Monopolistic Competition: Characteristics & Demand Curve

What is Monopolistic Competition?

A Monopolistic Competition Market consists of the features of both Perfect Competition and a Monopoly Market. A market situation in which there is a large number of firms selling closely related products that can be differentiated is known as Monopolistic Competition. The products of monopolistic competition include toothpaste, shampoo, soap, etc. For example, the market for soap enjoys full competition from different brands and has freedom of entry showing the features of a perfect competition market. However, every soap has its own different feature, which allows the firms to charge a different price for them. It shows the features of a Monopoly Market. 

Monopolistic Competition is the combination of a Monopoly and a Perfect Competition market (Monopolistic Competition = Monopoly + Competition)

The firm under Monopolistic Competition is the sole producer of a specific product or brand. In other words, as far as a specific brand is concerned, the firms under Monopolistic Competition enjoy a Monopoly position. However, the availability of close substitutes in the market influences the monopoly position of the firm as they face stiff competition from other firms in the industry. 

Hence, it can be said that Monopolistic Competition is a form of market in which there is competition among various monopolists. 

Features of Monopolistic Competition

1. Large number of Sellers: Under monopolistic competition, a large number of firms sell closely related but heterogeneous products. Every firm under this market structure acts independently and has limited share of the market, which means that an individual firm has a limited control over the market price of the product. However, as there are a large number of firms in the market, it leads to stiff competition. 

2. Product Differentiation: In spite of a large number of sellers in the market, each firm under monopolistic competition enjoys some degree of monopoly in the market. The firms exercise monopoly because of product differentiation. It means that the product of a firm is close to the product of another firm, but it is not a perfect substitute. The buyers of a monopolistic market structure differentiate the products manufactured by different firms and are also willing to pay different prices for the same differentiated product produced by different firms. The major benefit of product differentiation is that it gives monopoly power to a firm through which it can easily influence the market price of its product. 

Product Differentiation means differentiating the products of the market based on their brand, colour, shape, size, etc. Differentiation among the products can be based on either real or imaginary differences. Real differences include difference in colour, shape, flavour, warranty period, after sales service, etc. However, imaginary differences include differences that are not really obvious to everyone, but the buyers are made to believe by the firms that those differences exist, such as selling costs through advertisement, etc. For example, in cars, product differentiated firms are Ford, Hyundai, TATA Motors, etc. 

Product differentiation gives a monopoly to a firm by making the demand for the product less elastic. Because of the less elasticity of demand for the product, the firm can easily charge a higher price than the price charged by its competitors. For example, Red Label Tea is costlier than Brooke Bond Taaza Tea. 

3. Freedom of Entry and Exit: The sellers under the monopolistic competition market have the freedom of entry and exit in/from the industry. It means that there are no artificial restrictions or barriers to the entry of a new firm or exit of an existing firm. This feature of a monopolistic competition market ensures that abnormal profits and abnormal losses do not exist in the long run. 

Freedom of Entry of the new firms under a monopolistic competition market indicates that there are no barriers for the new firms to enter the industry. When the existing firms in the industry are making abnormal profits from their business, it attracts new firms to enter for profit, which in result increases the market supply of goods, ultimately resulting in the reduction in market price and profits. Hence, the entry of new firms into the industry only happens until every firm in the industry is earning normal profits only. 

Freedom of Exit of the existing firms under a monopolistic competition market indicates that there are no barriers for the existing firms to leave the industry. Firms generally exit the industry when they are facing losses, and their exit decreases the market supply of goods resulting in an increase in the market price of those goods. However, their exit also reduces the losses, and hence the firms exit the industry until all the losses are wiped out from the industry, and each of the existing firms earns normal profits. 

Even though monopolistic competitive firms and perfectly competitive firms enjoy freedom of entry and exit, the former is not as easy and free as the latter. 

Normal Profits:

The minimum profit required by a firm to run the business is Normal Profit. Normal profits are included in the total production costs of a firm.

Abnormal Profits:

The excess amount of earnings of a firm over its total production cost is known as Abnormal Profit.

Abnormal Losses:

The shortage in the amount of earnings of a firm over its total production cost is known as Abnormal Losses. 

4. Selling Costs: The products under monopolistic competition market are differentiated. The information about these differences in the products is given to the buyers through its selling costs. The firms add selling costs to the product so they can persuade the buyers in buying a specific brand of the product and keep that brand as their preference over the competitor’s brand. Therefore, under monopolistic competition, the total cost of a product includes its selling costs. 

Selling cost is the cost incurred on the advertisement, marketing, and sales promotion of the product. 

5. Pricing Decision: The firms under monopolistic competition are neither price-maker nor price-taker. However, as the firms produce unique and differentiated products from each other, each firm has partial control over the price of the product. The extent of a firm’s power to control the price of the product depends upon the strength of the buyers’ attachment to the brand. 

6. Lack of Perfect Knowledge: The buyers and sellers, under a monopolistic competition market, do not have perfect knowledge about the market conditions. The selling costs added in the total cost of a product manufactured by a monopolistic firm create an artificial superiority in the consumers’ minds, which makes it difficult for them to evaluate different products available in the market. Because of a lack of perfect knowledge and the creation of artificial superiority, a high priced product is preferred by the consumers even though other products provide the consumers with the same quality at a low price. 

7. Non-Price Competition: In monopolistic competition, there exists not only price competition, but also non-price competition. Non-Price Competition means competing with other firms by offering them gifts, better credit terms, etc. It is done by the firms without changing the price of the product. 

Demand Curve under Monopolistic Competition

There are a large number of sellers under Monopolistic Competition who sells closely related but differentiated products in the market. It makes the demand curve of a monopolistic competition market downward sloping. It means that a monopolistic firm can sell more products/output only when it reduces its price. This concept can be understood with the help of a graph/demand curve of a firm under Monopolistic Competition.  

As shown in the above demand curve, the output of the firm under Monopolistic Competition is measured along the X-axis, and its revenue and product’s price is measured along the Y-axis. At price OP, the seller of the Monopolistic Competition can sell OQ quantity of the output. The demand for the product will increase to OQ₁ only when the price of the product is reduced to OP₁. Therefore, the demand curve of the firms under Monopolistic Competition has a negative slope, or they can sell more products only when the price of the product decreases. 

Just like Monopoly, because of the negatively sloping demand curve, the MR under Monopolistic Competition is less than AR. 

Therefore, under Monopolistic Competition, MR < AR.