When the loss from a business-stealing externality exceeds the gain from a product-variety externality,
a. firms are more likely to operate at efficient scale.
b. there are likely to be too many firms in a monopolistically competitive market.
c. market efficiency is likely to be enhanced by the entry of new firms.
d. the market structure is likely to be in transition.
The correct answer and explanation is :
Correct Answer: b. there are likely to be too many firms in a monopolistically competitive market.
Explanation:
In monopolistic competition, many firms sell products that are similar but not identical. Entry and exit are relatively easy, and firms try to differentiate themselves to capture market share. Two key externalities influence the number of firms in such markets:
- Product-variety externality (positive): When a new firm enters the market, it offers a new product variety, which benefits consumers by increasing their choices. This externality is not fully captured in the firm’s profit calculation, meaning society values entry more than the firm does.
- Business-stealing externality (negative): When a new firm enters, it steals customers and profits from existing firms. This loss is not accounted for by the entering firm, meaning society bears a cost that the new entrant ignores.
When the business-stealing externality outweighs the product-variety externality, the market suffers from excessive entry. In other words, too many firms enter the market, each operating below efficient scale due to market fragmentation. This leads to wasted resources, as firms duplicate fixed costs like advertising, infrastructure, and R\&D to compete in similar product niches.
This misallocation occurs because individual firms decide to enter based on their private profits, not the overall social welfare. While entry can still benefit consumers through variety, the combined cost from reduced profits of existing firms and increased inefficiencies may surpass these gains.
Therefore, option b is correct: “There are likely to be too many firms in a monopolistically competitive market.” This highlights one of the inefficiencies of monopolistic competition compared to perfect competition, where firms produce at the lowest possible cost and entry stops at the efficient scale.