Characteristics of Monopolistic Competition: Videos & Practice Problems

Monopolistic competition features differentiated products, allowing firms some price-making power. Unlike perfect competition, where firms are price takers with a horizontal demand curve, monopolistic competition has a downward sloping demand curve. This means that to increase output, firms must lower prices, affecting marginal revenue. Firms can freely enter and exit the market, facing no significant barriers to entry. Examples include fast food chains and coffee shops, where product differentiation drives competition and influences pricing strategies.

Characteristics of Monopolistic Competition

Alright, now let's move on to our next market structure, monopolistic competition. This unit is great because it gives us a more realistic depiction of competition in the real world. So firms you deal with day-to-day are usually in a monopolistically competitive market. Let's check it out.

We're going to say that a market is monopolistically competitive, first, when the goods for sale are similar but not identical. Remember when we were talking about perfect competition, everybody's product was the same, right? You couldn't tell one farmer's wheat from another farmer's wheat. Well here, the products are going to be said to be differentiated, which just means similar but not identical. So if you think about a coffee from Starbucks, right? You might get this premium coffee, frappuccino, or something, but then there are other options for coffee. You could go to a convenience store, you could go to a little bakery, or other places to get coffee as well, right? But Starbucks has its differentiated product, its special coffee, and that's what drives its business.

We're going to say that the sellers in these markets that are monopolistically competitive are price makers to an extent. Notice "to an extent" here. When we talked about perfect competition, they couldn't pick their price. The price was set by the market based on supply and demand, and then all the individual firms had to sell at that price. Well here, they're going to have some influence over the price because what we're going to see is that there’s only one producer of the differentiated good. So if you think of something like McDonald's and Burger King, right? Burger King makes their Whopper, and they have their Whopper; McDonald's has their Big Mac, they're differentiated. They're both hamburgers, but they each have something special about them. Well, Burger King is the only one producing Whoppers, so they have some influence over the price of a Whopper. They might have fans who specifically like a Whopper and don't like Big Macs or any other burger; their favorite burger is a Whopper. So they're going to have some influence there, but there are going to be many producers of similar products. So there's going to be McDonald's with their Big Mac, there’s Wendy’s, but then there's all sorts of other stores that are also producing hamburgers as well.

You could go to a restaurant and get a nice hamburger, something like that, but then on top of that there is other similar products which could also be called substitute goods. For example, going to a Pizza Hut and getting a pizza could even be considered a substitute for a Whopper, or going and getting any other fast food. It doesn’t have to be a hamburger to be a substitute for this good. Imagine you're in a food court and you're the only company that has Chinese food, those little bourbon chicken samples you get in the food court all the time. Well, you're the only company that has a Chinese food store, but you're in a food court with tons of other stores, selling hamburgers, selling pizza, selling everything else. You're going to have some influence over what price you can charge, but you also have to stay competitive with the pizza and everything else. You might the pizza and the hamburger place might offer meals for $7; if you tried to sell your Chinese food for $15, a lot of people might say, well, I can get a meal right next door for $7, so it doesn’t have to be Chinese food to be in direct competition with you. Just other similar products. In this case, other food products. Cool?

So what we're going to say is that in monopolistic competition, we’re going to have some market power. Market power is going to be the ability of one person or a group to have influence over the price. You’re going to have some market power since you are the only producer of this differentiated good. You're going to have some influence over your price because of your good being special and unique, at least differentiated.

Another defining factor here is that firms can still freely enter and exit the market. Remember in perfect competition, if you wanted to start a wheat farm, you just got to get a farm and start growing wheat. Nothing is stopping you. Same thing here. You want to open a fast food restaurant or something like that? All you've got to do is rent a space, start cooking some burgers, and you're in the fast food business. So you can freely enter and exit this business; there are no barriers to entry like we'll see in a monopoly or something like that.

Let's wrap up this video with an example. The things we've been talking about, right? Fast food is a great example of monopolistic competition, and another good one, well, we mentioned, the coffee market. Starbucks versus a convenience store versus bakeries versus other places that have coffee as well. There's going to be differentiated products for this coffee. Not all the coffee is going to be the same, maybe we get our beans somewhere else, whatever it is, there's going to be some differentiation there. So that's the key here. The products are differentiated, and since they're differentiated, you get some influence over the price.

In the next video, let's discuss what the demand curves look like for a firm in monopolistic competition. Let's do that now.

Monopolistic Competition Demand Curve

Alright. Now let's go ahead and compare the demand curves in monopolistic competition and perfect competition. Alright. So on the left, we've got monopolistic competition. This will be something like, let's say, the BK Whopper, right? Compared to on the right, something like wheat, like we've been talking about, right? Wheat, something perfectly competitive like that. Okay, so let's think about what's happening here on the left. We have a downward sloping demand curve, right? This is like what we saw when we first started learning about demand, right? A downward sloping demand curve, so what does this entail for the company? That means let's say if Burger King is selling this many Whoppers right now at this price, right? There's this demand and they find that at this price \( p_1 \), they sell \( q_1 \) whoppers. Right? Well, if they wanted to increase that quantity of whoppers, right, if they wanted to increase the output, say to somewhere around here to \( q_2 \), well, they would have to lower their price, right?

