Monopolistic Competition

In Monopolistic Competition, there are many small firms who all have minimal shares of the market. Firms have many competitors, but each one sells a slightly different product. Firms are neither price takers (perfect competition) nor price makers (monopolies).

Example of Monopolistic Competition

The athletic shoe market:

When you walk into a sports store to buy running shoes, you will find a number of brands, like Nike, Adidas, New Balance, ASICS, etc.

  • On the one hand, the market for running shoes seems to be full of competition, with thousands of competing brands and low barriers to entry.
  • However, on the other hand, the market seems to be monopolistic, due to the uniqueness of each shoe brand and their power to charge a different price.

Characteristics of Monopolistic Competition

1. Product Differentiation

Products are differentiated (based on things like service, quality or design). The product of a firm is close, but not a perfect substitute for another firm. This differentiation gives some monopoly power to an individual firm to influence the market price of its product.

2. Barriers to Entry

There are no barriers to entry. It ensures that there are neither supernormal profits nor any supernormal losses to a firm in the long run.

3. Number of Sellers

There are large numbers of firms selling closely related, but not homogeneous products. Each firm acts independently and has a limited share of the market. So, an individual firm has limited control over the market price.

4. Marketing

Products are differentiated, and these differences are made known to the buyers through advertisement and promotion. These costs constitute a substantial part of the total cost under monopolistic competition.

5. Perfect Knowledge

There is imperfect knowledge in the market. People don’t know who is selling the good the cheapest or who has the best quality. Sometimes a higher priced product is preferred even though it is of inferior quality.

Monopolistic Competition: Short & Long Run Equilibrium

The Monopolistic Competition graph is the same as the monopolies graph. The firm has the same short and long equilibrium and makes zero economic profits. Using the Profit Maximization Rule, MC = MR, we can find the quantity and draw a vertical line to the Demand curve, and thus find the corresponding price. The cost is found by drawing a vertical line from where Quantity meets the Average Cost curve to the price line.

Any signs of supernormal profits would create an incentive for more firms to enter the market, and since there are no barriers to entry, companies will join to make supernormal profits. This process will continue until everyone makes normal or zero economic profits in the long run. Even though normal profits are break-even, it includes profits for the entrepreneur for taking on risk.

Even though there is allocative inefficiency (where Price exceeds Marginal Cost) in monopolistic competition, there is a greater variety of products for the customer to select. However, costs rise because firms are forced to spend money on advertising.

Monopolistic Competition Short and Long Run Equilibrium
Short & Long Run Equilibrium
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