Monopolistic competition is one form of imperfect competition. Monopolistically competitive markets have a number of specific features:
- Many firms - There are many firms in monopolistically competitive markets, and this is part of what sets them apart from monopolies.
- Product differentiation - Although the products sold by different firms in monopolistically competitive markets are similar enough to one another to be considered substitutes, they are not identical. This feature is what sets monopolistically competitive markets apart from perfectly competitive markets.
- Free entry and exit - Firms can freely enter a monopolistically competitive market when they find it profitable to do so, and they can exit when a monopolistically competitive market is no longer profitable.
In essence, monopolistically competitive markets are named as such because, while firms are competing with one another for the same group of customers to some degree, each firm's product is a little bit different from that of all the other firms, and therefore each firm has something akin to a mini-monopoly in the market for its output.
Because of product differentiation (and, as a result, market power), firms in monopolistically competitive markets are able to sell their products at prices above their marginal costs of production, but free entry and exit drives the economic profits for firms in monopolistically competitive markets to zero. In addition, firms in monopolistically competitive markets suffer from "excess capacity," which means that they are not operating at the efficient quantity of production. This observation, together with the markup over marginal cost present in monopolistically competitive markets, implies that monopolistically competitive markets do not maximize social welfare.