Monopolistic competition refers to a market structure that falls between perfect competition and pure monopoly, exhibiting features of both.
It involves many firms selling similar but not identical products.
Attributes of Monopolistic Competition
Many Sellers: Numerous firms compete for the same customer base. Examples include books, CDs, movies, computer games, restaurants, piano lessons, cookies, furniture, etc.
Product Differentiation: Each firm produces a slightly different product, leading to a downward-sloping demand curve instead of being a price taker.
Free Entry and Exit: Firms can freely enter or exit the market, adjusting the number of firms until economic profits are zero.
Competition with Differentiated Products
Short-Run Behavior: Short-run economic profits encourage new firms to enter, increasing product variety but reducing demand for existing firms. Conversely, short-run losses lead to firms exiting, decreasing product variety but increasing demand for remaining firms.
Long-Run Equilibrium: Firms will enter and exit until they make zero economic profits.
Long-Run Equilibrium Characteristics
Similar to a monopoly, price exceeds marginal cost due to the downward-sloping demand curve.
Similar to a competitive market, price equals average total cost due to free entry and exit driving economic profit to zero.
Monopolistic vs Perfect Competition
Excess Capacity: Unlike perfect competition, monopolistic competition results in excess capacity in the long run as output is less than the efficient scale (the scale in which the firm producing as much as possible, without wasting any resources).
they produce less than efficient scale to maximize profits, even though it means not using all the resources efficiently
Markup Over Marginal Cost: In monopolistic competition, price exceeds marginal cost, unlike in perfect competition where price equals marginal cost. This allows monopolistically competitive firms to make more profit per extra unit sold.
Monopolistic Competition and Societyβs Welfare
Monopolistic competition lacks some desirable properties of perfect competition.
It leads to a deadweight loss due to the markup of price over marginal cost, similar to monopoly pricing.
Regulating the pricing of all firms producing differentiated products would be administratively burdensome.
The number of firms in the market may not be ideal, leading to potential social inefficiency.
Externalities of Entry in Monopolistic Competition
Product-Variety Externality: Entry of a new firm introduces a new product, providing consumer surplus and a positive externality (Externality: This is a cost or benefit that affects someone who did not choose to incur that cost or benefit, JUST LIKE IMPACT).
Business-Stealing Externality: Entry of a new competitor can lead to customer and profit loss for existing firms, imposing a negative externality.
Advertising in Monopolistic Competition
Firms selling differentiated products have an incentive to advertise to attract more buyers.
Firms typically spend 10-20% of revenue on advertising, amounting to over $200 billion a year.
Critics argue that advertising manipulates peopleβs tastes and impedes competition by exaggerating product differences.
Defenders argue that advertising provides consumer information, increases competition by offering more product variety and prices, and signals product quality.
