Monopolistic competition exists when individual producers have moderate influence over product prices, where each product enjoys a degree of uniqueness in the perception of customers. This market structure has some important similarities and dissimilarities with perfectly competitive markets. Monopolistic competition is characterized by
• Large numbers of buyers and sellers. Each firm produces a small portion of industry output, and each customer buys only a small part of the total.
• Product heterogeneity. The output of each firm is perceived to be essentially different from, though comparable with, the output of other firms in the industry.
• Free entry and exit. Firms are not restricted from entering or leaving the industry.
• Perfect dissemination of information. Cost, price, and product quality information is known by all buyers and all sellers.
These basic conditions are not as restrictive as those for perfect competition and are fairly commonplace in actual markets. Vigorous monopolistic competition is evident in the banking, container and packaging, discount and fashion retail, electronics, food manufacturing, office equipment, paper and forest products, and most personal and professional service industries. Although individual firms are able to maintain some control over pricing policy, their pricing discretion is severely limited by competition from firms offering close but not identical substitutes.
Monopolistic competition is a realistic description of competition in a wide variety of industries. As in perfectly competitive markets, a large number of competitors make independent decisions in monopolistically competitive markets. A price change by any one firm does not cause other firms to change prices. If price reactions did occur, then an oligopoly market structure would be present. The most distinctive characteristic of monopolistic competition is that each competitor offers a unique product that is an imperfect substitute for those offered by rivals. Each firm is able to differentiate its product from those of its adversaries. Nevertheless, each firm's demand function is significantly affected by the presence of numerous competitors producing goods that consumers view as reasonably close substitutes. Exogenous changes in demand and cost conditions also tend to have a similar effect on all firms and frequently lead to comparable pricing influences.
Product differentiation takes many forms. Quality differentials, packaging, credit terms, or superior maintenance service can all differentiate products, as can advertising that leads to brand-name identification. Not only is a tube of Crest toothpaste different from Colgate toothpaste, but a tube of Crest at a nearby convenience store is different from an identical tube available at a distant discount retailer. Because consumers evaluate products on the basis of their ability to satisfy specific wants, as well as when and where they have them, products involve not only quantity, quality, and price characteristics but time and place attributes as well. The important factor in all of these forms of product differentiation is that some consumers prefer the product of one seller to those of others.
The effect of product differentiation is to create downward-sloping firm demand curves in monopolistically competitive markets. Unlike a price taker facing a perfectly horizontal demand curve, the firm is able to independently determine an optimal price/output combination. The degree of price flexibility enjoyed depends on the strength of product differentiation. The more differentiated a firm's product, the lower the substitutability of other products for it. Strong differentiation results in greater consumer loyalty and greater control over price. This is illustrated in Figure 11.1, which shows the demand curves of firms A and B. Consumers view firm A's product as being only slightly differentiated from the bulk of industry output. Because many other firms offer acceptable substitutes, firm A is close to being a price taker. Conversely, firm B has successfully differentiated its product, and consumers are therefore less willing to accept substitutes for B's output. Firm B's demand is relatively less sensitive to price changes.
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