Loading the player...

What is '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 the industry are low, and the decisions of any one firm do not directly affect those of its competitors. All firms have the same, relatively low degree of market power; they are all price makers. In the long run, demand is highly elastic, meaning that it is sensitive to price changes. In the short run, economic profit is positive, but it approaches zero in the long run. Firms in monopolistic competition tend to advertise heavily.

BREAKING DOWN 'Monopolistic Competition'

Monopolistic competition is a middle ground between monopoly, on the one hand, and perfect competition (a purely theoretical state), on the other, and combines elements of each. It is a form of competition that characterizes a number of industries that are familiar to consumers in their day-to-day lives. Examples include restaurants, hair salons, clothing and consumer electronics. To illustrate the characteristics of monopolistic competition, we'll use the example of household cleaning products.

Number of firms

Say you've just moved into a new house and want to stock up on cleaning supplies. Go to the appropriate aisle in a grocery store, and you'll see that any given item—dish soap, hand soap, laundry detergent, surface disinfectant, toilet bowl cleaner, etc.—is available in a number of varieties. For each purchase you need to make, perhaps five or six firms will be competing for your business. 

Product Differentiation

Because the products all serve the same purpose, there are relatively few options for sellers to differentiate their offerings from other firms'. There might be "discount" varieties that are of lower quality, but it is difficult to tell whether the higher-priced options are in fact any better. This uncertainty results from imperfect information: the average consumer does not know the precise differences between the various products, or what the fair price for any of them is.

Monopolistic competition tends to lead to heavy marketing, because different firms need to distinguish broadly similar products. One company might opt to lower the price of their cleaning product, sacrificing a higher profit margin in exchange—ideally—for higher sales. Another might take the opposite route, raising the price and using packaging that suggests quality and sophistication. A third might sell itself as more eco-friendly, using "green" imagery and displaying a stamp of approval from an environmental watchdog (which the other brands likely qualify for as well, but don't display). In reality, every one of the brands might be equally effective.

Decision-Making

Monopolistic competition implies that there are enough firms in the industry that one firm's decision does not set off a chain reaction. In an oligopoly, a price cut by one firm can set off a price war, but this is not the case for monopolistic competition. 

Pricing Power

As in a monopoly, firms in monopolistic competition are price setters, rather than price takers.

Demand Elasticity

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

Economic Profit

In the short run, firms can make excess economic profits. However, because barriers to entry are low, other firms have an incentive to enter the market, increasing the competition, until overall economic profit is zero. Note that economic profits are not the same as accounting profits; a firm that posts a positive net income can have zero economic profit, since the latter incorporates opportunity costs.

RELATED TERMS
  1. Monopolist

    A monopolist is an individual, group or company that controls ...
  2. Monopolistic State Fund

    A government owned and operated fund that is set up to provide ...
  3. Rate Of Return Regulation

    A form of price setting regulation where governments determine ...
  4. Pricing Power

    An economic term referring to the effect that a change in a firm's ...
  5. Demand Elasticity

    In economics, the demand elasticity refers to how sensitive the ...
  6. Competitive Advantage

    Competitive advantage is a superiority that a firm has over its ...
Related Articles
  1. Insights

    A Practical Look At Microeconomics

    Learn how individual decision-making turns the gears of our economy.
  2. Small Business

    What is an antitrust law?

    Learn about antitrust laws or "competition laws." These statutes protect consumers from predatory business practices by ensuring fair competition exists.
  3. Investing

    Calculating Economic Profit

    Economic profit is the difference between the revenue a firm earns from sales and the firm’s total opportunity costs.
  4. Small Business

    Antitrust Defined

    Check out the history and reasons behind antitrust laws, as well as the arguments over them.
  5. Investing

    3 Groups of Companies that are almost a Monopoly

    A look at companies that have a monopolistic place in the marketplace, and whether or not it's a good idea to invest in them.
  6. Investing

    Product Demand Elasticity

    Demand elasticity is the ultimate measure of how consumer shopping patterns will change with economic conditions.
RELATED FAQS
  1. What is the difference between a monopolistic market and perfect competition?

    Learn about monopolistic and perfectly competitive markets, what they are, and the main differences between perfect competition ... Read Answer >>
  2. How is profit maximized in a monopolistic market?

    Learn about monopolistic markets and how firms maximize their profits by solving for the quantity they must produce and the ... Read Answer >>
  3. What factors influence competition in microeconomics?

    Find out what influences competition in microeconomics and how perfect competition, monopoly and oligopoly vary in their ... Read Answer >>
  4. What are Common Examples of Monopolistic Markets?

    Providers of water, natural gas, telecommunications, and electricity have all been historically monopolistic markets. Read Answer >>
  5. What does it mean when a utility company has a natural monopoly on a market?

    Learn what it means when a utility company has a natural monopoly on a market and why natural monopolies are heavily regulated ... Read Answer >>
  6. If a particular good's price elasticity is high, does this mean the supplier should ...

    Learn the basics of price elasticity of supply and demand and how each influences a company's production of goods and pricing ... Read Answer >>
Hot Definitions
  1. Initial Public Offering - IPO

    The first sale of stock by a private company to the public. IPOs are often issued by companies seeking the capital to expand ...
  2. Cost of Goods Sold - COGS

    Cost of goods sold (COGS) is the direct costs attributable to the production of the goods sold in a company.
  3. Profit and Loss Statement (P&L)

    A financial statement that summarizes the revenues, costs and expenses incurred during a specified period of time, usually ...
  4. Monte Carlo Simulation

    Monte Carlo simulations are used to model the probability of different outcomes in a process that cannot easily be predicted ...
  5. Price Elasticity of Demand

    Price elasticity of demand is a measure of the change in the quantity demanded or purchased of a product in relation to its ...
  6. Sharpe Ratio

    The Sharpe ratio is the average return earned in excess of the risk-free rate per unit of volatility or total risk.
Trading Center