When incumbent firms lose customers and profits due to entry of a new competitor, a
a. predatory pricing externality occurs.
b. consumption externality occurs.
c. business-stealing externality occurs.
d. product-variety externality occurs.
The correct answer and explanation is :
Correct Answer: c. business-stealing externality occurs.
Explanation (300 words):
A business-stealing externality occurs when new firms enter a market and gain customers primarily by taking them away from existing firms, rather than by growing the total market. This phenomenon is common in monopolistically competitive markets, where multiple firms offer similar but differentiated products.
When a new competitor enters such a market, it doesn’t necessarily bring in new demand; rather, it divides the existing customer base. This can lead to reduced sales and profits for incumbent firms. The new entrant benefits at the expense of the existing businesses, effectively “stealing” their customers. This is why it’s termed a “business-stealing” externality.
This type of externality is considered negative for incumbent firms but may not be socially undesirable. From a social standpoint, the entry of a new firm could increase product variety and consumer choice, potentially improving welfare. However, the loss in profit for the incumbent firms is not taken into account by the new entrant when deciding to enter the market—this is the core idea of an externality: an effect on third parties not considered in the decision-making process.
The concept is often discussed in the context of models like monopolistic competition or endogenous growth theory, where free entry leads to too much entry from a social perspective. This happens because new firms ignore the negative impact their entry has on the profits of existing firms.
The other options describe different externalities:
- Predatory pricing is about setting prices low to drive competitors out.
- Consumption externality involves one consumer’s consumption affecting another’s utility.
- Product-variety externality occurs when new products increase consumer welfare through more choice.
In summary, when existing firms lose market share and profits because new firms enter and attract their customers, a business-stealing externality is taking place.