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 less deadweight loss than a monopoly. The major benefit of monopolistic competition is the supply of a wide variety of goods and services.

Monopolistic competition exists:

Firms do have some control over price, but it is limited by the close substitution of similar products.

Product Differentiation

Monopolistic competition cannot exist unless there is at least a perceived difference among products provided by the firms in the industry. The major tool of competition is product differentiation, which results from differences in product quality, location, service, and advertising. Product quality can differ in function, design, materials, and workmanship. Location is often a good differentiator of products. Generally, firms more conveniently located can charge higher prices. Likewise, stores open extended hours also provide convenience. For instance, if you need cold medicine in the middle of the night, you may go to a 24-hour drugstore to purchase the medicine, even if it is at a higher price, since you want immediate relief. Services include time of availability, the firm's reputation for servicing or exchanging products, and speed of service.

There are many examples of product differentiation 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. Clothes retailers sell different types of clothing at different prices, where people pay not only for good workmanship, but also for items that suit their taste.

Books are an excellent example of monopolistic competition because they vary in their prices, quality of workmanship, 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 will have many minor categories and the minor categories are also distinguished by the writing styles of the authors.

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 reviews of the products by consumers who actually bought the product. Other important qualities include trustworthiness of the firm and return policies.

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 amount of investment is generally larger than for pure competition, since there is an expense to developing differentiated products and for advertising. A primary feature of monopolistic competition is the constantly changing array of products that are competing in the marketplace. Firms must continually experiment with product, 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 where firms are losing money — thus, allowing the remaining firms to earn a normal profit.

Advertising and Brand Names

When there are only small differences between 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, in that they compel consumers to pay a higher price if they perceive — rightly or wrongly — that the quality is greater. Advertising serves to inform customers of the differentiated products and why they are superior over close substitutes. Even if there are no differences, as is often the case between store brands and national brands, or between a brand name drug and its generics, a consumer can still prefer one brand over another because of the advertising.

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

Advertising may also be used to build a brand image, which is the association of a lifestyle, or words or images that people will associate with the brand, rather than describing specific characteristics of the product itself. This type of advertising is often used for products that are mostly differentiated by personal taste, such as the 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.

The main benefit of brand names to consumers is that it allows them to 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, brand names give an incentive for the firm to maintain product quality so that the brand continues to be perceived as having value by the consumers.

Advertising also helps firms in ways besides increasing market share or building brand awareness. Advertising can help a company increase the quantity of 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

Diagram showing how advertising can lower a firms costs by increasing economies of scale.

As can be seen in this diagram, advertising will increase costs, shifting the ATC curve from ATC1 up to ATC2, but average costs may be lower if the advertising allows the firm to sell enough quantity so that it moves to a lower part of the ATC curve, as illustrated here.

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

However, advertising does have 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 that are not the best value for their money. Even comparisons with competing products are often misleading. Some people counter argue that if a firm is willing to spend a lot of money advertising, then they will have an incentive to maintain good quality so that people continue buying the product.

Nonetheless, many products and services are marketed that are not in the best interest of the consumer, such as debt consolidation services. Furthermore, it is difficult to compare many products or services directly, since the benefits and costs are not directly observable before buying, such as the services provided by professionals, like doctors, dentists, or lawyers. Many people also pay more money for identical products because of the advertising. For instance, 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 the generics are equally effective.

Like most other things, advertising has its benefits and drawbacks, but it will remain one of the primary tools of monopolistically competitive firms.