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Monopolistic competition is a market structure that is characterized by the following:
Many firms and consumers in the given market
Each firm produces a differentiated product
Ease of entry into and exit from the industry
Because there are many firms in a monopolistically competitive market, each firm has a small percentage of the market share and no one firm dominates the market. Although products in a monopolistic competition market structure are similar, each firm differentiates their product through attributes such as style, brand name, location and pricing strategies. In an effort to differentiate their products from their competitor’s products, each firm is attempting to create a loyal customer base. Customer loyalty gives the firm some influence over the market, in that it can raise prices without losing all of their customers. Entry into a market that is characterized as monopolistic competition is not difficult. The market is not regulated nor does it require significant investments in capital that are restrictive in nature.
A monopolistically competitive firm acts like a monopolist in that the firm is able to influence the market price of its product by altering the rate of production of the product. Unlike in Perfect Competition, monopolistically competitive firms produce products that are not perfect substitutes. In the short-run, the monopolistically competitive firm can exploit the heterogeneity of its brand so as to reap positive economic profit. In the long-run, however, whatever distinguishing characteristic that enables one firm to reap monopoly profits will be duplicated by competing firms. This competition will drive the price of the product down and, in the long-run, the monopolistically competitive firm will make zero economic profit.
Examples of Monopolistic Competition
Some examples of monopolistically competitive markets are fast-food restaurants, books and clothing. To examine the fast food market we find many firms that produce a hamburger, such as McDonalds, Burger King and Wendy’s. Each firm differentiates their hamburger and they are not made exactly the same. As Wendy’s raises their prices, some of their customers will begin eating at Burger King, while others will remain loyal to Wendy’s. This is a function of the downward demand curve that firms in a monopolistically competitive market structure experience. As price increases, quantity decreases. Similarly as price decreases, quantity increases.
Example Test Questions
1. True or False: There are many firms in a monopolistically competitive market and as a result many perfect substitutes for a firm’s product.
The answer is False. Although it is true that there are many firms in a monopolistically competitve market, because firms differentiate there products through attributes such as style, brand name, location and pricing strategies there are not many perfect substitutes for a firm's product.
2. What characteristics define a monopolistic competitive market structure?
a. Downward sloping demand curve
b. Highly elastic demand curve
c. One firm dominates the market
d. a and b
The answer is d. The answer a is correct; firms in a monopolistic competitive market structure experience a downward sloping demand curve. As price increases, quantity demanded will decrease and as price decreases, quantity demanded will increase. Products exist that are close substitutes and some customers will price shop and not be loyal customers. This results in a downward sloping demand curve. The answer b is also correct. A monopolistically competitive firm's demand curve is highly elastic, but not perfectly elastic. It is more elastic than a monopoly demand curve because there are many firms in the industry and because of the existence of close substitues. It is less elastic than a firm in perfect competition because the products are differentiated, not homogeneous. Answer c is incorrect because in a monopolistically competitive market structure one of the defining characteristics is that there are many firms the given market.
3. Which answer does not describe a characteristic of a monopolistic competitive market structure.
a) Each firm produces a differentiated product
b) Many consumers in the given market
c) One firm with a large percentage of the market share
d) Ease of entry into and exit from the industry
Answer is c. A monopolistic competitve market structure has many firms in the given market and as a result, no one firm has a large percentage of the market share.
4. True or False. Because entry into a monopolistic competitive market requires significant capitial expenditures it is uncommon for new firms to enter the market.
Answer is false. A monopolistic competitve market structure is characterized by ease of entry into the given market.
5. True or False. Firms is a monopolistic competitive market have no influence of the market.
Answer is false. Customer loyalty gives the firms some influence over the market in that it can raise prices without losing all of their customers.
6. In a monopolistic competitve market structure
a) as price increases, demand increases
b) as price increases, demand decreases
c) as price decreases, demand increases
d) b and c
Answer d. Because firms in a monopolistice competitive market structure experience a downward sloping demand curve, price and quantity demaned are inversely related.
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