Monopolistic competition describes a scenario where many firms compete by selling products that are differentiated from one other and hence are not perfect substitutes. Product differentiation may be due to the brand, product quality, location, or marketingstrategy. Monopolistic competition describes an industry where many firms offer products or services that are similar (but not perfect) substitutes.
Understanding monopolistic competition
Monopolistic competition combines elements of a monopoly and perfect competition – a theoretical market state in which companies sell identical products and have equal market share.
The term was first used by economists Edward Chamberlain and Joan Robinson in the 1930s to explain the competition that existed between firms with similar (but not identical) products.
Firms that are in monopolistic competition have a comparable and relatively low degree of market power.
They are said to be price makers, or companies that can dictate the price they charge for goods because there are no perfect substitutes in the market.
Importantly, prices can be lowered without inciting a price war which is a common problem in oligopolies.
As more firms enter a monopolistic market, the elasticity of the demand curve increases.
This means consumers become more sensitive to price, with a small price increase causing demand for a product to vanish.
Profit in the short term is positive, but over the long term, it approaches zero as marginal revenue equals marginal cost.
As a result, monopolistic competition is characterized by increased spending on advertising and marketing as firms seek to attain a competitive advantage.
Characteristics of monopolistic competition
To summarise and expand upon the information presented above, consider the following characteristics of monopolistic competition:
The presence of many firms and many consumers, with no firm having total control over the marketplace.
Few barriers to entry or exit. This means the market is dynamic as companies can easily enter or exit the market at their discretion.
Differentiated but similar products and services. Consumers perceive there to be differences between products that are not based on price.
Firms operate independently. That is, they operate with the knowledge that their actions will not affect the actions of other firms.
Potential supernormal profits in the short term. One firm can profit from identifying a gap in the market until competing firms move in and offer similar products.
Normal profits in the long run. Due to low barriers of entry, a new firm may see an existing firm make supernormal profits and enter the market to take their share. As competitors flock to an untapped market segment, profits are reduced to zero over time.
Imperfect information – with many firms offering slightly different products, a consumer may find it more difficult to make a purchasing decision. In the insurance industry, for example, several comparison sites now exist to help consumers understand the sometimes vague but important distinctions between products.
Examples of monopolistic competition
Monopolistic competition is present in many familiar industries. Examples include:
Clothing and apparel
Clothing items are inherently similar because each is designed for the same purpose.
Brand and style differentiation is common in this industry.
Restaurants
Which compete on food quality and customer service.
Among Indian restaurants, for example, product differentiation is key since each offers more or less the same regional dishes.
What’s more, there are also relatively few barriers to opening a new restaurant.
Accommodation
The accommodation industry is also characterized by many firms offering the same service.
Each provider differentiates itself with minor variations in quality level or access to perks.
Hairdressing
Another industry where the barriers to entry are low.
The ability for a hairdresser to offer quality customer service and earn repeat business is the point of differentiation here.
Coffee shops
Like most retail or food and beverage outlets, there are countless coffee shops around the world selling the same product.
Product differentiation occurs via the quality of the coffee beans and the level of customer service.
These establishments may also offer Wi-Fi or be located within bookstores to stand out.
Key takeaways
Monopolistic competition describes an industry where many firms offer products or services that are similar (but not perfect) substitutes. The term was first used by economists Edward Chamberlain and Joan Robinson in the 1930s.
Monopolistic competition has many characteristics, including the presence of many firms and consumers, low entry and exit barriers, short-term supernormal profits, long-term normal profits, and imperfect information.
Monopolistic competition is present in many familiar industries, including clothing and apparel, restaurants, accommodation, hairdressing, and coffee shops.
The idea of a market economy first came from classical economists, including David Ricardo, Jean-Baptiste Say, and Adam Smith. All three of these economists were advocates for a free market. They argued that the “invisible hand” of market incentives and profit motives were more efficient in guiding economic decisions to prosperity than strict government planning.
Positive economics is concerned with describing and explaining economic phenomena; it is based on facts and empirical evidence. Normative economics, on the other hand, is concerned with making judgments about what “should be” done. It contains value judgments and recommendations about how the economy should be.
When there is an increased price of goods and services over a long period, it is called inflation. In these times, currency shows less potential to buy products and services. Thus, general prices of goods and services increase. Consequently, decreases in the purchasing power of currency is called inflation.
Asymmetric information as a concept has probably existed for thousands of years, but it became mainstream in 2001 after Michael Spence, George Akerlof, and Joseph Stiglitz won the Nobel Prize in Economics for their work on information asymmetry in capital markets. Asymmetric information, otherwise known as information asymmetry, occurs when one party in a business transaction has access to more information than the other party.
Autarky comes from the Greek words autos (self)and arkein (to suffice) and in essence, describes a general state of self-sufficiency. However, the term is most commonly used to describe the economic system of a nation that can operate without support from the economic systems of other nations. Autarky, therefore, is an economic system characterized by self-sufficiency and limited trade with international partners.
Creative destruction was first described by Austrian economist Joseph Schumpeter in 1942, who suggested that capital was never stationary and constantly evolving. To describe this process, Schumpeter defined creative destruction as the “process of industrial mutation that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one.” Therefore, creative destruction is the replacing of long-standing practices or procedures with more innovative, disruptive practices in capitalist markets.
