qn 11 market structure (bte and competiton)

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Essay Question 11

Firms’ pricing and output decisions depend on barriers to entry and the behaviour of competitors. Discuss. [25]

Market Structures RI 2011 Prelim


VJC 2013 - Firms & How they Operate

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Discuss: To provide relevant arguments for and against an issue. Generally, the issues raised have some normative aspect, or have unspoken assumptions that can be challenged. Come to a judgment after reviewing the issues.

Characteristics of market structure

Behaviour of firms (Pricing and Output decisions)

Objectives of firms

No fixed context in terms of examples to be given. Answer has to relate back to firms’ pricing and output decisions.

Approach

Provide arguments for and against the issue as to whether barriers to entry and behaviour of competitors determine firms’ pricing and output decisions. If not, they may be other constraints.

Introduction State Assumptions i.e. Profit Maximisation objective Key Definitions- BTE Overview Body Thesis

An analysis of how barriers to entry affect price and output decisions

A TAS of whether behaviour of competitors affect a firm’s price and output decisions

Anti-Thesis Alternative objectives of firms e.g. sales/growth maximisation Constraints e.g. small niche markets Presence of Potential Contestable Markets Government Intervention e.g. price controls, nationalisation

Overall Evaluation and Conclusion Make a stand + Justification

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Introduction According to the theory of the firm, firms make their price and output decisions according to where they will maximize profits. This means all firms will produce where MC=MR and then set the price (or sell the output) at the highest that their consumers are willing and able to pay (given by the demand curve (AR) facing the firm). Define and explain BTE –natural and artificial. In this essay, I will discuss whether firms’ pricing and output decisions ultimately depend on barriers to entry and the behaviour of competitors.

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Body: THESIS 1 (Barriers to Entry) P: Firms’ pricing and output decisions depend on barriers to entry. E: BTE determines the type of market structure a firm is in. (The absence of BTE together with perfect market conditions lead to perfect competition while high barriers in the extreme lead to monopoly.) This in terms determines their price setting ability. Compare pricing and output decisions (and hence type of profits enjoyed in SR vs LR) of PC vs monopoly firms

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Body: THESIS 1 (Barriers to Entry) E: Use diagram to show SR P and Q decision of PC firm and how the lack of barriers result in entry of new firms in the LR, affecting P and Q decisions (and hence profits) Use diagram to show how high barriers result in lack of competition and hence high market power, in turn affecting pricing and output decisions of monopoly. L: Link to next paragraph on how behavior of competitors also affect P and Q decisions.

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Body: THESIS 2 (Behaviour of Competitors) P: Firms’ pricing and output decisions depend on the behaviour of competitors. E: Oligopoly: highly affected by behaviour of competitors, resulting in competitive oligopoly/ collusive oligopoly. Monopolistic Competition: MPC firms are able to set P&Q to maximize profits without depending on the behavior of their competitors because each firm has such a small market share that whatever one firm gains will have little effect on the other firms ( However, lack of barriers means they earn NP in the LR.)

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Body: THESIS 2 (Behaviour of Competitors) E: Draw kinked demand curve diagram (and cartel diagram to show interdependency in Oligopoly. Draw (SR and LR)P and Q and hence profit diagram of monopolistic competitive firm. L: Link to next paragraph to acknowledge that there are also other factors that can affect P & Q decisions of firms.

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Body: ANTI-THESIS 2 (Constraints) P: On the other hand, firms’ pricing and output decisions also depend on the constraints that firms face. E: Compare pricing and output decisions of firms should they have other objectives e.g. providing for a niche market, thus preventing firms from maximising profits at MC=MR. E:Show revenue maximisation diagram (MR cuts horizontal axis), L: Link to next paragraph to acknowledge that there are also other factors that can affect P & Q decisions of firms.

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Body: ANTI-THESIS 3 (Contestable Markets) P: On the other hand, firms’ pricing and output decisions also depend on the potential of contestable markets E: Firms with high market power may not charge at a price above marginal cost as the market may be one that involves zero entry and exit costs (i.e. contestable) to other firms. E: Limit pricing occurs where monopolies charge below profit-max price to prevent new entrants. L: Link to next paragraph to acknowledge that there are also other factors that can affect P & Q decisions of firms.

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Body: ANTI-THESIS 4 (Govt. Intervention) P: On the other hand, firms’ pricing and output decisions also depend on presence of government intervention. E: Governments may influence the pricing and output decisions of firms should they have other objectives. E: Regulation of natural monopoly (AC or MC pricing) L: Link to next paragraph to acknowledge that there are also other factors that can affect P & Q decisions of firms.

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Conclusion Acknowledge other factors that can affect firms’ pricing and output decisions. Conclude based on type of market structure Monopoly: BTE is a factor in determining P & Q, but

government intervention and theory of contestable markets do dictate to a certain degree its P & Q determination as well

Oligopoly: Due to presence of mutual interdependence, behaviour of competitors is an important determinant in its P & Q decisions

MPC and PC: not strong determinants In real world, market structure not clear-cut, firms’

abilities to take into account competitors’ behaviour is uncertain.

