Monopolistic Competition

16/04/2020 1 By indiafreenotes

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.

Features of monopolistic competition

The main features of monopolistic competition are as under:

  1. Large Number of Buyers and Sellers

There are large number of firms but not as large as under perfect competition.

That means each firm can control its price-output policy to some extent. It is assumed that any price-output policy of a firm will not get reaction from other firms that means each firm follows the independent price policy.

If a firm reduces its price, the gains in sales will be slightly spread over many of its rivals so that the extent to which each of the rival firms suffers will be very small. Thus these rival firms will have no reason to react.

  1. Free Entry and Exit of Firms

Like perfect competition, under monopolistic competition also, the firms can enter or exit freely. The firms will enter when the existing firms are making super-normal profits. With the entry of new firms, the supply would increase which would reduce the price and hence the existing firms will be left only with normal profits. Similarly, if the existing firms are sustaining losses, some of the marginal firms will exit. It will reduce the supply due to which price would rise and the existing firms will be left only with normal profit.

  1. Product Differentiation

Another feature of the monopolistic competition is the product differentiation. Product differentiation refers to a situation when the buyers of the product differentiate the product with other. Basically, the products of different firms are not altogether different; they are slightly different from others. Although each firm producing differentiated product has the monopoly of its own product, yet he has to face the competition. This product differentiation may be real or imaginary. Real differences are like design, material used, skill etc. whereas imaginary differences are through advertising, trade mark and so on.

  1. Selling Cost

Another feature of the monopolistic competition is that every firm tries to promote its product by different types of expenditures. Advertisement is the most important constituent of the selling cost which affects demand as well as cost of the product. The main purpose of the monopolist is to earn maximum profits; therefore, he adjusts this type of expenditure accordingly.

  1. Lack of Perfect Knowledge

The buyers and sellers do not have perfect knowledge of the market. There are innumerable products each being a close substitute of the other. The buyers do not know about all these products, their qualities and prices.

Therefore, so many buyers purchase a product out of a few varieties which are offered for sale near the home. Sometimes a buyer knows about a particular commodity where it is available at low price. But he is unable to go there due to lack of time or he is too lethargic to go or he is unable to find proper conveyance. Likewise, the seller does not know the exact preference of buyers and is, therefore, unable to get advantage out of the situation.

  1. Less Mobility

Under monopolistic competition both the factors of production as well as goods and services are not perfectly mobile.

  1. More Elastic Demand

Under monopolistic competition, demand curve is more elastic. In order to sell more, the firms must reduce its price.

Characteristics of Monopolistic Competition

Monopolistically competitive markets exhibit the following characteristics:

  1. Each firm makes independent decisions about price and output, based on its product, its market, and its costs of production.
  2. 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.
  3. The entrepreneur has a more significant role than in firms that are perfectly competitive because of the increased risks associated with decision making.
  4. There is freedom to enter or leave the market, as there are no major barriers to entry or exit.
  5. 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.
  6. Differentiation through distribution, including distribution via mail order or through internet shopping, such as, which differentiates itself from traditional bookstores by selling online.
  7. 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.
  8. 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.
  9. Monopolistically competitive firms are assumed to be profit maximizers because firms tend to be small with entrepreneurs actively involved in managing the business.
  10. There are usually a large numbers of independent firms competing in the market.

Examples of monopolistic competition

  • Restaurants: restaurants compete on quality of food as much as price. Product differentiation is a key element of the business. There are relatively low barriers to entry in setting up a new restaurant.
  • A service which will give firms a reputation for the quality of their hair-cutting.
  • Designer label clothes are about the brand and product differentiation
  • TV programmes: globalization has increased the diversity of tv programmes from networks around the world. Consumers can choose between domestic channels but also imports from other countries and new services, such as Netflix.

Limitations of the model of monopolistic competition

  • Some firms will be better at brand differentiation and therefore, in the real world, they will be able to make supernormal profit.
  • New firms will not be seen as a close substitute.
  • There is considerable overlap with oligopoly except the model of monopolistic competition assumes no barriers to entry. In the real world, there are likely to be at least some barriers to entry
  • If a firm has strong brand loyalty and product differentiation this itself becomes a barrier to entry. A new firm can’t easily capture the brand loyalty.
  • Many industries, we may describe as monopolistically competitive are very profitable, so the assumption of normal profits is too simplistic.