As discussed in oligopoly, it is reasonable to think that firms with differentiated products do not act as price-takers. “Monopolistic Competition” is how some researchers (mostly in international trade and macroeconomics) think about this problem.
This topic is here for completeness and is not a core part of the course. If you want to understand it better, I recommend the chapter by Krugman and Wells linked below (Krugman is a top international trade guy).
What is it?
Mathematically, we have
- MC(q) = MR(q) because the firms are not price-takers, and
- P = AC(q) because free entry implies zero profit.
There are two major differences between this and the hedonic-Demand-with-Bertrand-pricing model of oligopoly:1
- Assumptions on preferences. Goods are differentiated, but the modeler does not care how — whether two goods are complements or substitutes and their cross-price elasticity. Instead, all goods are viewed as imperfect substitutes, with the relationship summarized by an "elasticity of substitution."
- Scope for strategic behavior. Free entry means that there are no (or weaker) concerns about collusion, predatory pricing, etc.
- Perloff, Chapter 13 ``Oligopoly and Monopolistic Competition''
- Krugman and Wells, Chapter 16 “Monopolistic Competition”