Monopolistic competition is a form of imperfect competition where many competing producers sell products that aredifferentiated from one

another (that is, the products are substitutes but, because of differences such as branding, not exactly alike). In monopolistic competition, a firm takes the prices charged by its rivals as given and ignores the impact of its own prices on the prices of other firms. [1] In a monopolistically competitive market, firms can behave like monopolies in the short run, including by using market power to generate profit. In the long run, however, other firms enter the market and the

means in the long run, a monopolistically competitive firm will make zero economic profit. This illustrates the amount of influence the firm has over the market; because of brand loyalty, it can raise its prices without losing all of its customers. This means that an individual firm's demand curve is downward sloping, in contrast to perfect competition, which has a perfectly elastic demand schedule. Major characteristics There are six characteristics of monopolistic competition (MC):

benefits of differentiation decrease with competition; the market becomes more like a perfectly competitive one where firms cannot gain economic profit. In practice, however, if consumer rationality/innovativeness is low and heuristics are preferred, monopolistic competition can fall into natural monopoly, even in the complete absence of government intervention.[2] In the presence of coercive government, monopolistic competition will fall into government-granted monopoly. Unlike perfect competition, the firm maintains spare capacity. Models of monopolistic competition are often used to model industries. Textbook examples of industries with market structures similar to monopolistic competition include restaurants, cereal, clothing, shoes, and service industries in large cities. The "founding father" of the theory of monopolistic competition is Edward Hastings Chamberlin, who wrote a pioneering book on the subject, Theory of Monopolistic Competition (1933).[3] Joan Robinson is also credited as an early pioneer of the concept. between goods in such a market is positive. In fact, the XED would be high. [7] MC goods are best Monopolistically competitive markets have the following characteristics: described as close but imperfect substitutes.[7] The goods perform the same basic functions but have differences in qualities such as type, style, quality, reputation, appearance, and location that tend to There are many producers and many consumers in the market, and no business has total control over distinguish them from each other. For example, the basic function of motor vehicles is basically the same the market price. to move people and objects from point A to B in reasonable comfort and safety. Yet there are many Consumers perceive that there are non-price differences among the competitors' products. different types of motor vehicles such as motor scooters, motor cycles, trucks, cars and SUVs and many There are few barriers to entry and exit.[4] variations even within these categories. Producers have a degree of control over price. [edit]Many firms There are many firms in each MC product group and many firms on the side lines prepared to enter the competitive market. Two differences between the two are that monopolistic competition produces heterogeneous products and monopolistic competition involves a great deal of non-price competition, each MC firm the freedom to set prices without engaging in strategic decision making regarding the prices which is based on subtle product differentiation. A firm making profits in the short run will nonetheless of other firms and each firm's actions have a negligible impact on the market. For example, a firm could only break even in the long run because demand will decrease and average total cost will increase. This market. A product group is a "collection of similar products".[8] The fact that there are "many firms" gives MC firms sell products that have real or perceived non-price differences. However, the differences are not so great as to eliminate other goods as substitutes. Technically, the cross price elasticity of demand

Product differentiation Many firms Free entry and exit in the long run Independent decision making Market Power Buyers and Sellers have perfect information[5][6]

[edit]Product differentiation

The long-run characteristics of a monopolistically competitive market are almost the same as a perfectly

cut prices and increase sales without fear that its actions will prompt retaliatory responses from competitors. How many firms will an MC market structure support at market equilibrium? The answer depends on factors such as fixed costs, economies of scale and the degree of product differentiation. For example, the higher the fixed costs, the fewer firms the market will support. [9] Also the greater the degree of product differentiation - the more the firm can separate itself from the pack - the fewer firms there will be at market equilibrium. [edit]Free entry and exit In the long run there is free entry and exit. There are numerous firms waiting to enter the market each with its own "unique" product or in pursuit of positive profits and any firm unable to cover its costs can leave the market without incurring liquidation costs. This assumption implies that there are low start up costs, no sunk costs and no exit costs. [edit]Independent decision making Each MC firm independently sets the terms of exchange for its product. [10] The firm gives no consideration to what effect its decision may have on competitors.[11] The theory is that any action will have such a negligible effect on the overall market demand that an MC firm can act without fear of prompting heightened competition. In other words each firm feels free to set prices as if it were a monopoly rather than an oligopoly. [edit]Market power MC firms have some degree of market power. Market power means that the firm has control over the terms and conditions of exchange. An MC firm can raise it prices without losing all its customers. The firm can also lower prices without triggering a potentially ruinous price war with competitors. The source of an MC firm's market power is not barriers to entry since they are low. Rather, an MC firm has market power because it has relatively few competitors, those competitors do not engage in strategic decision making and the firms sells differentiated product.[12] Market power also means that an MC firm faces a downward sloping demand curve. The demand curve is highly elastic although not "flat".

