8. Profit-maximizing entrepreneurial firms.

Firms can have many goals and be organized in a variety of ways. For perfect competition to exist, firms' goals must be profit and only profit, and the people who make the decisions must receive only profits and no other form of income from the firms.

3. Imperfect Competition

Imperfect competition exists when more than one seller competes for sales with other sellers of similar products, each of whom has some control over price. Individual sellers in such markets have a degree of monopoly power, which means they can influence on the price of their product by controlling its availability to buyers. Firms can control prices by differentiating their products either by quality or by brand.

For example, loyal buyers of Coca-Cola, Bayer aspirin gladly pay higher prices for these products than they would for generic ones. In other markets, firms control price by gaming large market shares. We will first discuss imperfectly competitive markets in which sellers gain monopoly power by differentiating their products from those of their competitors.

Monopolistic Competition

Monopolistic competition exists when many sellers compete to sell a differentiated product in a market into which the entry of new sellers is possible. In a monopolistically competitive market:

1. There are relatively large numbers of firms, each satisfying a small, but not microscopic, share of the market demand for a similar, but not identical product. The market share of each rival firm is generally larger than it would have under perfect competition, but it's unlikely that any one firm satisfies not more than 10 percent of market demand.

2. The product of each firm is not a perfect substitute for the products of competing firms. Each seller's product has unique qualities or characteristics that cause some buyers to prefer it to products of competing firms. The product is therefore differentiated from any other product.

For example, people who believe that Reeboks are more comfortable than other sports shoes will pay higher prices for Reeboks than for another shoes. Similarly, people who like the cut or fabrics of Calvin Klein's clothes will pay more for them. Although each seller's product is unique, there's enough similarity among particular kinds of products to group sellers into broad categories. A product group represents several closely related, but not identical, items that serve the same general purpose for consumers. The sellers in each product group can be considered competing firms within an industry.

Arbitrary decisions are necessary to define a product group. Is the footwear industry, for example, to include all types of footwear including men’s shoes, women’s shoes, children's shoes, boots, athletic shoes, and rubber overshoes? Are the providers of fast-food services like McDonald's to be considered members of the restaurant-services product group? The answer isn't clear. Many buyers don't think the meals served by these firms are good substitutes for meals in a full service-restaurant.

3. Firms in an industry don't consider the reaction of their rivals when choosing their product prices or annual sales targets. Because there are a relatively large number of firms in a monopolistically competitive industry, a firm's managers believe that their actions can't significantly reduce the market share of their rivals.

If a single firm cuts the price of its shoes by 20 percent to gain more sales, other firms may experience only a small decrease in sales and are therefore unlikely to react by cutting their prices also. The managers of the first firm know this, so they don't bother to consider any possible reaction from competitors.

4. Relative freedom of entry and exit by new firms exists in monopolistically competitive markets. It's easy to set up new firms in monopolistically competitive markets. Entry may not be quite as easy as it is in perfect competition because new firm with new brands or product features may initially have difficulty establishing their reputations. Existing firms with established brands and reputations for service are likely to hold some competitive edge over new entrants.

Free entry means that profitable conditions in the industry are likely to attract new sellers. In the long run the magnet of profits will serve to increase supplies of the product sold by the industry. This in turn will put downward pressure on both price and profits.

5. Neither the opportunity nor the incentive exists for firms in the industry to cooperate in ways that decrease competition. The firms in a monopolistically competitive market don't cooperate to fix prices in order to increase their group profits. They can't effectively prevent new entrants from responding to profit opportunities by opening rival enterprises.

Product Differentiation

Product differentiation is crucial to monopolistic competition. In fact, product differentiation is really what stands between perfect competition and the real world. People differentiate among many similar products.

What makes one good or service differ from another? We need only for the buyer to believe it's different, because product differentiation takes place in the buyer's mind. In the real world, however, buyers generally do differentiate. We're always differentiating, and it doesn't have to be based on taste, smell, size, or even any physical differences among the products.

Example: Two record shops might carry the same poor excuse that passes for music these days — it can only be played loud, so those young people suffering from hearing loss can still pick up some of the sounds. Both shops charge exactly the same prices. Both shops are conveniently located. But one is always crowded and the other is always empty.

Perhaps one place lets you play a CD before you buy it. Perhaps one place will take special orders for you. Perhaps the sales clerks and owner is nice, helpful people, while in the other store, they're all grouches.

Now we're dealing with a differentiated product. The CDs are the same. The prices are the same. But one store's got ambience up to here, and the other has to send out for it. The buyer prefers Mr. Nice Guy's store over the grouch's store, so we have a differentiated product.

When sellers try to get buyers to differentiate between their products and those of competitors, the sellers do so based on not just physical differences between their product and those of the competitors. Also used are convenience, ambience, reputation of the seller, and appeals to your vanity, unconscious fears, and desires, as well as snob appeal.