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ECONOMY ECONOMICS

Monopolistic Competition
REVIEWED BY JIM CHAPPELOW

Updated May 1, 2019

What is Monopolistic Competition?
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

KEY TAKEAWAYS

 Monopolistic competition occurs when an industry has many firms offering products that
are similar but not identical.
 Unlike a monopoly, these firms have little power to set curtail supply or raise prices to
increase profits.
 Firms in monopolistic competition typically try to differentiate their product in order to
achieve in order to capture above market returns.
 Heavy advertising and marketing is common among firms in monopolistic competition
and some economists criticize this as wasteful.
Volume 75%

1:46

Monopolistic Competition

Understanding Monopolistic Competition

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. To illustrate the characteristics of monopolistic competition,
we'll use the example of household cleaning products.

Number of firms
Say you've just moved into a new house and want to stock up on cleaning supplies. Go to the
appropriate aisle in a grocery store, and you'll see that any given item—dish soap, hand soap,
laundry detergent, surface disinfectant, toilet bowl cleaner, etc.—is available in a number of
varieties. For each purchase you need to make, perhaps five or six firms will be competing for
your business.
Product Differentiation
Because the products all serve the same purpose, 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.

Monopolistic competition tends to lead to heavy marketing, because different firms need to
distinguish broadly similar products. One company might opt to lower the price of their cleaning
product, sacrificing a higher profit margin in exchange—ideally—for higher sales. Another
might take the opposite route, raising the price and using packaging that suggests quality and
sophistication. A third might sell itself as more eco-friendly, using "green" imagery and
displaying a stamp of approval from an environmental watchdog (which the other brands might
qualify for as well, but don't display). In reality, every one of the brands might be equally
effective.

Decision-Making
Monopolistic competition implies that there are enough firms in the industry that one firm's
decision does not set off a chain reaction. In an oligopoly, a price cut by one firm can set off
a price war, but this is not the case for monopolistic competition.

Pricing Power
As in a monopoly, 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 the range of similar offerings, demand is highly elastic in monopolistic competition. In
other words, demand is very responsive to price changes. If your favorite multipurpose surface
cleaner suddenly costs 20% more, you probably won't hesitate to switch to an alternative, and
your counter tops probably won't know the difference.

Economic Profit
In the short run, firms can make excess economic profits. However, because barriers to entry are
low, other firms have an incentive to enter the market, increasing the competition, until overall
economic profit is zero. Note that economic profits are not the same as accounting profits; a firm
that posts a positive net income can have zero economic profit, since the latter
incorporates opportunity costs.

Advertising in Monopolistic Competition

Economists who study monopolistic competition often highlight the social cost of this type of
market structure. Firms in monopolistic competition expend 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 consume 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, then real resources spent on advertising and marketing represent a
kind of wasteful rent-seeking behavior, which produces a deadweight loss to society.

Related Terms

Understanding Perfect Competition

Pure or perfect competition is a theoretical market structure in which a number of criteria such as
perfect information and resource mobility are met.
more
How a Monopoly Works
A monopoly occurs when a company and its offerings dominate an industry. Although many
monopolies are illegal, some are government sanctioned.
more
How Substitutes Work
A substitute, or substitute good, is a product or service that a consumer sees as the same or
similar to another product.
more
Price Maker
A price maker is an entity with a monopoly that has the power to influence the price it charges as
the good it produces does not have perfect substitutes.
more
The Characteristics of Monopolistic Markets
A monopolistic market is typically dominated by one supplier and exhibits characteristics such
as high prices and excessive barriers to entry.
more
What You Need to Know About Market Power
Market power describes a company's relative ability to manipulate the price of an item by
manipulating the level of supply, demand or both.
more
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