Monopolistic Competition: Features & Differentiation
Monopolistic Competition: Features and Differentiation
As the term suggests, monopolistic competition is a market structure that combines characteristics of both monopoly and perfect competition. Because each company offers a slightly different product, it is, in a way, a monopoly: it faces a downward-sloping demand curve and possesses some market power, i.e., a certain ability to set the price of its product. However, unlike a pure monopoly, a firm in monopolistic competition faces competition: the quantity of product it sells depends on the prices and products offered by other companies. The same is true for an oligopoly. However, in a situation of monopolistic competition, there are a large number of producers and no barriers to entry, making collusion, both explicit and tacit, virtually impossible.
Monopolistic Competition in the Short Term
Short-term equilibrium means that the number of firms is constant. The long-term equilibrium, by contrast, is reached only after a period during which companies can enter and exit the industry. Like a monopoly, each firm in an industry operating in a situation of monopolistic competition faces a downward-sloping demand curve and a decreasing marginal revenue curve. In the short term, it may gain or lose money when it produces the profit-maximizing quantity, which is the quantity at which marginal revenue equals marginal cost. The key to whether a firm with market power is profitable or not in the short term lies in the relationship between the demand curve and the average total cost curve.
- If the demand curve intersects the average total cost curve, a certain section of the demand curve rises above the average total cost curve. Therefore, there are some price-quantity combinations in which the price is higher than the average total cost, indicating that the company can choose a quantity to obtain a positive profit (case *a* in a graph).
- If the demand curve does not intersect the average total cost curve, it is always situated below, and consequently, the price for any quantity demanded is always less than the average total cost of producing that quantity. There is no quantity that prevents the company from losing money (case *b* in the figure).
Monopolistic Competition in the Long Term
If the typical company obtains a positive profit, new firms will enter the industry in the long term, and the demand curve and marginal revenue associated with each of the existing enterprises will shift to the left. If the standard company incurs losses, some existing firms will leave the industry in the long term, and the demand curve and marginal revenue associated with each of the remaining companies will shift to the right. In the long run, a monopolistically competitive industry ends in a zero-profit equilibrium: each firm makes zero profit when it produces the quantity of goods that maximizes its profits. The demand curve of each standard company is tangent to its average total cost curve, with the tangent point maximizing the quantity of goods for profit. This is because free entry and exit of firms imply that a situation of profit or loss is not a long-run equilibrium. If there are profits, new firms will enter the industry, and the demand curve for each of the companies will move to the left until all profits have disappeared. In the case of losses, some existing firms will leave the industry, and the demand curve for each of the companies that remain will shift to the right until all losses are gone. The entries and exits only stop when each firm makes a profit equal to zero, producing the quantity that maximizes its profits.
Product Differentiation
When companies try to convince consumers that their product is different from that produced by other firms in the sector, it is said that they are seeking product differentiation. This product differentiation can occur in oligopolies that fail to achieve tacit collusion and, with capital importance, in situations of monopolistic competition. The key to product differentiation is that different consumers have different preferences, and each producer can create a niche market by producing what satisfies the specific preferences of a consumer group better than products from other companies.