Mark Fisher
Economic Review, Vol. 90, No. 2, 2005
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The standard supply-and-demand model is typically an economist's most important analytical tool, but in some situations it does not capture the features of interest. For example, during "happy hour," bars near workplaces sell a higher-than-usual quantity of alcoholic beverages at a lower-than-usual price. This practice makes little sense using the standard competitive model, but an alternative model—the model of monopolistic competition—provides the needed analytic framework.
This article provides a step-by-step construction of a monopolistic competition model in which many firms each produce the same product, and thus bear the same production costs, as their competitors. Yet each firm's product is differentiated from its competitors', resulting in a falling demand curve.
These seemingly contradictory conditions can be rationalized by assuming the firms are separated in space and that consumers bear costs to travel to the firms. A local firm has some monopoly power because local consumers may be willing to pay a higher price for the convenience of shopping nearby. Conversely, local consumers may be willing to travel farther for a lower price. Firms charging a lower price may also be able to attract faraway consumers who are willing to travel.
Thus, when consumers' demand increases, the demand curve facing a local monopolist becomes more sensitive to changes in its own price. This increase in sensitivity in turn can cause the equilibrium price to be lower during periods of high demand.
July 2005