What are the similarities and differences between perfect competition and monopolistic competition monopoly and monopolistic competition?

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Economists can predict and describe the nature of a firm based upon its existing size, structure, behaviour and relationship to other firms (market power). This is known as theory of the firm. Two possible market structures that a firm may belong to are perfect competition and monopolistic competition (there are also oligopolies and monopolies).

Perfect competition exists when an industry consists of an infinite amount (in reality a very large number) of firms. There are a number of assumptions that accompany a perfectly competitive market:

1) Each individual firm has no market power

- Firms are too small, relative to the whole industry, to have a noticeable effect on the output of the whole industry by altering its own output.

- The firm cannot affect the supply curve of the industry so it can’t affect the price of the product

2) The firm is a price-taker

- Meaning, the firm has to sell at whatever price is set by the demand and supply in the industry as a whole

3) Firms produce homogenous goods (identical).

- Not possible to distinguish between goods produced by different firms

ie. No brand names or marketing

4) There are no barriers to entry/exit.

- Firms are completely free to enter or leave the industry as they wish

ie. No costs or legal barriers

5) All producers/ consumers possess perfect knowledge of the market

ie. Prices, costs, quality of products, availability, etc.

In real life, the closest industry to representing perfect competition is the agricultural market.

ie. Wheat production in Europe

Monopolistic competition exists if an industry has a fairly large number of firms present (albeit, fewer firms than in perfect competition). The assumptions that underlie a market in monopolistic competition are:

1) The firm has some price-setting ability

- Firms are still relatively small compared to the industry, so actions of one firm are unlikely to have a great effect on its competitors.

- Firms act independently of each other

2) It is possible to slightly differentiate between products.

- Firms produce slightly different products from each other, so the consumer has choice.

3) There are no barriers to entry/exit

-Firms are free to enter or leave the industry

4) Producers/consumers have almost perfect knowledge of the industry

There exist a number of real life examples of markets in monopolistic competition, for example: nail salons, restaurants, car mechanics, etc.

There are additionally similarities and differences in the profit abilities and efficiency of each market type:

In both perfect competition and monopolistic competition, firms in the industry are profit maximisers. A firm is only able to make normal (zero economic) profits in the long run, but can make short-run abnormal profits or losses.

In perfect competition, a firm achieves both allocative and productive efficiency in the long run. Consumers pay lower prices than in monopolistic competition, as they are only able to purchase homogenous products.

In monopolistic competition, a firm never achieves allocative or productive efficiency as consumers are willing to pay a slightly higher price in order to have differentiated products (choice). 

Perfect competition and monopolistic competition are two types of economic markets.

Similarities

One of the key similarities that perfectly competitive and monopolistically competitive markets share is elasticity of demand in the long-run. In both circumstances, the consumers are sensitive to price; if price goes up, demand for that product decreases. The two only differ in degree. Firm's individual demand curves in perfectly competitive markets are perfectly elastic, which means that an incremental increase in price will cause demand for a product to vanish ). Demand curves in monopolistic competition are not perfectly elastic: due to the market power that firms have, they are able to raise prices without losing all of their customers.

This is the demand curve in a perfectly competitive market. Note how any increase in price would wipe out demand.

Also, in both sets of circumstances the suppliers cannot make a profit in the long-run. Ultimately, firms in both markets will only be able to break even by selling their goods and services.

Both markets are composed of firms seeking to maximize their profits. In both of these markets, profit maximization occurs when a firm produces goods to such a level so that its marginal costs of production equals its marginal revenues.

Differences

One key difference between these two set of economic circumstances is efficiency. A perfectly competitive market is perfectly efficient. This means that the price is Pareto optimal, which means that any shift in the price would benefit one party at the expense of the other. The overall economic surplus, which is the sum of the producer and consumer surpluses, is maximized. The suppliers cannot influence the price of the good or service in question; the market dictates the price. The price of the good or service in a perfectly competitive market is equal to the marginal costs of manufacturing that good or service.

In a monopolistically competitive market the price is higher than the marginal cost of producing the good or service and the suppliers can influence the price, granting them market power. This decreases the consumer surplus, and by extension the market's economic surplus, and creates deadweight loss.

Another key difference between the two is product differentiation. In a perfectly competitive market products are perfect substitutes for each other. But in monopolistically competitive markets the products are highly differentiated. In fact, firms work hard to emphasize the non-price related differences between their products and their competitors'.

