Monopolistic Competition

Report by: MA. RONNETH P. LAYUG

KAYLE ANN PETALIO

MONOPOLISTIC COMPETITION

Monopolistic competition is a market structure which combines

elements of monopoly and competitive markets. Essentially a monopolistic
competitive market is one with freedom of entry and exit, but firms can
differentiate their products. Therefore, they have an inelastic demand curve
and so they can set prices. However, because there is freedom of entry,
supernormal profits will encourage more firms to enter the market leading to
normal profits in the long term.

KEY TAKEAWAYS

✔ Monopolistic competition occurs when an industry has many

firms offering products that are similar but not identical.
✔ Unlike monopoly, these firms have little power to set curtail
supply or raise prices to increase profits.
✔ Firms in monopolistic completion typically try to differentiate
their product in order to achieve and to capture above market
returns.
✔ Heavy advertising and marketing is common among firms in
monopolistic competition and some economist criticize this as
wasteful.

THREE BASIC CHARACTERISTICS

✔ There are large number of independent sellers and buyers in the

market.
✔ The relative market shares of all sellers are insignificant and
more or less equal.
 ✔ There are any legal nor any economic barriers against the entry
of new firms into the market. New firms are free to enter the
market and existing firms are free to leave the market.
✔ Product differentiation is the only characteristic that
distinguishes monopolistic competition from perfect competition.

PRODUCT DIFFERENTIATION

There are relatively few options for sellers to differentiate their

offerings from other firms. There might be “discount” varieties that are of
lower quality, but it is difficult to tell whether the higher-priced options are in
fact any better. This uncertainty results from imperfect information: the
average consumer does not know the precise differences between the
various products, or what the fair price for any of them is.

DECISION-MAKING

Monopolistic competition implies that there are enough firms in the

industry that one firms’ decision does not set off a chain reaction.

PRICING POWER

Firms in monopolistic competition are price setters or makers rather

than price takers. However, the firms nominal ability to set their prices is
effectively offset by the fact that demand for their products is highly price
elastic. In order to actually raise their prices, the firms must be able to
differentiate their product from their competitors by increasing its quality,
real or perceived.

DEMAND ELASTICITY

Due to range of similar offerings, demand is highly elastic in

monopolistic competition. In other words, demand is very responsive to price
changes.

ADVERTISING IN MONOPOLISTIC COMPETITION

 Firms in monopolistic competition spend large amounts real resources
on advertising and other forms of marketing. When there is a real difference
between the products of different firms, which the consumer might not be
aware of, these expenditures can be useful. However, if it is instead the case
that the products are near perfect substitutes, which is likely in monopolistic
competition, ten real resources spent on advertising and marketing represent
a kind of wasteful rent-seeking behaviour, which produces a deadweight loss
to society.

Efficiency of firms in monopolistic competition

 Allocative inefficient. The above diagrams show a price set above

marginal cost

 Productive inefficiency. The above diagram shows a firm not producing

on the lowest point of AC curve

 Dynamic efficiency. This is possible as firms have profit to invest in

research and development.

 X-efficiency. This is possible as the firm does face competitive pressures

to cut cost and provide better products

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.
 Key difference with monopoly

In monopolistic competition there are no barriers to entry. Therefore in long

run, the market will be competitive, with firms making normal profit.

Key difference with perfect competition

In Monopolistic competition, firms do produce differentiated products,

therefore, they are not price takers (perfectly elastic demand). They have
inelastic demand.

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.

 Hairdressers. A service which will give firms a reputation for the quality
of their hair-cutting.

 Clothing. Designer label clothes are about the brand and product
differentiation

 TV programmes – globalisation 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.