Questions: Product Differentiation and Monopolistic Competition

Question 1

Firm A and Firm B sell competing products with significant horizontal differentiation. Firm A raises its price by 10%. What is the most likely outcome?

• A. Firm A loses all its customers to Firm B immediately — the Bertrand outcome
• B. Firm A loses some but not all customers, retaining those whose preferences are close to its product variant
• C. Firm A gains customers because the higher price signals superior quality
• D. Nothing changes, because differentiated products are in entirely separate markets

Answer: (B)

Product differentiation creates 'local monopoly power': customers who strongly prefer Firm A's variant bear a disutility (transportation cost in Hotelling's terms) from switching, so only those near the indifference point switch. Firm A does not lose everyone — only the marginal consumers. This is the defining difference from Bertrand competition with identical products, where a single penny difference in price costs the higher-priced firm its entire market.

Question 2

A market has many firms with horizontally differentiated products and free entry. At long-run equilibrium, which outcome occurs?

• A. Firms earn positive economic profit because each firm has a monopoly over its specific product variant
• B. Prices equal marginal cost because the large number of competitors eliminates all pricing power
• C. Firms earn zero economic profit, but prices exceed marginal cost — markups persist but are offset by fixed costs
• D. Firms earn zero economic profit and prices equal marginal cost, exactly as in perfect competition

Answer: (C)

In monopolistic competition, each firm faces a downward-sloping demand curve (its product is unique), so it charges a markup over marginal cost. But free entry drives new variants into the market until each firm's markup exactly covers its fixed costs — economic profit is zero. This differs from perfect competition (where prices = marginal cost) and from monopoly (where profits are positive). The markup without profit is the hallmark of the monopolistic competition equilibrium.

Question 3

The strategic purpose of product differentiation is to reduce the price elasticity of demand that a firm faces, allowing it to charge above marginal cost without losing all its customers.

• T. True
• F. False

Answer: True

Differentiation is fundamentally about escaping price competition. When a firm's product is distinct, customers who value that specific variant will not immediately defect to a rival on a small price increase — they bear a switching cost equal to the mismatch between their preferences and the rival's product. This reduced elasticity is the source of the markup. Brand investment, product design, and location choice are all strategies for increasing this mismatch cost.

Question 4

In long-run monopolistic competition equilibrium, prices equal marginal cost — just as in perfect competition — because free entry eliminates most pricing power.

• T. True
• F. False

Answer: False

Free entry eliminates economic profit, but not the markup. Firms still face downward-sloping demand curves (because their products are differentiated), so they still charge above marginal cost. What free entry does is ensure that the markup is exactly large enough to cover fixed costs, leaving zero profit. Prices exceeding marginal cost is a permanent feature of monopolistic competition, even at long-run equilibrium.

Question 5

Why does horizontal product differentiation give a firm pricing power, and how does Hotelling's linear city model illustrate this mechanism?

Model answer: Horizontal differentiation means consumers have heterogeneous preferences across product characteristics — no variant is universally 'better.' A consumer whose ideal point is close to a firm's product would need to incur a 'transportation cost' (disutility from mismatch) if switching to a rival's variant. This switching cost is the buffer that gives the firm pricing power: the firm can raise its price up to the point where the price premium equals the transportation cost savings of buying the preferred variant. In Hotelling's linear city, firms locate along a taste spectrum and each serves consumers who are geographically (preferentially) nearest; the distance to the nearest competitor determines how much the firm can charge above its rival.

The linear city is a spatial metaphor for taste: physical distance represents preference distance. A firm with a nearby competitor has less pricing power (consumers face low transportation costs to switch), while a firm in a unique position has more. This directly models how distinctiveness creates markup.