Product Variety and Business Stealing Externality
In this section we see the advantages and disadvantages of new firms entering the market.
Business-Stealing Externality
Because other firms lose customers and profits from the entry of a new competitor, entry of a new firm imposes a negative externality on existing firms
Example: If Nike, Adidas and Puma are making profits and now Reebok enters the market for shoes, some of their customers will switch to Reebok which is a negative externality for Nike, Adidas and Puma.
Product Variety Externality
Entry of a new firm provides new products and new consumer surplus, conveying a positive externality in the market. Example: If Nike, Adidas and Puma are making profits and now Reebok enters the market for shoes, some consumers may prefer the style and comfort of Reebok shoes so they will experience a positive externality.
Product Variety and Business Stealing Externality
When the loss from a business-stealing externality exceeds the gain from a product-variety externality, what do we expect will happen?
A) There are likely to be too many firms in a monopolistically competitive market
B) There are likely to be too few firms in a monopolisitically competitive market
C) There is the optimal number of firms in the market
D) Cannot be determined
A.
Whenever the loss exceeds the gain that is a bad thing. This means that there are too many firms in the market and some should leave.