Monopolistic Competition

A type of market structure where companies in an industry produce similar but differentiated products

What is Monopolistic Competition?

Monopolistic competition is a type of market structure where many companies are present in an industry, and they produce similar but differentiated products. None of the companies enjoy a monopoly, and each company operates independently without regard to the actions of other companies. The market structure is a form of imperfect competition.

 

Monopolistic Competition

 

The characteristics of monopolistic competition include the following:

  • The presence of many companies
  • Each company produces similar but differentiated products
  • Companies are not price takers
  • Free entry and exit in the industry
  • Companies compete based on product quality, price, and how the product is marketed

 

Companies in a monopolistic competition make economic profits in the short run, but in the long run, they make zero economic profit. The latter is also a result of the freedom of entry and exit in the industry. Economic profits that exist in the short run attract new entries, which eventually lead to increased competition, lower prices, and high output.

Such a scenario inevitably eliminates economic profit and gradually leads to economic losses in the short run. The freedom to exit due to continued economic losses leads to an increase in prices and profits, which eliminates economic losses.

In addition, companies in a monopolistic market structure are productively and allocatively inefficient as they operate with existing excess capacity. Because of the large number of companies, each player keeps a small market share and is unable to influence the product price. Therefore, collusion between companies is impossible.

In addition, monopolistic competition thrives on innovation and variety. Companies must continuously invest in product development and advertising and increase the variety of their products to appeal to their target markets. Competition with other companies is thus based on quality, price, and marketing.

Quality entails product design and service. Companies able to increase the quality of their products are, therefore, able to charge a higher price and vice versa. Marketing refers to different types of advertising and packaging that can be used on the product to increase awareness and appeal.

 

Industries Exhibiting Features of Monopolistic Competition

Examples of industries in monopolistic competition include the following:

  • Clothing and apparel
  • Sportswear products
  • Restaurants
  • Hairdressers
  • PC manufacturers
  • Television services

 

Short-Run Decisions on Output and Price

The short-run equilibrium under monopolistic competition is illustrated in the diagram below:

 

Monopolistic Competition - Short-Run Equilibrium

 

Profits are maximized where marginal revenue (MR) is equal to marginal cost (MC). The point determines the company’s equilibrium output. The price is determined at a point where the imaginary line from the equilibrium output passes through the point of intersection of the MR, and MC curves and meets the average revenue (AR) curve, which is also the demand curve.

Total profit is represented by the cyan-colored rectangle in the diagram above. It is determined by the equilibrium output multiplied by the difference between AR and the average total cost (ATC). Companies in monopolistic competition determine their price and output decisions in the short run, just like companies in a monopoly.

Companies in monopolistic competition can also incur economic losses in the short run, as illustrated below. They still produce equilibrium output at a point where MR equals MC in which losses are minimized. The cyan-colored rectangle shows the economic loss incurred.

 

Short-Run Economic Losses

 

Long-Run Decisions on Output and Price

In the long run, companies in monopolistic competition still produce at a level where marginal cost and marginal revenue are equal. However, the demand curve will have shifted to the left due to other companies entering the market. The shift in the demand curve is a result of reduced demand for an individual company’s products due to increased competition.

Such an action reduces economic profits, depending on the magnitude of the entry of new players. Individual companies will no longer be able to sell their products at above-average cost.

 

Long-Run Decisions on Output and Price

 

Companies in monopolistic competition will earn zero economic profit in the long run. At this stage, there is no incentive for new entrants in the industry.

 

Monopolistic Competition vs. Perfect Competition

Companies in monopolistic competition produce differentiated products and compete mainly on non-price competition. The demand curves in individual companies for monopolistic competition are downward sloping, whereas perfect competition demonstrates a perfectly elastic demand schedule.

However, there are two other principal differences worth mentioning – excess capacity and mark up. Companies in monopolistic competition operate with excess capacity, as they do not produce at an efficient scale, i.e., at the lowest ATC. Production at the lowest possible cost is only completed by companies in perfect competition.

Mark-up is the difference between price and marginal cost. There is no mark-up in a perfect competition structure because the price is equal to marginal cost. However, monopolistic competition comes with a product mark-up, as the price is always greater than the marginal cost.

 

Inefficiencies in Monopolistic Competition

  • The equilibrium output at the profit maximization level (MR = MC) for monopolistic competition means consumers pay more since the price is greater than marginal revenue.
  • As indicated above, monopolistic competitive companies operate with excess capacity. They do not operate at the minimum ATC in the long run. Production capacity is not at full capacity, resulting in idle resources.
  • Monopolistic competitive companies waste resources on selling costs, i.e., advertising and marketing to promote their products. Such costs can be utilized in production to reduce production costs and possibly lower product prices.
  • Since companies do not operate at excess capacity, it leads to unemployment and social despondency in society.
  • Inefficient companies continue to exist under monopolistic competition, as opposed to exiting, which is associated with companies under perfect competition.
  • Another scope of inefficiency for monopolistic competitive markets stems from the fact that the marginal cost is less than the price in the long run.
  • Monopolistic competitive market structures are also allocatively inefficient. Their prices are higher than the marginal cost.

 

Limitations of Monopolistic Competition Market Structure

  • Companies with superior brands and high-quality products will consistently make economic profits in the real world.
  • Companies entering the market will take a long time to catch up, and their products will not match those of the established companies for their products to be considered close substitutes. New companies are likely to face barriers to entry because of strong brand differentiation and brand loyalty.

 

Additional Resources

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To keep learning and developing your knowledge of financial analysis, we highly recommend the additional resources below:

  • Aggregate Supply and Demand
  • Barriers to Entry
  • Legal Monopoly
  • Oligopoly

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