International Trade Theory and Policy
by Steven M. Suranovic

Trade 80-5

Monopolistic Competition

Monopolistic competition refers to a market structure that is a cross between the two extremes of perfect competition and monopoly. The model allows for the presence of increasing returns to scale in production and for differentiated (rather than homogeneous or identical) products. However the model retains many features of perfect competition, such as the presence of many many firms in the industry and the likelihood that free entry and exit of firms in response to profit would eliminate economic profit among the firms. As a result, the model offers a somewhat more realistic depiction of many common economic markets. The model best describes markets in which numerous firms supply products which are each slightly different from that supplied by its competitors. Examples include automobiles, toothpaste, furnaces, restaurant meals, motion pictures, romance novels, wine, beer, cheese, shaving cream and many more.

The model is especially useful in explaining the motivation for intra-industry trade, i.e. trade between countries that occurs within an industry rather than across industries. In other words the model can explain why some countries export and import automobiles simultaneously. This type of trade, although frequently measured is not readily explained in the context of the Ricardian or Heckscher-Ohlin models of trade. In those models a country might export wine and import cheese, but it would never export and import wine at the same time.

The model demonstrates not only that intra industry trade may arise, but that national welfare can be improved as a result of international trade. One reason for the improvement in welfare is that individual firms produce larger quantities, which, because of economies of scale in production, leads to a reduction in unit-production costs. This means there is an improvement in productive efficiency. The second reason welfare improves is that consumers are able to choose from a greater variety of available products with trade compared to autarky.

International Trade Theory and Policy - Chapter 80-5: Last Updated on 2/15/07