In the American economy, most industries have market structures that are somewhere in between perfect competition and monopoly.

These intermediate cases are grouped into two categories:

I. Monopolistic Competition – an industry with many small firms where individual firms gain some monopoly power through product differentiation.
II. Oligopoly – an industry dominated by a few large firms which are each conscious of the behavior of rival firms.

I. Monopolistic Competition

1. Characteristics

Monopolistic competition is a market structure where there are a large number of firms each trying to differentiate their product from other firm’s products in the industry. There is a considerable amount of competition and each firm represents only a small fraction of the total market. Firms act independently since there is little opportunity for collusion.

A firm can obtain some control over price or monopoly power through product differentiation and other types of non-price competition. Product differentiation may be achieved through quality, service, location, or brand names and packaging. To the extent that a firm achieves monopoly power it gains control over price. As in pure competition, it is easy for firms to enter a monopolistically competitive industry.

2. Price and Output Determination

To the extent that the firm gains control over price its demand curve becomes less elastic. It is more elastic than the monopoly’s demand curve because there is competition.

In the short run the firm’s profit maximizing output level occurs where marginal cost equals marginal revenue. This is the same for pure competition and monopoly. In the long run the firm will break even since new firms will enter the industry and eliminate any economic profit.

As firms enter the industry, the demand curve facing an individual firm will shift to the left as customers are lost to new firms. The demand curve will reach equilibrium when the firm breaks even. If the demand curve falls below the break even point (including a normal profit), some firms will be driven out of the industry until equilibrium is achieved.

Of course, some firms may realize an economic profit in the long run if they are able to differentiate their product in a way that cannot be duplicated by other firms such as a unique brand names or location.

Monopolistic Competition and Economic Efficiency

Definitions

allocative efficiency –from society’s point of view the optimal amount of resources are allocated to the product (P = MC).

Productive efficiency – the firm is producing at lowest possible cost per unit or at the least-cost combination of inputs.

Allocative efficiency
A monopolistically competitive industry will experience excess capacity in the long run. In the long run marginal cost is less than price which means that the potential benefit to society is greater than the cost.

Productive efficiency
Firms are also not producing at the minimum ATC. Because of the expense of differentiating a product such as advertising, average costs will be higher than under pure competition.

Monopolistic Competition: Product Variety
There are advantages to the consumer from a monopolistically competitive market. Firms can obtain greater than normal profits by advertising, improving and developing their products. Compared to pure competition it will provide consumers with a much greater diversity of choices. Of course, the larger the number of choices, the larger the problem of excess capacity.