 19.1, the red line is the firm’s marginal revenue curve. Since the firm faces a downward-sloping demand curve, they have a downward-sloping marginal revenue curve similar to a monopolist. The difference is this marginal revenue curve is from their individual demand curve, which is only a part of total demand. Monopolistically competitive firms are profit maximizing firms and therefore set their output where marginal revenue equals marginal cost. To find this point, we look at the firm’s cost curves, in blue, and find the intersection of marginal revenue and marginal cost. In the figure, this occurs at the quantity [latex]q^*[/latex]. The maximum price the firm can charge and sell [latex]q^*[/latex] is [latex]p^*[/latex]. The firm’s average cost at [latex]q^*[/latex] is equal to [latex]p^*[/latex], so its total cost is equal to its total revenue, and therefore its economic profits are zero.

How is this equilibrium reached? Start by considering a firm that is making positive economic profits while facing a downward-sloping demand curve, as in figure 19.2, panel a. As other entrepreneurs observe the profits being made by incumbent firms, they will decide to enter the market. This will whittle away some of the demand for the incumbent firm, as seen in panel b. This will continue as long as any positive economic profits remain but will stop once economic profits arrive at zero, as seen in panel c. Note that on the firm level, this outcome is not the same as the competitive market outcome, where a firm’s price is equal to marginal cost. This means that there is some welfare loss from a firm’s ability to differentiate products. It can also be true that the process of product differentiation can be costly—for example, when Nike pays athletes to wear its shoes and advertises its brand. This leads to higher costs and further diminishes welfare produced by the athletic shoe market.

19.3 Policy Example
Should Public Schools Require Students to Wear Uniforms?

Learning Objective 19.3: Use knowledge of monopolistically competitive markets to explain how switching to generic uniforms can improve welfare.

There are a number of rationales for school uniforms in public schools: to assure that kids from poorer households don’t feel disadvantaged, to reduce problems with inappropriate attire, to eliminate the possibility of gang-related attire, and so on. All of these are potentially good reasons, but good policy analysis requires that we think about the social welfare of the market itself. By removing the incentive to differentiate through fashion and brands, school districts are forcing pupils to move from a monopolistically competitive market to one that is closer to a perfectly competitive market. The cost to individuals could be a loss of utility from being unable to express individual style, but the potential gain to the community is a lower cost of attending school.

LEARN: KEY TOPICS

Terms

Monopolistic competition

Monopolistically, competitive markets are markets in which low fixed costs and free entry and exit of firms make them competitive but in which firms are able to differentiate their products, which causes them to face downward-sloping demand curves like imperfectly competitive firms, such as monopolists.

Graphs

Equilibrium in monopolistically competitive markets

Achieving equilibrium in monopolistically competitive markets