In a perfectly competitive market—a market in which there is many buyers and sellers, none of whom represents a large part of the market—firms are price takers. That is, they are sellers of products who believe they can sell as much as they like at the current price but cannot influence the price they receive for their product. For example, a wheat farmer can sell as much wheat as she likes without worrying that if she tries to sell more wheat, she will depress the market price. The reason she need not worry about the effect of her sales on prices is that any individual wheat grower represents only a tiny fraction of the world market. When only a few firms produce a good, however, the situation is different.
To take perhaps the most dramatic example, the aircraft manufacturing giant Boeing shares the market for large jet aircraft with only one major rival, the European firm Airbus. As a result, Boeing knows that if it produces more aircraft, it will have a significant effect on the total supply of planes in the world and will therefore significantly drive down the price of airplanes. Or to put it another way, Boeing knows that if it wants to sell more airplanes, it can do so only by significantly reducing its price. In imperfect competition, then, firms are aware that they can influence the prices of their products and that they can sell more only by reducing their price. This situation occurs in one of two ways: when there are only a few major producers of a particular good, or when each firm produces a good that is differentiated from that of rival firms.
Monopoly profits rarely go uncontested. A firm making high profits normally attracts competitors. Thus situations of pure monopoly are rare in practice. Instead, the usual market structure in industries characterized by internal economies of scale is one of oligopoly, in which several firms are each large enough to affect prices, but none has an uncontested monopoly. The general analysis of oligopoly is a complex and controversial subject because in oligopolies, the pricing policies of firms are interdependent. Each firm in an oligopoly will, in setting its price, consider not only the responses of consumers but also the expected responses of competitors.
In monopolistic competition models, two key assumptions are made to get around the problem of interdependence. First, each firm is assumed to be able to differentiate its product from that of its rivals. That is, because a firm’s customers want to buy that particular firm’s product, they will not rush to buy other firms’ products because of a slight price difference. Product differentiation thus ensures that each firm has a monopoly in its particular product within an industry and is therefore somewhat insulated from competition.
Second, each firm is assumed to take the prices charged by its rivals as given—that is, it ignores the impact of its own price on the prices of other firms. As a result, the monopolistic competition model assumes that even though each firm is in reality facing competition from other firms, each firm behaves as if it were a monopolist—hence the model’s name.