Monopolistic competition combines features of both perfect competition and monopoly, creating a unique structure with product differentiation and relatively free market entry.
Characteristics of Monopolistic Competition
Monopolistic competition is a market structure often observed in real-life industries such as retail, cafés, and service-based businesses. It reflects a middle ground between the intense competition of perfect markets and the single-firm dominance of monopoly.
Many Firms
There are a large number of firms in a monopolistically competitive market. Each firm accounts for a relatively small market share and acts independently. While none of the firms can individually affect the overall market price significantly, each has some influence over the price of its own product.
Differentiated Products
Firms sell differentiated products, meaning the goods are close but not perfect substitutes. Differentiation can take many forms:
Physical differences in quality, design, or functionality.
Branding and advertising, which create perceived differences.
Customer service and location advantages.
This means that consumers can distinguish between products, even if they serve similar purposes.
Some Price-Making Power
Due to product differentiation, each firm faces a downward-sloping demand curve. This allows them some price-making power, unlike in perfect competition where firms are price takers. The more differentiated the product, the greater the ability to influence price without losing all customers.
Low Barriers to Entry and Exit
Entry and exit barriers are low, allowing new firms to enter when existing firms make profits. Similarly, firms can exit without incurring significant losses. This makes long-run economic profit unsustainable, as new entrants increase competition and reduce demand for existing firms.
Independent Behaviour
Firms act independently, setting prices and output without collusion. Unlike in oligopoly, there is no strategic interdependence. Each firm’s pricing decisions are based on its own costs and perceived demand.
Short-run Equilibrium in Monopolistic Competition
In the short run, a firm in monopolistic competition behaves similarly to a monopolist. It chooses the price and output level that maximises its profit, subject to its downward-sloping demand curve.
Supernormal Profits or Losses
A firm may earn supernormal (economic) profits if its average revenue (AR) exceeds average cost (AC).
Alternatively, if AR < AC, the firm incurs short-run losses.
The profit-maximising condition is marginal cost (MC) = marginal revenue (MR).
This is shown where the MR curve intersects the MC curve from below.
Since the firm is not producing where AC is at its minimum, it is productively inefficient.
Likewise, because price (P) > marginal cost (MC) at equilibrium, there is a loss of allocative efficiency — society would prefer more output at a lower price.
Diagram Explanation
The diagram would show:
A downward-sloping AR and MR curve.
An upward-sloping MC curve.
A U-shaped AC curve.
The firm maximises profit where MR = MC.
Price is determined from the AR curve vertically above this point.
Supernormal profits exist where AR > AC at the chosen output.
If the firm is making a loss, the AR curve lies below the AC curve at the chosen output.
Long-run Equilibrium in Monopolistic Competition
In the long run, any short-run supernormal profits attract new entrants to the market. These new firms offer similar products, leading to a reduction in demand for the existing firm's product.
Normal Profit Only
As firms enter, each existing firm's AR curve shifts leftward and becomes more elastic, due to increased availability of close substitutes.
This continues until the AR curve becomes tangent to the AC curve.
At this point, firms are earning normal profit only — enough to cover their opportunity cost.
No incentive remains for entry or exit, and the market is in long-run equilibrium.
Diagram Explanation
In the long-run diagram:
AR is tangent to AC at the profit-maximising output.
MR still intersects MC to determine output.
At this point, AR = AC, so normal profit is earned.
However, P > MC, so allocative inefficiency remains.
The firm still produces at less than minimum AC, indicating productive inefficiency.
Excess Capacity in Monopolistic Competition
A prominent inefficiency in monopolistic competition is excess capacity. This term refers to a situation where a firm is not producing at the lowest point on its AC curve, even in the long run.
What Causes Excess Capacity?
The downward-sloping AR curve forces the firm to set output below the minimum efficient scale.
Producing more would reduce average cost, but would require lowering the price, which would reduce or eliminate profits.
Economic Consequences
Inefficient resource allocation: Firms use more resources per unit of output than necessary.
Wasted potential: Capacity is underutilised; factories, workers, or retail space could produce more efficiently.
