Monopolistic competition is an interesting form of competition found in certain industries that feature characteristics of monopolies and competitive firms
Monopolistic competition has the following characteristics:
There are few barriers to entry into the market and it is easy for firms to recoup their capital expenditure on exit from the market.
Firms have some influence on the market price and are therefore price makers.
Monopolistic competition arises when the market comprises many producers who tend to use product differentiation to distinguish themselves from others.
Although their products may be very similar, because producers differentiate their products they are able to create a short-term 'monopoly', as customers see their product as unique. Therefore, for monopolistic competition to exist, consumers must perceive differences in the products offered by different firms.
Examples of monopolistic competition
Restaurants – restaurants compete on both price and food quality. Differentiation of products is an important aspect of the business. When it comes to opening a new restaurant, the barriers to entry are relatively low.
Hairdressers. A service that will help businesses establish a reputation for high-quality hair-cutting.
Clothing. It's all about the brand and product differentiation when it comes to designer label clothing.
TV shows – as a result of globalisation, the variety of television shows available from around the world has increased. Consumers can choose between domestic channels but also imports from other countries and new services, such as Netflix.
Limitations of the Monopolistic Competition Model
Some businesses will be better at brand differentiation than others, allowing them to make above-average supernormal profits in the real world.
New companies will not be seen as as a close substitute.
There is significant overlap with oligopoly – except that the model of monopolistic competition assumes no entry barriers. In the real world, there will almost certainly be some barriers to entry.
When a company has strong brand loyalty and product differentiation, it becomes a barrier to entry. A new company will find it difficult to gain brand loyalty.
Many industries that we might describe as monopolistically competitive are particularly profitable, so assuming normal profits is overly simplistic.
The main distinction between monopoly and monopolistic competition
There are no barriers to entry in monopolistic competition. As a result, in the long run, the market will be competitive, with firms earning normal profits.
The main distinction between perfect competition and monopolistic competition
Firms in monopolistic competition produce differentiated products and thus are not price takers (perfectly elastic demand). They have inelastic demand.
If typical firms are earning abnormal profit, new firms will enter the industry in the long run. As they do, they will take some of the customers away from established firms. The demand for the established firms will therefore fall. Their demand (AR) curve will shift to the left, and will continue doing so as long as abnormal profits remain and thus new firms continue entering.
Long-run equilibrium is reached when only normal profits remain: when there is no further incentive for new firms to enter.
The firm’s demand curve settles at D=AR, where it is tangential to the firm’s ATC curve. Output will be Q: where AR = ATC.
At any other output, ATC is greater than AR and thus less than normal profit would be made.