Monopolistic competition is characterized by four factors: a large number of firms, product differentiation, competition on price, product quality, and marketing, and firms are free to enter and exit.
- A Large Number of Firms
The large number of firms implies
- A small market share for each firm.
- No market dominance by a single firm, so no one’s firm’s actions directly affect the actions of other firms.
- Collusion is impossible because there are so many firms.
- Product Differentiation
Product differentiation is making a product that is slightly different from the products of competing firms. As a result there are no perfect substitutes and so the firm in monopolistic competition faces a downward-sloping demand curve.
- Competing on Quality, Price, and Marketing
A firm in monopolistic competition will compete on:
A firm promotes the idea that its product has better attributes than its competitors’ products. These attributes include design, reliability, the service provided to the buyer, and the buyer’s ease of access to the product.
A firm in monopolistic competition faces a downward-sloping demand curve so the firm can set both its price and its output.
A firm uses advertising and packaging to publicize its product’s uniqueness.
- Entry and Exit
If firms in monopolistic competition earn an economic profit in the short run, new firms enter the market. This increase in supply decreases each firm’s demand and lowers the price until only a normal profit is earned. If firms incur economic losses in the short run, some firms exit the industry. The price rises until a normal profit is earned by the remaining firms.