Monopolistic Competition
Refers to the type of market competition in which different firms offer products and services that are identical but are not considered to be perfect substitutes for each other.
In economics, market competition refers to the market structure where different economic firms are competing against each other and are trying to procure goods and services that are limited by changing the elements of the marketing mix: price, place, promotion, and product.
Monopolistic competition refers to the type of market competition in which different firms offer products and services that are identical but are not considered to be perfect substitutes for each other.
The firms engaged in this form of competition in the market cannot reduce the supply of products or increase the prices to increase their profits, as is the case in a monopoly where all the decision-making power lies in the firm.
This competition is based on the marketing idea of product differentiation. To be successful in such environments, firms tend to focus on differentiating their products from competitors to earn above-average returns.
Economists Edwards Chamberlain and Joan Robinson gave the term in the 1930s to describe the competition between firms with similar but not wholly identical products.
This form of competition is supposed to be the middle ground between a monopoly and perfect competition (products are perfect substitutes). As a result, demand elasticity is considered low in the long run, and profits in the short run tend to be positive.
Other Types of Competition
There are four significant types of market structures that can exist in an economy. They are explained as follows:
1. Monopoly:
A monopoly refers to a market condition where only one firm offers goods and services to the consumers. It is considered the opposite of perfect competition, where an infinite number of firms can offer products.
In such market conditions, the firm that holds the monopoly has the power to change the prices, restrict supply, and can enjoy abnormal profits in the long run.
Some famous examples of monopolies are Microsoft and Windows, DeBeers and diamonds, and water, natural gas providers, and electricity providers in the United States.
2. Perfect Competition:
This is a theoretical market condition that is opposite to monopolies. In this structure, all firms operating in the market sell identical products, and all the firms are considered price takers.
The market share of firms in this industry does not influence the prices of goods and services, and buyers/consumers have complete information about the market. Barriers to entry and exit are very low, so it is easy for firms to operate here.
Examples of perfect competition are agricultural products, foreign exchange markets, etc.
3. Oligopoly:
Oligopoly refers to the theoretical market structure where a small number of firms operate with a strong influence over a given industry.
Although the group in a particular industry holds high market power, no individual firm can undermine another firm’s market share. Thus prices in such industries are fairly the same to avoid excessive competition.
One of the most famous examples of oligopoly is the OPEC organization which consists of a few countries that control the supply of crude oil across the globe.
Features
The characteristics are as follows:
1. Product Differentiation:
Since all the products offered in this form of a market are similar to each other and serve the same purpose, sellers are left with very few options to differentiate their products from their competitors.
Although sellers would sell products of lower quality at discount prices, it is challenging to assess if the higher-priced products are any better than other products offered in the market.
This uncertainty about the quality of goods and services circulating in the market arises from the imperfect information available to consumers. As a result, most customers need to learn the precise differences between the products.
Thus, firms competing in such environments tend to invest large amounts of money in marketing activities, such as advertising campaigns, promotional activities, etc., to attract consumers.
Different marketing campaigns pursued by different organizations play an essential role in offering the firms a competitive advantage, thereby ensuring a firm’s success.
One firm might adopt a policy of offering discounts and other promotional offers while purchasing the product. In contrast, another firm might invest heavily in advertising campaigns and public relations.
Some firms have recently adopted a new approach of launching green products that indicate the environment-friendly approach the firm is undertaking to differentiate itself from its competitors.
2. Competition in the market:
In monopolistic competition, several firms compete for identical by-products but might differentiate based on quality and features.
Certain firms perform better than other firms in such markets as the products offer higher value and quality to customers at a price equivalent to the products of competing firms.
An excellent example to understand such markets would be the soap industry, where different brands such as Dove, Pantene, Head and Shoulders, and Sunsilk compete by offering similar products at similar prices.
3. Barriers to Entry and Exit:
As in perfect competition, firms operating in monopolistic competition can also freely enter or exit the market at any given time.
New firms tend to enter the market when the existing firms make an abnormal profit. Due to the entry of new firms, the total supply of goods and services in the market increases, forcing downward pressure on the prices.
As a result of reducing prices, the profitability of firms operating in the market starts reducing, thereby reducing the total supply of products in the market. As the supply reduces, prices now start to increase.
Thus, firms operating in these markets tend to earn abnormal profits in the short run. However, firms are only left with average profits in the long run.
