Monopolistic Competition

The economic environment faced by many firms cannot be described as perfectly competitive. Likewise, few firms enjoy clear monopoly. Real-world markets commonly embody elements of both perfect competition and monopoly. Firms often introduce valuable new products or process innovations that give rise to above-normal rates of return in the short run. In the long run, however, entry and imitation by new rivals erode the dominant market share enjoyed by early innovators, and profits eventually return to normal. Still, in sharp contrast to perfectly competitive markets, the unique product characteristics of individual firms often remain valued by consumers. Consumers often continue to prefer Campbell's Soup, Dockers, Oil of Olay, Rubbermaid, Tide, and other favorite brands long after comparable products have been introduced by rivals. The partly competitive, partly monopolistic market structure encountered by firms in the apparel, food, hotel, retailing, and consumer products industries is called monopolistic competition. Given the lack of perfect substitutes, monopolistically competitive firms exercise some discretion in setting prices—they are not price takers. However, given vigorous competition from imitators offering close but not identical substitutes, such firms enjoy only a normal risk-adjusted rate of return on investment in long-run equilibrium.

Monopolistic competition is similar to perfect competition in that it entails vigorous price competition among a large number of firms. The major difference between these two market structure models is that consumers perceive important differences among the products offered by monopolistically competitive firms, whereas the output of perfectly competitive firms is homogeneous. This gives monopolistically competitive firms at least some discretion in setting prices. However, the availability of many close substitutes limits this price-setting ability and drives profits down to a normal risk-adjusted rate of return in the long run. As in the case of perfect competition, above-normal profits are possible only in the short run, before the monop-olistically competitive firm's rivals can take effective countermeasures.


A market structure characterized by few sellers and interdependent price/output decisions

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