Table of Contents
What is monopolistic competition?
Monopolistic competition is a market structure whereby there are many sellers or firms in the market or industry that offer similar products or services but not perfect substitutes. In other words, these many firms offer similar commodities but these commodities are not homogeneous or identical. The reason why these commodities are not homogeneous is the adoption of branding and the use of trademarks or differences in the quality of services offered. In this market condition, the barriers of entry and exit of firms in the industry are very low and the decisions of a single firm have no direct effect on the decisions of its competitors. Monopolistic competition has a close relationship with the business strategy of brand or product differentiation.
In this market structure, competition is intense with low barriers to entry and exit thereby making it necessary for companies to work hard and be extra creative to be able to squeeze out a profit. They also have to be aware that if they hike prices too much, they are bound to lose their customers to competitors.
Monopolistic competitive firms
Firms under this market structure do not have much power to reduce supply or increase prices to maximize their profits. This implies that their degree of market power is relatively low and they are all price makers. These firms make efforts to differentiate their products so that they can achieve above-market returns. Because of this, heavy spending, marketing, and advertising are a common norm among firms in this market structure. However, some economists criticize this, describing the act as wasteful, stating that it is an act of wasting resources.
Monopolistic competition is a middle ground that exists between perfect competition and monopoly and combines the characteristics of the two market structures. Although, this is a purely theoretical state.
In the long run, the demand in this market structure is perfectly elastic, which means that it is sensitive to changes in price. Economic profit is positive in the short run but in the long run, it approaches zero in the long run.
Firms in monopolistic competition are faced with a significantly different business environment than their counterparts in either monopoly or perfect competition. Aside from increasing their economies of scale, firms in this market have the ability to distinguish themselves using other means.
Monopolistic competition examples
Monopolistic competition is something that is applicable to our daily lives. The following are some examples;
- Fast food
- Running shoe brands
The great examples of this form of the market include Burger King and McDonald’s. The products they sell are similar but they cannot replace or substitute one each. This is so because of the differences in shape, packaging, consumer taste, etc. Everything of theirs is dependent upon their consumers as they decide the company to choose based on their tastes and preferences.
There are different bakeries that are visible in each town and they offer products that are different in appearance, tastes, and branding. However, if only one bakery exists in a town, it can charge higher prices for its products. If a bakery becomes famous for its tasty pastry as well as many clients, it is very certain that this bakery can charge a higher price since customers are willing to pay more for the quality products.
Running shoe brands
We consider a market that runs shoes as one that has a high level of competition. Examples of firms in this industry are Reebok, Nike, New Balance, etc., just a few that people prefer to buy. Though all these companies produce sneakers, each firm’s product is unique because of its brand designs and features. This is the reason why firms have the power to charge different prices from their competitors.
In a town, one can find a wide range of customers. For a product, a firm can charge a higher price than the other in another place yet they produce similar products. This is greatly dependent upon many factors such as quality, location, and other services.
Examples of clothing under this market model include Gucci, Versage, D&G, etc. They all produce clothes but each firm is unique in its own patterns such as packaging and other features.
Although many economists consider this market structure to be inefficient because of how companies spend excess funds on publicity and advertising rather than increasing their product quality, it is realistic because many firms make provision for differentiated products. Although barriers to entry still exist, these barriers are low. This makes it possible to find many examples of firms and businesses around.
Characteristics of monopolistic competition
As earlier pointed out, monopolistic competition exhibits the elements of both perfect competition and monopoly. Mentioned below are the characteristics;
- A large number of firms
- Product differentiation
- Low market power
- A few barriers to entry
- Freedom in decision-making
- A high rate of competition
- The high elasticity of demand
- Economic profit
A large number of firms
This type of market is in place when a large number of companies produce goods that are similar but not identical. Firms here operate in accordance with the market rules and make decisions independently from other businesses.
Products and services, in this case, have just a slight price difference. This can include the intangible aspects of the products or their location. These products, however, cannot completely replace competitors’ products though we cannot deny the fact that they can serve a similar purpose. They are still different in style, reputation, appearance, packaging, and quality.
Low market power
Although firms under this market structure have market/pricing power, it is very low. Firms have power or control over the terms and conditions that apply to exchange. However, they can raise the prices without losing customers or prompting a price war among other rivals. In other words, they are price makers. Also, their power is tied to the number of competitors, independence in decision-making, and differentiated products.
A few barriers to entry
It is easy for firms and businesses to enter and exit the market. New or potential firms can join the market then existing firms obtain a great level of revenue. As new firms arrive in the industry, the supply of products increases on one side, and price decreases on the other side. In other words, this has a great effect on the profits of existing firms. With this, there is no room for these firms to obtain abnormal profits (supernormal profits).
Freedom in decision-making
Monopolistic competitive firms do not consider the effects their decisions have on competitors. This makes it possible for each firm to operate without the fear of heightening competition. In other words, the large number of firms makes it possible for the decision of one firm not to affect the behavior of other firms. It is unlike the case in oligopoly when a price cut by one firm can trigger a price war.
