This is “Monopolistic Competition”, section 6.8 from the book Managerial Economics Principles (v. 1.0).
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Next we will consider some slight variations on the perfect competition model. The first is the oddly named monopolistic competitionA model of a market that is similar to perfect competition but in which the good sold may have slight variations from seller to seller. model,The monopolistic competition model is discussed in Samuelson and Marks (2010). which uses the same assumptions as the perfect competition model with one difference: The good sold may be heterogeneous. This means that while all sellers in the market sell a similar good that serves the same basic need of the consumer, some sellers can make slight variations in their version of the good sold in the market.
As an example, consider midsized passenger automobiles. Some firms may sell cars that are a different color or different shape, have different configurations of onboard electronics like GPS systems, and so on. Some firms may make the cars more reliable or built to last longer.
Variation in the product by sellers will only make sense if consumers are responsive to these differences and are willing to pay a slightly higher price for the variation they prefer. The reason that slightly higher prices will be necessary is that in order to support variation in product supplied, sellers may no longer be able to operate at the same minimum efficient scale that was possible when there was one version of the good that every seller produced in a manner that was indistinguishable from the good of other sellers.
The fact that firms may be able to charge a higher price may suggest that firms can now have sustained positive economic profits, particularly if they have a variation of the product that is preferred by a sizeable group of buyers. Unfortunately, even under monopolistic competition, firms can expect to do no better than a zero economic profit in the long run. The rationale for this is as follows: Suppose a firm has discovered a niche variation that is able to sustain a premium price and earn a positive economic profit. Another firm selling in the market or a new entrant in the market will be attracted to mimic the successful firm. Due to free entry and perfect information, the successful firm will not be able to stop the copycats. Once the copycats are selling a copy of this product variation, a process of price undercutting will commence as was described for perfect information, and prices will continue to drop until the price equals average cost and firms are earning only a zero economic profit.