Monopolistic Competition

What Is Monopolistic Competition?

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

Understanding Monopolistic Competition

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.

Number of firms

Say you've just moved into a new house and want to stock up on cleaning supplies. Go to the appropriate aisle in a grocery store, and you'll see that any given item — dish soap, hand soap, laundry detergent, surface disinfectant, toilet bowl cleaner, etc. — is available in a number of varieties. For each purchase you need to make, perhaps five or six firms will be competing for your business.

Product Differentiation

Because the products all serve the same purpose, there are relatively few options for sellers to differentiate their offerings from other firms'. There might be "discount" varieties that are of lower quality, but it is difficult to tell whether the higher-priced options are in fact any better. This uncertainty results from imperfect information: the average consumer does not know the precise differences between the various products, or what the fair price for any of them is.

Monopolistic competition tends to lead to heavy marketing, because different firms need to distinguish broadly similar products. One company might opt to lower the price of their cleaning product, sacrificing a higher profit margin in exchange — ideally — for higher sales. Another might take the opposite route, raising the price and using packaging that suggests quality and sophistication. A third might sell itself as more eco-friendly, using "green" imagery and displaying a stamp of approval from an environmental watchdog (which the other brands might qualify for as well, but don't display). In reality, every one of the brands might be equally effective.

Decision-Making

Monopolistic competition implies that there are enough firms in the industry that one firm's decision does not set off a chain reaction. In an oligopoly, a price cut by one firm can set off a price war, but this is not the case for monopolistic competition.

Pricing Power

As in a monopoly, firms in monopolistic competition are price setters or makers, rather than price takers. However, the firms nominal ability to set their prices is effectively offset by the fact that demand for their products is highly price elastic. In order to actually raise their prices, the firms must be able to differentiate their products from their competitors by increasing its quality, real or perceived. 

Demand Elasticity

Due to the range of similar offerings, demand is highly elastic in monopolistic competition. In other words, demand is very responsive to price changes. If your favorite multipurpose surface cleaner suddenly costs 20% more, you probably won't hesitate to switch to an alternative, and your counter tops probably won't know the difference.

Economic Profit

In the short run, firms can make excess economic profits. However, because barriers to entry are low, other firms have an incentive to enter the market, increasing the competition, until overall economic profit is zero. Note that economic profits are not the same as accounting profits; a firm that posts a positive net income can have zero economic profit, since the latter incorporates opportunity costs.

Advertising in Monopolistic Competition

Economists who study monopolistic competition often highlight the social cost of this type of market structure. Firms in monopolistic competition expend large amounts real resources on advertising and other forms of marketing. When there is a real difference between the products of different firms, which the consume might not be aware of, these expenditures can be useful. However, if it is instead the case that the products are near perfect substitutes, which is likely in monopolistic competition, then real resources spent on advertising and marketing represent a kind of wasteful rent-seeking behavior, which produces a deadweight loss to society.