Economics Online Tutor
Monopolistic Competition
Monopolistic competition is a market structure in which entry into the
market is easy, and the market has many sellers. These factors make
monopolistic competition similar to perfect competition. But
monopolistic competition differs from perfect competition because
firms in monopolistic competition sell differentiated products.

Consumers consider the products of firms in a monopolistically
competitive industry to be close substitutes for one another, but not
identical. This is what the term “differentiated” refers to.

Firms in monopolistic competition are free to set their own prices.
However, they must do so with the knowledge that at higher prices,
some consumers will switch to a competitor's product.  The firm that
raises its prices will sell a lower quantity.

Because the firm will sell a lower quantity at a higher price, the firm's
demand curve is downward sloping. Its marginal revenue curve lies
below its demand curve. A profit maximizing firm will sell the quantity
where marginal revenue (MR) is equal to marginal cost (MC), but this
will be lower than the quantity for a firm in perfect competition.

At the output quantity where MR=MC, the firm can sell at the price
where this quantity intersects the demand curve. This price will be
higher than the price that equates to MR and MC at that quantity,
making monopolistic competition less efficient than perfect
This lower quantity, higher price combination is due to the fact that the demand curve is downward
sloping. The marginal revenue curve lies below the demand curve. This makes a firm in monopolistic
competition similar to a monopoly firm, with the associated loss of consumer and total surplus.

One difference between a firm in monopolistic competition and a firm in monopoly is ease of entry. In
monopoly, entry is prohibitive and firms can earn economic profits in the long run. In monopolistic
competition, entry is easy and any economic profits will be a signal for new firms to enter the market. In
the long run, firms will enter and exit the industry until economic profits are equal to zero.
Because the products of firms in monopolistic competition are
close substitutes, but not identical, firms engage in non-price
competition. In fact, non-price competition is often an important
part of the decisions made by firms in monopolistic competition.

Advertising is important, as firms try to inform consumers of the
benefits of their specific products. Brand name recognition
helps to build consumer confidence in a particular product,
increasing its demand.

Firms can use convenience as a form of non-price competition.
Store location can be a convenience to specific consumers. So
can the availability of online shopping.

The availability of other products and services offered by the
seller can also be a form of non-price competition that utilizes
convenience for consumers.

Grocery stores often distinguish themselves from the
competition by the overall product selection available in their
stores, as well as the addition of other products and services at
the same location. For example, a grocery store may try to lure
in customers by providing a full-service bakery, deli, pharmacy,
dry cleaning business, check cashing, video rentals, other
product rentals (such as carpet cleaners), delivery services
(such as being a drop-off and pick-up location for Fedex), wire
services such as western union, an onsite gas station,
recycling services, even banking services.

Other forms of non-price competition include such things as
customer service, different product features, style, warranties,
and even packaging.

Such non-price competition is often designed to separate
consumers into different groups with separate demands.

Because of the existence of many close substitutes, the
demand for products in monopolistic competition is highly
elastic.  Non-price competition is designed to decrease the
price elasticity of demand by rotating the demand curve.
What is a better deal for consumers,
the brand name products or the less
expensive store or generic brands?

I remember an economics instructor
bringing up this question when I was
a student in the late 1970s.  I
remember the instructor's advice:

Consumers should give the cheaper
brands a try, and compare the quality
and price of the brand name vs the
store brand or generic brand.  Then,
consumers will know which they
prefer, on a product by product
basis, rather than having a strategy
of always choosing one or the other.

This means maximizing utility per
dollar for each type of product.

Take canned vegetables, for
example.  The same consumer may
find that more value can be achieved
by buying the store brands for
canned corn and green beans, while
at the same time more value can be
achieved by buying the name brand
for peas and spinach.

This approach means that the value
of coupons is lowered, since
coupons usually apply only to brand
name products.  Any savings from
using coupons can potentially be
offset by savings from using store
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