Walk down a supermarket aisle and count the brands of toothpaste. Colgate, Crest, Sensodyne, Tom's of Maine, and a dozen store labels. They are not identical, but they are close substitutes. Each brand has a small amount of pricing power because some consumers prefer it. That is monopolistic competition: many sellers offering products that are similar but not the same.

The structure sits between perfect competition and monopoly. Like perfect competition, there are many firms and free entry. Like monopoly, each firm faces a downward-sloping demand curve because its product is differentiated. A coffee shop can raise prices slightly without losing all its customers, but raise them too much and people switch to the shop next door.

Firms in monopolistic competition compete on more than price. They advertise, design packaging, offer loyalty programs, and cultivate brand images. These efforts can be wasteful, but they also give consumers variety. The equilibrium outcome is inefficient in the textbook sense: firms produce less than the socially optimal quantity and charge more than marginal cost. Yet the inefficiency buys diversity, and most consumers seem willing to pay for it.

Key features

• Many buyers and sellers
• Product differentiation
• Free entry and exit
• Some pricing power
• Non-price competition