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558 CHAPTER 13 MARKET STRUCTURE AND COMPETITION

the outcome predicted by the Bertrand model of minutes fell by about 5 percent, and plans with large
oligopoly with homogeneous products, in which the numbers of minutes fell by about 7 percent. In addition,
equilibrium is actually equal to marginal cost. the dispersion (variance) in prices fell dramatically.
Did this happen? Since 2003, over 10 million indi- What we learn from this example is that removing
viduals in the United States have taken their cell phone conditions that create switching costs can intensify com-
numbers with them when they switched service petition. Put another way, creation of switching costs
providers. Research by Minjung Park documents inten- across sellers can reduce competition and keep prices
sified price competition as a result. 35 The average price high. Firms understand this, of course, which is why we
for a monthly plan with the fewest minutes of call time see phenomena such as frequent flyer programs, loyalty
fell only about 1 percent. However, call plans with more cards, and hundreds of millions of dollars spent every
minutes had larger price drops. Plans with intermediate year on advertising aimed at differentiating products.

13.5 A monopolistically competitive market has three distinguishing features. 36 First, the

MONOPOLISTIC market is fragmented—it consists of many buyers and sellers. Second, there is free
entry and exit—any firm can hire the inputs (labor, capital, and so forth) needed to
COMPETITION compete in the market, and they can release these inputs from employment when they
do not need them. Third, firms produce horizontally differentiated products—
consumers view firms’ products as imperfect substitutes for each other.
Local retail and service markets often have these characteristics. Consider, for
example, the restaurant market within the city of Evanston, Illinois. The market is
highly fragmented—the Evanston Yellow Pages, for example, has nearly five pages of
restaurant listings. The Evanston restaurant market also has free entry and exit.
Prospective restaurateurs can easily rent space, acquire cooking equipment, and hire
servers. A comparison of the Yellow Pages listings for 2004 with those for 2010 reveals
a remarkable turnover of establishments. When times are good, new restaurants are
opened. When a restaurant proves to be unprofitable, it is shut down.
Market fragmentation and free entry and exit are also characteristics of perfectly
competitive markets. But unlike perfectly competitive firms, Evanston restaurants are
characterized by significant product differentiation. There are many different types of
restaurants (Chinese, Thai, Italian, vegetarian) that cater to the wide variety of buyer
tastes in Evanston. Some restaurants are formal, while others are casual. And each
restaurant is conveniently located for people who live or work close to it but might be
inconvenient for people who have to drive several miles to get to it.

SHORT-RUN AND LONG-RUN EQUILIBRIUM
IN MONOPOLISTICALLY COMPETITIVE MARKETS
In choosing their prices, monopolistic competitors behave much like the differenti-
ated products oligopolists that we studied in the previous section. Even though the
market is fragmented, each firm’s demand curve is downward sloping because of product
differentiation. Taking the prices of other firms as given, each firm maximizes its
profit at the point at which its marginal revenue equals marginal cost.
Figure 13.13 illustrates the profit-maximization problem facing a typical firm
under monopolistic competition. The firm faces a demand curve D. When the firm
maximizes its profit along this demand curve, it charges a price of $43 and produces

35 Minjung Park, “The Economic Impact of Wireless Number Portability,” Working Paper, University of
Minnesota, October 2009.
36 This model of monopolistic competition was developed by the economist Edward Chamberlin in his
book, The Theory of Monopolistic Competition (Cambridge, MA: Harvard University Press, 1933).