Definition of monopolistic competition: Where there is only one dominant seller of a good in a marketplace, the seller is said to be a monopoly.

In a monopolistic marketplace, a dominant seller is able to increase prices above the market equilibrium to extract a premium profit, at the detriment of other market participants.

What is monopolistic competition?

Monopolistic competition occurs when there is only one seller of a good or service, or there a dominant seller who can control the market.

An example might be a water utility, which owns the pipes and reservoirs in a local area, and is the only available supplier of tap water to households.

Monopolies can be observed at the large scale or small scale. The following are all examples of monopolistic competition:

• A dominant search engine which receives the vast majority of all search queries
• A corporation which owns each brand of opticians in a town centre
• A mining company sat on the only active mine for a rare earth material in a country.

Monopolistic competition v free competition

As covered in our definitions of a free market and the invisible hand, a free marketplace settles at a market price which maximises the number of buyers and sellers who are willing to trade.

In a free market, buyers and sellers are numerous, and they are all price takers. This means that despite their best wishes, they do not have the power to pull the market price in a favourable direction. Sellers cannot force the sale price upwards, and buyers cannot force the sale price downwards. Let’s look at why this is the case:

Why most market participants are price takers

If a good is selling at £9 on the market, this implies that buyers are willing to pay £9 and enough suppliers are willing to sell at £9 to satisfy this demand.

Suppliers would naturally prefer the price to be £10, allowing them to earn an additional gross profit of £1 on each item they sold.

However they have no power as independent individuals to bring this change about. If a supplier decided to set their price at £10, buyers would choose instead to buy from the existing suppliers who are trading at the market price of £9. For want of an extra £1 of gross margin, the supplier’s turnover would fall to zero. To continue trading, they would need to take the price offered by the market. This is why we call free market participants price-takers.

In a similar way, if a buyer offered £8 to purchase a product, no vendor would choose to serve them. As £9 was the equilibrium price, every vendor willing to sell their goods at £9 would find a buyer for their stock. This means a vendor would have to sacrifice a sale they would otherwise make at £9, to sell to the hard-bargainer. It isn’t rationale to do so, therefore the buyer would eventually need to either stump up £9 or not buy altogether.

Monopolies are price makers

Monopolies have a crucial advantage over the supplier in the example above. They operate in a market with limited or no competition.

This means that if they choose to increase their price to £10, a buy cannot simply switch vendor and continue to buy at £9.

A monopoly can therefore control their selling price, within limits.

Monopolies cannot escape the limitations of the demand curve itself. The laws of supply and demand will still hold in that higher prices will reduce demand for the product.

However, depending on the slope of the demand curve, it will probably be advantageous for the monopoly to increase prices to maximise their income.

For example, perhaps the monopoly originally priced their product at £9, and saw demand of 100,000 at this price. This resulted in £900,000 of sales.

If they increased the price to £15, the demand may fall to 75,000. This would still generate £1,125,000 of turnover. Depending on their variable costs, this may result in more net profit for the firm.

It is clear to see that in this case, the ability of the monopoly to increase prices has resulted in a worse outcome for consumers. Fewer consumers are receiving the product they wanted, and they’re paying a higher price for it.

This is why monopolies are almost universally viewed as blights upon economies. They pull markets away from the market equilibrium which would otherwise see the total potential of those markets realised.

Economics books can explain, using visual diagrams, how a monopoly will distort any market they enter in this way.

Further drawbacks of monopolies:

Due to their economies of scale, they may price products at a price far lower than the marginal cost of a small scale firm. This will deter potential entrants to the market from even trying to enter, as they will struggle to demonstrate that their business plan is workable.

Monopolies may also engage in anti-competitive practises such as selling products at a loss in the short term, until any remaining competition has become bankrupt or has left the market.

Due to their size, power and influence, we also see monopolies use their wealth to buy influence and lobby for favourable regulations which further protects their position in the marketplace.

Monopolies have very little incentive to spend money on research & development and to innovate. They simply do not need to improve their product to continue to generate turnover. Reducing research and development is actually a strategy which could increase profits.

Monopolies provide the consumer with fewer choices and therefore a narrower range of products. Even the ‘best choice available’ may not be an excellent match for every consumer.

Monopolies in the real world

It’s interesting to apply the principles of free markets and monopoly to real-life purchase decisions.

Most economics theories assume that a product is homogenous (i.e. identical in every way). Therefore buyers are indifferent between firms selling at the same price.

In the real world, branding and product design demolish this assumption.

When a company adds a brand or patents a unique design, they are effectively creating a tiny monopoly over that specific product. This is because intellectual property laws give companies the means to block any competition from producing the exact same product.

This means that even competitive markets can feel more like a crowd of individual monopolies hawking different products than they are a crowd of price-takers offering a single product.

This means that modern markets often contain elements of both free-market competition and monopolistic competition.

For example, if a restaurant adds $2 onto the price of all of its food items, it’s unlikely that its entire floor would empty into a lower-price competitor.

After all, as it is the only supplier of that exact food experience, some customers with a strong preference will be prepared to pay a higher price to continue to eat there.

Therefore, even a restaurant operating on a street with plenty of competition has some price-making power, although the existence of those alternatives will act as a constrain upon how far the restaurant can move prices before customers flock to a neighbouring venue.

How does the definition of monopolistic competition relate to investing?

Understanding that monopolies have the power to increase prices and extract more profit from a market than possible in in free market, investors may purposefully look for companies with dominant market positions.

This is also known as a type of economic moat, i.e. a competitive advantage which will likely persist for some time.

Investing books and investing courses about value investing will highlight the advantage of this and other economic moats, and encourage you to screen possible investments for such qualities before buying shares.