Imperfect Competition

Monopolistic Competition

In monopolistic competition, many firms sell products that are not perfect substitutes for one another because of product differentiation.
Monopolistic competition is a market structure in which many firms, each with a low degree of market power, produce similar but differentiated products. These products are not perfect substitutes (replacements of equal value to consumers) for each other, although they may broadly perform the same function or fulfill the same need. The firms use product differentiation (giving their products unique characteristics to distinguish them from competitors) and advertising to stress the supposedly unique qualities of products that may otherwise seem indistinguishable because they perform the same service as competing products. This situation differs from other market structures such as perfect competition, pure monopoly, duopoly, and oligopoly.

Unlike an oligopoly, but like perfect competition, in monopolistic competition the barriers to entry are usually low or nonexistent. There are so many firms that one firm's decision to raise or lower prices is unlikely to have any effect on other firms' pricing decisions. Consequently, firms independently decide how much they will produce and at what price they will sell their product, largely based on production costs.

Although this situation resembles a perfectly competitive market to the extent that entry barriers are low and there are many producers, it is different from perfect competition in which the market sets the prices for a good. In a perfectly competitive market, the individual firm has no pricing power whatsoever. Therefore, firms in a perfectly competitive market face a horizontal demand curve, meaning the amount of demand stays the same no matter how much of a good is produced. In an imperfectly competitive market, each firm faces a downward-sloping demand curve. The ability of firms to affect the market price of goods means the more of a good produced, the lower the price the good will be.
In a monopolistically competitive market, firms can set the price of their products (PMC) and earn an economic profit in the short run with each firm facing a downward-sloping demand curve (D). This price is set where the average total cost curve (ATC) crosses D. The quantity at this price (QMC) is the quantity produced where marginal revenue (MR) is equal to marginal cost (MC). In contrast, in a perfectly competitive market, firms have no ability to change prices (PPC). Price is set at marginal revenue (MR), which is the demand curve for this market. The point where marginal cost (MC) crosses this curve is where average total cost (ATC) crosses as well. Thus firms earn no economic profit because they always face a horizontal demand curve.
The firm seeks to distinguish its product from its competitors' products by product differentiation, aimed at securing brand loyalty. The product itself can be differentiated by improving its build quality, improving its performance, changing its shape and color, or adding extra features. Even when the product is almost indistinguishable from competing products, it can be differentiated by distinctive packaging. A manufacturer may develop a strong brand image based on the skill of its workforce created by recruitment and training programs and supported by quality control systems so consumers trust its products.

All these forms of product differentiation are emphasized and communicated to consumers through advertising. To the extent a firm can convince consumers that its product is superior to and distinct from potential substitutes, it creates a situation where it has the equivalent of a monopolistic power.

In monopolistic competition, as distinct from other forms of imperfect competition, firms tend to be small. Examples include restaurants, personal services (such as hair and nail salons), hotels, and small shops, most of which operate in monopolistically competitive markets.

In the short run, profits tend to be higher than normal (that is, higher than they would be under conditions of perfect competition). In the long run, it is difficult to maintain such prices because low entry barriers attract new firms who also benefit from product differentiation. The resulting competition brings prices down to sustainable levels.

Monopolistic competition provides diversity to consumers, but it is inefficient because it makes it difficult to take advantage of economies of large-scale production. At a firm's optimal output the price exceeds marginal cost, whereas in perfect competition the price is reduced to marginal cost.

Product Differentiation

Product differentiation is the creation of distinguishing features of a product so competing products are not regarded as close substitutes.
Using product differentiation, a firm creates distinguishing features in a product so consumers consider the product unique and do not regard competing products as close substitutes. Product differentiation is designed to create a near-monopoly in a monopolistically competitive market in which there are many competing firms. Firms also use product differentiation in oligopolistic markets as a tactic against existing competitors and potential market entrants.

The firm distinguishes its product from its competitors' products to secure brand loyalty. A firm can differentiate a product by its form or physical appearance with a unique shape or color. For example, two athletic shoes may fulfill almost the same functions, but one will have one shape of sole and the other a different shape; another shoe will be offered in more colors than similar ones. Another element of form is size. One firm may differentiate by offering a larger product or a smaller one. A product may also have expanded functionality, such as the type of athletic shoe with an internal inflation mechanism (a pump). It may be sold with distinctive branding, such as the Nike swoosh logo. In some cases, a manufacturer may differentiate a product by offering the buyer the ability to customize it; for example, with a monogram or made-to-order sizes.

Differentiation may be accomplished across a range of products by developing a reputation for high quality through years of well-implemented worker recruitment and training programs and a strong quality control system. As a result, consumers will trust the brand and attribute extra qualities of reliability, durability, repairability, safety, and performance to that firm's products, even when the products appear similar to competitors' products. For example, certain brands of automobiles have higher resale values than others because of the brand's better repair record.

