Monopolistic competition vs. Perfect competition

Bernadette Giene Cain
BUS650: Managerial Finance
Dr. Stanley Atkinson
April 20, 2015

Perfect competition has a large number of buyers and sellers that buy and sell identical products, and they are identical in all their features, and the prices charged are a uniform price. The players in the market are not large enough alone to be a market leader or set prices since the products are sold and priced identically, with no barriers of entry or exit into the market. Perfect competition is defined as “A market structure in which the following five criteria are met: 1) all firms sell an identical product; 2) all firms are price takers - they cannot control the market price of their product; 3) all firms have a relatively small market share; 4) buyers have complete information about the product being sold and the prices charged by each firm; and 5) the industry is characterized by freedom of entry and exit. Perfect competition is sometimes referred to as "pure competition" (Investopedia, LLC. N.d.).
A monopolistic market has a large number of buyers with very few sellers, which sell goods that are different from each other and are able to charge different prices based on the value of the product. In this market, one seller can control the market, which in turn renders control of prices, quality, and product features. Market power is short term as new companies enter the market and create a need for new and/or cheaper products. Monopolistic competition is defined as “A type of competition within an industry where: 1)all firms produce similar yet not perfectly substitutable products; 2) all firms are able to enter the industry if the profits are attractive; 3) all firms are profit maximizers; and 4) all firms have some market power, which means none are price takers” (Investopedia, LLC. N.d.). Monopolistic competition differs from perfect competition in that the production is not occurring at the lowest cost possible and companies are left with an excess in production capacity.
“Monopolistic competition requires specialized inputs because some product differentiation is compatible with perfect competition. If we think of a good or service as a bundle of attributes, each different product could be a different combination of the same attributes. Perfect competition in the supply of each attribute could then result in perfect competition in the supply of products” (Carson, R. 2006). When a company can take on a unique attribute as part of their production or output, this cannot be duplicated by anyone else and there is no perfect substitute, and we are no longer in perfect competition in either products or attributes. For example, let's say that a supplier offers one unique item, and there is no other product like this, nor can it be duplicated. In order to ensure there cannot be a rival supplier, entry to the market is protected, thus creating a cost advantage for this product. Under a monopolistic competition there are no barriers to entry, and the seller is the sole possessor of that specialized product or service. Without a specialization, perfect competition would prevail due ease of entry into the market.
Monopolistic competition allows free entry of firms that are producing output levels that are less than optimal, and have higher costs of production due to the cost of variety. By understanding the monopolistic competition, two concepts are involved, economies of scale and elasticity of substitution. Economies of scale is caused by fixed costs associated with setting up the new variety of the particular product. Elasticity of substitution are the varieties of a generic product. Being that consumers love variety, it is reflected in the elasticity of substitution. Thus, the higher the elasticity of substitution, the smaller consumers’ love for variety. The greater their love for variety, the smaller the elasticity of substitution and results in a decrease in the elasticity