Monopolistic competition is a market structure in which entry into the market is easy, and the market has many sellers. These factors make monopolistic competition similar to perfect competition. But monopolistic competition differs from perfect competition because firms in monopolistic competition sell differentiated products.
Consumers consider the products of firms in a monopolistically competitive industry to be close substitutes for one another, but not identical. This is what the term “differentiated” refers to.
Firms in monopolistic competition are free to set their own prices. However, they must do so with the knowledge that at higher prices, some consumers will switch to a competitor's product. The firm that raises its prices will sell a lower quantity.
Because the firm will sell a lower quantity at a higher price, the firm's demand curve is downward sloping. Its marginal revenue curve lies below its demand curve. A profit maximizing firm will sell the quantity where marginal revenue (MR) is equal to marginal cost (MC), but this will be lower than the quantity for a firm in perfect competition.
At the output quantity where MR=MC, the firm can sell at the price where this quantity intersects the demand curve. This price will be higher than the price that equates to MR and MC at that quantity, making monopolistic competition less efficient than perfect competition.
This lower quantity, higher price combination is due to the fact that the demand curve is downward sloping. The marginal revenue curve lies below the demand curve. This makes a firm in monopolistic competition similar to a monopoly firm, with the associated loss of consumer and total surplus.
One difference between a firm in monopolistic competition and a firm in monopoly is ease of entry. In monopoly, entry is prohibitive and firms can earn economic profits in the long run. In monopolistic competition, entry is easy and any economic profits will be a signal for new firms to enter the market. In the long run, firms will enter and exit the industry until economic profits are equal to zero.
Because the products of firms in monopolistic competition are close substitutes, but not identical products, firms engage in non-price competition. In fact, non-price competition is often an important part of the decisions made by firms in monopolistic competition.
Advertising is important, as firms try to inform consumers of the benefits of their specific products. Brand name recognition helps to build consumer confidence in a particular product, increasing its demand.
Firms can use convenience as a form of non-price competition. Store location can be a convenience to specific consumers. So can the availability of online shopping. The availability of other products and services offered by the seller can also be a form of non-price competition that utilizes convenience for consumers.
Grocery stores often distinguish themselves from the competition by the overall product selection available in their stores, as well as the addition of other products and services at the same location. For example, a grocery store may try to lure in customers by providing a full-service bakery, deli, pharmacy, dry cleaning business, check cashing, video rentals, other product rentals (such as carpet cleaners), delivery services (such as being a drop-off and pick-up location for Fedex), wire services such as western union, an onsite gas station, recycling services, even banking services.
Other forms of non-price competition include such things as customer service, different product features, style, warranties, and even packaging.
Such non-price competition is often designed to separate consumers into different groups with separate demands.
Because of the existence of many close substitutes, the demand for products in monopolistic competition is highly elastic. Non-price competition is designed to decrease the price elasticity of demand by rotating the demand curve.
What is a better deal for consumers, the brand name products or the less expensive store or generic brands?
I remember an economics instructor bringing up this question when I was a student in the late 1970s. I remember the instructor's advice:
Consumers should give the cheaper brands a try, and compare the quality and price of the brand name vs the store brand or generic brand. Then, consumers will know which they prefer, on a product by product basis, rather than having a strategy of always choosing one or the other.
This means maximizing utility per dollar for each type of product.
Take canned vegetables, for example. The same consumer may find that more value can be achieved by buying the store brands for canned corn and green beans, while at the same time more value can be achieved by buying the name brand for peas and spinach.
This approach means that the value of coupons is lowered, since coupons usually apply only to brand name products. Any savings from using coupons can potentially be offset by savings from using store brands.