Monopolistic competition is a market model that involves many companies offering differentiated products (differ in quality, branding, style, and reputation) and competing with each other. The goods or services they provide to customers are similar but aren’t substitute goods.

Why is monopolistic competition inefficient?

This market model is a type of imperfect competition and is considered inefficient because of selling costs, excess capacity, lack of specialization, and unemployment. It’s worth noting that firms engaged in this kind of market system often spend a big sum of money on advertising. This step isn’t crucial since it increases the price of a product or service and thus makes a company lose leads and customers.

Very often the resources lie idle because companies don’t fully use their production capacity although it’s large. This leads to unemployment because workers have nothing to do.

Since mass production is a complicated process, companies can’t fully exploit their fixed factors. As a result, firms demonstrate excess capacity. In the long and short-run these businesses show that they are productively inefficient.

So it’s time to proceed to the features.

Characteristics of Monopolistic Competition

  • Many companies
  • The differentiation of goods
  • Low market power
  • A few barriers to entry
  • Freedom in decision-making

Let’s explore the characteristics of this market structure that will enable you to understand the principles of monopolistic competition.

  • Many companies. The market structure occurs when there are many companies that offer similar but not identical goods. These firms operate according to the rules of the market and make decisions independently from other businesses.
  • The differentiation of goods. Products and services have only a slight non-price difference. It can be the location of the product or its intangible aspects. Yet these products can’t completely replace the products of competitors. We can’t omit the fact that these goods perform a similar function. However, they still differ in quality, packaging, style, reputation, branding, appearance, etc.
  • Low market power. Firms have market power albeit very low. They have the power over the terms and conditions of exchange. Besides, companies are price makers and can increase the prices without losing customers and triggering a price war among competitors. Their power is in the number of competitors which is relatively low, independence in decision making, and differentiated goods.
  • A few barriers to entry. Businesses can easily enter and exit the market. New firms are inclined to join it when existing businesses obtain great revenue. With the arrival of new companies to the market, the supply increases, and the price decreases. This affects the profits of the existing firms and doesn’t allow these companies to obtain abnormal profits.
  • Freedom in decision-making. Firms in monopolistic competition don’t take into consideration how their decisions influence competitors. So each firm can operate without fear of starting heightened competition.

So now when you are acquainted with the features, let’s make the difference between monopolistic competition and a monopoly clear.

Monopolistic Competition vs Monopoly

In this section, we’ll review two market systems. First and foremost you should remember that these market models can be distinguished by the number of players, the presence or absence of competition, barriers to entry, and profits. So let’s dive in.

Monopolistic Competition

It is a market model in which many sellers provide products or services that are slightly different from competitors’. Products are not perfect substitutes, since they can differ in branding, style, or quality, for example. New companies can easily enter or leave this competitive environment since the barriers to entry are low. This system combines some characteristics of a monopoly and perfect competition.

Companies are price makers but they don’t possess a big market share. This market structure can be found in industries the products of which you use in your everyday life: restaurants, barbershops, clothing stores, and hotels.

Monopoly

It is a market structure in which there is only one seller that dominates the industry. Companies in monopolies usually have an advantage over possible competitors since they are the only providers of goods or services in particular industries and control most of the market share. The firm that operates a monopoly is a price maker which means that this company decides and sets the price of its goods or services. Besides, its owner can raise the price at will.

In monopolistic competition, you can find two and more sellers that compete with each other whereas in a monopoly there is only one seller. If compared with a monopoly where a company has to comply with the high standards to enter or exit, monopolistic competition has low barriers to entry which enables businesses to join the market easily.

So now that you know the difference, let’s proceed to the next section where you’ll get to know who is responsible for setting the price in this market model.

Who sets the price in monopolistic competition?

Firms are price makers which means that they set the prices. Since each company produces a unique product (that slightly differs from the competitors’ alternatives), it can decide whether to charge customers more or less money for this product. Unlike companies in oligopoly, firms in this market structure shouldn’t collude to set the prices and are independent.

To compete with rivals and win the trust and love of customers, companies often use advertising. Ads allow firms to inform consumers about their products and show how they differ from goods of other companies.

Let’s move to the advantages and disadvantages of this market model.

Advantages and Disadvantages of Monopolistic Competition

Restaurants and clothing stores, hair salons, hotels, and pubs operate under monopolistic competition. This market model along with others has its pros and cons. So it’s essential to be aware of those before entering this market structure.

The advantages of monopolistic competition include:

  • a few barriers to entry for new companies;
  • active business environment;
  • customers can obtain a great variety of products and services since the products are differentiated;
  • consumers are informed about goods and services available in the market;
  • higher quality of products;

The disadvantages include:

  • an excess waste of resources;
  • limited access to economies of scale because of the big number of companies;
  • misleading advertising;
  • excess of capacity;
  • a lack of standardized goods;
  • inefficient allocation of resources;
  • impossibility to obtain abnormal profits.

Let’s now move to the examples to understand how it works.

Examples of Monopolistic Competition

You can find this type of market structure in your day-to-day life and now we’ll prove it with some examples.

  • Fast food. McDonald’s and Burger King that offer fast food are great examples of the market model we review. They sell similar types of products but at the same time, they can’t replace each other. This is due to the difference in taste, shape, packaging, etc. Everything depends on the consumers — they decide what company to choose according to their tastes and preferences.
  • Bakeries. You can see a lot of bakeries in each town. They offer products that differ in appearance, taste, and branding. However, if there is only one bakery in a town then it can charge consumers a higher price for its products. In case, there is a bakery famous for its tasty pastry and pies and it has many clients, for sure, this place can also charge a higher price since customers are ready to pay more for taste pastry.
  • Running shoe brands. The market for running shoes is considered one with a high level of competition. Adidas, Nike, New Balance, and Reebok are just a few brands people prefer to buy. They compete for customer loyalty. Although all mentioned companies produce sneakers, their products are still unique because of the design and features each brand provides. That’s why companies have the power to charge a price that is usually different from their competitors.
  • Restaurants. In every town, you can also find a wide variety of restaurants. One can charge for a product $70 while a similar product can cost $40 at another place. This depends on many factors: place, quality, and other services.

Simply put, monopolistic competition is often considered inefficient because of the excess funds companies spend on advertising and publicity instead of increasing the quality of their products. However, this market model is a realistic one because there are many companies offering differentiated goods and there are still barriers to entry although very low. That's why you can see a lot of examples of such businesses around you: restaurants, hotels, bakeries, and stores.

Resources:

  1. This article covers the definition of the term and the characteristics of this market structure.
  2. In this article, readers can explore the difference between monopoly and monopolistic competition.
  3. This article provides readers with the advantages and disadvantages of monopolistic competition.
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