Another manufacturer may strive to offer better after-sales service, potentially attracting customers away from alternative products for which the after-sales service is less certain.

Another method of differentiation is to offer accessories and consumables at a lower price, bringing down the total cost of ownership of the original product. For example, a car with lower fuel consumption will be cheaper to run than a similar car with higher fuel consumption.

Even when a product is no better than the competition in all these respects, consumers may prefer it if they are persuaded that it is more in keeping with their own style. Therefore, maintaining a distinct style across a firm's products is another mode of product differentiation. For example, Converse makes shoes in a number of styles that all use the same canvas material and All-Star branding.

Effect of Entry on a Monopolistically Competitive Firm

The entry of new firms into a market characterized by monopolistic competition reduces the economic profit of an existing firm to zero.
In monopolistic competition, there are no, or low, barriers to entry, so it is easy for new firms to enter the industry. Firms in such a market produce close substitutes (products with equal value to the consumer) that are differentiated from each other in many ways. For example, if there is just one Chinese restaurant, the Golden Dragon, in the town center, it will probably offer dishes not available in nearby restaurants. If the Golden Dragon raises prices, it may not deter diners who like to eat Chinese cuisine regularly, unless meals become so expensive customers decide to switch to the nearby Indian or Mexican restaurants.

Because the Golden Dragon has a local monopoly of Chinese cuisine, it can charge relatively high prices and make an economic profit that exceeds the normal profit that would be available if there were many competing Chinese restaurants on the same street. Unless establishing more Chinese restaurants in the area is restricted (such as by a zoning law), the profitability of the existing restaurant is likely to attract competitors. These may differentiate their cuisine; for example, by offering Sichuanese or Cantonese menus, while attempting to cater to the same customers as the Golden Dragon.

As more Chinese restaurants open for business, the Golden Dragon's downward-sloping demand curve shifts to the left, as its customers try the alternatives. The competition will force the Golden Dragon to lower prices to stay open. Eventually, prices fall to a point where economic profits are eliminated.
As new competitors enter the market in monopolistic competition, the demand curve shifts to the left from D1 to D2. This lowers the price the firm can charge from P1 to P2.

Long-Run Equilibrium for a Firm in Monopolistic Competition

A firm reaches long-run equilibrium at the point where the long-run marginal cost equals the marginal revenue at a point corresponding to the quantity of output at which the long-run average cost curve touches the demand curve.
In the short run (meaning an amount of time too short for a firm to significantly change the scale of its operations), a firm operating in conditions of monopolistic competition has pricing power because it can differentiate its product from its competitors' products. In these conditions, a monopolistically competitive firm faces the same downward-sloping demand curve that a monopoly or oligopoly faces. Therefore, the firm can reduce its output and raise its price without fear of being undercut by competitors, unless the price difference is so large that consumers are prepared to forgo all the perceived benefits of the product they usually buy. The increase in price allows the firm to reduce output (and thus, operating costs) without losing profit. As with a monopoly, the firm will maximize its profits by producing up to the point where marginal revenue (the amount earned from the last unit of a good sold) equals marginal cost (the amount it costs to produce the last unit of a good produced.) If the average total cost at this point is below market price, the firm will make a profit. If it is above the market price, the firm will make a loss and eventually exit the industry, leaving those firms whose average total cost is below market price with an increased overall market share.

However, this position cannot be maintained indefinitely. In a monopolistically competitive market, entry barriers are low, so if existing firms are making a profit, competition will emerge from newcomers entering the industry. These newcomers will be able to differentiate their products to attract customers away from the products of existing firms. As a result, the demand curve for existing profitable firms in the industry will shift to the left.

The firm will reach long-run equilibrium in a monopolistically competitive market when the long-run marginal cost curve crosses the marginal revenue curve where the long-run average cost curve touches the demand curve for its product. At this combination of price and quantity of output, there will be no economic profit, all firms will make normal profits (as in perfect competition), newcomers will no longer be attracted to gain entry, and the market will stabilize.
In the long run, when marginal cost (MC) is equal to marginal revenue (MR), price (P) is the same as average total cost (ATC). The result is zero profit, also called normal profit.
The difference between monopolistic competition and perfect competition is that at long-run equilibrium, the perfectly competitive firm will be producing at optimum efficiency, while the monopolistically competitive firm will be producing at a less efficient point. In order to maximize profits and minimize costs, firms will reduce output and raise prices, rather than utilizing all the resources at their disposal. Consequently, there will be excess capacity (a situation where the output level of production less than what a firm could theoretically achieve) in the firm and in the entire industry. This underutilization of resources is evident in many monopolistically competitive markets. Examples include specialized retailers and restaurants, which are often not full of customers. Other examples include aircraft not filled to capacity on flights, or hotels that are not fully booked.