In monopolistic competition, there are many sellers competing, each seller offers a differentiated product, and there is free entry and exit from the industry in the long run. This type of market structure is so named because it combines some features typical of monopoly with other features typical of perfect competition. Monopolistic competition tends to arise in industries that are highly fragmented, with a large number of sellers.
In monopolistic competition, each seller charges a price that is above marginal cost. As a result, some customers who might prefer to purchase a particular seller’s product are deterred from doing so. In short, some mutually beneficial transactions go unexploited.
A further criticism of monopolistic competition is that it is inefficient because of the wasteful duplication that arises from the prevalence of too much variety in products and services. In other words, it would be better if there were fewer sellers, meaning each seller would have lower average total costs due to the higher sales volume, and therefore lower prices. The duplication that arises in monopolistic competition results in sellers holding excess capacity which cannot be sold to the marketplace.
In a sense, monopolistic competition offers a tradeoff. The greater variety of products and services means that consumers gain greater flexibility and freedom in their choice of sellers, while having to pay higher prices for this greater convenience. The net benefit to consumers means that they will put up with some inefficiency to gain greater choice. However, it also means that firms operating in monopolistically competitive industries face greater price competition as a result.