From a societal viewpoint, this is sub-optimal, but it is the result of profit-maximising behaviour in a competitive setting with product differentiation.
Product Differentiation and Efficiency
Product differentiation plays a central role in shaping both consumer experiences and production costs in monopolistic competition.
Impact on Costs
Marketing and branding incur significant costs.
Firms may spend heavily on advertising, packaging, and customer loyalty programmes.
These add to average costs, shifting the AC curve upwards.
Impact on Efficiency
Productive efficiency is compromised as output is below the minimum average cost.
Allocative efficiency is also lost because price exceeds marginal cost (P > MC).
However, dynamic efficiency may be present:
Firms seek to improve their products through innovation and investment in quality.
The prospect of short-run supernormal profits gives incentive for research and development.
Thus, while static inefficiencies exist, product variety and innovation can enhance consumer welfare in the long run.
Comparison with Perfect Competition
Although monopolistic competition shares some features with perfect competition, key differences influence market outcomes significantly.
Shared Characteristics
Large number of firms: Both structures feature many small firms.
Freedom of entry and exit: Low barriers ensure long-run normal profits.
Independence: Firms make decisions on price and output independently.
Key Differences in Outcomes
Product differentiation is the hallmark of monopolistic competition; in perfect competition, all products are homogeneous.
Firms in monopolistic competition are price makers, whereas firms in perfect competition are price takers.
Efficiency differs substantially:
Perfect competition achieves both allocative (P = MC) and productive (producing at minimum AC) efficiency in the long run.
Monopolistic competition results in P > MC and P > minimum AC, causing inefficiencies.
Consumer Impacts
Advantages:
Greater variety: Consumers benefit from diverse options tailored to preferences.
Non-price competition: Firms improve quality, design, or service to attract customers.
Disadvantages:
Higher prices: Consumers pay more than marginal cost.
Inefficient output levels: Output is restricted, and production costs are not minimised.
Firm Impacts
Benefits:
Possibility of supernormal profits in the short run.
Ability to build brand loyalty and maintain some price power.
Incentives to innovate and offer unique features.
Challenges:
Continuous competitive pressure due to ease of entry.
Erosion of profit margins over time.
Need for constant marketing and investment to stay relevant.
Real-world Examples of Monopolistic Competition
Several industries operate in ways that closely resemble the theoretical model of monopolistic competition. These include:
Restaurants
Vast numbers of independent restaurants compete in local markets.
Each offers a unique combination of cuisine, atmosphere, pricing, and service.
Low start-up costs mean new entrants are frequent, reducing long-term profits.
Retail Clothing
Numerous clothing brands exist, each with its own style, brand image, and pricing strategy.
While all offer similar products, brand perception creates differentiation.
Hair Salons and Barbers
Salons vary in services, skill levels, branding, and customer experience.
Customers often show brand loyalty despite there being many close substitutes.
Coffee Shops
Both chains (e.g. Costa, Pret) and independents operate with differentiated offerings.
Differences in location, ambience, and quality create price-making ability for each.
These examples highlight how monopolistic competition explains real-world markets more accurately than perfect competition, particularly where consumer preference and branding matter.
FAQ
Firms in monopolistic competition rely on advertising because it helps them differentiate their products in a market full of close substitutes. Since products are not identical, branding and promotion become essential tools for creating perceived value and loyalty. Advertising shifts the firm’s demand curve to the right and makes it more inelastic, allowing the firm to raise prices without losing as many customers. While advertising increases average costs in the short run, it may lead to higher revenues and greater customer retention in the long term. Firms often invest in persuasive advertising to convince consumers that their product is superior, even if the physical differences are minimal. This is crucial in markets like clothing, cosmetics, or cafés, where brand identity and image matter significantly. Moreover, advertising helps maintain market share as new firms enter. It becomes a defensive strategy, not just an offensive one, protecting firms from the erosion of profits caused by competition.
