Definition of monopoly competition

What is monopoly competition?

Monopolistic competition characterizes an industry in which many firms offer products or services that are similar, but not perfect, substitutes. Barriers to entry and exit in a monopoly competitive industry are low, and a firm’s decisions do not directly affect those of its competitors. Monopolistic competition is closely linked to the business strategy of brand differentiation.

Understanding monopoly competition

Monopoly competition is a happy medium between monopoly and perfect competition (a purely theoretical state) and combines elements of each. All monopolistically competitive firms have the same relatively low degree of market power; they are all price makers.

In the long run, demand is very elastic, that is, it is sensitive to price changes. In the short run, economic profit is positive, but it is close to zero in the long run. Firms in monopoly competition tend to advertise a lot.

Example of monopoly competition

Monopoly competition is a form of competition that characterizes a number of industries familiar to consumers in their daily lives. Examples include restaurants, hair salons, clothing, and consumer electronics. To illustrate the characteristics of monopolistic competition, we will take the example of household cleaning products.

Competitor companies

Suppose you have just moved into a new home and want to stock up on cleaning supplies. Go to the appropriate aisle of a grocery store and you will see that any item (dish soap, hand soap, laundry detergent, surface sanitizer, toilet bowl cleaner, etc.) is available in one. number of varieties. For every purchase you need to make, maybe five or six companies will be competing for your business.

Product differentiation

Since the products all serve the same purpose, sellers have relatively few options to differentiate their offerings from other competing companies. There may be lower quality “lower priced” varieties, but it is difficult to tell if the more expensive options are in fact better. This uncertainty results from imperfect information: the average consumer does not know the precise differences between the different products, nor what is the fair price of one of them.

Monopolistic competition tends to lead to intensive marketing as different companies have to distinguish between broadly similar products. A business might choose to lower the price of its cleaning product, sacrificing a higher profit margin in exchange for, ideally, higher sales. Another could go the other way, raising the price and using packaging that suggests quality and sophistication.

A third could market itself as more environmentally friendly, using “green” images and displaying a seal of approval from an environmental certifier. In fact, each of the brands could be just as effective.

Special considerations

Firms in monopoly competition face a significantly different business environment from those in monopoly or perfect competition. In addition to competing to reduce costs or increase production, monopolistically competitive firms may also differentiate themselves in other ways.

Decision making

Monopoly competition implies that there are enough firms in the industry that one firm’s decision does not force other firms to change their behavior. In an oligopoly, a lower price by a company can trigger a price war, but this is not the case with monopoly competition.

Pricing power

As in a monopoly, monopolistically competing firms are price setters or makers, rather than price takers. However, their nominal ability to set prices is effectively offset by the fact that demand for their products is highly price elastic. In order to really increase their prices, companies must be able to differentiate their products from their competitors by increasing their quality, real or perceived.

Elasticity of demand

Due to the range of similar offers, demand is very elastic in monopolistic competition. In other words, demand is very responsive to price changes. If your favorite all-purpose surface cleaner suddenly costs 20% more, you probably won’t hesitate to switch to an alternative, and your countertops probably won’t know the difference.

Economic profit

In the short term, companies can realize excess economic profits. However, since the barriers to entry are low, other firms are incentivized to enter the market, increasing competition, until the overall economic profit is zero. Note that economic benefits are not the same as accounting benefits; a company that shows a positive net result may have zero economic profit since the latter incorporates opportunity costs.

Advertising in monopoly competition

Economists who study monopoly competition often highlight the social cost of this type of market structure. Firms in monopoly competition devote large amounts of actual resources to advertising and other forms of marketing.

Where there is a real difference between the products of different companies, which the consumer may not be aware of, these expenses can be useful. However, if it turns out instead that the products are near-perfect substitutes, which is likely in monopoly competition, then the actual resources devoted to advertising and marketing represent a kind of unnecessary rent-seeking behavior, which produces deadweight loss for society.