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'Monopolistic competition' is a common market form. Many markets can be considered as monopolistically competitive, often including the markets for restaurants, cereal, clothing, shoes and service industries in large cities.
Monopolistically competitive markets have the following characteristics:

★ There are many producers and many consumers in a given market.

★ Consumers have clearly defined preferences and sellers attempt to differentiate their products from those of their competitors; the goods and services are 'heterogeneous', usually (though not always) intrinsically so.

★ There are few barriers to entry and exit^[1].

★ Producers have a degree of control over price.
The characteristics of a monopolistically competitive market are almost the same as in perfect competition, with the exception of heterogeneous products, and that monopolistic competition involves a great deal of non-price competition (based on subtle product differentiation). A firm making profits in the short run will break even in the long run because demand will decrease, average total cost will increase. This means in the long run, a monopolistically competitive firm will make zero economic profit. This gives the company a certain amount of influence over the market; it can raise its prices without losing all the customers, owing to brand loyalty. This means that an individual firm's demand curve is downward sloping, in contrast to perfect competition, which has a perfectly elastic demand schedule.

Contents

Definition of monopolistic competition

Problems

Notes

External links

Definition of monopolistic competition

A monopolistically competitive firm acts like a monopolist in that the firm is able to influence the market price of its product by altering the rate of production of the product. Unlike in perfect competition, monopolistically competitive firms produce products that are not perfect substitutes. As such, brand X's product, which is different (or at least perceived to be different) from all other brands' products, is available from only a single producer. In the short-run, the monopolistically competitive firm can exploit the heterogeneity of its brand so as to reap positive economic profit (i.e. the rate of return is greater than the rate required to compensate debt and equity holders for the risk of investing in the firm). One possible effect of advertising on a firm's long run average cost curve when earning an economic profit in the short run is to raise the curve.

In the long-run, however, whatever distinguishing characteristic that enables one firm to reap monopoly profits will be duplicated by competing firms. This competition will drive the price of the product down and, in the long-run, the monopolistically competitive firm will make zero economic profit (i.e. a rate of return equal to the rate required to compensate debt and equity holders for the risk of investing in the firm).
Unlike in perfect competition, the monopolistically competitive firm does not produce at the lowest attainable average total cost. Instead, the firm produces at an inefficient output level, reaping more in additional revenue than it incurs in additional cost versus the efficient output level.

Problems

While monopolistically competitive firms are inefficient, it is usually the case that the costs of regulating prices for every product that is sold in monopolistic competition by far exceed the benefits; the government would have to regulate all firms that sold heterogeneous products—an impossible proposition in a market economy. A monopolistically competitive firm is inefficient because the firm produces at an output where average total cost is not a minimum.
Another concern of critics of monopolistic competition is that it fosters advertising and the creation of brand names. Critics argue that advertising induces customers into spending more on products because of the name associated with them rather than because of rational factors. This is refuted by defenders of advertising who argue that (1) brand names can represent a guarantee of quality, and (2) advertising helps reduce the cost to consumers of weighing the tradeoffs of numerous competing brands. Monopolistic competition is an inefficient market structure because marginal cost is less than price in the long run.
There are unique information and information processing costs associated with selecting a brand in a monopolistically competitive environment. In a monopoly industry, the consumer is faced with a single brand and so information gathering is relatively inexpensive. In a perfectly competitive industry, the consumer is faced with many brands. However, because the brands are virtually identical, again information gathering is relatively inexpensive. Faced with a monopolistically competitive industry, to select the best out of many brands the consumer must collect and process information on a large number of different brands. In many cases, the cost of gathering information necessary to selecting the best brand can exceed the benefit of consuming the best brand (versus a randomly selected brand). Evidence suggests that consumers use information obtained from advertising not only to assess the single brand advertised, but also to infer the possible existence of brands that the consumer has, heretofore, not observed, as well as to infer consumer satisfaction with brands similar to the advertised brand.^[2]

Notes

1. Principles of Economics, Joshua Gans, Stephen King, Robin Stonecash, N. Gregory Mankiw, , , Thomson Learning, 2003, ISBN 0-17-011441-4
2. A Consumer Behavior Approach to Modeling Monopolistic Competition, Antony Davies & Thomas Cline, , , Journal of Economic Psychology, 2005

External links

★ A free business game about monopolistic competition(setup program is in Italian but application is in English)

★ Monopolistic Competition by Elmer G.

★ BasicEconomics.info - Monopolistic Competition