Question

Suppose you manage a local grocery store, and you learn that a very popular national grocery chain is about to open a store just a few miles away. Use the model of monopolistic competition to analyze the impact of this new store on the quantity of output your store should produce (Q) and the price your store should charge (P). What will happen to your profits? Explain your reasoning in detail. How and why do profits change? What could you do to defend your market share against the new store?

Answer 1

When you face a competition from a very popular national grocery chain that is about to open its store near you, you can experience some of your consumers switching to the new store. This is a reflection of a reduction in the demand for your grocery's products. Hence demand curve and MR curve faced by your store would be shifting to the left. This would derive down the price (P), reduce the quantity sold by you (Q) and so with unchanged costs, you are going to bear a reduction in profits or as the diagram shows, no profits at all.

You can change this situation either by reducing your cost or by increasing advertising expenditure. The latter will shift the demand curve and MR curve somehow to the right (not as much as they were before because your competitor is a very popular national grocery chain). This would increase the price (P) and the quantity sold (Q) so that some of your lost profits are back.