A high rate of competition
Competition exists among firms in this market structure. They have to carry out heavy advertising, product differentiation, branding, etc., gain a competitive edge over rivals.
The high elasticity of demand
In monopolistic competition, demand is highly elastic as a result of the range of similar offerings. In other words, a slight change in price amounts to a great level of change in demand, that is, demand is highly responsive to changes in price. By implication, if a firm increases the price of its products or services, customers will not hesitate to switch to an alternative. The countertops of these customers will probably not know the difference.
It is possible for firms to generate excess economic/abnormal profits in the short run. Because of the low barriers to the entry of new firms, competition keeps increasing until the overall economic profit falls to zero. It is important to note that economic profit does not mean the same thing as accounting profit. A firm that has a positive net income can have its economic profit fall to zero because this economic profit incorporates opportunity costs.
Monopolistic competition pros and cons
Advantages of monopolistic competition
The following are the advantages of monopolistic competition;
- A few barriers to entry
- Active business environment
- Product differentiation
- Informed consumers
- More competition
- Better products and services
A few barriers to entry
Because of the fact that there are no significant barriers to entry, markets are relatively contestable. This provides room for diversity, choice, and utility. On the other hand, new firms can enter the market without having to face restrictions. These firms can be unique in offering their products and services.
Active business environment
The market tends to be more efficient than monopoly although it is less efficient in resource allocation and productively than perfect competition. However, they may be dynamic in their efficiency and innovation especially in terms of new production processes or new products. For instance, it is necessary for retailers to constantly develop new ways of attracting and retaining local customs. Competition is key and businesses make business decisions on the basis of economic factors such as production costs, the nature of the market, and the type of products they offer.
Product differentiation enables customers to obtain a great variety of products because they are differentiated. It is necessary for firms under monopolistic competition to differentiate their products from their competitors. With this, it becomes possible for consumers to choose a product from a company for its unique qualities such as packaging color, size, or price. Companies work towards finding distinctive features to differentiate their products from that of their competitors that offer the same price.
Customers have perfect information about goods and services that are available in the market. It is necessary for customers to become more informed about the goods and services that are available in the market. Firms in this market, therefore, engage in aggressive advertising in order to enhance their visibility. On the other hand, consumers obtain information with regard to the unique aspects of production which include pricing, packaging, and other special offers and services they offer through advertising channels such as radio and newspapers. In monopolistic competition, consumers are usually well informed about the market and therefore make informed choices based on their knowledge.
This market structure provides room for new businesses to enter most industries without any form of systematic opposition or challenge. Lucid laws are in place in order to provide for the registration of enterprises, the operation of businesses, the sales of products and services, and profit maximization.
There are some industries with exemption where only state-owned firms or a few companies can enter. These are usually sensitive positions that have more to do with public and social welfare than the general consumer market. There is more competition where businesses find a solid grip. The fact that there are few barriers to entry into the market, as well as exit, allows for creativity and an active business environment for competitors. Also because the market structure is less restrictive, there is no room for a single firm to play as a monopolist. Consumers can get a variety of products and services from which they can choose.
Better products and services
Every firm will try to secure an admirable market share and as well desire to hold on to it. In an attempt to do this, a firm has to continue to deliver quality products and satisfactory services. This makes consumers get the best value for their money. Only the best firms will get to stay over the years. It is usually all about an overall win-win for any and sundry.
Disadvantages of monopolistic competition
The following are the disadvantages of monopolistic competition;
- Excessive waste of resources
- Limited access to economies of scale
- Predatory pricing
- High costs and expenses
- Excess capacity
Excessive waste of resources
Differentiation does not always bring about utility but rather generates unnecessary waste such as excess packaging. Some economists consider advertising as a wasteful act although most are informative rather than informative.
Limited economies of scale
Because of the large number of firms, monopolistic competitors have limited access to economies of scale. This is as a result of the aggressive advertising and other means of promoting visibility they engage in. This adds up to their cost of production, they spend so much. This inn turn limits the ability of firms to minimize their average cost of production while maximizing profit.
Firms under monopolistic competition are usually inefficient in the allocation of resources. This is the case both in the short run and the long run. It happens so because in both cases, the price is above marginal cost. In the long run, firms are less inefficient in the allocation of resources but still inefficient.
Predatory pricing and other strategies
Many ways to eradicate any form of competition exist, one of which is predatory pricing. Monopolistic competition does not do anything exactly against such practices. However, there are fair trading rules in most countries.
High costs and expenses
Firms under this market structure incur high expenses in marketing and advertising. It is always expensive to do advertising and firms have to spend more to gain visibility. They have to put in extra efforts to differentiate their products in the face of stiff competition using marketing strategies such as product packaging, unique marketing, and channels of distribution to differentiate their products. This is an additional cost thereby making their operational costs high.
In monopolistic competition, there is a high tendency for excess capacity because it is impossible for firms to fully exploit their fixed factors because mass production is difficult.
