What is monopolistic competition?

Monopolistic competition is not the same as a monopoly market. Monopolistic competition is very similar to a perfectly competitive market in some ways, with a few small differences.

In a market operating in conditions of monopolistic competition, there are a large number of producers and consumers for any good (or service), and there is freedom to enter the market in the long run (these two assumptions are the same as for perfect competition).

The difference is that, in monopolistic competition, producers produce a good that differs in some way from their rivals', and they can therefore raise prices without losing all of their customers. Take, for example, your current hairdresser. They may not necessarily be the cheapest hairdresser, but you go to them because you value their service, they are in a convenient location for you, you like their small talk etc.

However, the ability to raise prices is limited because there are a large number of producers, and prices are therefore elastic - meaning an increase in price may result in a disproportionately large decrease in quantity demanded.

The ability of firms to differentiate their goods is a form of non-price competition.

Another form of non-price competition is advertising - letting people know of the good's existence and availability and trying to persuade them to buy the good by stressing specific qualities compared to rival goods. Advertising may increase demand for a good (push out the demand curve) and reduce its price elasticity.

Advertising is possible because goods are not identical, even if very similar. For example, in the electronics space there are different types of microwave, even if all do the same basic thing. The same applies for bottled water, other soft drinks etc.

Profit maximisation in a monopolistic competition will depend upon a combination of price, differentiation of product, and level and variety of advertising.

Pros

There are a large number of firms in competition which keeps prices low and services very consumer centric. This means there is a good level of productive efficiency (production at the minimum possible cost for the maximum possible output) and allocative efficiency (firms and consumers allocating their resources in a way that brings the most benefit to them).

There is some product differentiation, so consumers do have some choice.

Cons

Monopolistic competition does not result in as much efficiency as a perfect market, although it could be argued that the efficiency loss is small and outweighed by the choice for consumers.

There may also not be as much cash available for R&D when compared to a monopoly, since firms are not able to make large amounts of supernormal profits due to the high levels of competition.

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