Introduction to Monopolistic Competition

Imagine you’re hungry and craving pizza. If you’re like me, you’d open your favorite food delivery app and search for pizza. But what kind do I want. I could get a regular pizza cut in slices, or I could get a thin crust pizza cut into squares, or maybe I’m feeling saucy and want a deep dish. You could look at these three pizza places as monopolistic competition, because they’re producing similar but not identical products.

Monopolistic competition falls between perfect competition, where sellers are selling identical products, and a monopoly, where a seller is the only one able to sell that product.

Like perfectly competitive businesses, monopolistically competitive businesses compete against lots of other businesses, and usually it’s pretty easy to enter and exit the market.

That is, there are few or no barriers, that prevent businesses from competing.

However, unlike perfect competition, the products or services monopolistically competitive businesses sell are different from one another. These businesses compete on more than just price. This means they have some power to choose the price they charge—like a monopolist who faces no competition. But instead of competing on just one dimension, such as price, they’re competing on lots of subjective dimensions.

In the case of pizza, it can be the style, size, dough, ingredients, price, location of the restaurant, customer service, speed.

What monopolistic competitive businesses try to do is try to become a monopoly in a very narrow field. A mini-monopoly, if you will.

Imagine a business that sells fruit pizza and they’re the only business in the world who sells those, but there are a lot of near substitutes if you’re looking for a pizza or even a sweet pizza.

And then, crucially, the businesses tell you about its uniqueness. Oh my goodness, does it tell you about it! Advertising is a crucial part of a monopolistically competitive business’s strategy because it needs to let you know about its product’s subtle differences.

Because the monopolistically competitive business sells a product with near but not perfect substitutes, they have some control over the price they charge: they have a bit of market power. In other words, they don’t take the market prices given like a perfectly competitive business.

Thus, they will choose a price and quantity that maximizes profits and is above what would normally be charged in a perfectly competitive market. That is, they sell a smaller quantity of their product at a higher price than a firm in a perfectly competitive market.

To an economist, this is an inefficient outcome -- if they lowered the price, they could still cover their costs, and more people would buy it.

But these companies do not have as much pricing power as a monopoly. Because there are usually few barriers to entering a monopolistically competitive market, the threat of rivals is always imminent. This means that if it were charging too high of a price, then other businesses would enter the market and try to compete.

For this reason, pricing and output decisions for the monopolistically competitive business look more like those for a perfectly competitive business than for a monopolist.

So to recap, monopolistically competitive businesses sell in markets with lots of other businesses and no barriers to market entry, but they compete with those businesses on more than just price by offering some product differentiation and advertising. This means they have some control over prices.

The more important decisions for monopolistic businesses, and businesses in general, are the decisions that differentiate their product from the competition—where to sell, what to sell, what specific features to include, and then how to let the world know about their great product or service.

If you’re hungry for more videos about the different types of competition and other economic concepts, visit stlouisfed.org-slash-education or our free teacher portal, econlowdown.org. Econ Lowdown. Click. Teach. Engage.