Monopolistic competition theory

the long version

In the 1920s, when the world economy began to show signs of crisis, a number of leading economists questioned the ability of a free-market economy to ensure automatic stability. They were also dissatisfied with the claim of theoretical orthodoxy that a firm's output was limited by its production costs rather than by consumer demand. Economists such as Piero Sraffa, Joan Robinson, and Edward Chamberlin thus began to develop monopolistic competition theory in order to raise theory's empirical relevance as well as its analytical sharpness. Economist Jan Keppler traces the development of monopolistic competition theory within the context of the political, economic, and historical developments of its time. With its combination of theoretical progress, intuitive realism, and the ability to address the pressing problems of economic instability and unemployment, monopolistic competition theory became the generally accepted foundation of microeconomic reasoning in the 1930s. It provided, at times, arguments for market intervention and income redistribution. After World War II, monopolistic competition theory proved to be vulnerable to the methodological criticisms of the Chicago school's Milton Friedman and George Stigler (due to its inability to cope with the new demands of mathematical tractability of comparative equilibrium economics) and was largely abandoned. Most recently, though, a series of new approaches has drawn increased attention to the ability of monopolistic competition theory to combine practical relevance and theoretical elegance in explaining the real economy.