Consumer loyalty significantly affects the price elasticity of demand for individual firms in monopolistic competition. If a firm has built strong customer loyalty through branding, advertising, or consistent product quality, its demand curve becomes less elastic. This means that when the firm increases its price, loyal customers are less likely to switch to competitors, allowing the firm to maintain higher prices without a large drop in quantity demanded. On the other hand, if consumer loyalty is weak and alternatives are perceived as close substitutes, the demand is more elastic, and price increases will lead to greater loss of customers. In the short run, firms with more loyal customers can enjoy supernormal profits by exploiting this inelasticity. However, in the long run, as new entrants erode brand loyalty or replicate the product’s key features, elasticity may increase. Therefore, firms must continually invest in maintaining customer relationships and reinforcing brand value to sustain pricing power.
Sunk costs, which are irrecoverable once incurred, play a crucial role in shaping strategic behaviour in monopolistic competition. These include expenses like advertising campaigns, brand development, or specialised equipment that cannot be resold or recovered upon market exit. Because firms know they cannot recover these costs, they tend to think more carefully before entering a market. In monopolistic competition, where entry and exit barriers are low, sunk costs can create a psychological or strategic barrier. Existing firms may invest heavily in advertising or customer loyalty programmes not only to build market share but to raise the perceived risk of entry for potential competitors. Sunk costs can also influence pricing behaviour. For example, if a firm has incurred high sunk costs, it may continue operating in the short term despite losses, hoping to recover variable costs and survive until conditions improve. This makes sunk costs an important, though sometimes invisible, factor in real-world competition.
Firms in monopolistic competition typically do not achieve minimum efficient scale (MES) because of the structure of their demand. MES is the output level at which a firm minimises average costs. However, due to the downward-sloping and relatively limited demand curve each firm faces (as a result of product differentiation and many competitors), they often cannot produce enough to reach this point. Operating below MES leads to productive inefficiency, as the firm is not fully exploiting economies of scale. The implications are significant: higher unit costs get passed on to consumers as higher prices, and firms forgo potential cost savings. At an industry level, this results in a larger number of firms operating with spare capacity, which is considered inefficient from a resource allocation standpoint. However, this inefficiency may be offset by the benefits of variety and consumer choice. The trade-off reflects the balance between efficiency and diversity in product offerings.
Yes, dynamic efficiency — improvements in productive or allocative outcomes over time — can be achieved in monopolistic competition under certain conditions. Although firms only earn normal profit in the long run, they can still be dynamically efficient during the short-run phase when supernormal profits are possible. These profits provide the incentive for firms to innovate, improve quality, or invest in new production techniques. The desire to gain temporary competitive advantage can drive firms to develop new product features, enter new markets, or enhance customer service. However, for dynamic efficiency to materialise, there must be some level of retained profit, consumer responsiveness to innovation, and scope for differentiation. In industries where consumer preferences evolve rapidly — such as technology, fashion, or hospitality — the pressure to innovate is particularly strong. Moreover, even if firms cannot sustain dynamic gains indefinitely, the cycle of innovation followed by imitation contributes to a continually evolving market, benefiting consumers in the long term.
Practice Questions
Using a diagram, explain how a firm in monopolistic competition can earn only normal profit in the long run.
In monopolistic competition, low barriers to entry attract new firms when existing ones earn supernormal profits. As more firms enter, each firm's demand curve shifts left and becomes more elastic due to increased substitutes. This reduces the firm's market power and revenue. In the long run, the average revenue curve becomes tangent to the average cost curve at the profit-maximising output, where marginal cost equals marginal revenue. At this point, price equals average cost and firms earn only normal profit. The diagram shows AR tangent to AC, indicating no supernormal profit, and P remains greater than MC, showing allocative inefficiency.
Evaluate whether monopolistic competition leads to an efficient allocation of resources.
Monopolistic competition does not result in allocative efficiency, as price exceeds marginal cost (P > MC), leading to underproduction from society’s perspective. Productive efficiency is also not achieved because firms operate below the minimum point of their average cost curve due to excess capacity. However, consumer welfare may benefit from product variety, innovation, and non-price competition, which are not present in perfect competition. Furthermore, differentiation can increase satisfaction despite higher prices. In the long run, firms earn only normal profit due to free entry, which limits inefficiency. Overall, monopolistic competition provides dynamic benefits but lacks static efficiency.
