Market Structures and Market Failures

What happens when markets do not work perfectly?

7.5 What Is Monopolistic Competition, and How Does It Affect Markets?

The fourth market structure, monopolistic competition, is the one we encounter most often in our daily lives. When we eat in a restaurant, buy gas at a gas station, or shop at a clothing store, we are doing business in monopolistically competitive markets.

Monopolistic Competition: Many Producers. Similar but Varied Products

In An monopolistic competition, a large number of producers provide goods that are similar but varied. Like oligopoly, this market structure falls between the extremes of perfect competition and monopoly. However, it lies on the more competitive end of the spectrum.

The shoe business is a good example of monopolistic competition. If you go to a discount shoe store, you will find hundreds of pairs of shoes on display, made by many different companies. Each company has marked its shoes with its own brand, or trade name.

Each has worked to make its line of shoes distinctive in style, color, material, or quality of construction. Because of these differences. shoes are not commodities. Therefore. the shoe industry does not fit the model of perfect competition. At the same time, the sheer number of shoe producers indicates that the shoe industry is neither a monopoly nor an oligopoly.

You might well wonder why a market like this would be called monopolistic. The main reason is that the goods offered by the competing brands are distinct enough to appear unique. As a result, customers may develop brand loyalty, favoring one company over all others. Such customer loyalty gives the favored company some degree of market power. In effect, the company “monopolizes“ its brand and can charge more for it.

Monopolistic competition is especially common in service industries. such as banks. auto repair shops. and supermarkets. But as our shoe example indicates, it also exists in many manufacturing industries.

Monopolistic competitions share four basic characteristics.

Many producers. Monopolistically competitive markets have many producers or sellers. In a big city, many restaurants compete with one another for business. The same is true for gas stations and hotels.

Differentiated products. Firms in this type of market engage in product differentiation, which means they seek to distinguish their goods and services from those of other firms, even when those products are fairly close substitutes for one another. For example, a pizza stand and a taqueria both offer fast foods. A customer may have a taste for one type of food over the other, but either will provide a suitable lunch.

Few barriers to entry. Start-up costs are relatively low in monopolistically competitive markets. This allows many firms to enter the market and earn a profit. For example. it does not cost much to get into the custom T-shirt business. That means that an entrepreneur with a good set of T-shirt designs may be able to open a shop or create a Web site and sell enough shirts to make a profit.

Some control over prices. Because producers control their brands. they also have some control over prices. However, because products from different producers are close substitutes. this market power is limited. If prices rise too much. customers may shift to another brand. In addition, there are too many producers for price leadership or collusion to be feasible.

Increasing Market Share Through Nonprice Competition

To compete with rival firms, producers in monopolistically competitive markets have to take price into consideration. But they also engage in nonprice competition, using product differentiation and advertising to attract customers. By convincing consumers that their brand is better than others, these producers hope to increase their firm’s market share, or proportion of total sales in a market. Nonprice competition typically focuses on four factors.

Physical characteristics. There are many kinds of products that consumers will pay more for because of their unique physical characteristics. For example, a pair of running shoes may stand out from its competitors because of the shoe’s unique design, color, or materials. A consumer who likes that particular shoe may not consider buying any other pair, regardless of price.

Service. Some producers offer better service than others and can therefore charge higher prices. For example, a fast food chain and a sit-down restaurant both offer food, but the more expensive restaurant also offers table service. Upscale grocery stores may offer their customers free food samples or special services, such as food delivery and catering. Some department stores provide personal shopping assistants to help customers make selections. Such enhanced services may appeal to consumers who are willing to pay for them.

Location. Gas stations, dry cleaners, motels, and other businesses may compete with one another based on location. Although they offer the same basic product or service, a firm may win customers because it is located near a highway, a shopping mall. or some other convenient spot.

Status and image. Sometimes companies compete on the basis of their perceived status or trendiness. One brand may be regarded as more exclusive, more “natural,“ or more fashionable than another. For example, a handbag from an expensive boutique may have greater status in a customer’s eyes than a similar bag from a discount store. Another customer may willingly pay more for designer jeans, even though a similar product without the designer label might be had for much less money.

These perceived status differences are usually established through advertising. Although advertisers often provide information about their products in ads, their main goal is to increase their sales and market share.


Next Reading: 7.6 (Market Failures: What Are Externalities and Public Goods?)