Monopolistic competition strikes a middle ground between competition and monopoly, i.e., it contains elements of both monopoly and perfect competition, and, as such, a market under monopolistic competition possesses the following characteristic features:
1. In the market (like that under competition), there should be a large number of buyers and sellers of the good concerned.
2. The sellers sell differentiated, but close-substitute, products. There may be differences between the products in respect of quality—these are real differences, or there may be differences in packaging materials or design, brand name, etc.—these are often spurious differences.
In any case, this should be noted that when products are differentiated, each product is unique and its producer has some degree of monopoly power, although this power is usually very small. Because, other producers can always market closely related goods. That is why the selling price of cigarettes is almost uniform from brand to brand.
3. In the market under monopolistic competition, if the producer of a commodity raises its price even by a small proportion, the number of buyers and the demand for the good would fall drastically, since there are so many close-substitute rival products, but the demand would not fall to zero (as it does under perfect competition) because the product is different, in some way, from the other products and would be able to attract at least a few customers even at the higher price.
That is why the demand curve for each firm under monopolistic competition would be a very flat, highly elastic downward sloping curve (but it would not be a horizontal straight line as under perfect competition).
4. Since the demand curve or the AR curve of a firm under monopolistic competition is downward sloping towards right, its MR curve would also be downward sloping, and at any q > 0, the MR curve would lie below the AR curve. That is why, here also, as under monopoly, the firm is a price-maker and p > MR.
5. In the market under monopolistic competition, the firms sell a large number of close-substitute products. That is why, here the firms are required to undertake advertisement expenditures for campaigning for their products.
It may be noted here that advertisement does not feature in monopoly, since the pure monopolist is the only producer and seller of his product, nor does it feature in perfect competition because the competitive firms produce a homogeneous commodity and there is perfect knowledge of this among the buyers.
6. The close-substitute products in a market under monopolistic competition are together called the product-group. The product of each firm is a ‘unique’ product of this group.
7. In the market under monopolistic competition, very much like the perfectly competitive market, new firms may enter the industry in the long run if the existing firms happen to earn more than normal profit in the short run.
On the other hand, the existing firms may leave the industry in the long run if they are unable to earn pure profit in the short run and even in the long run. Owing to this feature of free entry and free exit, each firm under monopolistic competition (like that under perfect competition) can earn only normal profit in the long run.
8. In a market under monopolistic competition, the number of producers of each separate product is only one. That is why this market possesses an important feature of monopoly. Again, this market possesses many features of a competitive market.
For example, in this market, the number of buyers and sellers is large, nearly homogeneous products are bought and sold, and the firms earn only normal profit in the long run owing to the feature of free entry and free exit. Because of the existence of the features of both monopoly and competition, this market is called a market under monopolistic competition.
In the real world, we frequently come across the markets under monopolistic competition. For example, different types of soap, tooth brush, perfumed oil and other cosmetic goods, ready-made shoes and dresses, are all sold in markets under monopolistic competition. Close substitutes of each of these goods are produced by a large number of sellers.