Monopolistic Competition

Monopolistic competition is a market structure characterized by many firms selling products that are similar but not identical, so firms compete on other factors besides price. Monopolistic competition implies imperfect competition because the market structure is between pure monopoly and pure competition.

Economic efficiency is also middling. Competitive markets provide efficient outcomes; monopoly markets exhibit deadweight losses. Monopolistic competition is somewhere in between, not as efficient as pure competition but with less deadweight loss than a monopoly. The major benefit of monopolistic competition is the supply of a wider variety of goods and services.

Monopolistic competition exists where:

• there are many sellers with slightly different products or services, each with a small market share;
• the small interdependence among firms allows them to price their product with little regard for how the competition will react;
• too many firms make it unlikely they will collude to fix prices.

Firms have some control over price, but it is limited by the similarity of their offerings, allowing consumers to substitute a more expensive product for a similar, less expensive one.

Product Differentiation

Monopolistic competition cannot exist unless there is some perceived difference among products or services or in convenience provided by the firms in the industry.

Product differentiation results from differences in product quality, function, design, materials, or workmanship. Many examples of product differentiation exist in modern economies. Restaurants serve different menu items at different prices in different locations, thus providing varying degrees of time and place utility. Furniture stores sell different types of furniture made of different materials, such as oak, walnut, cherry, and maple. Clothing retailers sell different types of clothing at different prices, where people pay not only for quality but also for items that suit their taste.

Books are an excellent example of monopolistic competition because they vary in their prices, physical quality, readability, quality of illustrations, or the lack thereof, and differ according to target audience and subjects, such as college textbooks and novels. Each major category has minor categories and the minor categories are also distinguished by the writing styles of the authors.

The differentiation of service offerings often depends on marketing, especially advertising, a quality online presence, and good customer reviews. Shopping convenience includes time of availability, the firm's reputation for servicing or exchanging products, and speed of service. Location is often a major consideration for purchases. Firms with more convenient locations can charge higher prices. Likewise, stores open extended hours also provide convenience. If you need cold medicine in the middle of the night, you may go to a 24-hour drugstore to purchase the medicine, even for a higher price, since you want immediate relief.

Another major factor differentiating firms is marketing, especially advertising. A firm could sell its products for higher prices with better marketing; people are not going to buy what they did not know about. Advertising and a good online presence also help to build trust.

A new front of monopolistic competition occurs among online retailers. In this case, their location does not really matter. What matters is the convenience of shopping online, how well the products are described, and product reviews by consumers who actually bought the product. Trustworthiness of the firm and return policies are more important for online retailers, especially for retailers without local physical stores.

Easy Entry And Exit

Because most firms engaged in monopolistic competition have low capital requirements, firms can easily enter or exit the market. However, the investment needed is usually larger than for pure competition since money is needed to develop differentiated products and to advertise. A primary feature of monopolistic competition is the constantly changing array of products competing in the marketplace. Firms must continually experiment with products, prices, and advertising to see what yields the greatest profit. Although this leads to productive and allocative inefficiency, the variety of goods offered more than compensates for this inefficiency.

With easy entry and exit, firms will enter a market where present firms are earning an economic profit and will exit the market if they lose money — thus, allowing the remaining firms to earn a normal profit.

Advertising and Brand Names

With only small differences among products, product differentiation would not be useful unless it can be communicated to the consumer. This communication is accomplished through advertising, brand names, and packaging, which are forms of nonprice competition. They compel consumers to pay a higher price if they perceive — rightly or wrongly — that the quality is greater. Advertising informs customers of the differentiated products and why they are superior over close substitutes. Even without differences, as is often the case between store and national brands, or between brand-name drugs and their generics, consumers may still prefer one brand because of the advertising.

Brand names distinguish identical or nearly identical products and increase the value of advertising. A brand name serves as an object to which desirable characteristics can be attached. Advertising builds brand awareness or loyalty to a particular company.

Advertising may also be used to build a brand image, associating a lifestyle or words or images with the brand that people will like rather than describing specific product characteristics. This type of advertising is often used for products differentiated by personal taste, such as advertising for soft drinks. The bandwagon effect is also often used, where the advertising tries to convey that more people prefer a particular brand. Celebrities are often used for this type of advertising.

Brand names benefit consumers because they can readily identify the product, and brand names are well protected by law so that competing firms cannot try to deceive customers by closely imitating an established brand name. Moreover, firms will maintain product quality so that their brands continue to be preferred by consumers.

Advertising also helps in other ways. More sales from advertising help a company to increase production, which usually leads to lower prices, since fixed costs are spread over a larger quantity of product.

Next: Monopolistic Competition: Short-Run Profits and Losses, and Long-Run Equilibrium

Advertising allows new firms to attract customers who are buying competing products, thus allowing easier entry of new firms. Advertising also informs customers of price differences so that they can buy at lower prices. Advertising is also beneficial for products or services that cannot easily be compared, such as the services provided by professionals like doctors, dentists, or lawyers.

In the past, professional firms, such as doctors and lawyers, were prohibited from advertising prices because it was considered unprofessional. However, the courts decided that the real reason was to limit competition, so they overturned the many state laws prohibiting some advertisements.

Many also pay more money for identical products because of advertising. For instance, eye contacts are made by only a few companies but are marketed by many opticians, who charge widely varying prices. Likewise, people often buy brand-name drugs over generics even though generics are equally effective.

However, advertising has its critics. Advertising often does not convey true information or conveys misleading information, causing consumers to buy products that are not in their best interest or the best value for their money. Even comparisons with competing products are often misleading. Some people counterargue that if a firm is willing to spend on advertising, they will maintain good quality so that people continue buying the product.

Advertising has its benefits and drawbacks, but it will remain a primary tool of monopolistically competitive firms.