Monopolistic competition is a form of imperfect competition where many competing producers sell

products that aredifferentiated from one another (that is, the products are substitutes, but, with
differences such as branding, are not exactly alike). In monopolistic competition firms can behave
like monopolies in the short-run, including using market power to generate profit. In the long-run, other
firms enter the market and the benefits of differentiation decrease with competition; the market
becomes more like perfect competition where firms cannot gain economic profit. Unlike perfect
competition, the firm maintains spare capacity. Models of monopolistic competition are often used to
model industries. Textbook examples of industries with market structures similar to monopolistic
competition include restaurants, cereal, clothing, shoes, and service industries in large cities. The
"founding father" of the theory of monopolistic competition was Edward Hastings Chamberlin in his
pioneering book on the subject Theory of Monopolistic Competition (1933).[1] Joan Robinson also
receives credit as an early pioneer on the concept.

Monopolistically competitive markets have the following characteristics:

 There are many producers and many consumers in a given market, and no business has total
control over the market price.

 Consumers perceive that there are non-price differences among the competitors' products.

 There are few barriers to entry and exit.[2]

 Producers have a degree of control over price.

The long-run characteristics of a monopolistically competitive market are almost the same as in perfect
competition, with the exception of monopolistic competition having heterogeneous products, and that
monopolistic competition involves a great deal of non-price competition (based on subtle product
differentiation). A firm making profits in the short run will break even in the long run because demand
will decrease and average total cost will increase. This means in the long run, a monopolistically
competitive firm will make zero economic profit. This gives the amount of influence over the market;
because of brand loyalty, it can raise its prices without losing all of its customers. This means that an
individual firm's demand curve is downward sloping, in contrast to perfect competition, which has
a perfectly elastic demand schedule.

Monopolistic competition
From Wikipedia, the free encyclopedia
Short-run equilibrium of the firm under monopolistic competition. The firm maximizes its profits and produces a
quantity where the firm's marginal revenue (MR) is equal to its marginal cost (MC). The firm is able to collect a
price based on the average revenue (AR) curve. The difference between the firms average revenue and average
cost gives it a profit.

Long-run equilibrium of the firm under monopolistic competition. The firm still produces where marginal

cost and marginal revenue are equal; however, the demand curve (and AR) has shifted as other

firms entered the market and increased competition. The firm no longer sells its goods above

average cost and can no longer claim an economic profit

Major characteristics
There are six characteristics of monopolistic competition (MC):

 product differentiation

 many firms

 free entry and exit in long run

  Independent decision making

 Market Power

 Buyers and Sellers have perfect information[3][4]

Product differentiation
MC firms sell products that have real or perceived non-price differences. However, the differences are
not so great as to eliminate goods as substitutes. Technically the cross price elasticity of demand
between goods would be positive.In fact the XED would be high.[5] MC goods are best described as
close but imperfect substitutes.[5] The goods perform the same basic functions. The differences are in
"qualities" and circumstances such as type, style, quality, reputation, appearance, and location that
tend to distinguish goods. For example, the function of motor vehilces is basically the same - to get
from point A to B in reasonable comfort and safety. Yet there are many different types of motor
vehicles, motor scooters, motor cycles, trucks, cars and SUVs.

Many firms
There are many firms in each MC product group and many firms on the side lines prepared to enter
the market. A product group is a "collection of similar products".[6] The fact that there are "many firms"
gives each MC firm the freedom to set prices without engaging in strategic decision making.The
requirements assures that each firm's actions have a negligible impact on the market. For example. a
firm could cut prices and increase sales without fear that its actions will prompt retaliatory responses
from competitors.

How many firms will an MC market structure support at market equilibrium? The answer depends on
factors such as fixed costs, economies of scale and the degree of product differentiation. For example,
the higher the fixed costs the fewer firms the market will support.[7] Also the greater the degree of
product differentiation - the more the firm can separate itself from the pack - the fewer firms there will
be in market equilibrium.

