Question

The major difference between monopolistic competition and perfect competition is that firms produce differentiated products in the former and homogeneous products in the latter. How does product differentiation generate the differences between the two models?

Answer 1

Monopolistic Competition : It is a market situation characterised by fairly large number of firms producing and selling differentiated goods and services. Pure monopoly and perfect competition are rare in practice. The markets that we come accross in our daily life have characteristics of competition and monopoly. Such a market is called monopolistic competition.

Perfect Competition : Perfect Competition means complete freedom in economic life and absence of rivalry among firms. Perfect Competition is a market situation in which there are a large number of buyers and sellers of a homogeneous products and the price of the products is determined by the market forces. Perfect Competition has many buyers and sellers of a product, so no single buyer or seller can affect the market price.

Product Differentiation generate the differences between perfect and monopolic competition :

Product Differenciation is the means of differentiated products and services from that of the other firms in the market. For monopolistic competition product differentiation is the most important characteristics as products are differentiated according to different brand names. Products of each firm is differentiated from the products of each other firms in the market. Through differentiation each seller tries to be different that that its competitors. Due to product differentiation, in monopolistic competition different products are sold at different prices. Due to the presence of product differentiation, monopolistic firms incur a lot of selling costs like advertisement which will create an impact upon the price as it won't be the case with perfect competition. In perfect competition as they sell homogenous products where all firms produce and sell identical goods and services. Like differentiated products, homogeneous products firm doesn't require the need to incur selling costs like advertisement and transportation costs which will impact the prices of the products. Since all products are homogeneous, customers will be having perfect knowledge about market condition and about the products. Eventhough perfect competition and monopolistic competition are entirely two different scenarios, the major difference among them is caused due the reason that one has product differentiation while the other has only homogeneous products.