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Introduction A firm’s price and output decision is affected by the market structure it operates in. In this essay, we first assume that the objective of the firm is one of profit maximisation. With this assumption that all firms aim to profit-maximize, firms will be able to determine their output levels by producing at the point where MC = MR. Here, firms will then set the price at the highest that their consumers are willing and able to pay (given by the demand curve facing the firm). I will discuss whether firms’ pricing and output decisions ultimately depend on barriers to entry and the behaviour of competitors.

Body: THESIS 1 (Barriers to Entry)

P: Firms’ pricing and output decisions do depend on barriers to entry. We will be comparing a PC firm and monopoly firm to show the differences in pricing and output decisions. E: Any condition that prevents other potential firms from entering the industry, thereby limiting the competition for existing firms is called a barriers to entry. There exist both natural and artificial BTEs.

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NATURAL BTE ARTIFICIAL BTE

EOS; Large MES Ownership/Control over Key inputs/markets

Legal Protection e.g. Patents

Product Differentiation & Brand Loyalty

High Start-up Costs e.g. R&D

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E: (Compare PC vs M) (PC) In perfect market conditions, PC firms are price-takers where BTEs are non-existent. Price is determined by market DD and SS, where DD facing the PC firm is perfectly price elastic. Although they are able to earn supernormal profits in the SR, PC firms can only make normal profits in the LR. [Candidates are required to link absence of BTE into industry when SPN profits are earned in SR, market SS increases, P falls, firm’s DD falls to min. AC and Q falls as industry output is now shared amongst more firms. ] E: (PC)Use diagram to illustrate this. [next slide]

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E: Use diagram to illustrate erosion of SNP (shaded area) in the LR as barriers to entry (and exit) are absent in the PC market.

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E: (Compare PC vs M) (M) Monopolies are single firms in the entire industry, where the DD curve facing the monopolistic is very price inelastic. Monopolists are price-setters and they can afford to raise prices without losing many customers. Hence, at MC=MR, their prices are higher than the MC of producing the good. Due to the presence of extremely high BTE, monopolists can continue to price above AC and earn supernormal profits even in the LR. E: [Show diagram to compare M’s P & Q with that of the PC –next slide] As such, PM>PC and QM<QC

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Body: THESIS 1 (Barriers to Entry) E: Draw a diagram to show comparison between P & Q of monopoly vs a PC firm.

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Body: THESIS 1 (Barriers to Entry) L: Therefore, we can conclude that BTEs are heavy influences on a firm’s P & Q decisions as they determine each firm’s output quantity and price (and hence their profit levels) in the long run.

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Body: THESIS 2 (Behaviour of Competitors)

P: Firms’ pricing and output decisions also depend on the behaviour of competitors. We will be comparing MPC with OLI to show differences in P & Q decisions.

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E: (Oligopoly) The existence of high BTEs result in only a few large firms in oligopoly, each with a significant market share. Here, there is a high degree of mutual interdependence. The actions of one firm will affect the other firm’s market share, and therefore profit levels, significantly. Therefore, firms in oligopoly have to monitor and react quickly to the behaviour of their competitors in order to stay viable and earn supernormal profits in the LR. [Show kinked DD curve & explain how the kink comes about, where P & Q are determined.]

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E: (Oligopoly) As shown by the kinked DD curve of an oligopoly firm, [explain the diagram] price rigidity exists, because they are reluctant to cut prices for fear of triggering a price war. P and Q are hence the oligopoly firm’s pricing and output decisions.

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E: (Oligopoly) In oligopolies, price leadership and other forms of tacit collusions can also demonstrate the importance of competitors’ behaviour to a firm’s pricing decisions. Because there are few large firms, the decision by the largest firm to raise prices allows other firms to similarly raise their prices as demand for their goods will not be adversely affected. This also explains why cartels are desirable to oligopolists –by preventing competitors from competing, firms can max profits by reducing output across the industry, as OPEC does. (Price wars, collusions and price leaderships are other examples of firms’ behavior that illustrate the interdependence of oligopolists.)

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E: (MPC) On the other hand, monopolistic competition refers to a market where there are low barriers to entry such that there are many firms each selling a differentiated product. BTEs such as high start up costs, patents or government licensing programs restricting the number of firms do not exist in MPC. As such there is little the existing firms can do to stop new firms from entering the industry and as such, like PC firms, they are able to earn only normal profits in the LR. However, MPC firms have some degree of price-setting ability due to their products being slightly differentiated from their competitors. They therefore have highly price elastic but downward slopping DD curves.

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E: (MPC) MPC firms are able to set P & Q to maximise profits without depending on the behaviour of their competitors because each firm has such a small market share that whatever one firm gains will have little effect on the other firms (no presence of mutual interdependence, unlike OLI firms).

