Monopolistic Competition

There are a large number of firms selling closely related, but not homogeneous products. Each firm acts independently and has a limited share of the market. So, an individual firm has limited control over the market price. A large number of firms leads to competition in the market.

Each firm is in a position to exercise some degree of monopoly (in spite of a large number of sellers) through product differentiation. Product differentiation refers to differentiating the products on the basis of brand, size, colour, shape, etc. The product of a firm is a close, but not a perfect, substitute for another firm. The implication of 'Product differentiation' is that buyers of a product differentiate between the same product produced by different firms. Therefore, they are also willing to pay different prices for the same product produced by different firms. This gives some monopoly power to an individual firm to influence the market price of its product.

Under monopolistic competition, products are differentiated and these differences are made known to the buyers through selling costs. Selling costs refer to the expenses incurred on marketing, sales promotion and advertisement of the product. Such costs are incurred to persuade the buyers to buy a particular brand of the product in preference to a competitor's brand. Due to this reason, selling costs constitute a substantial part of the total cost under monopolistic competition. It must be noted that there are no selling costs in perfect competition because products are homogeneous in nature and there is perfect knowledge amongst buyers and sellers. Similarly, under monopoly, selling costs are of a small amount (only for informative purposes) as the firm does not face competition from any other firm.

Under monopolistic competition, firms are free to enter into or exit from the industry at any time they wish. Free entry and exit of firms means that there are no barriers before the firm for entering into the industry and leaving the industry. New firms can enter when they find that the existing firms are earning abnormal profits. With their entry, the output of the industry increases, which leads to a fall in the price of the product. This continues till each firm is earning only normal profit. The existing firms leave when they face losses. As they leave, the output of the industry goes down, raising the price of the product till the losses are wiped out. It ensures that there are neither abnormal profits nor any abnormal losses to a firm in the long run. However, it must be noted that entry under monopolistic competition is not as easy and free as under perfect competition.

Buyers and sellers do not have perfect knowledge about the market conditions. Selling costs create artificial superiority in the minds of the consumers and it becomes very difficult for a consumer to evaluate different products available in the market. As a result, a particular product (although highly priced) is preferred by the consumers even if other less priced products are of the same quality.

A firm under monopolistic competition is neither a price-taker nor a price-maker. However, by producing a unique product or establishing a particular reputation, each firm has partial control over the price. The extent of power to control price depends upon how strongly the buyers are attached to his brand.

In addition to price competition, non-price competition also exists under monopolistic competition. Non-Price Competition refers to competing with other firms by offering free gifts, making favourable credit terms, etc., without changing prices of their own products. Firms under monopolistic competition compete in a number of ways to attract customers. They use both Price Competition (competing with other firms by reducing the price of the product) and Non-Price Competition to promote their sales.