Monopolistic Competition: Definition, Function, Pros & Cons

Definition

Monopolistic competition is a market structure in which companies compete against each other by offering products or services that are only slightly different. As a result, no single product or service dominates the market.

Key Takeaways

Monopolistic competition features many companies selling similar but not identical products.
Entry barriers are low in monopolistic competition, making it easier for new firms to enter.
Individual company decisions have little direct impact on competitors.
Companies differentiate through pricing strategies and marketing efforts.

What Is Monopolistic Competition?

Monopolistic competition exists when many companies offer competing products or services that are similar but not perfect substitutes. The barriers to entry in a monopolistically competitive industry are low and the decisions of any one firm don't directly affect its competitors. Competing companies differentiate themselves based on pricing and marketing decisions.

Monopolistic Market — Investopedia / Joules Garcia

Understanding the Mechanics of Monopolistic Competition

Monopolistic competition exists along the spectrum between a complete monopoly and perfect competition. It combines elements of each.

Demand is highly elastic for goods and services of the competing companies and pricing is often a key strategy for these competitors. One company might opt to lower prices and sacrifice a higher profit margin, hoping for increased sales. Another might raise its price and use packaging or marketing that suggests better quality or sophistication.

Companies often use distinct marketing strategies and branding to distinguish their products. The products may all serve the same purpose so the average consumer often doesn't know the precise differences between the various products or how to determine what a fair price may be.

Fast Fact

Household items provide an example of monopolistic competition. Items like dish soap or hamburgers are sold, marketed, and priced by many competing companies.

Key Traits of Monopolistic Competition

Monopolistic competition can take many shapes and have varying results and benefits.

Low Barriers to Entry

A single firm doesn't monopolize the market in monopolistic competition. Multiple companies can enter the market and all can compete for market share. Companies don't have to consider how their decisions influence competitors, and each firm can operate without fear of increasing competition.

Product Differentiation

Competing companies differentiate their similar products with distinct marketing strategies, brand names, and different quality levels.

Pricing

Companies in monopolistic competition act as price makers and set prices for goods and services. Firms can raise or lower prices without inciting a price war often found in oligopolies.

Demand Elasticity

Demand is highly elastic in monopolistic competition and very responsive to price changes. Consumers will change from one brand name to another for items like laundry detergent based solely on price increases.

Pros and Cons of Monopolistic Competition

Monopolistic competition provides both benefits and pitfalls for companies and consumers.

Pros

Few barriers to entry for new companies
Variety of choices for consumers
Company decision-making power for prices and marketing
Consistent quality of product for consumers

Cons

Having many competitors limits access to economies of scale
Inefficient company spending on marketing, packaging, and advertising
Too many choices for consumers means extra research required
Misleading advertising or imperfect information for consumers

What's the Difference Between Monopolistic Competition and Perfect Competition?

The product offered by competitors is the same item in perfect competition. A company will lose all its market share to the other companies based on market supply and demand forces if it increases its price.

Supply and demand forces don't dictate pricing in monopolistic competition. Firms are selling similar but distinct products so they determine the pricing. Product differentiation is the key feature of monopolistic competition because products are marketed by quality or brand. Demand is highly elastic and any change in pricing can cause demand to shift from one competitor to another.

How Does Monopolistic Competition Function in the Short and Long Terms?

Companies aim to produce a quantity where marginal revenue equals marginal cost to maximize profit or minimize loss. New firms will enter the market when existing firms are making a profit.

The demand curve and the marginal revenue curve then shift. New firms stop entering when all firms are making zero profit in the long run. Some firms will exit the market if existing firms are incurring losses. The firms stop exiting the market after all firms start making zero profit. The market is at equilibrium in the long run only when there's no further exit or entry in the market or when all firms make zero profit in the long run.

What Industry Is an Example of Monopolistic Competition?

Monopolistic competition is present in the fast food industry. Burger King and McDonald's are both fast-food chains that target a similar market and offer similar products and services. These companies actively compete with each other and seek to differentiate themselves through brand recognition, price, and by offering different food and drink packages.

What's the Difference Between Monopolistic Competition and a Monopoly?

A monopoly occurs when a single company dominates an industry and can set prices for its product without fear of competition. Monopolies limit consumer choices and control production quantity and quality.

Monopolistically competitive companies must compete with others, restricting their ability to substantially raise prices without affecting demand and providing a range of product choices for consumers. Monopolistic competition is more common than monopolies, which are discouraged in free-market nations.

The Bottom Line

Monopolistic competition exists when many companies offer competitive products or services that are similar but not exact substitutes. Hair salons and clothing are examples of industries with monopolistic competition. Pricing and marketing are key strategies for competing companies and they often rely on branding or discount pricing strategies to increase market share.