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A Monopolistic competition is a market structure in which many firms sell a differentiated product into which entry is relatively easy in which the firm has some control over its product price and in which there is considerable non price competition.

Monopolistic competition is a type of imperfect competition such that many producers sell products that are differentiated from one another as goods but not perfect substitutes (such as from branding, quality, or location). In monopolistic competition, a firm takes the prices charged by its rivals as given and ignores the impact of its own prices on the prices of other firms.

Unlike in perfect competition, firms that are monopolistically competitive maintain spare capacity. Models of monopolistic competition are often used to model industries. Textbook examples of industries with market structures similar to monopolistic competition include restaurants, cereal, clothing, shoes, and service industries in large cities.

Monopolistic competition is different from a monopoly. A monopoly exists when a person or entity is the exclusive supplier of a good or service in a market. The demand is inelastic and the market is inefficient.

Characteristics of Monopolistic Competition

Monopolistic competitive markets characteristics:

  1. Monopolistic competition have products that are highly differentiated, meaning that there is a perception that the goods are different for reasons other than price.
  2. Monopolistic competition have many firms providing the good or service.
  3. In Monopolistic competition,firms can freely enter and exits in the long-run.
  4. Firms can make decisions independently
  5. There is some degree of market power, meaning producers have some control over price.
  6. Buyers and sellers have imperfect information.

Product Differentiation

Product differentiation is the process of distinguishing a product or service from others to make it more attractive to a target market.

Differentiation occurs because buyers perceive a difference between products. Causes of differentiation include functional aspects of the product or service, how it is distributed and marketed, and who buys it.

Differentiation affects performance primarily by reducing direct competition. As the product becomes more different, categorization becomes more difficult, and the product draws fewer comparisons with its competition.

types of product differentiation

There are three types of product differentiation: simple, horizontal, and vertical.

Simple

The products are differentiated based on a variety of characteristics.

Horizontal

The products are differentiated based on a single characteristic, but consumers are not clear on which product is of higher quality.

Vertical

The products are differentiated based on a single characteristic and consumers are clear on which product is of higher quality.

Differentiation occurs because buyers perceive a difference. Drivers of differentiation include functional aspects of the product or service, how it is distributed and marketed, and who buys it. The major sources of product differentiation are as follows:

  • Differences in quality, which are usually accompanied by differences in price
  • Differences in functional features or design
  • Ignorance of buyers regarding the essential characteristics and qualities of goods they are purchasing
  • Sales promotion activities of sellers, particularly advertising
  • Differences in availability (e.g. timing and location).

The objective of differentiation is to develop a position that potential customers see as unique. Differentiation affects performance primarily by reducing direct competition. As the product becomes more different, categorization becomes more difficult, and the product draws fewer comparisons with its competition. A successful product differentiation strategy will move the product from competing on price to competing on non-price factors.

Demand Curve

The demand curve in a monopolistic competitive market slopes downward, which has several important implications for firms in this market.

The demand curve of a monopolistic competitive market slopes downward. This means that as price decreases, the quantity demanded for that good increases. While this appears to be relatively straightforward, the shape of the demand curve has several important implications for firms in a monopolistic competitive market.

Short Run Outcome of Monopolistic Competition

Monopolistic competitive markets can lead to significant profits in the short-run, but are inefficient.

In terms of production and supply, the “short run” is the time period when one factor of production is fixed in terms of costs while the other elements of production are variable. The most common example of this is the production of a good that requires a factory. If demand spikes, in the short run you will only be able to produce the amount of good that the capacity of the factory allows. This is because it takes a significant amount of time to either build or acquire a new factory. If demand for the good plummets you can cut production in the factory, but will still have to pay the costs of maintaining the factory and the associated rent or debt associated with acquiring the factory. You could sell the factory, but again that would take a significant amount of time. The “short run” is defined by how long it would take to alter that “fixed” aspect of production.

In the short run, a monopolistically competitive market is inefficient. It does not achieve allocative nor productive efficiency. Also, since a monopolistic competitive firm has powers over the market that are similar to a monopoly, its profit maximizing level of production will result in a net loss of consumer and producer surplus, creating deadweight loss.

Setting a Price and Determining Profit

Like monopolies, the suppliers in monopolistic competitive markets are price makers and will behave similarly in the short-run. Also like a monopoly, a monopolistic competitive firm will maximize its profits by producing goods to the point where its marginal revenues equals its marginal costs. The profit maximizing price of the good will be determined based on where the profit-maximizing quantity amount falls on the average revenue curve. The profit the firm makes is the the amount of the good produced multiplied by the difference between the price minus the average cost of producing the good.

profit maximizing economic profits IN SHORT RUN

long Run Outcome of Monopolistic Competition

In the long run, firms in monopolistic competitive markets are highly inefficient and can only break even.

In terms of production and supply, the “long-run” is the time period when there is no factor that is fixed and all aspects of production are variable and can therefore be adjusted to meet shifts in demand. Given a long enough time period, a firm can take the following actions in response to shifts in demand:

  • Enter an industry;
  • Exit an industry;
  • Increase its capacity to produce more; and
  • Decrease its capacity to produce less.

In the long-run, a monopolistically competitive market is inefficient. It achieves neither allocative nor productive efficiency. Also, since a monopolistic competitive firm has power over the market that is similar to a monopoly, its profit maximizing level of production will result in a net loss of consumer and producer surplus.

Setting a Price and Determining Profit

Like monopolies, the suppliers in monopolistic competitive markets are price makers and will behave similarly in the long-run. Also like a monopoly, a monopolistic competitive firm will maximize its profits by producing goods to the point where its marginal revenues equals its marginal costs. The profit maximizing price of the good will be determined based on where the profit-maximizing quantity amount falls on the average revenue curve.

While a monopolistic competitive firm can make a profit in the short-run, the effect of its monopoly-like pricing will cause a decrease in demand in the long-run. This increases the need for firms to differentiate their products, leading to an increase in average total cost. The decrease in demand and increase in cost causes the long run average cost curve to become tangent to the demand curve at the good’s profit maximizing price. This means two things. First, that the firms in a monopolistic competitive market will produce a surplus in the long run. Second, the firm will only be able to break even in the long-run; it will not be able to earn an economic profit.

Efficiency of Monopolistic Competition

Monopolistic competitive markets are never efficient in any economic sense of the term.

  • Because a good is always priced higher than its marginal cost, a monopolistically competitive market can never achieve productive or allocative efficiency.
  • Suppliers in monopolistically competitive firms will produce below their capacity.
  • Because monopolistic firms set prices higher than marginal costs, consumer surplus is significantly less than it would be in a perfectly competitive market. This leads to dead weight loss and an overall decrease in economic surplus.

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