Monopolistic competition is a market structure in which many firms sell products that are similar but not identical. Monopolistic competition describes a market with the following attributes:
there are many firms competing for the same group of customers
Each firm produces a product that is at least slightly different from those of other
Firms can enter or exit the market without restriction.
Monopolistic competition, like oligopoly, is a market structure that lies between the extreme cases of competition and monopoly.
- 1 Competition with differentiated products
- 2 Advertising
Competition with differentiated products
To understand monopolistically competitive markets, we first consider the decisions facing an individual firm.
The monopolistically competitive firm in the short run
Each firm in a monopolistically competitive market is like a monopoly. Because its product is different from those offered by other firms, it faces a downward sloping
demand curve. Thus, the monopolistically competitive firm follows a monopolit’s rule for profit maximation: it chooses the quantity at which marginal revenue equals marginal cost and then uses its demand curve to find the price consistent with that quantity. In the short run, the monopolistically competitive market structure and the monopolist market structure are similar.
The long run equilibrium
When firms are making profits new firms have an incentive to enter the market. This entry increases the number of products from which customers can choose and, therefore, reduces the demand faced by each firm already in the market. In other words, profit encourages entry, and entry shifts the demand curves faced by the incumbent firms to the left. As the demand for incumbent firms’ products falls, these firms experience declining profit. Conversely, when firms are making losses firms in the market have an incentive to exit.
This process of entry and exit continues until the firms in the market are making exactly zero economic profit. The demand curve and the average total cost curve must be tangent once entry and exit have driven profit to zero. Because the profit per unit sold is the difference between price and average total cost, the maximum profit is zero only if these two curves touch each other without crossing.
To sum up, two characteristics describe the long-run equilibrium in a monopolistically competitive market:
- As in a monopoly market, price exceeds marginal cost. This conclusion arises because a profit maximization requires marginal revenue to equal marginal cost and because the downward sloping demand curve makes marginal revenue less than price.
- As in a competitive market, price equals average total cost. This conclusion arises because free entry and exit drive economic profit to zero.
Monopolistic versus perfect competition
There are two noteworthy differences between monopolistic and perfect competition: excess capacity and the mark-up.
Excess capacity: The quantity of output in a competitive market is smaller than the quantity that minimizes average total cost. Thus, under monopolistic competition, firms produce on the downward sloping portion of their average total cost curves. The quantity that minimizes average total cost is called the efficient scale of the firm. Whereby firms are said to have excess capacity under monopolistic competition.
Mark-up over marginal cost
For a competitive price equals marginal cost. For a monopolistically competitive firm, price exceeds marginal cost, because the firm always has some market power.
Monopolistic competition and the welfare of society
A monopolistically competitive market has the normal deadweight loss of monopoly pricing. There is no easy way for policy makers to fix this problem, because the policymakers would need to regulate all firms that produce differentiated products. Because such products are so common, the administrative burden of such regulation would be overwhelming. Also monopolistic competitors are making zero profits. A regulation would make them have losses.
Another way in which monopolistic competition may be socially inefficient is that the number of firms in the market may not be the ideal one. Whenever a new firm considers entering the market with a new product, it considers only the profit it would make. Yet its entry would also have two external effects:
- The product-variety-effect
- The business-stealing-effect
Both of these externalities are closely related to the conditions for monopolistic competition.
When firms sell differentiated products and charge prices above marginal cost, each firm has an incentive to advertise in order to attract more buyers to its particular product. The amount of advertising varies substantially across products. Firms that sell highly differentiated consumer goods typically spend between 10 and 20 per cent of revenue for advertising. Firms that sell industrial products typically spend very little on advertising and firms that sell homogenous products spend nothing at all.
The debate over advertising
Critics of advertising argue that firms advertise in order to manipulate people’s tastes. Much advertising is psychological rather than informational. They also argue that advertising impedes competition. Advertising often tries to convince consumers that products are more different than they truly are.
Defenders of advertising argue that firms use advertising to provide information to customers. Defenders also argue that advertising fosters competition. Because it allows customers to be more fully informed about all the firms in the market, customers can more easily take advantage of price difference.
Advertising as a Signal of quality
Many types of advertising contain little apparent information about the product being advertised. Defenders of advertising argue that even advertising that appears to contain little hard information may in fact tell consumers something about product quality. The willingness of the firm to spend a large amount of money on advertising can itself be a signal to consumers about the quality of the product being offered. What is most surprisingly about this theory of advertising is, that the content of the advertisement is irrelevant. A firm signals the quality of its product by its willingness to spend money on advertising.
Advertising is closely related to the existence of brand names. In many markets, there are two types of firms. Some firms sell products with widely recognized brand names, while other firms sell generic substitutes. Most often, a firm with a famous brand name spends more on advertising and charges a higher price for its product.
Critics of brand names argue that brand names cause consumers to perceive differences that do not really exist. Economists have defended brand names as a useful way for consumers to ensure that the goods they buy are of high quality. First, brand names provide consumers with information about quality. Second, brand names give firms an incentive to maintain high quality.
The debate over brand names thus centres on the question of whether consumers are rational in preferring brand names over generic subsitiutes.