Market structure tutorial/H2 Alevels 2008 Q2 Firms pricing and output decisions depend on barriers to entry and the

behaviour of competitors.
(a) Explain why barriers to entry are a key determinant in firms pricing decisions [10] As firms are all rational and profit maximizers, they produce at the profit maximizing output where marginal cost (MC) equals to marginal revenue (MR), then charges at corresponding point on the AR curve, the maximum price consumers willing and able to pay at the varying levels of output. This is because when MC is larger than MR, rational and profit maximizing firm increase production till revenue earned from extra unit equals to the cost of producing an extra unit of good (MC=MR), ensuring that any possible positive marginal profit is exhausted. When MC< MR, rational and profit maximizing firms decrease production till MC=MR to avoid negative marginal profit. When MC equals to MR, last unit of output produced and sold add as much to the firm s revenue as it does to the firm s cost. No other level of output allows firm to earn higher level of profit, hence profit is maximised. ($) MC P AR= DD MR Q Q1 Q2 Profit maximizing level and output Also, MC curve has to cut MR from below. When MC cuts MR from above at Q1, producing one extra unit of output adds more to the revenue than the cost, hence profit maximizing and rational producers continue to produce more. However, when MC cuts MR from above at Q2, one extra unit of output produced and sold, adds more the firms cost than revenue. Hence firms only produce at Q2 and charges at P. Barrier to entry determines a firm s ability to set the price hence the pricing strategies used. Barrier to entry is defined as anything that prevents or impedes the entry of new firms into an industry, thereby limits the degree of competition faced by existing firms. Barriers to entry can be artificial, due to laws and legal decrees such as copyright law. It can also be natural, whereby there is high fix sunk cost. When there is low barrier to entry, there exist a large number of sellers in the market as the set up cost is low and it is easy to enter the market with perfect information available. Large number of sellers leads to small market share and hence insignificant influence of firms over the market price. Firms are price takers. Low barrier to entry is a feature of the perfectly competitive market. Homogeneous goods which are perfect substitutes that provide same level

of satisfaction are sold. Demand is hence perfectly price elastic and firms are unable to increase price above the market price as increasing the price would result in demand falling to zero. Firms in perfect competition hence take the market price and produce at the output where the marginal revenue equals to the marginal cost. When there are relatively higher barriers to entry, such as set up cost that can go up to millions, there are a few dominant sellers and exists imperfect information. Hence, firms operate in an oligopolistic market. Oligopolies are price setters to a small extent due to price rigidity which is explained by the kinked demand curve. Price rigidity is due to the mutually interdependent relationship whereby competitors will match any decrease in price but an increase in price. Assuming that oligopolies want to protect and maintain market share. (refer to graph below) If a firm increases its price above Pm, no firm will follow as rational and incentive driven customers will turn to them for cheaper prices. There will be large substitution effect away from firm that raises price and quantity demand decreases more than proportionately when price rise and demand is price elastic, due to availability of few close substitutes, which provides similar level of satisfaction, in an oligopoly market. If firm decreases price below Pm, all other firms match to remain competitive. The price cut of one firm is unable to lure many customers away. The decrease in price results in the less than proportionate increase in quantity demanded and hence demand is price inelastic. Hence, demand is kinked at Pm. Firms produces up till the profit maximizing level: MC=MR, whereby MC can be any curve that cuts between upper limit and lower limit of MR. The profit maximizing quantity is Q* and profit maximizing price is Pm. Hence, there exist price rigidity, and there is no price increase even if cost of production increases from MC1 to MC2. Only large changes in cost can induce oligopolistic firm to change price and output. Oligopolist thus avoids unnecessary price changes. When there are very high barriers to entry, such as high fixed sunk cost that can go up to billions, there will only be one dominant seller in the market, a monopoly. The good is an unique good and imperfect information exist. Imperfect information can happen due to the enforcement of intellectual property rights. This prevents competitors from producing the similar good, satisfying similar level of satisfaction. Hence, the monopolist has huge market share and there are few availability of substitutes. Demand is price inelastic and monopolist is a price setter to a large extent. Profit maximizing and rational monopolies also price at profit maximizing output. Since demand is price inelastic, the ability of firm to set price above MR at corresponding point on AR curve when MC=MR is higher than that of oligopolies that face comparatively lower barriers of entry. Monopolies are able to limit and increase price to a greater extent since a rise in price leads to a less than proportionate decrease in the quantity demanded of its good compared to that of firms in oligopolistic market structure.

Pm Po

Oligopoly

Po

Monopoly

The graph shows that the Pm Po in oligopoly market structure is less than that of Pm Po in monopoly market structure. Hence, showing that monopolist can increase its price higher than oligopolies due to monopolist s price inelastic demand.