Happiness economics seeks to relate economic decisions to wider measures of individual welfare than traditional measures which focus on income and wealth. Happiness economics, therefore, is the formal study of the relationship between individual satisfaction, employment, and wealth.
An oligopsony is a market form characterized by the presence of only a small number of buyers. These buyers have market power and can lower the price of a good or service because of a lack of competition. In other words, the seller loses its bargaining power because it is unable to find a buyer outside of the oligopsony that is willing to pay a better price.
The term “animal spirits” is derived from the Latin spiritus animalis, loosely translated as “the breath that awakens the human mind”. As far back as 300 B.C., animal spirits were used to explain psychological phenomena such as hysterias and manias. Animal spirits also appeared in literature where they exemplified qualities such as exuberance, gaiety, and courage. Thus, the term “animal spirits” is used to describe how people arrive at financial decisions during periods of economic stress or uncertainty.
State capitalism is an economic system where business and commercial activity is controlled by the state through state-owned enterprises. In a state capitalist environment, the government is the principal actor. It takes an active role in the formation, regulation, and subsidization of businesses to divert capital to state-appointed bureaucrats. In effect, the government uses capital to further its political ambitions or strengthen its leverage on the international stage.
The boom and bust cycle describes the alternating periods of economic growth and decline common in many capitalist economies. The boom and bust cycle is a phrase used to describe the fluctuations in an economy in which there is persistent expansion and contraction. Expansion is associated with prosperity, while the contraction is associated with either a recession or a depression.
The paradox of thrift was popularised by British economist John Maynard Keynes and is a central component of Keynesian economics. Proponents of Keynesian economics believe the proper response to a recession is more spending, more risk-taking, and less saving. They also believe that spending, otherwise known as consumption, drives economic growth. The paradox of thrift, therefore, is an economic theory arguing that personal savings are a net drag on the economy during a recession.
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Rational choice theory states that an individual uses rational calculations to make rational choices that are most in line with their personal preferences. Rational choice theory refers to a set of guidelines that explain economic and social behavior. The theory has two underlying assumptions, which are completeness (individuals have access to a set of alternatives among they can equally choose) and transitivity.
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The term “knowledge economy” was first coined in the 1960s by Peter Drucker. The management consultant used the term to describe a shift from traditional economies, where there was a reliance on unskilled labor and primary production, to economies reliant on service industries and jobs requiring more thinking and data analysis. The knowledge economy is a system of consumption and production based on knowledge-intensive activities that contribute to scientific and technical innovation.
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How do you protect your rights as a worker? Who is there to help defend you against unfair and unjust work conditions? Both of these questions have an answer, and it’s a solution that many are familiar with. The answer is a labor union. From construction to teaching, there are labor unions out there for just about any field of work.
The bottom of the pyramid is a term describing the largest and poorest global socio-economic group. Franklin D. Roosevelt first used the bottom of the pyramid (BOP) in a 1932 public address during the Great Depression. Roosevelt noted that – when talking about the ‘forgotten man:’ “these unhappy times call for the building of plans that rest upon the forgotten, the unorganized but the indispensable units of economic power.. that build from the bottom up and not from the top down, that put their faith once more in the forgotten man at the bottom of the economic pyramid.”
Glocalization is a portmanteau of the words “globalization” and “localization.” It is a concept that describes a globally developed and distributed product or service that is also adjusted to be suitable for sale in the local market. With the rise of the digital economy, brands now can go global by building a local footprint.
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The L-shaped recovery refers to an economy that declines steeply and then flatlines with weak or no growth. On a graph plotting GDP against time, this precipitous fall combined with a long period of stagnation looks like the letter “L”. The L-shaped recovery is sometimes called an L-shaped recession because the economy does not return to trend line growth. The L-shaped recovery, therefore, is a recession shape used by economists to describe different types of recessions and their subsequent recoveries. In an L-shaped recovery, the economy is characterized by a severe recession with high unemployment and near-zero economic growth.
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The Easterlin paradox was first described by then professor of economics at the University of Pennsylvania Richard Easterlin. In the 1970s, Easterlin found that despite the American economy experiencing growth over the previous few decades, the average level of happiness seen in American citizens remained the same. He called this the Easterlin paradox, where income and happiness correlate with each other until a certain point is reached after at least ten years or so. After this point, income and happiness levels are not significantly related. The Easterlin paradox states that happiness is positively correlated with income, but only to a certain extent.
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In Economics, a Diseconomy of Scale happens when a company has grown so large that its costs per unit will start to increase. Thus, losing the benefits of scale. That can happen due to several factors arising as a company scales. From coordination issues to management inefficiencies and lack of proper communication flows.
An economy of scope means that the production of one good reduces the cost of producing some other related good. This means the unit cost to produce a product will decline as the variety of manufactured products increases. Importantly, the manufactured products must be related in some way.
Price sensitivity can be explained using the price elasticity of demand, a concept in economics that measures the variation in product demand as the price of the product itself varies. In consumer behavior, price sensitivity describes and measures fluctuations in product demand as the price of that product changes.
Gennaro is the creator of FourWeekMBA, which reached about four million business people, comprising C-level executives, investors, analysts, product managers, and aspiring digital entrepreneurs in 2022 alone | He is also Director of Sales for a high-tech scaleup in the AI Industry | In 2012, Gennaro earned an International MBA with emphasis on Corporate Finance and Business Strategy.
