Monopolistic competition is a form of economic competition in which there are many producers and many consumers in a given market, consumers have clearly defined preferences, the goods and services are heterogeneous, and there is freedom of entry. It harbors some characteristics of monopoly as well as some of perfect competition. A monopoly is defined as a persistent market situation where there is only one provider of a kind of product or service. Monopolies are characterized by a lack of economic competition for the good or service that they provide and a lack of usable substitute goods. Perfect competition is a model in economic theory. It describes a hypothetical market form in which no producer or consumer has the market power to influence prices in the market. This would lead to an outcome which is efficient, according to the standard definition in economics. The analysis of perfectly competitive markets provides the foundation of the theory of supply and demand as well.
As far as classifying market organizations, the characteristics that must be taken into consideration are number of firms in the market, type of product sold, ease of entering or leaving the industry, amount of information about the market, and degree of price control. These five characteristics mean that a given monopolistically competitive firm has a little bit of control over its small corner of the market. The large number of small firms, all producing nearly identical products, means that a very large number of close substitutes exists for the output produced by any given firm.
Freedom of entry into and exit out of the industry means that capital and other resources are highly changeable and that any barriers to entry that might exist are few. These entry barriers allow real world firms to get and maintain above normal economic profit. The amount of information characteristic basically means that all firms operate on the same footing, that buyers know a lot about possible substitutes for a given good, and that firms are aware of essentially the same production techniques.
A monopolistically competitive industry contains a large number of small firms, each of which is relatively small compared to the overall size of the market, making sure that all firms are somewhat competitive with very little market control over price or quantity, due in part to the fact that the types of products sold are differentiated. In particular, each firm has hundreds or even thousands of potential competitors.
Each firm in a monopolistically competitive market sells a similar product. Yet each product is slightly different from the others. The term used to describe this is product differentiation. Product differentiation is responsible for giving each monopolistically competitive a little bit of a monopoly, and a negatively-sloped demand curve. Differences among products generally fall into one of three categories: (1) physical difference, (2) perceived difference, and (3) difference in support services. This characteristic means that every monopolistically competitive firm produces a good that is a close, but not a perfect substitute for the good produced by every other firm in the market. As such, different firms can charge slightly different prices.
Monopolistically competitive firms, like perfectly competitive firms, are free to enter and exit an industry. The resources might not be as "perfectly" mobile as in perfect competition, but they aren't as restricted by government rules and regulations, start-up cost, or any other barriers to entry. While some other firms bring upon high start-up cost or need government permits to enter an industry, this is not the case for monopolistically competitive firms. Likewise, a monopolistically competitive firm is not prevented from leaving an industry. Most important, monopolistically competitive firms can get whatever labor, capital, and other resources that they need with ease. There is no racial, ethnic, or sexual discrimination.