Monopolistic competition is a market model that involves many companies offering differentiated products (differing in quality, branding, style, and reputation) and competing with each other. The goods or services they provide to their 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 significant sums of money on advertising. This step isn't crucial since it increases the price of a product or service and makes a company lose leads and customers.

The resources often lie idle because companies don't fully use their production capacity despite it being 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, and it results in firms demonstrating excess capacity. In the long and short run, these businesses show that they are productively inefficient.

Now that we have cleared that up, it's time to proceed to the features of monopolistic competition.

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. This market structure works out when many companies 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. However, 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, and appearance.
  • Low market power. Firms have market power, albeit very low. They have control 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 their competitors. Their power lies 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, 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. Therefore, each firm can operate without fear of starting heightened competition.

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'. These products are not perfect substitutes since they can differ in branding, style, or quality. New companies can easily enter or leave this competitive environment as the barriers to entry are low. This system combines some characteristics of a monopoly and perfect competition.

Companies in monopolistic competition 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, including restaurants, barbershops, clothing stores, or 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 for 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.

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?

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.

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

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. Just like any other market model, it has its pros and cons. It's essential to be aware of those before entering this market structure.

The advantages of monopolistic competition include:

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

The disadvantages include:

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

Let's now move to the examples to understand how it all 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 are great examples of the market model we review. They sell similar types of products, but they can't replace each other. This is due to the difference in taste, shape, packaging, etc. Everything depends on their 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, it can charge consumers a higher price for its products. In case there is a bakery famous for its tasty pastry, and it has many clients, for sure, this place can also charge a higher price since customers are ready to pay more for the quality of products.
  • 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 from which people prefer to buy. They compete for customer loyalty. Although all the mentioned companies produce sneakers, their products are still unique because of each brand's design and features. That's why companies have the power to charge a price that is usually different from their competitors.
  • Restaurants. You can find a wide variety of restaurants in any town. One can charge $70 for a product, while a similar one can cost $40 at another place. This depends on many factors, including location, 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 realistic because many companies offer differentiated goods, and there are still barriers to entry, albeit very low. That's why you can see a lot of examples of such businesses around you.

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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