What is Monopolistic Competition?

Monopolistic competition is like jumbo shrimp…

Not many people would look at a shrimp and describe it as jumbo. That is, unless you are comparing it to other shrimp. Likewise, monopolistic competition might not seem entirely monopolistic, but it is compared to a market with perfect competition.

If a company is engaged in monopolistic competition, there are a few characteristics that you will notice. First, with low barriers to entry, there are a large number of firms offering products that are very similar to each other.

All of these companies are competing for the attention and attraction of the same pool of potential customers. Each firm produces a good that is a close substitute for its competitor's product. That leads to fierce competition, which makes it hard for existing firms to charge a premium for their product, or for new firms to gain a foothold. However, the market participants aren’t trying to sell identical products. Each individual firm has a hook, a brand name, or some differentiating characteristic that makes it unique.

When a customer looks at two competing goods, they typically see the similarities but also the differences. And those differences allow a customer to justify paying more for one than the other.

That is the monopoly characteristic in the market. Each company has more ability to set prices than pure competition would allow. And that limited pricing power leads to increased profits.

When you walk into a grocery store, you are bombarded with examples of monopolistic competition. Walking past the bakery, you see dozens of brands of bread. They are all pretty much the same, but you probably have a favorite that you pick up without noticing a lower-cost option.

Head over to toilet paper, and you will see dozens of brands selling very similar products. Some have different thicknesses, scents, or softness. Those small acts of differentiation just might get you to pay a few extra pennies.

The same condition exists in every aisle. From dog food to diapers, from cola to cleaning supplies, these nearly identical products can charge different prices without losing all of their sales.

But does your car run any different with one brand of oil versus another? Probably not. And it probably doesn’t notice if you fill the tank at the station across the street to save a nickel a gallon. Examples of monopolistic competition are all around you.

A monopoly is a business without competition. And because that company has 100% of the market share, it sets the price you pay. By restricting output and charging a higher rate, a monopoly can make way more profit than if they had competitors. This is called supernormal profits.

Monopolists are price makers with unlimited pricing power. They set their prices to capture as much of the gains from trade as possible. Consequently, they produce fewer goods than a competitive market would create.

Because monopoly power leads to higher prices and fewer jobs (which is called a deadweight loss to society), governments tend to discourage monopolies from forming.

Businesses engaged in monopolistic competition, on the other hand, are in a competitive industry. In fact, there are usually a lot of competitors. Nonetheless, a company in such a market still has some limited pricing power — Which allows them to act a little like a monopolist. Through product differentiation and effective marketing, companies in monopolistic competition can entice consumers into paying a little extra for their products.

Perfect competition is a theoretical market condition in which many businesses offer identical products to consumers. However, people who study microeconomics can usually find some reason that no two products are exactly the same.

Even subtle differences in branding, geography, imperfect information, and even ownership of the company, can lead customers to value seemingly identical products differently.

If the theoretical perfect market did exist, then customers would have perfect price elasticity of demand (that is, they’d be extremely sensitive to changes in price). With no other characteristic to consider, the lower price would be the only distinguishing factor. Therefore, all competitive firms in such a market are price takers (they have to accept the market price).

Any business attempting to increase its price by even one penny would immediately see its sales fall to zero. And any seller able to charge even one penny less than the competition would get all of the market. In theory, this leads to a price war, with each company slashing its price until everyone is ultimately charging the absolute minimum it can without going out of business. Of course, such a situation squeezes all of the potential economic profit (revenues minus total costs, including opportunity costs) out of the market.

In the real world, most industries are engaged in imperfect competition. It’s hard to find an example of a company losing all of its sales by charging one penny more than the competition. Most markets have a little bit of slack, which gives companies a taste of market power. The closer products are to one another, the more limited that power becomes.

To create that gap in perception, these companies must convince buyers that the products are not perfect substitutes. That is monopolistic competition.

From the perspective of the consumer, perfect competition is the ideal market condition. It is the most efficient use of resources, creates the most jobs, and generates the lowest prices.

From the perspective of the producer, monopoly is the best possible outcome. It makes the most profit, avoids the risk of loss, and doesn’t require any innovation to keep the money rolling in.

Because monopolistic competition falls in between the two extremes, the advantages and disadvantages depend on one’s perspective. Namely, the limited pricing power allows some supernormal profits for the company, which is good for the seller and bad for the buyer. But the check on that pricing power is better than monopoly pricing from the consumer’s point of view.

However, there are a couple of pros and cons that are not perspective dependent. For one, companies spend a lot of time and money trying to one-up the competition. Rather than competing solely on price, they strive to make higher quality products, build strong brands, and find innovative solutions to solve the consumer’s problem.

Of course, all of this costs money — Something companies would rather not spend. Some companies might spend a lot on marketing rather than making meaningful improvements to the products they sell.

This process can lead to inefficiency, as competitors end up charging consumers more for their products so that they can engage in advertising combat. There are no winners in that war.

Nothing lasts forever. In business, your ability to charge more than the marginal cost of production is like blood in the water. It attracts sharks. As new firms see what you are doing, they adopt your successful idea, and they attack your high gross profit margins.

To fight them off, all the extra profits you were able to earn in the short-run become ammunition in a battle to protect them. You use them to combat patent infringement, to increase marketing efforts, or to create new ways to distance yourself from the competition.

In the end, monopolistic competition leads to the same long-run equilibrium. Either a price war pushes the market price down or the cost of doing business increases. Ultimately, the market becomes efficient (marginal revenue equals marginal cost).

The economics of imperfect competition erode those supernormal profits down to normal profits.