4. Lack of Perfect Knowledge:
Buyers need to have complete information about such markets. Hundreds of firms offer different products that are close substitutes for each other. The buyers only know a little bit about them.
As a result, at times, buyers are unable to make a purchase decision, and they end up buying products offered at discounted prices without knowing about the quality of the product.
Moreover, even the sellers need to have complete information about the market as they are unaware of the buyers' exact preferences and cannot take advantage of opportunities arising in the market.
5. Mobility of Resources:
The mobility of both inputs and outputs in monopolistic competition is very low.
Factors differentiating firms in monopolistic competition
There are several factors apart from the ones that are listed above that affect the performance of different firms in such a market. The factors are listed as follows:
1. Decision-Making Power:
As many firms are operating in the market, one firm’s decision-making power does not affect the decision-making process of other firms.
However, in oligopolies, price reduction by one firm can initiate a price war where all the firms start lowering their selling prices to increase their sales and capture maximum market share.
2. Pricing Abilities:
Like monopolies, firms in monopolistic competitions are considered price setters, not price takers. Although firms can set prices, the high demand for highly elastic products is offset.
Firms in such markets can only have the ability to charge higher prices if the product offered by them is superior in terms of quality and features as compared to their competitor’s products.
3. The elasticity of Demand:
Since the products offered by firms in monopolistic competition are similar, the elasticity of Demand for such products tends to be high, i.e., greater than 1.
This implies that a slight price increase will cause more significant fluctuations in the quantity demanded. Let us consider an example of a product priced at $10 with the quantity demanded is 100 units.
Suppose the price increases to $12, which reduces the quantity demanded to 60 units. Then, the elasticity of Demand can be calculated as the change in quantity demanded concerning the price change and, in this case, turns out to be -2.
Difference between Monopoly and Monopolistic Competition
A single firm dominating an entire industry refers to a monopoly, whereas many firms competing against each other by selling similar goods and services is known as monopolistic competition.
Monopolies enjoy the power of restricting the supply of products and changing prices whenever it wishes to increase their sales and profit, as customers in such cases would have no other option but to purchase that firm's products.
Although firms in monopolistic competition are also price setters, they do not enjoy the degree of flexibility that a firm in a monopoly enjoys. As firms compete against each other for higher market share, they must keep prices the same.
Unlike monopolies that generally arise in free market nations and lead to price gauging and reducing quality due to a lack of alternatives, monopolistic competition is considered a healthy environment for businesses to compete with each other.
The demand curve for a monopoly is steep, whereas the one for monopolistic competition is a downward-sloping flat line. Unlike monopolistic competition, monopolies have high barriers to entry and exit to prevent new firms from entering the market.
Disadvantages
The drawbacks are listed as follows:
1. Lower Production Efficiency:
Since many firms are in the market, this leads to difficulties for individual firms as firms need help to achieve economies of scale.
As a result, in the event of a need for economies of scale, individual firms find it extremely tedious to achieve high production efficiency.
2. Higher Focus on Advertising than Product Quality:
To differentiate products from that competitors, firms have to invest heavily in marketing techniques such as advertising and promotional activities.
Thus, the firm's focus primarily shifts from improving product quality to creating a better image of the existing ones in the eyes of the customers, which is considered disadvantageous due to the need for more innovation.
3. Predatory Price:
Firms with a higher market share and large potential in the market tend to keep low prices of the product to attract customers, as a famous firm with lower prices can attract more customers than others would be able to.
Competitors in such situations cannot incur losses due to the resulting fall in sales revenue and, at times, are forced to exit the market, increasing the dominant firms' market share.
4. Higher Resource Wastage:
As all firms produce similar goods and services using the same available resources, they might need more than efficient production to achieve economies of scale.
This leads to an increase in waste generated during the production process in the industry.
5. Misleading Advertising:
Since firms compete against each other by offering similar products to consumers, all firms try to invest as much as possible in advertising and other marketing activities.
Some advertisements tend to be false and misleading as they display products of higher quality than what it is, which puts the burden upon the consumers as consumers spend more on products that are not worth it.
6. Lack of Standardized Products in the market:
With a heavy focus on marketing techniques and neglecting attention to innovation and improving product quality, firms try to improve the image of their products rather than the quality.
This raises the question in the market if the products being circulated are standardized in nature or not.
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