Buyers know exactly what goods are being offered, where the goods are being sold, all differentiating characteristics of the goods, the good's price, whether a firm is making a profit and if so how much.[13]
Market Structure comparison

Mark Elastici Num Product et ty of ber of differentia pow deman firms tion er d

Excess profits

Profit Pricin Efficie maximiza g ncy tion powe condition r

Perfect Perfec Infinit Competit None tly None e ion elastic

No

Yes

[14]

Price P=MR=M [ taker [15] C 15]

Monopol istic Many Low competiti on

Highly elastic [17] High (long [16] run)

Yes/No [19] (Short/Lon No [18] g)

MR=MC
]

[15

Price setter
[15]

Monopol One y

Relativ Absolute ely High (across Yes inelast industries) ic

No

MR=MC
]

[15

Price setter
[15]

[edit] [edit]Inefficiency
There are two sources of inefficiency in the MC market structure. First, at its optimum output the firm charges a price that exceeds marginal costs, The MC firm maximizes profits where MR = MC. Since the

Perfect information

MC firm's demand curve is downward sloping this means that the firm will be charging a price that exceeds marginal costs. The monopoly power possessed by an MC firm means that at its profit maximizing level of production there will be a net loss of consumer (and producer) surplus. The second source of inefficiency is the fact that MC firms operate with excess capacity. That is, the MC firm's profit maximizing output is less than the output associated with minimum average cost. Both a PC and MC firm will operate at a point where demand or price equals average cost. For a PC firm this equilibrium condition occurs where the perfectly elastic demand curve equals minimum average cost. A MC firms demand curve is not flat but is downward sloping. Thus in the long run the demand curve will be tangent

number of different brands to be able to select the best of them. In many cases, the cost of gathering information necessary to selecting the best brand can exceed the benefit of consuming the best brand instead of a randomly selected brand. Evidence suggests that consumers use information obtained from advertising not only to assess the single brand advertised, but also to infer the possible existence of brands that the consumer has, heretofore, not observed, as well as to infer consumer satisfaction with brands similar to the advertised brand.[21] [edit]Examples In many U.S. markets, producers practice product differentiation by altering the physical composition of

to the long run average cost curve at a point to the left of its minimum. The result is excess capacity. [20] Problems While monopolistically competitive firms are inefficient, it is usually the case that the costs of regulating prices for every product that is sold in monopolistic competition far exceed the benefits of such regulation. The government would have to regulate all firms that sold heterogeneous productsan impossible proposition in a market economy. A monopolistically competitive firm might be said to be marginally inefficient because the firm produces at an output where average total cost is not a minimum. A monopolistically competitive market might be said to be a marginally inefficient market structure because marginal cost is less than price in the long run.[citation needed] Another concern of critics of monopolistic competition is that it fosters advertising and the creation of brand names. Critics argue that advertising induces customers into spending more on products because of the name associated with them rather than because of rational factors. Defenders of advertising dispute this, arguing that brand names can represent a guarantee of quality and that advertising helps reduce the cost to consumers of weighing the tradeoffs of numerous competing brands. There are unique information and information processing costs associated with selecting a brand in a monopolistically competitive environment. In a monopoly market, the consumer is faced with a single brand, making information gathering relatively inexpensive. In a perfectly competitive industry, the consumer is faced with many brands, but because the brands are virtually identical information gathering is also relatively inexpensive. In a monopolistically competitive market, the consumer must collect and process information on a large products, using special packaging, or simply claiming to have superior products based on brand images or advertising. Toothpastes, toilet papers, computer software and operating systems are examples of differentiated products.

Short-run equilibrium of the firm under monopolistic competition. The firm maximizes its profits and produces a quantity where the firm's marginal revenue (MR) is equal to its marginal cost (MC). The firm is able to collect a price based on the average revenue (AR) curve. The difference between the firms average revenue and average cost, multiplied by the quantity sold (Qs), gives the total profit.

Long-run equilibrium of the firm under monopolistic competition. The firm still produces where marginal cost and marginal revenue are equal; however, the demand curve (and AR) has shifted as other firms entered the market and increased competition. The firm no longer sells its goods above average cost and can no longer claim an economic profit

Market Structure comparison

Number Market Elasticity of Product of firms power demand differentiation

Excess profits

Efficiency

Profit maximization condition

Pricing power

Perfect Perfectly Infinite None None Competition elastic

No

Yes[14] P=MR=MC[15]

Price taker[15]

Monopolistic Many Low competition

Highly elastic (long run)[16]

High[17]

Yes/No [19] [18] No (Short/Long)

MR=MC[15]

Price setter[15]

Monopoly

One

Absolute Relatively High (across Yes inelastic industries)

No

MR=MC[15]

Price setter[15]