Many industries are characterized by a number of sellers. These sellers offer products or services that are closely similar, but having enough differences to be distinctive. This distinctiveness is mild differentiation. The differentiation may take the form of style, appearance, functionality, location (important for services), quality, etc.
Industries characterized by a number of sellers offering differentiated products and services is what economists call a “monopolistically competitive” industry or market structure. The term “monopolistic competition” indicates that this market structure combines some of the features of both monopoly and perfect competition. Because each monopolistically competitive firm is offering a distinct product it is, in a small way, like a monopolist: it faces a downward sloping demand curve and has some market power where it can, within limits, determine the price of its product. However, unlike the pure monopolist, the monopolistically competitive firm does face competition – the amount of its product that it can sell depends upon the prices and products offered by other firms within its industry.
The challenge in monopolistic competition is that each seller is competing for a limited market. While each firm can offer a distinct product, it is hard to differentiate sufficiently to build significant market share. Unless the differentiation is unique and valuable to customers, it will not command a price premium and the monopolistically competitive firm will not earn higher rates of return than rivals. Monopolistically competitive firms, therefore, have limited market power (the ability to influence price).
As more sellers enter a monopolistically competitive market and increase the variety of differentiation, profits are bid down since each producer is selling less at a given price. The strategic options for addressing this scenario are the following:
- Focus the differentiation on a distinct segment(s) of the marketplace to address unmet or underserved needs.
- Defragment the industry through mergers and acquisitions to gain market power under a single corporate umbrella.
- Gain a cost advantage that allows you to undercut all other rivals in price, thereby undermining their differentiation.
It is important to know the difference between real differentiation that commands a price premium and that which merely represents an attempt to provide a distinctive offering. The former will result in advantage while the latter may actually bid down industry profits because each producer will be selling less at a given price.