Question

Would you expect the demand for a monopolistically competitive firm's product to be more or less elastic than that for a perfect competition firm’s product? Explain.

Answer 1

Monopolistic competition lies in-between. It involves many firms competing against each other, but selling products that are distinctive in some way. Examples include stores that sell different styles of clothing, restaurants or grocery stores that sell different kinds of food and even products like golf balls or beer that may be at least somewhat similar but differ in public perception because of advertising and brand names. Firms producing such products must also compete with other styles, flavours and brand names. The term “monopolistic competition” captures this mixture of mini-monopoly and tough competition.

Differentiated Products

A firm can try to make its products different from those of its competitors in several ways: physical aspects of the product, selling location, intangible aspects of the product, and perceptions of the product. Products that are distinctive in one of these four ways are called differentiated products.

Physical aspects of a product include all the phrases you hear in advertisements: such as an unbreakable bottle, nonstick surface, freezer-to-microwave, non-shrink, extra spicy, newly redesigned for your comfort. The location of a firm can also create a difference between producers. For example, a gas station located at a busy intersection can probably sell more gas than one located on a small side-road. A supplier to an automobile manufacturer may find that it is advantageous to locate near the car factory.

Intangible aspects can differentiate a product, too. Some intangible aspects may be promises like a guarantee of satisfaction or money back, a reputation for high-quality services like free delivery, or a loan to purchase the product. Finally, product perception may occur in the minds of the buyers. For example, many people could not tell the difference in taste between common varieties of beer or cigarettes if they were blindfolded, but because of past habits and advertising, they have strong preferences for certain brands. Advertising can play a role in shaping these intangible preferences.

The concept of differentiated products is closely related to the degree of variety that is available. If everyone in the economy wore only blue jeans, ate only white bread, and drank only tap water, then the markets for clothing, food, and drink would be much closer to perfectly competitive. The variety of styles, flavors, locations, and characteristics creates product differentiation and monopolistic competition.

Monopolistic competition refers to a market where many firms sell differentiated products. Differentiated products can arise from characteristics of the good or service, location from which the product is sold, intangible aspects of the product, and perceptions of the product.

If the firms in a monopolistically competitive industry are earning economic profits, the industry will attract entry until profits are driven down to zero in the long run. If the firms in a monopolistically competitive industry are suffering economic losses, then the industry will see an exit of firms until economic profits are driven up to zero in the long run.

A monopolistically competitive firm is not efficient because it does not produce at the minimum of its average cost curve or produce where P = MC. Thus, a monopolistically competitive firm will tend to produce a lower quantity at a higher cost and charge a higher price than a perfectly competitive firm.

Monopolistically competitive industries do offer benefits to consumers in the form of greater variety and incentives for improved products and services. There is some controversy over whether a market-oriented economy generates too much variety.

The following table summarizes the three types of market structure we have examined. The fourth, oligopoly, is not in the scope of this course.

Market type	Description	MR v P	P v MC	LR Π	LR ATC	DWL
Perf. Comp.	Many sellers, identical goods, free entry in LR	MR = P	P = MC	Π = 0	ATCLR = ATCMIN	No
Monopoly	Single seller, barriers to entry	MR < P	P > MC	Π > 0	ATCLR > ATCMIN	Yes
Monopolistic Comp.	Many sellers, differentiated products, free entry in LR	MR < P	P > MC	Π = 0	ATCLR > ATCMIN	Y