Association of Chartered Certified Accountants (ACCA) Certification Practice Test

What characterizes monopolistic competition in a market?

1. Only one producer dominates the market

2. Many producers utilize product differentiation

3. All goods are identical with no differentiation

4. High barriers to entry and exit

The correct answer is: Many producers utilize product differentiation

Monopolistic competition is characterized primarily by the presence of many producers in the market, each offering products that are differentiated from one another. This differentiation can be based on various factors such as quality, branding, features, or other attributes that make products distinct. As a result, firms have some degree of market power, allowing them to set prices above marginal cost without losing all customers, since not all products are seen as perfect substitutes. In this market structure, despite the number of sellers, the differentiation of products means that each firm faces a downward-sloping demand curve. This contrasts with other market structures, such as perfect competition, where products are identical, and monopoly, where one producer dominates. Monopolistic competition also features relatively low barriers to entry and exit, which is conducive to new firms entering the market when profits are available and exiting in response to losses, further facilitating competition. The other options do not accurately reflect the characteristics of monopolistic competition: a single producer dominating the market defines a monopoly, identical goods denote perfect competition, and high barriers to entry and exit relate to monopoly or oligopoly conditions, rather than the relatively fluid entry and exit dynamics inherent in monopolistic competition.