November 15, 2010

Pure Competition vs. Monopolistic Competition

In common usage, the word competition is associated with contention, rivalry, contest, or opposition.  These synonyms are viewed as hostile.  Webster's Dictionary defines competition as the striving for something that is sought by another at the same time. Competition may be friendly but rivalry is commonly hostile.  In business, the chief antonym of competition is monopoly. In economics, when used with the word pure, it takes on a different meaning.

Pure Competition.  In economics, pure competition takes on an impersonal nature. One producer of a particular product does the best that is possible without any intent to get or defeat other producers of the same product.  In other words, there is no enmity, it is frictionless. There are four necessary conditions for pure competition to exist: (1) homogeneity of the product, (2) smallness of each buyer or seller relative to the market, (3) absence of artificial restraint, and (4) mobility or free entry and exit.

These conditions are however far from reality.  But the principles of pure competition us used as take off in economic analysis for the following reasons:
  1. It provides a simple and logical starting point for economic analysis.
  2. It provides a "norm" against which the actual performance of the economy can be evaluated.
  3. The theory leads to the sets of conditions defining maximum economic welfare or well being given the distribution of income.
The purely competitive model is frequently used by economists as basis for public regulation of imperfectly competitive situations such as monopolistic forces.
Monopolistic Competition. Monopolistic competition is a form of imperfect competition. Monopolistic competitive markets have the following characteristics:
  1. Product differentiation.  Sellers in monopolistic competitive markets sell products with either real or perceived non-price difference.The products are basically substitutes, the differentiation comes in with branding.  For instance, Nike shoes is differentiated from Adidas shoes through branding.
  2. Many firms. There are many firms and consumers of the product that not one firm has total control over market price.
  3. Free entry and exit in the long run. The entry of firms will erode the benefits of differentiation in the long run.
  4. Independent decision making. A firm in a monopolistic competitive market independently sets its own terms such as pricing structure without any consideration on the reaction of its competitors.
  5. Market power.  To a certain degree, a firm in a monopolistic competitive market especially if it has solidly established a differentiation advantage.
  6. Perfect information.  In this type of product market, buyers know what products are offered in the market, price differences and the differentiating characteristics of the product.

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