2008 Essay Question 2

Question

Firms’ pricing and out decisions depend on barriers to entry and the behavior of competitors.

(a) Explain why barriers to entry are a key determinants in firms’ pricing decisions. [10]

(b) Discuss the extent to which the behaviour of firms depends in reality on the actions of their competitors. [15]

Answer

(a) A barrier to entry is an obstacle which restricts potential firms from entering a market to compete with the incumbent firm or firms.

A firm will maximise profit when it produces the output level where marginal cost (MC) is equal to marginal revenue (MR).

In the above diagram, profit is maximised at Q0 where MC is equal to MR. If the firm increases output from Q0, both total revenue and total cost will rise. However, at an output level higher than Q0, such as Q1, MC is higher than MR. Therefore, the increase in total cost will be greater than the increase in total revenue and hence the increase in output will lead to a decrease in profit. If the firm decreases output from Q0, both total revenue and total cost will fall. However, at an output level lower than Q0, such as Q2, MR is higher than MC. Therefore, the decrease in total revenue will be greater than the decrease in total cost and hence the decrease in output will lead to a decrease in profit. Since profit cannot be increased by changing output from Q0, it must be maximised at Q0. The profit is represented by the shaded area, assuming the firm is making supernormal profit.

Barriers to entry affect the pricing and output decisions of a firm in terms of the price relative to the average cost. Monopoly is a market structure where there is a single large firm which dominates the whole market selling a unique product that has no close substitutes. A monopoly is a price-setter in the sense that it is able to set its price by setting its output level. In monopoly, there are high barriers to entry which means that the firm can make supernormal profit in the long run. In other words, high barriers to entry allow a monopoly to charge a price higher than its average cost in the long run. An example of monopoly is the television broadcast market in Singapore.

In the above diagram, at the profit-maximising output level (Q0) where marginal cost (MC) is equal to marginal revenue (MR), the price (P0) is higher than the average cost (AC0). The supernormal profit is represented by the shaded area. Although the supernormal profit will induce potential firms to enter the market, high barriers to entry will prevent them from entering. Therefore, high barriers to entry allow the monopoly to charge a price higher than its average cost in the long run. There are several barriers to entry. For example, a monopoly may emerge naturally if it can reap very substantial economies of scale due to very high capital costs such that the market can accommodate only one firm. In such a market where the market demand is low which results in a high minimum efficient scale relative to the market demand and hence the long-run average cost curve falling over the entire range of market demand, a single firm can meet the market demand at an average cost which allows it to make supernormal profit. However, with two or more firms, all firms will make subnormal profit as there is simply no price that will allow any firm to cover its average cost. A monopoly that emerges in this way is commonly known as a natural monopoly. An example of a firm with the characteristics of a natural monopoly is an electricity utility firm.

In the above diagram, the monopoly which faces the demand curve (D1) can make at least normal profit by producing anywhere within the output range from QMIN to QMAX. With two firms in the market, each firm faces the demand curve (D2), which lies entirely below the long-run average cost (LRAC) curve and hence neither firm can make at least normal profit regardless of the output level. Even if a market can accommodate more than one firm, if the monopoly is experiencing substantial economies of scale, potential firms may decide not to enter the market as it will be difficult for them to achieve the same level of cost competitiveness and hence the same level of price competitiveness. In contrast, a monopolistically competitive firm cannot charge a price higher than its average cost in the long run due to low barriers to entry. Monopolistic competition (MC) is a market structure where there are a large number of small firms each with a small market share selling differentiated products that are close substitutes. MC firms are price-setters in the sense that they are able to set their prices by setting their output levels. In MC, there are low barriers to entry which means that firms can make only normal profit in the long run. In other words, low barriers to entry preclude an MC firm from charging a price higher than its average cost. An example of MC is the restaurant market. If firms in an MC market are making supernormal profit, potential firms will enter the market in the long run due to low barriers to entry. As the number of firms in the market increases, the demand for the good produced by each firm will decrease which will lead to a fall in the price resulting in a fall in the profits of the firms. This process will continue until firms in the market make only normal profit.

In the above diagram, the supernormal profit represented by the shaded area induces potential firms to enter the market in the long run, which leads to a leftward shift in the demand curve of each firm (D) from D0 to D1. When this happens, the price (P) falls from P0 to P1. At P1 which is equal to average cost (AC1), as firms in the market make only normal profit, the incentive for potential firms to enter the market disappears.

Barriers to entry affect the pricing and output decisions of a firm in terms of the price relative to the marginal cost. High barriers to entry limit the number of firms and hence the number of substitutes in the market. For example, high barriers to entry in monopoly limit the number of firms to one. With only one firm in the market, there are no substitutes. Therefore, the demand for the good is likely to be price inelastic which allows the firm to charge a price substantially higher than its marginal cost.

In the above diagram, due to the inelastic demand which gives rise to the steep demand curve (D), the price (P0) is substantially higher than the marginal cost (MC0). In contrast, low barriers to entry lead to a large number of firms in the market resulting in a large number of substitutes. For example, low barriers to entry in MC lead to a large number of firms in the market. With a large number of firms in the market, there are a large number of substitutes. Therefore, the demand for the good of an MC firm is likely to be price elastic which does not allow the firm to charge a price substantially higher than its marginal cost.

