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Monopolistic Competition

Monopolistic Competition

Author: Kate Eskra
This lesson will explain Monopolistic Competition
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Hi, welcome to Economics. This is Kate. This tutorial is on Monopolistic Competition. As always my key terms are in red, and my examples are in green.

So in this tutorial we'll talk about monopolistic competition as one of the four market structures studied in economics. You'll be able to define this market structure, and you'll understand its main characteristics at the end of the tutorial.

OK. So we know that firms are the ones who take the factors of production and turn them into the goods and services that we then purchase. And we know that firms are not all created equal. They all behave a little bit differently-- or a lot differently-- and economics studies the behavior of firms.

And it definitely is going to vary depending on a lot of factors. Some of the factors that it varies based on are their size; what kind of product they're selling; how much competition they're facing; and how easy or how difficult it is to get into that business.

So let's talk about where monopolistic competition falls in the spectrum of market structures. We have the extremes of perfect competition where there are many, many, many sellers selling the exact same product, which is homogeneous. We have the other end of the spectrum, which is monopoly, where there's only one firm selling something that's one of a kind.

What is kind of confusing about monopolistic competition sometimes is that kind of looks like the word monopoly. But in fact that's why I wanted to give you this visual. It's actually closer to perfect competition on the spectrum than it is to monopoly, so try to separate the two. You know monopolistic competition is not going to have a whole lot in common with monopoly. OK?

So monopolistic competition defined is, "An industry market structure characterized by a large number of firms selling similar products." They do have a differentiated product. So they may be very, very similar, but that's the name of the game here. They will do everything they can to differentiate their product. And that's the biggest difference between this and perfect competition where there was no ability to differentiate.

So some of the classic examples are the fast food industry, where there are a whole lot of fast food restaurants. And yes, they may be selling something extremely similar, but you know whether you're walking into a McDonald's, or Burger King, or Wendy's. You may have a preference over one or the other.

Clothing stores. Basically they're selling a whole lot of the same thing, but you know whether you're purchasing something from Gap or American Eagle. If you couldn't tell from just the look of the clothes, you could certainly tell from the tag.

OK. So like I said there are many firms selling a similar product. They do have some control over market price. So they have the ability to choose what price they want to charge, but they do have to be careful. So I pose the question here, "Can McDonald's raise prices significantly?" Do they have enough market power that they could raise the price of their hamburgers by a few dollars?

And more than likely the answer is, no. They face a lot of competition in the fast food industry, and so they have to be careful. But it is their prerogative. They do have some control over market price, and they've tried to differentiate themselves from their competition.

All right. So another word about them and their pricing. There are too many firms for them to strategically price. And what we mean by strategic pricing would be for them to get together and try to charge a very similar price. So there's too many.

But what we do want to note here is that if a firm enters or exits the market-- so if McDonald's would leave the fast food industry-- certainly that can effect the market pricing strategies for the remaining players, or for the remaining restaurants. So one firm exiting or entering can have an impact on the overall market price.

All right. So imperfect information. When we have perfect information about something, we know everything about it before we purchase it. We know how much it costs to make it. We know the market price exactly-- where it's been, where it will be. We know everything about the company.

I certainly know that unfortunately I don't have all the information about most of the goods that I purchase, and sometimes I regret my purchase. In this market structure-- monopolistic competition-- information is not perfectly shared between the firm and the consumer. So there is not what we would consider perfect information, as there is only in perfect competition.

OK. So there are going to be some inefficiencies that arise here. In perfect competition-- the reason we start with that market structure sometimes when we teach about it is because perfect competition is so efficient in terms of how productively efficient they are. They have no choice but to drive their production costs down to the lowest possible, because of how much competition they face. And they have no control over the price that they're charging. So if they're not doing it the cheapest way, the most efficient way, somebody else is going to.

In monopolistic competition because the name of the game is differentiating their product, they're going to spend a lot of money on advertising. For example-- this is just one example here. And so that's going to increase the cost of production. So certainly their cost of production is not the absolute lowest it could be.

And that kind of begs the question, does the money that they're spending on advertising really increase the quality of the product that we are getting? Is all of this money that they're spending going into anything that's good for us as the consumer? I've heard some people argue that it can help increase the information as I talked about on the last slide. You know with the imperfect information?

But what kind of information are we really getting from advertisements? You know is it something that is true and real, or not? And that's something that you can have your own opinion about. But we just did want to bring up here that there are some production inefficiencies that can arise due to all this money that can be spent on advertising, for example.

OK. So again let's take a look at where this falls in the spectrum. From perfect competition to monopolistic competition, the biggest difference here is now that there is product differentiation and some control over price. But certainly they are not a monopoly with, you know, sole power in the market-- the only one selling something.

What we need to look at is so who do they act more like? Are they more like a perfect competitor, or are they more like a monopolist? Well it depends on whether we're talking short or long run.

In the short run, they actually-- we kind of find that they behave a little bit more like monopolists, because they're trying to differentiate their product. They're trying to establish their market power as someone selling something unique, so that consumers go to them and not the competition. And they're going to set prices and produce the quantity that maximizes their profit. Just as a monopolist would do, because they do have enough power to set their own price.

But in the long run, because barriers to entry are pretty low-- meaning it's going to be pretty easy to get into and out of this industry-- monopolistic competitors are going to face a lot of competition in the long run. Again because of these barriers to entry being really low.

Let's say in the fast food industry almost anybody, in theory, could get in and start another restaurant. So because of those low barriers to entry, they face so much competition, and they're forced to kind of behave more like perfect competitors. So it depends on how you look at it, short or long run.

So in this tutorial we talked about monopolistic competition and where it falls in the spectrum. And the main characteristics of it are that they sell a differentiated product. There are many firms with some control over price. There is free entry and exit, so the barriers to entry are relatively low. And there are some production inefficiencies that we talked about.

Thank you so much for listening. Have a great day.

Notes on "Monopolistic Competition"

Terms to Know

Monopolistic Competition

An industry market structure characterized by a large number of firms selling similar products.