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? Please show graphically and explain your reasoning in detail. For example, how and why do profits change? How can that be seen on the graph? What could you do to defend your market share against the new store?

Answer 1

In monopolistic competition, there is a mix between perfect competition and monopoly. They set their prices like a monopoly firm, set at MR=MC then up to the demand curve and they advertise like in perfect competition. In the graph above, it can be seen at D1 where the price P1 would be if it was only one firm. When the new firm enters the market, the original firm will drop down to P2, the demand and marginal revenue shift to the left now at D2. Depending on if the marginal revenue is greater than the marginal cost the company should continue to expand because every extra product sold would bring in extra profit. If the marginal revenue is less than the cost the company needs to downsize. The original firm must find a way to attract more customers, and keep the loyalty of those they had. Customer loyalty can be considered a barrier to entry because who's to say the consumers will switch to a new product.

As we learned product differentiation is what makes these companies stay afloat. If stores sold the same thing and were located in different areas, then the consumers would just go to the closes store. This is location differentiation which can fall into the product differentiation category. There must be something to tell these places apart.

I can use myself as an example, I only purchase meat from Publix because of the cleanliness of the store, and the way the meat is usually clean of most fat. Stores like Winn-Dixie and Penn-Dutch are dark and not as friendly, the meat is usually full of fat, and the chicken breast is huge (weirds me out). The Winn-Dixie is right across from Publix, although Publix prices are a bit higher, I prefer to shop there. This is product differentiation; I prefer specific stores products over another regardless of price in a monopolistic competitive market.

To defend market share, I need to differentiate my product (modified and improved features and/or improved after-sale service and/or use of advertising) to attract customers to purchase my products.