Monopolistic competition is a market structure very similar to perfect competition. There are many buyers and sellers, barriers to entry are minimal or at least equal for all firms, and information is readily available. However, in monopolistic competition, firms do not offer identical products but differentiate their products from their competition. Product differentiation is the process by which producers are able to convince consumers that their particular product is different from other producers.
The industry that should come to mind when you think of monopolistic competition is fast-food. The fast-food industry has many different producers competing for the dollars of many different consumers. All are welcome to start a fast-food restaurant as long as they pay the required licenses. Most producers have a good idea of what they are getting into and customers tend to understand the products quite well. Why is fast food monopolistically competitive? Product differentiation. Each firm offers a different menu. Taco Bell, Chick-Fil-A, McDonald's, and Subway all compete against each other in the fast-food market while providing customers with a variety of choices. Product differentiation is one of the reasons that new entrants are able to survive in this cutthroat industry. If you are different enough, then you might have a chance.
Can monopolistically competitive firms maintain economic profits in the long run?
No. Over time, the presence of competition will eventually erode the monopolistically competitive firm's profits. The end result is an industry with excess capacity, high cost, and no economic profits.
Next time you are in the produce section of the grocery store, take a look at how many varieties of apples are available. Do you remember the days when apples were either red or green? Today there are Red Delicious, Pink Lady, Granny Smith, Gala, Fuji, and Honeycrisp, to name a few. In addition, there are small, medium, and large. There are organic and pesticide-treated. Some are sold individually and some are packaged. Apple producers have differentiated their product. Why? Remember how competitive firms were unable to influence price? When producers differentiate their product and are successful, they are able to charge a higher price than their competition.
The problem with product differentiation is that it becomes a never-ending process. Firms must continually find ways to differentiate. This explains why firms will spend large sums of money on advertising. Much of the advertising is not so much an attempt to gain new customers as it is an effort to build brand loyalty. However, firms have limited resources, so engaging in product differentiation through advertising means that resources used in advertising are no longer available for production. As a result, industries that are monopolistically competitive do not produce as much output as they could if they were perfectly competitive. Consumers are missing out on what could have been. Not to worry, it seems that consumers have a strong preference for the variety that monopolistic competition brings, and so the benefits may at least equal the costs.