Monopolistic competition characterizes an industry in which many firms offer products or services that are similar, but not perfect substitutes. Barriers to entry and exit in a monopolistic competitive industry are low, and the decisions of any one firm do not directly affect those of its competitors. Monopolistic competition is closely related to the business strategy of brand differentiation.
Monopolistic competition is a middle ground between monopoly and perfect competition (a purely theoretical state), and combines elements of each. All firms in monopolistic competition have the same, relatively low degree of market power; they are all price makers. In the long run, demand is highly elastic, meaning that it is sensitive to price changes. In the short run, economic profit is positive, but it approaches zero in the long run. Firms in monopolistic competition tend to advertise heavily.
Monopolistic competition is a form of competition that characterizes a number of industries that are familiar to consumers in their day-to-day lives. Examples include restaurants, hair salons, clothing, and consumer electronics. To illustrate the characteristics of monopolistic competition, we’ll use the example of household cleaning products.
Characteristic of Monopolistic Competition
- Each firm makes independent decisions about price and output, based on its product, its market, and its costs of production.
- Knowledge is widely spread between participants, but it is unlikely to be perfect. For example, diners can review all the menus available from restaurants in a town, before they make their choice. Once inside the restaurant, they can view the menu again, before ordering. However, they cannot fully appreciate the restaurant or the meal until after they have dined.
- The entrepreneur has a more significant role than in firms that are perfectly competitive because of the increased risks associated with decision making.
- There is freedom to enter or leave the market, as there are no major barriers to entry or exit.
- A central feature of monopolistic competition is that products are differentiated. There are four main types of differentiation:
- Physical product differentiation, where firms use size, design, colour, shape, performance, and features to make their products different. For example, consumer electronics can easily be physically differentiated.
- Marketing differentiation, where firms try to differentiate their product by distinctive packaging and other promotional techniques. For example, breakfast cereals can easily be differentiated through packaging.
- Human capital differentiation, where the firm creates differences through the skill of its employees, the level of training received, distinctive uniforms, and so on.
- Differentiation through distribution, including distribution via mail order or through internet shopping, such as Amazon.com, which differentiates itself from traditional bookstores by selling online.
- Firms are price makers and are faced with a downward sloping demand curve. Because each firm makes a unique product, it can charge a higher or lower price than its rivals. The firm can set its own price and does not have to ‘take’ it from the industry as a whole, though the industry price may be a guideline, or becomes a constraint. This also means that the demand curve will slope downwards.
- Firms operating under monopolistic competition usually have to engage in advertising. Firms are often in fierce competition with other (local) firms offering a similar product or service, and may need to advertise on a local basis, to let customers know their differences. Common methods of advertising for these firms are through local press and radio, local cinema, posters, leaflets and special promotions.
- Monopolistically competitive firms are assumed to be profit maximisers because firms tend to be small with entrepreneurs actively involved in managing the business.
- There are usually a large numbers of independent firms competing in the market.