The model of Monopolistic Competition describes a market structure where a large number of independent firms sell many similar products with slightly different characteristics.
Products are differentiated from each other by the means of design, distribution, quality, colour, packaging, customer service or branding etc. and hence they are not perfect substitutes of each other.
In Monopolistic Competition, a firm takes the price charged by its rivals as given and ignores the impact of it's own price on the prices of the other firms.
Mainly small businesses operate under the Monopolistic Competition, including independently owned and operated high street stores, restaurants, retailers etc. Each one offers similar products but possesses an element of uniqueness, and are essentially competing for the same customers.
Key Characteristics of a Monopolistic Competitive Market
Large Number of Participants
There are many producers / sellers and consumers in the market, and no business has total control over the market or the market price.
Law Barriers to Entry & Exit
There is freedom to enter or leave the market, as there are no major barriers to entry or exit.
Widespread Knowledge About the Products
Knowledge is widely spread between the market participants, but it is unlikely to be perfect. Customers choices may be influenced by the product differentiation, like packaging or other promotional features.
Individual Firm as Price Maker
Unlike Perfect Competition, in Monopolistic Competition each individual firms is Price Maker for it's own product, as there are no perfect substitute for that product. The market price may only acts as a guideline. Each firm produces unique products, and can charge a higher of lower price than it's rivals.
Freedom To Make Decisions
Each firm makes independent decisions about the terms of exchange of it's products or price or output of it's product, based on its costs of production and it's profit making appetite. The firm gives no consideration to, any effect it's decision will have on the competitors.
The entrepreneur has a more significant role than in a perfectly competitive market, because of the increased risk associated with decision making.
Advertising / Branding
Firms operating under Monopolistic Competition usually have to engage in advertising, to let the customers know about their product's differences.
The central feature of the Monopolistic Competitive Market is that the products are differentiated. There are four main types of differentiation.
- Physical Distribution, where firms use size, design, colour, shape, performance or features to make their products different.
- Marketing Differentiation, where firms try to differentiate their products by distinctive packaging or other promotional techniques.
- Differentiation through Distribution, firms try to differentiate via ease of deliveries, like through Online Shopping, Phone Order Bookings, Delivery at costumer door step, COD etc.
- Human Capital Differentiation, where the firm creates differences through the skills of it's employees, through the customer support services that they provide. The level training given to the staff or distinctive uniforms etc.
Super Normal Profits in Short Run
In short run, firms can make excess economic profits or super normal profits. However because the barriers of entry are low, other firms has incentive to enter the market, increasing the competition, and driving down the prices, until all super normal profits are eroded away.
As the product variety in the market increases with the entrance of new members, the product demand of the existing firms become more elastic, and starts depreciating, at this point the existing firms have reached their long run equilibrium. Firms benefit most when they are in their short run and hence try to remain in the short run by innovating and further product differentiation.