(b) Discuss the extent to which the behavior of firms depends in reality on the actions of their competitors. [15m] When competitors lower price of close substitutes, whereby cross price elasticity of demand is elastic, firms will engage in price war. This is assuming that the firm has the financial ability to sustain them through a period of earning subnormal profits, and that they aim to earn supernormal profits in the long run. Goods of competitors and firms are substitutes, which gives the similar level of satisfaction to consumers. As demand for good is cross price elastic, a decrease in price of good of firm will result in a more than proportionate decrease in quantity demanded for good of competitor, ceteris paribus. Hence, profit maximizing firms with the financial capability will engage in a price war so as to undercut the low price of competitors, forcing them to earn subnormal profit in the long run, end up leaving the market, while the firm itself gain large market share and earn supernormal profits in the long run. This comes with the assumption that the rational and incentive driven competitor is unable to sustain subnormal profits in the long run and chooses to leave the market, preventing further losses that might accumulate if they continue their operation. Therefore, firms might choose to compete with pricing strategies. For example, Starbucks might introduce a half price discount for coffee before 10am. Consumers are thus more willing and able to consume Starbucks coffee instead of Coffeebean coffee. However, when goods sold by competitor and firm itself are weak substitutes, whereby demand for good is cross price inelastic, firms engage in independent decision making. When goods sold by firm and competitors are weak substitutes (i.e. differentiated products), they provide dissimilar level of satisfaction. As a result, price changes of good produced by firm will result in insignificant changes in demand of competitors good, ceteris paribus. In this case, each firm caters to the needs of different groups of consumers; any decision made by the firm will have little or no effect on competing firms. Although both Ba Wang and Pantene are shampoo brands, their distributors may price their own shampoo brand independently. Ba Wang targets at consumers who wish to engage in herbal hair care, strengthening their hair, while Pantene focuses on consumers who wish to have soft and silky hair (mainly female consumers). As such, these 2 shampoo brands being differentiated products are able to be priced at different price, independent of price of other brands. When products are not perfect but close substitutes, firms engage in non-price competition. When competitors produce close substitutes of the firm s products, demand for good become price elastic. To decrease price elasticity of demand (PED), firms engage in non-price competition such as advertising. Advertising allows imaginary product differentiation. It creates brand loyalty for a product, differentiating the product from competitors and reduces substitution effect as consumers are led to believe that there is no close substitute. Demand for good becomes price inelastic, whereby an increase in price of good will result in a less than proportionate decrease in quantity demanded for the good, ceteris paribus. Firms being rational and profit maximising will be able to increase price of good to increase total revenue (TR) earned which is defined as the product between the price of good sold and the quantity sold (PxQ); also in profits which is the difference between TR and total cost (TC); TR-TC.

However, when products are perfect substitutes, providing same level of satisfaction (homogenous goods), firms decision in engaging in non-price competition do not depend on the actions of their competitors. Firms have no incentive to engage in non-price competition. When competitors produce and sell homogenous goods, PED for firm s good is perfectly elastic. Since goods provide same level of satisfaction, non-price competition such as advertising in an attempt to differentiate goods is ineffective in influencing consumers taste and preference for the good. As such demand for good will not increase. Being rational and profit maximizing, firms are not willing to engage in activities that increase their total cost as investing in advertising is sunk cost which cannot be recovered. In an oligopoly market, firms practice tacit collusion, in which smaller firms match price set by dominant firm without discussing pricing strategies. In this case, firms behavior is dependent on the action of other competitor, such as the dominant firm. Smaller firms are afraid to differ in their pricing as it might incite retaliation and a price war from the dominant firm. The dominant firm, having far greater resources, capacity and better branding compared to smaller competing firms, are more able to survive a price war (while earning subnormal profits in the short run) than the smaller firms. Hence, pricing decisions of smaller firms might be depended on larger dominant firms. This is evident when Comfort Delgro announced a price hike, subsequently, other taxi companies such as SMRT and Transcab followed. However, firms might have alternative objective that is independent on the actions of competing firms. Being rational and profit-maximising are characteristics exhibited by all firms. But, before they can maximize profits, they must ensure that they have enough factor of inputs to sustain production of output, this is especially for firms in which manufacturing of product require raw materials. They have to ensure that their supply chain is stable enough to continuously provide them with enough raw materials for production, so as to ensure that production cost will not rise or face termination due to shortage of factor of inputs. Therefore, if firm has the financial ability to do so, firm would invest in producing or maintaining the existence of the needed raw material. Only with stable output, could the firm ensure generation of revenue (PxQ), and hence profit (TR-TC). Such an investment decision is made independently of actions of other competing firms as the investment will still proceed despite competing firms decide to engage in aggressive price or non-price competition. For example, water is the main ingredient for The Coca-Cola Company. As such, in collaboration with World Wildlife Fund (WWF), Coca-Cola invests in water conservation so as to ensure the sustainability of water and to ensure that safe water is used in Coca-Cola s manufacturing process. In most situations, firms behaviors are dependent on competitors action to a large extent. Firstly, technology is rapidly improving, thereby giving rise to many substitutes for almost every product. This results in the demand being cross price elastic for many goods. Hence, firms behavior is largely dependent on competitors action and firms are likely to compete with price competition. Secondly, there are only few industries that sell homogeneous goods. In reality, almost no industry operates in a perfect competition market selling homogeneous goods. Hence, most firms engage in non-price competition, such as advertisement, to influence consumers taste

and preferences, create imaginary product differences and thus brand loyalty. This causes demand to be price inelastic, hence enabling them to increase price to a greater extent. Lastly, firms alternative objectives serve as a way to differentiate their product from competitors. Hence, it can also be considered as a form of non0price competition, a form of strategy firm take to decrease price elasticity of demand, hence increasing profits when there are many competitors producing close substitutes to the firm s product. Overall, as all firms are rational and profit maximisers, their main motive is to earn supernormal profits (TC-TR>0), or at least normal profits (TC-TR=0), in the long run. In order to do so, they have to increase their market share so as to increase their price setting ability. To increase their market share, they have to drive existing competitors out or deter potential competitors from entering. Thus, firms engage in price and non-price competition and other rational and profit maximizing firms will retaliate in order retain or increase their market share as well. Hence, the behavior of firms depends in reality on the actions of their competitors to a large extent.