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Understanding Monopolistic Competition in Economics

Understanding Monopolistic Competition in Economics
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  • 0:01 Monopolistic Competition
  • 0:30 Conditions
  • 4:12 Lesson Summary
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Lesson Transcript
Instructor: Dr. Douglas Hawks

Douglas has two master's degrees (MPA & MBA) and is currently working on his PhD in Higher Education Administration.

In this lesson, we'll learn about monopolistic competition. This type of competition can be found in a free market where products are differentiated, but not so differentiated that any single firm has the power to influence market prices.

Monopolistic Competition

Monopolistic competition may sound like an oxymoron, since the term 'monopoly' might suggest the absence of competition. But, remember, in economics, everything exists on a continuum, or a range with two extremes, one at each end. That's just what monopolistic competition is: an industry somewhere on the continuum between a pure monopoly, where a single firm holds all market power, and perfect competition, where many firms exist and each is a perfect substitute for the other.

Conditions of Monopolistic Competition

There are four conditions that must be met for monopolistic competition to exist. These conditions influence how producers and consumers interact, and ultimately determine the behaviors of industry participants. The four conditions of a monopolistic competition that must exist:

  1. There are many consumers and producers in the market, but no single producer has significantly more control than any other producer.
  2. There are differences between the competitors' products, but not price differences.
  3. The producers have some control over the price they charge.
  4. There are low barriers to enter and exit the market.

The first condition may seem counterintuitive. Why would a market defined as 'monopolistic' be required to have many producers? Remember, the term 'monopolistic' refers to the industry. While it isn't a monopoly, because there isn't a single firm; it is monopolistic because the many producers that do exist make products that while not perfect substitutes for one another, are close enough that from the consumer's perspective, they can't go outside the industry to meet their needs.

Before we talk about the four conditions, it might be helpful to take this first condition and think of an example. What sort of industry do you think meets this first condition? What sort of goods or services can you think of where you might think, 'I want a ____, and could go to company A, B, or C to get it?' Fill in the blank. Hamburger? New pair of shoes? Real estate agent? All are good examples of industries structured as monopolistic competition. Apply the first condition: the requirement for many producers. Doesn't that apply in each of those? How many different places could you get a hamburger, shoes, or a real estate agent? A lot. And, while there may be subtle differences, the products are essentially the same.

The second condition is that there is more than just price difference between the products. Again, go back to the hamburger example. You could go to one popular national chain and get a hamburger or go to another and get a hamburger. You might pay slightly different prices, although likely not significant, and there will also be other differences in the burger. The products may both be hamburgers on a bun with some sides, but most of the time you can tell the difference, can't you? This is an important part of monopolistic competition, because remember, the industry as a whole is like a monopoly that offers similar products, but has many firms offering those products.

The third condition is that producers have the ability to set their own prices. That seems like an obvious statement, but remember, this is economics. Thus, we aren't saying that a hamburger joint can just set their price, but that they can set their price without significantly impacting demand. Of course, there are limits to doing that, but the general idea is that firms are price setters, not price takers. This is because, as an industry, there are no perfect substitutes; you could go get a salad or a chicken sandwich, but hamburgers are a specific good.

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