Monopolistic competition and oligopoly provide differing perspectives on the nature of competition in imperfectly competitive markets. Attributes of the monopolistic competition and oligopoly market models are outlined in this section and then elaborated on in the rest of the chapter.

Monopolistic Competition

The economic environment faced by many firms cannot be described as perfectly competitive. Likewise, few firms enjoy clear monopoly. Real-world markets commonly embody elements of both perfect competition and monopoly. Firms often introduce valuable new products or process innovations that give rise to above-normal rates of return in the short run. In the long run, however, entry and imitation by new rivals erode the dominant market share enjoyed by early innovators, and profits eventually return to normal. Still, in sharp contrast to perfectly competitive markets, the unique product characteristics of individual firms often remain valued by consumers. Consumers often continue to prefer Campbell’s Soup, Dockers, Oil of Olay, Rubbermaid, Tide, and other favorite brands long after comparable products have been introduced by rivals. The partly competitive, partly monopolistic market structure encountered by firms in the apparel, food, hotel, retailing, and consumer products industries is called monopolistic competition. Given the lack of perfect substitutes, monopolistically competitive firms exercise some discretion in setting prices—they are not price takers. However, given vigorous competition from imitators offering close but not identical substitutes, such firms enjoy only a normal risk-adjusted rate of return on investment in long-run equilibrium.

Monopolistic competition is similar to perfect competition in that it entails vigorous price competition among a large number of firms. The major difference between these two market structure models is that consumers perceive important differences among the products offered by monopolistically competitive firms, whereas the output of perfectly competitive firms is homogeneous. This gives monopolistically competitive firms at least some discretion in setting prices. However, the availability of many close substitutes limits this price-setting ability and drives profits down to a normal risk-adjusted rate of return in the long run. As in the case of perfect competition, above-normal profits are possible only in the short run, before the monopolistically competitive firm’s rivals can take effective countermeasures.


Oligopoly is the market structure model that describes competition among a handful of competitors sheltered by significant barriers to entry. Oligopolists might produce a homogeneous product, such as aluminum, steel, or semiconductors; or differentiated products such as Cheerios, Coca-Cola, Marlboro, MTV, and Nintendo. Innovative leading firms in the ready-to-eat cereal, beverage, cigarette, entertainment, and computer software industries, among others, have the potential for economic profits even in the long run. With few competitors, economic incentives also exist for such firms to devise illegal agreements to limit competition, fix prices, or otherwise divide markets. The history of antitrust enforcement in the United States provides numerous examples of “competitors” who illegally entered into such agreements. Yet there are also examples of markets in which vigorous competition among a small number of firms generates obvious long-term benefits for consumers. It is therefore erroneous to draw a simple link between the number of competitors and the vigor of competition.

In an industry characterized by oligopoly, only a few large rivals are responsible for the bulk of industry output. As in the case of monopoly, high to very high barriers to entry are typical.

Under oligopoly, the price/output decisions of firms are interrelated in the sense that direct reactions among rivals can be expected. As a result, decisions of individual firms anticipate the likely response of competitors. This competition among the few involves a wide variety of price and nonprice methods of rivalry, as determined by the institutional characteristics of each particular market. Even though limited numbers of competitors give rise to a potential for economic profits, above-normal rates of return are far from guaranteed. Competition among the few can be vigorous.

Dynamic Nature of Competition

In characterizing the descriptive relevance of the monopolistic competition and oligopoly models of seller behavior, it is important to recognize the dynamic nature of real-world markets. For example, as late as the mid 1980s it seemed appropriate to regard the automobile and personal computer manufacturing markets as oligopolistic in nature. Today, it seems fairer to regard each industry as monopolistically competitive. In the automobile industry, GM, Ford, and Daimler Chrysler have found Toyota, Honda, Nissan, and a host of specialized competitors to be formidable foes. Aggressive competitors like Dell, Compaq, Hewlett-Packard, and Gateway first weakened, and then obliterated, IBM’s early lead in the PC business. Prices and profit margins for PCs continue to fall as improving technology continues to enhance product quality.

In many formerly oligopolistic markets, the market discipline provided by a competitive fringe of smaller domestic and foreign rivals is sufficient to limit the potential abuse of a few large competitors. In the long-distance telephone service market, for example, AT&T, MCI WorldCom, and Sprint have long dominated the industry. However, emerging competition from the so-called regional Bell operating companies (REBOCs), along with a host of smaller specialized providers, cause long-distance phone service price and service quality competition to be spirited. Similarly, the competitive fringe in wireless communications and cable TV promises to force dramatic change during the years ahead. It is unfortunate, but public perceptions and government regulatory policy sometimes lag behind economic reality. It is essential that timely and accurate market structure information be available to form the basis for managerial investment decisions that relate to entry or exit from specific lines of business. Similarly, enlightened public policy requires timely information.

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