Assumptions of Monopolistic Competition
Monopolistic competition is nearer to the competitive end of the spectrum - Assumptions of Monopolistic Competition introduction. It can best be understood as a situation where there are a lot of firms competing, but where each firm does nevertheless have some degree of market power (hence the term ‘monopolistic’ competition): each firm has some choice over what price to charge for its products.
• There are quite a large number of firms. As a result, each firm has an insignificantly small share of the market, and therefore its actions are unlikely to affect its rivals to any great extent. This means that when each firm makes its decisions it does not have to worry how its rivals will react. It assumes that what its rivals choose to do will not be influenced by what it does. This is known as the assumption of independence. This is not the case under oligopoly. There we assume that firms believe that their decisions do affect their rivals, and that their rivals’ decisions will affect them. Under oligopoly, we assume that firms are interdependent.
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• There is freedom of entry of new firms into the industry. If any firm wants to set up in business in this market, it is free to do so. In these two respects, therefore, monopolistic competition is like perfect competition. Unlike perfect competition, however, each firm produces a product or provides a service in some way different from its rivals. As a result, it can raise its price without losing all its customers. Thus its demand curve is downward sloping, albeit relatively elastic given the large number of competitors to whom customers can turn. This is known as the assumption of product differentiation.
Petrol stations, restaurants, hairdressers and builders are all examples of monopolistic competition. A typical feature of monopolistic competition is that, although there are many firms in the industry, there is only one firm in a particular location.
This applies particularly in retailing. There may be many hairdressers in a town, but only one in a particular street. In a sense, therefore, it has a local monopoly. People may be prepared to pay higher prices for their haircuts there to avoid having to go elsewhere.
If typical firms are earning supernormal profit, new firms will enter the industry in the long run. As they do, they will take some of the customers away from established firms. The demand for the established firms will therefore fall. Their demand curve will shift to the left, and will continue doing so as long as supernormal profits remain and thus new firms continue entering. Long-run equilibrium is reached when only normal profits remain: when there is no further incentive for new firms to enter.