Association of Chartered Certified Accountants (ACCA) Certification Practice Test

In what type of market does product differentiation play a crucial role?

1. Monopoly

2. Perfect competition

3. Monopolistic competition

4. Duopoly

The correct answer is: Monopolistic competition

Product differentiation is a vital aspect of monopolistic competition. In this market structure, many firms sell products that are similar but not identical, which allows them to have some degree of market power. Firms strive to distinguish their products through various means, such as branding, features, quality, and after-sales service. This differentiation creates a perceived variation in products, which can lead consumers to prefer one product over another, even if the fundamental purpose of the products is the same. In monopolistic competition, the presence of numerous competitors combined with product differentiation leads to a situation where firms can set their prices above marginal cost. This contrasts with perfect competition, where products are homogenous, and no single firm can influence the market price. In a monopoly, a single firm dominates the market, and product differentiation is not a factor as there are no competing products. Similarly, while a duopoly features a limited number of firms, the competition is not based on differentiation but rather the strategic interactions between the two dominant firms. Thus, monopolistic competition is the market structure where product differentiation is most crucial for success and competitive advantage.