Monopolistic Competition
Overview
Monopolistic competition is a type of imperfect competition such that many producers sell products that are differentiated from one another. 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.
Characteristics
Monopolistic competition is characterized by a large number of potential buyers and sellers. Firms within this market structure sell products that are close, but not perfect substitutes for one another. This means that each firm has a mini-monopoly in its particular version of the industry's product.
Product Differentiation
In a monopolistically competitive market, firms are neither price takers (as in perfect competition) nor price makers (as in monopoly). Rather, they have some degree of market power, which allows them to charge higher prices than in a perfectly competitive market. This is due to product differentiation, where firms make their products different from those of their competitors. Product differentiation can be achieved through various means such as quality, design, location, and service.
Short Run and Long Run
In the short run, firms in monopolistic competition behave like monopolies. They maximize their profits by producing a quantity where marginal cost equals marginal revenue. They can also earn abnormal profits. In the long run, however, the demand for a firm's product will decrease and become more elastic due to the entry of more firms in the industry. This will cause the firm's demand curve to shift to the left, reducing the price and quantity of its product. The firm will then earn only normal profit.
Efficiency
Monopolistic competition is inefficient. In the short run, firms produce at an output level where average total cost is not at its minimum point, leading to productive inefficiency. In the long run, firms operate at an output level where price does not equal marginal cost, leading to allocative inefficiency. Moreover, there is also excess capacity in monopolistic competition.
Examples
Examples of monopolistic competition can be found in industries such as restaurants, hair salons, clothing, and service industries in large cities. The restaurant industry, for example, is monopolistically competitive as there are many producers (restaurants) that offer similar, but not identical products (menu offerings).
Criticisms
Some criticisms of monopolistic competition revolve around its inherent inefficiency. Critics argue that the social cost of such a market structure may outweigh the benefits of product variety and differentiation. Others point out that firms in monopolistically competitive markets often spend too much on advertising and brand management, costs that are ultimately passed on to consumers.