What is monopolistic competition? (With key characteristics)

By Indeed Editorial Team

Published 3 May 2022

Monopolistic competition is the term in economics used to describe a situation where many companies are vying to sell similar goods or services. When this occurs in the market, competitors can make profits by being innovative or making shrewd decisions. Learning about monopolistic competition can help you understand the dynamics of microeconomics and how economic markets work. In this article, we look at the characteristics of monopolistic competition and explore the differences between it and perfect competition.

What is monopolistic competition?

Monopolistic competition occurs when many companies produce and sell goods or services that are similar in an economic market. Although these products are similar, they are not perfect copies of each other and each differs slightly from their market competitor's products. There are few restrictions that prevent competitive entry or exit from this market, and competing firms can do little to affect each other's practices. Consequently, companies can enter a marketplace quickly when they identify profitable opportunities and leave when there may be a risk of generating losses.

When evaluating its competitive levels, this type of market exists between an openly competitive market and a complete monopoly. In these competitive markets, individual companies can not maintain a market monopoly over their competitors, but they have some leeway in the prices they set for their products or services. Short-term profitability usually characterises markets of this type and requires higher levels of innovation to maintain long-term profitability. Monopolistic competition bears a close resemblance to the marketing strategy known as brand differentiation.

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Main characteristics of monopolistic competition

You can differentiate monopolistic competition from other marketing structures by several features. These characteristics include:

Products and services differ slightly

Although every company within a monopolistic marketplace sells similar products or services, a key aspect of their trading ensures their products or services maintain slightly different features from their competitors. These differentiating features can be physical, aesthetic or artificial. For example, within a district, there may be a number of coffee outlets and these vendors may all sell a similar range of coffee products, such as cappuccinos and mochas. For a customer to select their preferred coffee shop, the shop uses innovative methods to differentiate their products from their competitors, like deals, offers or loyalty stamps.

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Companies can enter and exit the market freely

The low barriers of entry and exit into an economic market allow companies to begin selling their goods or services with relative ease to generate profits. That same company can also opt out of the market with few obstacles when financial circumstances are looking less profitable. Since starting a business can include varying expenses, monopolistic competition affords companies the flexibility for companies to enter and exit a market with very few restrictions.

This is a highly lucrative factor for competing companies, as often, when one company becomes profitable, others seek to experience the same market success. Successful companies are wise to factor in the possibility of rival companies making an impact on their own profits.

Numerous companies

Because there are so many companies vying for success within a competitive-monopolistic market, few of them can make any substantial impact or influence their competitors' decision-making or business strategies. For example, if a coffee outlet decides to increase the cost of its products, its customers can simply choose to buy from the coffee shop down the street. Conversely, if an outlet decides to undercut a competitor's price too much, a customer may deem it an inferior product and the customer may no longer shop there and purchase their coffee elsewhere.

Imperfect consumer knowledge

Before choosing a product, customers often weigh the options that the available information presents to them to make a well-informed product selection. When a highly competitive market offers numerous choices of near-identical products, the customer's decision-making process can become more complex and choosing the right product can seem more difficult. Customers rarely obtain a perfect knowledge of the products they buy and companies can capitalise on this opportunity, by presenting the perception of a superior product, even if there is little or no difference to another product.

For example, a customer is looking to buy coffee beans in a supermarket. There may be shelves presenting a variety of coffee beans, all on display with different prices and attractive packaging. The label on one packet might boast about the content's quality, richness and flavour, which may appeal to the coffee connoisseur. Another label may claim the product's green credentials and the sustainability of its source. While on the aisle, weighing these options, the customer may reach a conflict of choice. This hesitation provides the coffee producer with an opportunity to employ marketing strategies that can persuade consumer decisions.

Profits

Within a monopolistic competitive market, companies can achieve substantial profits over short-term periods. Very often this is due to customers eager to experience, sample or purchase a brand new service or product or avail of special new deals or offers. When this demand in the market becomes visible and more competitors begin to supply this demand, the initial companies see their profits diminish and return to normal levels. Many companies generate short-term profits, but competitors can reduce their margins as soon as they enter the market.

To compensate, companies look at ways of innovating and creating new selling points to differentiate their products. They may also choose or leave the market entirely. The low barrier to entry and exit means many companies earn short-term profits and withdraw from the markets before sustaining heavy losses.

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What's the difference between monopolistic and perfect competition?

Here are some key factors to help you differentiate between monopolistic and perfect competition:

Products and pricing

The perfect market is the theoretical opposite of the monopolistic market. A perfectly competitive market is ideal, where all products and services are identical in terms of quality and have no differentiating anomalies. This means producers and consumers know the product information well and there are no transaction costs. In a perfect market, all prices are equal as a customer would have no reason to pay more for an identical product. No monopolies exist in a perfect market.

In contrast, the wares of monopolistic markets are all very similar with slight differences. Producers can promote their goods or services to customers using innovative strategies in a variety of ways. Producers can alter the prices of goods or services. Monopolies can exist in monopolistic markets, but typically become evened out by competitors.

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Entry and exit barriers

There are no trade barriers in perfect competition, allowing a boundless number of companies to enter and leave the market without costs or restrictions. This means that companies could continue to flood the market until it reaches saturation point, all the while they remain prohibited from differentiating their products.

Even though monopolistic competitions have very low entry and exit barriers and both markets have very large numbers of companies, there are some factors that could deter companies from saturating the market. Those companies competing in the monopolistic market remain able to differentiate their products.

Amount of companies

Perfect competition markets are full of businesses, just as monopolistic competition markets are and for similar reasons. The tools of marketing and product differentiation allow the many companies within a monopolistic competition to create sales and generate profits. If profit margins shrink, these companies are able to innovate, modify or alter the price of their product in an effort to increase their appeal to the customer.

The enormous number of companies that might exist in a perfect market creates a situation whereby it's almost impossible for any company to gain a competitive edge. This scenario could result in the influx of companies until they reach the saturation point. Accordingly, the cost of the product would reach its perfect price equilibrium and all goods or services would cost almost exactly the same.

Informed consumers

Consumers have first-rate knowledge about a product in a perfectly competitive marketplace. They clearly understand what a fair market value for that product is and know the shipping costs from the producer to the supplier to the retailer. Because consumers in this market structure are aware that every competitor's products are the same, companies have little need for marketing strategies or innovations to differentiate their products.

This is in contrast with consumers in a monopolistic marketplace. Here, while the consumers can equip themselves with as much information they can source on the product, they are still susceptible to innovative marketing tactics and can perceive the value of the product differently.

Control

A company operating within perfect competition doesn't control the pricing of its products, they can only control the quantity they produce. As a result, a company in perfect competition can produce more products, but what determines the price is supply and demand. Companies in monopolistic competition, in contrast, have a degree of control over the prices they set for their products, although these prices rarely deviate far from those of their competitors.