In the above diagram, due to the elastic demand which gives rise to the flat demand curve (D), the price (P0) is modestly higher than the marginal cost (MC0).

Conclusion

The conclusion can simply be a summary or recommendation as there are no evaluation marks.

Answer

(b) The question on the extent to which the behaviour of firms depend in reality on the actions of their competitors can be discussed with reference to the concepts of market structure, strategic interdependence, the objective of the firm and government regulation.

The behaviour of competitors may affect the pricing and output decisions of a firm. Oligopoly is a market structure where there are a small number of large firms each with a large market share generally selling differentiated products. Oligopolists are price-setters in the sense that they are able to set their prices by setting their output levels. In oligopoly, there are high barriers to entry which means that firms can make supernormal profit in the long run. Oligopolists are strategically interdependent. An example of oligopoly is the pharmaceutical market. In oligopoly, due to the small number of large firms and hence the large market share of each firm, the actions of one firm affect and are affected by the actions of the other firms in the market, and this is commonly known as strategic interdependence. When an oligopolist changes its price, it will have a significant effect on the other firms in the market. The rival firms will hence react by changing their prices which will affect the first firm. Therefore, when an oligopolist makes pricing and output decisions, it must take into consideration the reactions of the other firms in the market. In this sense, the pricing and output decisions of an oligopolist depend on the behaviour of competitors. For example, if Honda reduces the price of its cars, the quantity demanded is likely to increase by a smaller proportion which will lead to a decrease in the total revenue if the rival car manufacturers such as Toyota and Nissan follow suit to prevent losing customers to Honda. Therefore, Honda is unlikely to reduce the price of its cars to increase the total revenue if the rival car manufacturers are likely to follow suit. The converse is also true.

The behaviour of competitors may not affect the pricing and output decisions of a firm. In MC, due to the large number of small firms and hence the small market share of each firm, the actions of one firm do not affect and are not affected by the actions of the other firms in the market, and this means that there is no strategic interdependence. When an MC firm changes its price, it will not have any significant effect on the other firms in the market. The rival firms will hence not react by changing their prices. Therefore, when an MC firm makes pricing and output decisions, it need not take into consideration the reactions of the other firms in the market. In this sense, the pricing and output decisions of an MC firm do not depend on the behaviour of competitors. For example, if a restaurant reduces the price of its dishes, the reduction in the price will not have any significant effect on other restaurants which will not prompt them to react. Therefore, the restaurant does not need to consider the reactions of other restaurants.

The pricing and output decisions of a firm may be affected by other factors to a larger extent such as the objective of the firm and government regulation. Instead of maximising profit, a firm may seek to maximise long-run profit, sales revenue or market share. For example, one of the potential problems of a monopoly maximising profit is that the profit-maximising price may attract potential firms to enter the market. If this happens, the profit of the firm will fall in subsequent periods. Therefore, to maximise long-run profit, the firm may need to practise limit pricing which is a pricing strategy where a monopoly charges a price below the profit-maximising price with the objective of preventing potential firms from entering the market. In this case, although profit will not be maximised, long-run profit may be maximised. To achieve allocative efficiency, the government may decrease the price that a firm charges by passing a pricing regulation that requires the firm to charge a price equal to its marginal cost which is commonly known as marginal cost pricing.

In the above diagram, marginal cost pricing leads to a fall in the price (P) from P0 to PMC and an increase in the output level (Q) from Q0 to QMC. As the price (PMC) is equal to the marginal cost (MCM), allocative efficiency is achieved. The output level (QMC) is equal to the allocatively efficient output level (QAE).

Evaluation

In the final analysis, whether the behaviour of competitors affects the pricing and output decisions of a firm depends on several factors. For example, unlike firms that provide services, firms that produce goods generally operate in oligopoly. This is because unlike firms that provide services, the nature of the machines used by firms that produce goods generally allow them to reap more technical economies of scale. As a result, firms that produce goods are generally larger than firms that provide services. Therefore, the pricing and output decisions of a firm that produces a good is more likely to be affected by the behaviour of competitors. If the market produces an essential good such as public transport or telecommunications, government regulation is likely to be a major determinant of the pricing and output decisions of the firm or firms. For example, the Singapore government regulates the public transport market through the Public Transport Council. The two public transport operators are required to seek approval from the Public Transport Council for any fare increments. Furthermore, the Public Transport Council has implemented a fare adjustment formula which allows a maximum fare increment of 2.8 per cent. These pricing regulations affect the pricing and output decisions of the operators to a large extent.

A more elaborate answer to 2008 Essay Question 2 will be provided in the economics tuition class.

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted by any means, electronic, mechanical, photocopying, recording, or otherwise, without the prior written permission of the publisher. If you are an economics tutor or teacher who wishes to use the materials for teaching, you may submit a request to Economics Cafe.

 

economics tuition, back to homepage

Economics Tuition Singapore @ Economics Cafe
Principal Economics Tutor: Mr. Edmund Quek