Free entry and exit

In the long run there is free entry and exit. There are numerous firms awaiting to enter the market each
with its own "unique" product or in pursuit of positive profits and any firm unable to cover its costs can
leave the market without incurring liquidation costs. This assumption implies that there are low start up
costs, no sunk costs and no exit costs.
Independent decision making
Each MC firm independently sets the terms of exchange for its product.[8] The firm gives no
consideration to what effect its decision may have on competitors.[9] The theory is that any action will
have such a negligible effect on the overall market demand that an MC firm can act without fear of
prompting heightened competition. In other words each firm feels free to set prices as if it were a
monopoly rather than an oligopoly.

Market power
MC firms have some degree of market power. Market power means that the firm has control over the
terms and conditions of exchange. An MC firm can raise it prices without losing all its customers. The
firm can also lower prices without triggering a potentially ruinous price war with competitors. The
source of an MC firm's market power is not barriers to entry since there are none. An MC firm derives
it's market power from the fact that it has relatively few competitors, competitors do not engage in
strategic decision making and the firms sells differentiated product.[10] Market power also means that
an MC firm faces a downward sloping demand curve. The demand curve is highly elastic although not
"flat".

Perfect information
Buyers know exactly what goods are being offered, where the goods are being sold, all differentiating
characteristics of the goods, the good's price, whether a firm is making a profit and if so how much.[11]

Market Structure comparison

Elasticity Product Profit

Number Market Pricing
of differentiatio Excess profits Efficiency maximizatio
of firms power power
demand n n condition

Highly
Monopolisti
elastic Yes/No Price
c Many Low High[15] No[17] MR=MC[13]
(long run) (Short/Long)[16] setter[13]
competition [14]
Inefficiency
There are two sources of inefficiency in the MC market structure. First, at its optimum
output the firm charges a price that exceeds marginal costs, The MC firm maximizes
profits where MR = MC. Since the MC firm's demand curve is downward sloping this
means that the firm will be charging a price that exceeds marginal costs. The monopoly
power possessed by an MC firm means that at its profit maximizing level of production
there will be a net loss of consumer (and producer) surplus. The second source of
inefficiency is the fact that MC firms operate with excess capacity. That is, the MC firm's
profit maximizing output is less than the output associated with minimum average cost.
Both a PC and MC firm will operate at a point where demand or price equals average
cost. For a PC firm this equilibrium condition occurs where the perfectly elastic demand
curve equals minimum average cost. An MC firm’s demand curve is not flat but is
downward sloping. Thus in the long run the demand curve will be tangent to the long run
average cost curve at a point to the left of its minimum. The result is excess capacity.

Problems
While monopolistically competitive firms are inefficient, it is usually the case that the costs of regulating
prices for every product that is sold in monopolistic competition by far exceed the benefits; the
government would have to regulate all firms that sold heterogeneous products—an impossible
proposition in a market economy. A monopolistically competitive firm might be said to be marginally
inefficient because the firm produces at an output where average total cost is not a minimum. A
monopolistically competitive market might be said to be a marginally inefficient market structure
because marginal cost is less than price in the long run.[citation needed]

Another concern of critics of monopolistic competition is that it fosters advertising and the creation
of brand names. Critics argue that advertising induces customers into spending more on products
because of the name associated with them rather than because of rational factors. This is disputed by
defenders of advertising who argue that (1) brand names can represent a guarantee of quality, and (2)
advertising helps reduce the cost to consumers of weighing the tradeoffs of numerous competing
brands. There are unique information and information processing costs associated with selecting a
brand in a monopolistically competitive environment. In a monopoly industry, the consumer is faced
with a single brand and so information gathering is relatively inexpensive. In a perfectly competitive
industry, the consumer is faced with many brands. However, because the brands are virtually identical,
again information gathering is relatively inexpensive. Faced with a monopolistically competitive
industry, to select the best out of many brands the consumer must collect and process information on
a large number of different brands. In many cases, the cost of gathering information necessary to
selecting the best brand can exceed the benefit of consuming the best brand (versus a randomly
selected brand).

Evidence suggests that consumers use information obtained from advertising not only to assess the
single brand advertised, but also to infer the possible existence of brands that the consumer has,
heretofore, not observed, as well as to infer consumer satisfaction with brands similar to the advertised
brand.[19]

Examples
In many U.S. markets, producers practice product differentiation by altering the physical composition,
using special packaging, or simply claiming to have superior products based on brand images and/or
advertising. Toothpastes and toilet papers are examples of differentiated products.