- What is Monopolistic Competition
- How Does Monopolistic Competition Work in Economics?
- What are the Characteristics of Monopolistic Competition?
- Supply-Demand Curve Graph in Monopolistic Competition
- Monopolistic Competition vs. Perfect Competition vs. Monopoly
- What are Examples of Monopolistic Competition?
What is Monopolistic Competition
Monopolistic Competition is defined as an environment wherein the market participants sell differentiated products, yet serve the same end market.
In economics, monopolistic competition is considered to be a hybrid between a monopoly and perfect competition, as the market structure blends the characteristics of each.
How Does Monopolistic Competition Work in Economics?
In the field of economics, monopolistic competition refers to a market structure that entails many companies (i.e. sellers) offering a differentiated product but with a virtually identical utility to the end-user.
While the products might be largely the same in their intended purpose, i.e. the benefit received by the customer, there are still attributes that cause the products to be somewhat differentiated.
Therefore, in an environment of monopolistic competition, market participants compete on quality, price, and marketing.
The most common characteristics of monopolistic competition are as follows:
- High Number of Market Participants: In monopolistic competition, there are many independent companies involved that actively compete within the market.
- Differentiated Products to Serve an Identical End-Market: Each company produces and sells a differentiated product, but the function of the product is comparable, i.e. the product has many close substitutes, although there is no perfect substitute.
- Low Barriers to Entry: Another unique feature of monopolistic competition is the freedom of entry and exit present in the market. Entrance and competing in the market are relatively easy for new companies (and it is also easy to exit), but of course, there is the opportunity cost of time to consider.
What are the Characteristics of Monopolistic Competition?
Companies in monopolistic competition often operate with excess capacity, meaning there is a mismatch in supply and demand.
The reason for the inefficiency is that these companies must strategize methods to differentiate their offerings from the rest of the market.
For example, a company can overspend on marketing and advertising, or focus too much on the non-core components of a product such as the packaging material rather than focusing on product capabilities.
Differentiated products can be identified by consumers by their specific marketing tactics, branding, and quality. The products sold can be different on the basis of the following aspects:
- Product Quality
- Marketing Tactics
- Branding, i.e. Public Perception
- Stylistic Add-On Features
- End-User Convenience
- Geographical Location
Notably, a market with monopolistic competition comprises a high number of active competitors in the space that each sell product(s) to serve the same or an adjacent end-market. In effect, consumers have more options in terms of which product to purchase.
The market participants compete on many of the traits listed above and try to improve upon their offerings in order to grab more market share. The specific factors that differentiate the company’s offerings tend to dictate its marketing and sales strategy.
The drawback to the ease of entry into such a market is that the news of selling products at high-profit margins spreads quickly and eventually causes an increasing number of new companies to enter the market.
Low barriers to entry indicate that new entrants encounter minimal challenges when entering the market, or at least not enough in comparison to a monopoly. The absence of high barriers to entry means that no company can make outsized economic profits over the long run.
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Enroll TodaySupply-Demand Curve Graph in Monopolistic Competition
In general, the demand for a specific product declines as more companies enter and obtain a piece of the market.
Demand is highly elastic in monopolistic competition. If demand is highly elastic, consumers are very responsive to changes in prices and will switch to a different brand as the product function is only marginally different.
The relationship between competition and pricing is that an increase in competition directly causes a reduction in the overall profitability of the industry (and vice versa).
The total economic profit and margins erode over time, resulting in the curve being shaped in a downward slope pattern.
The industry-wide economic profits observed across the short run that initially attracted more companies to enter the market tend to peak early on.
But gradually over the long run, the previous level of profitability starts to noticeably reduce with time, and eventually, fewer companies enter the industry, as the market opportunity is no longer as compelling as it used to be.
From the perspective of the companies involved, operating in a market with monopolistic competition is unsustainable in the long term. Typically, such markets eventually reach a stage when there is no monetary incentive to drive new entrants into the market in question.
Short-Run and Long-Run Monopolistic Competition Diagram (Source: Economicshelp.org)
Monopolistic Competition vs. Perfect Competition vs. Monopoly
- Perfect Competition: In a perfectly competitive market, each company possesses such minimal market share that no individual seller can influence the industry-wide pricing of the product or service, i.e. each company is a price taker.
- Monopolistic Competition: Compared to perfect competition, monopolistic competition is not price-oriented. Instead, the companies produce similar but still differentiated products and competition is not on the basis of pricing. If displayed on a supply-demand graph, perfect competition would demonstrate perfectly elastic demand, while monopolistic competition would show a downward sloping curve. Because of the excess capacity, the potential markup in perfect competition is near zero, i.e. the selling price equals the marginal cost. In contrast, a markup is present in monopolistic competition since the price exceeds the marginal cost, especially early on in the industry lifecycle.
- Monopoly: On the other hand, a monopoly would be placed at the opposite end of the spectrum as perfect competition. In a monopoly, a single company holds enough influence to be capable of changing the price of a good or service at its discretion, i.e. “market power”. But in monopolistic competition, there is no single company with sufficient influence over the market to control prices. In fact, companies can freely enter the market and compete for market share up until the point at which there are too many participants.
What are Examples of Monopolistic Competition?
Commonly cited examples of industries with monopolistic competition are the following:
- Grocery Stores
- Restaurants, e.g. Fast Food Chains
- Retail Clothing and Footwear, e.g. Shoe Stores
- Stylists, e.g. Hair Dressers
- Hospitality Industry, e.g. Hotels
A real-life example of monopolistic competition would be the carbonated soft drink beverage industry, where incumbents such as Coca-Cola compete on branding and advertising.
While a large proportion of consumers would be open to paying more for a Coca-Cola drink, as opposed to a non-branded drink, the premium (i.e. pricing power) is capped.
If the Coca-Cola Company (NYSE: KO) were to hypothetically raise the pricing of their canned drinks to $100 per can, the vast majority of their customers would not remain a customer.
Other competitors would also not follow suit by raising prices. Instead, most would likely view it as an opportunity to capitalize on, taking as much market share as possible.
