This is “Model Assumptions: Monopolistic Competition”, section 6.5 from the book Policy and Theory of International Trade (v. 1.0).
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A monopolistically competitive market has features that represent a cross between a perfectly competitive market and a monopolistic market (hence the name). The following are some of the main assumptions of the model:
The differentiated products are imperfectly substitutable in consumption. This means that if the price of one good were to rise, some consumers would switch their purchases to another product within the industry. From the perspective of a firm in the industry, it would face a downward-sloping demand curve for its product, but the position of the demand curve would depend on the characteristics and prices of the other substitutable products produced by other firms. This assumption is intermediate between the perfectly competitive assumption in which goods are perfectly substitutable and the assumption in a monopoly market in which no substitution is possible.
Consumer demand for differentiated products is sometimes described using two distinct approaches: the love-of-variety approach and the ideal variety approach. The love-of-variety approach assumes that each consumer has a demand for multiple varieties of a product over time. A good example of this would be restaurant meals. Most consumers who eat out frequently will also switch between restaurants, one day eating at a Chinese restaurant, another day at a Mexican restaurant, and so on. If all consumers share the same love of variety, then the aggregate market will sustain demand for many varieties of goods simultaneously. If a utility function is specified that incorporates a love of variety, then the well-being of any consumer is greater the larger the number of varieties of goods available. Thus the consumers would prefer to have twenty varieties to choose from rather than ten.
The ideal variety approach assumes that each product consists of a collection of different characteristics. For example, each automobile has a different color, interior and exterior design, engine features, and so on. Each consumer is assumed to have different preferences over these characteristics. Since the final product consists of a composite of these characteristics, the consumer chooses a product closest to his or her ideal variety subject to the price of the good. In the aggregate, as long as consumers have different ideal varieties, the market will sustain multiple firms selling similar products. Therefore, depending on the type of consumer demand for the market, one can describe the monopolistic competition model as having consumers with heterogeneous demand (ideal variety) or homogeneous demand (love of variety).
These main assumptions of the monopolistically competitive market show that the market is intermediate between a purely competitive market and a purely monopolistic market. The analysis of trade proceeds using a standard depiction of equilibrium in a monopoly market. However, the results are reinterpreted in light of these assumptions. Also, it is worth mentioning that this model is a partial equilibrium model since there is only one industry described and there is no interaction across markets based on an aggregate resource constraint.
Jeopardy Questions. As in the popular television game show, you are given an answer to a question and you must respond with the question. For example, if the answer is “a tax on imports,” then the correct question is “What is a tariff?”