What we're going to see in the demand curve here is we've got a lower price, right? And this goes with the law of demand, right? The opposite where the price goes up, quantity goes down, price goes down, quantity goes up. Right? So we've got the downward sloping demand curve here compared to what we had in perfect competition on the right, we've got that flat demand curve. Right? Remember in perfect competition, the price was set by the market. Right? We have a market supply and a market demand doing our X and at that equilibrium point, right, that is the price that the firms have to sell at, right? That's gonna be \( p^* \), the equilibrium on the market, but at that price, the individual firm can produce as much as it wants because their portion of the entire market is so minimal, right? We could say there's like 2,000,000,000 bales of hay or bales of wheat being made every year, and each firm is making say like 10,000 or something. Something really small compared to the huge total demand, right? So what does that mean? They can produce this quantity right here and sell it all at that price. Right? Or this quantity here and sell it all at the equilibrium price or here, right? Any quantity they want, it's not gonna affect the price, but for monopolistic competition, it does affect the price, right? If they're going to increase their quantity, that price is going to go down because of the downward sloping demand curve.

So, let's go down here and let's summarize this information, right? The demand curve in monopolistic competition, we just saw, is downward sloping, right? Downward sloping compared to perfect competition where we have a horizontal demand curve, right? It's horizontal and that is perfectly elastic. Remember perfectly elastic that's when we're flat like this, we're laying down, we're so elastic and sleepy, right? Perfectly elastic horizontal demand curve. Okay. And what did we see when we increase output, in monopolistic competition? Well, we have to lower our price, right? However, in perfect competition, we saw that we can keep the same price when we increase our output. Okay? So this decrease in the price that we're seeing in monopolistic competition, this is going to have effects on our marginal revenue, right? If we want to sell one more unit, well, we can't sell it at the same price anymore, right? That one more unit is going to be at a lower price, so that's going to affect our marginal revenue. When we talked about marginal revenue and perfect competition, well, it was always the same. Right? You want to sell one more unit of hay? Well, it's going to sell at the market price. It's always going to be market price. It's not going to keep going down like we see with a downward sloping demand, right?

So, in perfect competition, we saw this relationship right here where the price equaled average revenue, which is always true, but it also equaled the marginal revenue, okay? We don't have that relationship in monopolistic competition, we still have price equal average revenue because that's always the case, right? And that price equals average revenue, that is our demand curve. Okay? But we're going to have a separate curve for marginal revenue. Okay? So we're going to see how we do that in a second. Let's go ahead and move on to the next video now.

Here’s what students ask on this topic:

What are the main characteristics of monopolistic competition?

Monopolistic competition is characterized by several key features: differentiated products, many sellers, some degree of market power, and free entry and exit. Differentiated products mean that while goods are similar, they are not identical, allowing firms to have some control over pricing. Many sellers ensure that no single firm dominates the market. Firms have some market power due to product differentiation, which allows them to influence prices. Lastly, there are no significant barriers to entry or exit, meaning new firms can easily enter the market and existing firms can leave without substantial obstacles.

How does the demand curve in monopolistic competition differ from perfect competition?

In monopolistic competition, the demand curve is downward sloping, indicating that firms must lower prices to increase the quantity sold. This contrasts with perfect competition, where the demand curve is horizontal, reflecting that firms are price takers and can sell any quantity at the market price. The downward sloping demand curve in monopolistic competition means that changes in output affect the price, whereas in perfect competition, the price remains constant regardless of the quantity produced.

Why do firms in monopolistic competition have some degree of market power?

Firms in monopolistic competition have some degree of market power due to product differentiation. Each firm offers a product that is similar but not identical to others, allowing them to set prices to some extent. This differentiation creates brand loyalty and reduces the direct substitutability of products, giving firms the ability to influence prices. Unlike in perfect competition, where products are identical and firms are price takers, the unique characteristics of each product in monopolistic competition provide firms with pricing power.

What are examples of industries that operate under monopolistic competition?

Industries that operate under monopolistic competition include fast food chains, coffee shops, clothing brands, and beauty products. In these industries, firms offer differentiated products that are similar but not identical. For example, fast food chains like McDonald's and Burger King offer unique menu items that set them apart from each other. Similarly, coffee shops like Starbucks differentiate their products through branding, quality, and unique offerings, allowing them to compete on factors other than just price.

How does product differentiation impact pricing strategies in monopolistic competition?

Product differentiation impacts pricing strategies in monopolistic competition by allowing firms to have some control over their prices. Since products are not identical, firms can charge higher prices for unique features, quality, or brand reputation. This differentiation reduces the direct price competition and enables firms to focus on non-price competition, such as advertising and product innovation. As a result, firms can maintain higher prices and profit margins compared to perfect competition, where products are identical and price is the primary competitive factor.