There are six characteristics of monopolistic competition (MC):
MC companies sell products that have real or perceived non-price differences. Examples of these differences could include physical aspects of the product, location from which it sells the product or intangible aspects of the product, among others. However, the differences are not so great as to eliminate other goods as substitutes. Technically, the cross price elasticity of demand between goods in such a market is positive. In fact, the cross elasticity of demand would be high. MC goods are best described as close but imperfect substitutes. The goods perform the same basic functions but have differences in qualities such as type, style, quality, reputation, appearance, and location that tend to distinguish them from each other. For example, the basic function of motor vehicles is the sameto move people and objects from point to point in reasonable comfort and safety. Yet there are many different types of motor vehicles such as motor scooters, motor cycles, trucks and cars, and many variations even within these categories.
There are many companies in each MC product group and many companies on the side lines prepared to enter the market. A product group is a "collection of similar products". The fact that there are "many companies" means that each company has a small market share. This gives each MC company the freedom to set prices without engaging in strategic decision making regarding the prices of other companies (no mutual independence) and each company's actions have a negligible impact on the market. For example, a company could cut prices and increase sales without fear that its actions will prompt retaliatory responses from competitors.
The number of companies that an MC market structure will support at market equilibrium depends on factors such as fixed costs, economies of scale, and the degree of product differentiation. For example, the higher the fixed costs, the fewer companies the market will support.
Freedom of entry and exitEdit
Like perfect competition, under monopolistic competition also, the companies can enter or exit freely. The companies will enter when the existing companies are making super-normal profits. With the entry of new companies, the supply would increase which would reduce the price and hence the existing companies will be left only with normal profits. Similarly, if the existing companies are sustaining losses, some of the marginal firms will exit. It will reduce the supply due to which price would rise and the existing firms will be left only with normal profit.
Independent decision makingEdit
Each MC company independently sets the terms of exchange for its product. The company gives no consideration to what effect its decision may have on its competitors. The theory is that any action will have such a negligible effect on the overall market demand that an MC company can act without fear of prompting heightened competition. In other words, each company feels free to set prices as if it were a monopoly rather than an oligopoly.
MC companies have some degree of market power, although relatively low. Market power means that the company has control over the terms and conditions of exchange. All MC companies are price makers. An MC companies can raise its prices without losing all its customers. The company can also lower prices without triggering a potentially ruinous price war with competitors. The source of an MC company's market power is not barriers to entry since they are low. Rather, an MC company has market power because it has relatively few competitors, those competitors do not engage in strategic decision making and the companies sells differentiated product. Market power also means that an MC company faces a downward sloping demand curve. In the long run, the demand curve is highly elastic, meaning that it is sensitive to price changes although it is not completely "flat". In the short run, economic profit is positive, but it approaches zero in the long run.
No other sellers or buyers have complete market information, like market demand or market supply.Market structure comparisonMarket StructureNumber of firmsMarket powerElasticity of demandProduct differentiationExcess profitsEfficiencyProfit maximization conditionPricing powerPerfect competitionInfiniteNonePerfectly elasticNoneYes/no (short/long)YesP=MR=MCPrice takerMonopolistic competitionManyLowHighly elastic (long run)HighYes/No (Short/Long)NoMR=MCPrice setterMonopolyOneHighRelatively inelasticAbsolute (across industries)YesNoMR=MCPrice setter