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E: (MPC) Therefore, MPC firms seldom engage in price competition. The existence of so many competitors make their profit margins very low since their prices are already very competitive. Even if one MPC firm cuts its price, other firms would not react to the price change, unlike in Oligopoly. Example: An oligopolistic fast-food industry has become increasingly monopolistically competitive due to the entry of several new firms in recent years e.g. Wendys, Popeyes…etc.

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Evaluation: (MPC) MPC firms are hence able to set P & Q to maximise profits without depending on the behaviour of their competitors because each firm has such a small market share that whatever one firm gains will have little effect on the other firms (no presence of mutual interdependence, unlike OLI firms).

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Body: THESIS 2 (Behaviour of Competitors) L: Thus, we see that oligopolies’ pricing and output decisions depend largely on behaviour of their competitors as compared to MPC firms.

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Body: ANTI-THESIS 1 (Alternative Objectives) P: On the other hand, firms’ pricing and output decisions also depend on other objectives of firms.

E: Firms that are able to make supernormal profits may face the Principal-Agent Problem due to the divorce of ownership and control. In this case, firms may choose profit-satisficing (making a target level of profits) instead of profit maximizing (absolute maximum level) to appease shareholders. Other alternative objectives include revenue maximisation (MR cuts horizontal axis), growth max (through mergers/acquisitions) or output max (where AR cuts AC) instead of profit max.

Evaluation: However, these objectives may not be mutually exclusive as growth max. etc, ultimately result in profit max and vice versa.

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Body: ANTI-THESIS 2 (Constraints) P: On the other hand, firms’ pricing and output decisions may also depend on the constraints that firms face. (E.g. constraints of location, funding, small & niche markets…etc.) E: Firstly, for small firms, they choose not to expand due to several DD as well as SS factors. For DD factors, it may be due to the firm catering to niche markets, providing direct and very personalised services, where its efficiency may be eroded if it decides to expand. As for SS side factors, it may be due to the lack of funds or unwillingness on the part of the firm to take risks.

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Body: ANTI-THESIS 2 (Constraints) E: Give real-life examples of small firms catering to niche markets? L: Thus, firms may not necessarily choose to produce at profit-maximising output levels, and therefore will not be constrained by BTEs and the behaviour of competitors.

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Body: ANTI-THESIS 3 (Contestable Markets) P: On the other hand, firms’ pricing and output decisions may also depend on the potential of contestable markets E: Even when there are extremely high BTEs present in a monopoly, the potential of contestable markets can affect a firm’s pricing and output decisions. Monopolies can possibly be influenced by the actions of potential entrants, as the theory of contestable markets suggests that limit pricing occurs as monopolies attempt to prevent potential entrants from entering by charging below profit-maximising prices. L: Hence in this case, a monopolist need not necessarily make pricing and output decisions due to high BTE and behaviour of competitors.

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Body: ANTI-THESIS 4 (Govt. Intervention) P: On the other hand, firms’ pricing and output decisions may also depend on presence of government intervention. E: Typically, monopolists are able to enjoy immense amount of market power and thus may not work in the society’s interest if left to their own devices (earning huge supernormal profits at the expense of consumers, where output is restricted results in market failure arising from market dominance). Hence, government intervention, where pricing and output decisions will be affected, is necessary to prevent such occurrences and maximise society’s welfare.

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Body: ANTI-THESIS 4 (Govt. Intervention)

E: The government may take over the monopoly completely and run it in public interest. This means the monopoly is nationalised. The aim of nationalised industries is to maximise society’s welfare instead of maximising profits. Hence over here, pricing and output decisions of the nationalised monopolies will be dependent on government regulation (in terms of MC or AC pricing).

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E: Explain the diagram

MC Pricing: P at PMC Q at QMC

AC Pricing: P at PAC, Q at QAC

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E: Give real-life examples e.g. Singapore Powers L: Hence, when the government intervenes by regulating monopolies, AC and MC pricing, instead of BTEs and behaviour of competitors will affect the pricing and output decisions of these monopolies.

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Conclusion In the absence of government intervention and regulations, when assumed that firms aim to maximise profits, pricing and output decisions will depend on the existence (or non) of BTEs. However, in imperfect markets e.g. monopoly, it is common for governments to intervene to correct the market failure (due to market dominance, leading to allocative inefficiency) arising from firm’s P & Q decisions (earning SNP profits at the expense of the consumers).

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Conclusion In the case of oligopolies, the presence of BTEs resulting in few large firms would cause firms in the industry to be mutually interdependent in their pricing and output decisions. Here, behaviour of competitors is therefore a very important determinant in P & Q decisions of oligopolists, as compared to MPC firms where there is more ‘independence’. Ultimately, in the real world, market structures are not so clear-cut, and the firms’ ability to take account of competitors’ behaviors are often uncertain.

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qn 11 market structure (bte and competiton)

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