Monopolistic Competition: Definition, How it Works, Pros and Cons

Monopolistic Market Definition

Investopedia / Joules Garcia

What Is Monopolistic Competition?

Monopolistic competition exists when many companies offer competing products or services that are similar, but not perfect, substitutes.

The barriers to entry in a monopolistic competitive industry are low, and the decisions of any one firm do not directly affect its competitors. The competing companies differentiate themselves based on pricing and marketing decisions.

Key Takeaways

  • Monopolistic competition occurs when many companies offer products that are similar but not identical.
  • Firms in monopolistic competition differentiate their products through pricing and marketing strategies.
  • Barriers to entry, or the costs or other obstacles that prevent new competitors from entering an industry, are low in monopolistic competition.


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Monopolistic Competition

Understanding Monopolistic Competition

Monopolistic competition exists between a monopoly and perfect competition, combines elements of each, and includes companies with similar, but not identical, product offerings.

Restaurants, hair salons, household items, and clothing are examples of industries with monopolistic competition. Items like dish soap or hamburgers are sold, marketed, and priced by many competing companies.

Demand is highly elastic for goods and services of the competing companies and pricing is often a key strategy for these competitors. One company may opt to lower prices and sacrifice a higher profit margin, hoping for higher sales. Another may raise its price and use packaging or marketing that suggests better quality or sophistication.

Companies often use distinct marketing strategies and branding to distinguish their products. Because the products all serve the same purpose, the average consumer often does not know the precise differences between the various products, or how to determine what a fair price may be.

Characteristics of Monopolistic Competition

Low Barriers to Entry

In monopolistic competition, one firm does not monopolize the market and multiple companies can enter the market and all can compete for a market share. Companies do not need to consider how their decisions influence competitors so each firm can operate without fear of raising competition.

Product Differentiation

Competing companies differentiate their similar products with distinct marketing strategies, brand names, and different quality levels. 

Pricing

Companies in monopolistic competition act as price makers and set prices for goods and services. Firms in monopolistic competition can raise or lower prices without inciting a price war, often found in oligopolies.

Demand Elasticity

Demand is highly elastic in monopolistic competition and very responsive to price changes. Consumers will change from one brand name to another for items like laundry detergent based solely on price increases.

Advantages and Disadvantages of Monopolistic Competition

Monopolistic competition provides both benefits and pitfalls for companies and consumers.

Pros
  • Few barriers to entry for new companies

  • Variety of choices for consumers

  • Company decision-making power for prices and marketing 

  • Consistent quality of product for consumers

Cons
  • Many competitors limits access to economies of scale

  • Inefficient company spending on marketing, packaging and advertising

  • Too many choices for consumers means extra research for consumers

  • Misleading advertising or imperfect information for consumers

What Is the Difference Between Monopolistic Competition and Perfect Competition?

In perfect competition, the product offered by competitors is the same item. If one competitor increases its price, it will lose all of its market share to the other companies based on market supply and demand forces, where prices are not set by companies and sellers accept the pricing determined by market activity.

In monopolistic competition, supply and demand forces do not dictate pricing. Firms are selling similar, yet distinct products, so firms determine the pricing. Product differentiation is the key feature of monopolistic competition, where products are marketed by quality or brand. Demand is highly elastic, and any change in pricing can cause demand to shift from one competitor to another.

How Does Monopolistic Competition Function in the Short Term and Long Term?

Companies aim to produce a quantity where marginal revenue equals marginal cost to maximize profit or minimize losses. When existing firms are making a profit, new firms will enter the market. The demand curve and the marginal revenue curve shift and new firms stop entering when all firms are making zero profit in the long run. If existing firms are incurring a loss, some firms will exit the market. The firms stop exiting the market until all firms start making zero profit. The market is at equilibrium in the long run only when there is no further exit or entry in the market or when all firms make zero profit in the long run.

What Industry Is an Example of Monopolistic Competition?

Monopolistic competition is present in restaurants like Burger King and McDonald's. Both are fast food chains that target a similar market and offer similar products and services. These two companies are actively competing with one another, and seek to differentiate themselves through brand recognition, price, and by offering different food and drink packages.

What Is the Difference Between Monopolistic Competition and a Monopoly?

A monopoly is when a single company dominates an industry and can set prices for its product without fear of competition. Monopolies limit consumer choices and control production quantity and quality. Monopolistic competitive companies must compete with others, restricting their ability to substantially raise prices without affecting demand and providing a range of product choices for consumers. Monopolistic competition is more common than monopolies, which are discouraged in free-market nations.

The Bottom Line

Monopolistic competition exists when many companies offer competitive products or services that are similar, but not exact, substitutes. Hair salons and clothing are examples of industries with monopolistic competition. Pricing and marketing are key strategies for competing companies and often rely on branding or discount pricing strategies to increase market share.

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