Monopolistic Competition

Monopolistic competition, despite its name, is much closer in spirit to perfect competition than to monopoly — it simply relaxes the strict "homogeneous product" condition. A market is monopolistically competitive when a fairly large number of sellers compete, but each sells a product that is a close, though not perfect, substitute for its rivals' — differentiated by brand name, packaging, perceived quality, after-sales service, or location, even where the underlying product performs an essentially similar function. Everyday examples include toothpaste, soaps, shampoos, restaurants, and tailoring or salon services in a city — many sellers, a broadly similar product, yet each with its own loyal customers who do not treat every seller's offering as perfectly interchangeable.

This one difference — product differentiation instead of homogeneity — changes the market's economics in an important way. Because a seller's product is not identical to its rivals', the seller has some, though limited, control over its own price: a modest price increase does not send every customer instantly to a rival, because some buyers value the particular brand's features enough to pay a little more for it. This is why a monopolistically competitive firm's demand (AR) curve slopes downward like a monopolist's, but is far more elastic (flatter) than a monopolist's, since close — if imperfect — substitutes are readily available. Because differentiation, not cost or barrier-driven exclusivity, is the source of this limited price control, firms under monopolistic competition typically spend heavily on selling costs — advertising, packaging, branding — to persuade buyers that their product really is meaningfully different from a rival's, a form of competition that has no equivalent under perfect competition, where products are identical by definition. …