Perfect competition and pure monopoly represent the two extreme possibilities for a market's structure. The structure of almost all markets, however, falls somewhere between these two extremes. This section considers monopolistic competition, which, like oligopoly but for different reasons, lies between the extreme cases of perfect competition and monopoly. Monopolistic competition, as its name suggests, is a combination of monopoly and competition. However, monopolistic competition is more closely related to perfect competition than to monopoly. Oligopoly is also a combination of monopoly and competition, but it is more closely related to monopoly than to perfect competition.

Three conditions characterize a monopolistically competitive market. First, the market hasmany firms, none of which is large. Second, there is free entry and exit into the market; there are no barriers to entry or exit. Third, each firm in the market produces a differentiated product. This last condition is what distinguishes monopolistic competition from perfect competition. Examples of monopolistically competitive firms include restaurants, retail clothing stores, and gasoline service stations.

Differentiated products and monopolistic behavior. In many markets, competing firms sell products that can be differentiated from one another. A firm's product can be differentiated in a number of different ways: by its quality, its convenience, its size, its color, its look, its taste—even by its brand name! As a firm's product becomes more and more differentiated, the firm faces less and less competition and will be able to act more like a monopolist in its output and pricing decisions. Thus, in a monopolistically competitive industry, firms seek to differentiate their products as much as possible. Much of this differentiation is accomplished through advertising.