Monopolistic competition graphs
It is possible for firms to generate supernormal profits in the short run. In the long run, new firms get attracted to the industry as a result of low barriers to entry, perfect or good knowledge, and the opportunity to differentiate.
Monopolistic competition in the short run
The firms maximize profit where marginal cost equals marginal revenue, that is MC=MR given the output Q and price P. Given that price (AR) is above average total cost (ATC) at Q, it is possible to generate supernormal profits at PABC.
The demand for the products of the existing firms becomes more elastic as new firms enter the industry. In turn, the demand curve shifts to the left, lowering the price. Eventually, all supernormal profits are eliminated.
Monopolistic competition in the long run
Because of the supernormal profits, new firms become attracted to the industry. This then causes the demand curve for existing firms to shift to the left. New firms continue to enter until supernormal profit loses its place and normal profit becomes available. It is at this point that firms arrive at their long-run equilibrium.
This makes it clear that the firm benefits the most in the short run and will try everything possible to remain in the short run by being more innovative and further product differentiation.
Monopolistic competition vs monopoly
Monopolistic competition is, first and foremost, different from monopoly by the number of players in the market. In monopolistic competition, many sellers or firms provide products and services that have slight differences from competitors. On the other hand, a monopoly has to do with only one seller or firm that dominates the market without any close substitute.
It is easy for new firms to enter and leave the industry under monopolistic competition. That is, the barriers to entry are low. For monopoly, the barriers to entry and exit are high, there is usually no free entry and exit in the market. For a firm to either enter or exit the market, it has to comply with the high standards laid down.
Monopolistic competitive firms are price makers although they do not possess a large market share. Though a monopolist is a price maker, he possesses a large market share. In other words, a monopolist is a large firm. To simply put it, both a monopolistic competitor and a monopolist are price makers but their market shares differ.
In monopolistic competition, there is competition and market rivalry. This is not the case under monopoly where there is only one seller. In essence, a monopolist enjoys more luxury than a monopolistic competitive firm. Monopolistic competitors face restrictions in their ability to hike prices and bypass the natural forces of supply and demand. This is a result of the competition that is present among firms and sellers.
Many view monopolistic competition as healthier for the economy than monopolies. Free-market economies usually frown at monopoly because it leads to the deterioration of alternative choices. The reverse is the case for monopolistic competition. In a nutshell, monopolistic competition is more common than monopoly.
Monopolistic competition vs oligopoly
First and foremost, the difference that exists between monopolistic competition and oligopoly lies in the number of sellers or firms in the market. To explain this better, monopolistic competition involves a large number of firms in the industry. On the other hand, oligopoly involves a small number of large firms in the industry.
Also, the two market structures differ in the ease of entry and exit in the market. Under monopolistic competition, there are few barriers to entry and exit which brings about a large number of firms in the industry. On the other hand, Oligopoly imposes high barriers to the entry and exit of firms into the industry.
Under monopolistic competition, firms are independent in determining the price, demand, and supply of their products. In other words, the actions of one firm do not affect the actions of other firms. On the other hand, the interdependence of firms exists under oligopoly. That is, the actions of firms are interdependent from one firm to another. In other words, the actions of one firm affect the actions of competitors.
Monopolistic competition and oligopoly also differ in the nature of their products. The nature of products under monopolistic competition is differentiated. In other words, heterogeneous. Their differences are visible in size, shape, color, and price. On the other hand, the products of oligopolistic firms can either be homogeneous or differentiated. When the products are homogeneous, they can be similar in size, shape, price, material, and color. They sometimes sell differentiated products when they want to compete among themselves.
Frequently asked questions
What is monopolistic competition?
Monopolistic competition is a market structure whereby there are many sellers or firms in the market or industry that offer similar products or services but not perfect substitutes. In other words, these many firms offer similar commodities but these commodities are not homogeneous or identical
What are some examples of monopolistic competition?
Monopolistic competition is applicable and realistic in our daily lives. Some examples are fast food, bakeries, running shoe brands, restaurants, and clothing. When we look at these industries carefully, we will find out that there are many firms in the industry that compete among themselves. It is also certain that they embark on different marketing strategies such as advertising, packaging, and product differentiation to promote their visibility.
What are the 4 conditions to the monopolistic competition?
The conditions that make up a monopolistic competition are;
- A large number of firms
- Free entry and exit in the market
- The production of differentiated products
- The independence of firms in decision-making
- Competition among firms
- A perfectly elastic demand
What are the characteristics of monopolistic competition?
The characteristics of monopolistic competition include;
- There is a large number of firms in the industry.
- Firms engage in product differentiation to gain visibility and recognition.
- Though firms have market power, this market power is low.
- A few barriers to entry
- Freedom in decision-making. Firms can make decisions without considering the effects of these decisions on rivals.
- A high rate of competition exists in the market.
- The high elasticity of demand, that is, a slight change in price can lead to a significant or great change in the quantity demanded of products.
- Firms generate abnormal profits in the short run and generate normal profits in the long run.