A final difference involves barriers to entry and exit. Perfectly competitive markets have no barriers to entry and exit; a firm can freely enter or leave an industry based on its perception of the market's profitability. In a monopolistic competitive market there are few barriers to entry and exit, but still more than in a perfectly competitive market.

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Monopolistically competitive markets are less efficient than perfectly competitive markets.

Producer and Consumer Surplus

In terms of economic efficiency, firms that are in monopolistically competitive markets behave similarly as monopolistic firms. Both types of firms' profit maximizing production levels occur when their marginal revenues equals their marginal costs. This quantity is less than what would be produced in a perfectly competitive market. It also means that producers will supply goods below their manufacturing capacity.

Firms in a monopolistically competitive market are price setters, meaning they get to unilaterally charge whatever they want for their goods without being influenced by market forces. In these types of markets, the price that will maximize their profit is set where the profit maximizing production level falls on the demand curve.This price exceeds the firm's marginal costs and is higher than what the firm would charge if the market was perfectly competitive. This means two things:

• Consumers will have to pay a higher price than they would in a perfectly competitive market, leading to a significant decline in consumer surplus; and
• Producers will sell less of their goods than they would have in a perfectly competitive market, which could offset their gains from charging a higher price and could result in a decline in producer surplus.

Regardless of whether there is a decline in producer surplus, the loss in consumer surplus due to monopolistic competition guarantees deadweight loss and an overall loss in economic surplus .

Monopolistic competition creates deadweight loss and inefficiency, as represented by the yellow triangle. The quantity is produced when marginal revenue equals marginal cost, or where the green and blue lines intersect. The price is determined based on where the quantity falls on the demand curve, or the red line. In the short run, the monopolistic competition market acts like a monopoly.

Productive and Allocative Efficiency

Productive efficiency occurs when a market is using all of its resources efficiently. This occurs when a product's price is set at its marginal cost, which also equals the product's average total cost. In a monopolistic competitive market, firms always set the price greater than their marginal costs, which means the market can never be productively efficient.

Allocative efficiency occurs when a good is produced at a level that maximizes social welfare. This occurs when a product's price equals its marginal benefits, which is also equal to the product's marginal costs. Again, since a good's price in a monopolistic competitive market always exceeds its marginal cost, the market can never be allocatively efficient.

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One of the characteristics of a monopolistic competitive market is that each firm must differentiate its products. Two ways to do this is through advertising and cultivating a brand. Advertising is a form of communication meant to inform, educate, and influence potential customers about products and services. Advertising is generally used by businesses to cultivate a brand . A brand is a company's reputation in relation to products or services sold under a specific name or logo.

From 1921 until the mid-1970s, Listerine was also marketed as preventive and a remedy for colds and sore throats. In 1976, the Federal Trade Commission ruled that these claims were misleading, and that Listerine had "no efficacy" at either preventing or alleviating the symptoms of sore throats and colds. Warner-Lambert was ordered to stop making the claims and to include in the next $10.2 million dollars of Listerine ads specific mention that "contrary to prior advertising, Listerine will not help prevent colds or sore throats or lessen their severity. "

Benefits of Advertising and Branding

The purpose of the brand is to generate an immediate positive reaction from consumers when they see a product or service being sold under a certain name in order to increase sales. A brand and the associated reputation are built on advertising and consumers' past experiences with the products associated with that brand.

Reputation among consumers is important to a monopolistically competitive firm because it is arguably the best way to differentiate itself from its competitors. However, for that reputation to be maintained, the firm must ensure that the products associated with the brand name are of the highest quality. This standard of quality must be maintained at all times because it only takes one bad experience to ruin the value of the brand for a segment of consumers. Brands and advertising can thus help guarantee quality products for consumers and society at large.

Advertising is also valuable to society because it helps inform consumers. Markets work best when consumers are well informed, and advertising provides that information. Advertising and brands can help minimize the costs of choosing between different products because of consumers' familiarity with the firms and their quality.

Finally, advertising allows new firms to enter into a market. Consumers might be hesitant to purchase products with which they are unfamiliar. Advertising can educate and inform those consumers, making them comfortable enough to give those products a try.

Costs of Advertising and Branding

There are some concerns about how advertising can harm consumers and society as well. Some believe that advertising and branding induces customers to spend more on products because of the name associated with them rather than because of rational factors. Further, there is no guarantee that advertisements accurately describe products; they can mislead consumers. Finally, advertising can have negative societal effects such as the perpetuation of negative stereotypes or the nuisance of "spam. "