Economics Model Essay 11

(a)   Explain how the different characteristics of the market structures of monopolistic competition and oligopoly affect pricing and output decisions. [10]
(b)   Discuss whether the behaviour of oligopolistic firms is consistent with the objective of profit maximisation. [15]

Introduction

(a)   Market structure refers to the characteristics of a market such as the number of firms, the nature of their products, the availability of knowledge and the extent of barriers to entry which affect the behaviour of the firms in the market. The market structures of monopolistic competition (MPC) and oligopoly differ in terms of the number of firms, the extent of barriers to entry and the presence or absence of strategic interdependence which affect pricing and output decisions.

Body

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

Diagram

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.

MPC and oligopoly differ in terms of the number of firms which affects pricing and output decisions. MPC 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. An example of MPC is the restaurant market. Due to the large number of firms in the market and hence the large number of substitutes, the demand for the good of an MPC firm is likely to be price elastic. Therefore, an MPC firm has limited market power as it is able to charge a price only modestly higher than its marginal cost.

Diagram

In the above diagram, due to the elastic demand which gives rise to the relatively flat demand curve (D), the price (P0) is modestly higher than the marginal cost (MC0). In contrast, oligopoly is a market structure where there are a small number of large firms each with a large market share generally selling differentiated products. An example of oligopoly is the pharmaceutical market. Due to the smaller number of firms in the market and hence the smaller number of substitutes, the demand for the good of an oligopolistc firm is less price elastic. Therefore, an oligopolistic firm has greater market power as the difference between price and marginal cost is greater compared to an MPC firm.

MPC and oligopoly differ in terms of the extent of barriers to entry which affects pricing and output decisions. In MPC, 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 in MPC preclude an MPC firm from charging a price higher than its average cost. If the firms in an MPC market are making supernormal profit, potential firms will enter the market in the long run due to the low barriers to entry. As the number of firms in the market increases, the market demand will be split among a larger number of firms and hence the demand for the good produced by each firm will decrease which will lead to a fall in the price and the quantity resulting in a fall in the profits of the firms. This process will continue until the firms in the market make only normal profit.

Diagram

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 resulting in a fall in the price (P) from P0 to P1 and a fall in the quantity (Q) from Q0 to Q1. At P1 which is equal to average cost (AC1), as the firms in the market make only normal profit, the incentive for potential firms to enter the market disappears. In contrast, there are high barriers to entry in oligopoly which means that firms can make supernormal profit in the long run. Although the supernormal profit will induce potential firms to enter the market, the high barriers to entry will prevent them from entering. In other words, high barriers to entry in oligopoly allow an oligopolistic firm to charge a price higher than its average cost in the long run.

MPC and oligopoly differ in terms of the presence or absence of strategic interdependence which affects pricing and output decisions. 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. In contrast, MPC firms are not strategically interdependent. In MPC, 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. Therefore, the pricing and output decisions of an MPC firm do not depend on the behaviour of competitors.

Conclusion

In conclusion, MPC and oligopoly have different characteristics which have implications for pricing and output decisions.

Introduction

(b)   The question on whether the behaviour of oligopolistic firms is consistent with the objective of profit maximisation can be discussed with reference to the concepts of non-price competition, third-degree price discrimination, research and development, tacit collusion and alternative objectives of firms.

Body

The behaviour of oligopolistic firms may be consistent with the objective of profit maximisation as they typically engage in non-price competition instead of price competition. The theory of the kinked demand curve explains price stability in oligopolistic markets where there is no collusion. The theory of the kinked demand curve is based on two asymmetrical assumptions. First, if a firm in an oligopolistic market increases its price, its rivals will not follow suit because by keeping their prices the same, they can attract consumers from the firm. Accordingly, if a firm in an oligopolistic market increases its price, its quantity demanded will decrease by a larger percentage as consumers will switch from the firm to the rivals which will lead to a fall in revenue for the firm. Second, if a firm in an oligopolistic market reduces its price, its rivals will follow suit to avoid losing consumers to the firm. Accordingly, if a firm in an oligopolistic market reduces its price, its quantity demanded will increase by a smaller percentage as consumers will not switch from the rivals to the firm, which will lead to a fall in revenue for the firm. Therefore, oligopolists do not have the incentive to change their prices, assuming no substantial changes in the cost of production. The theory of the kinked demand curve can be illustrated with a diagram. A firm in an oligopolistic market faces a demand curve that is kinked at the equilibrium and the kink on the demand curve leads to a discontinuity on the marginal revenue curve.

Diagram

In the above diagram, as the price (P) and the output level (Q) are P0 and Q0, the marginal cost (MC) curve must be cutting the marginal revenue (MR) curve at the discontinuity. A change in the cost of production will lead to a shift in the MC curve. However, as long as the MC curve lies between MCโ€™ and MCโ€, the price will remain constant and this explains price stability in oligopolistic markets where there is no collusion. As the theory of the kinked demand curve explains price stability in oligopolistic markets where there is no collusion, it suggests that oligopolistic firms should engage in non-price competition instead of price competition. In reality, oligopolistic firms typically engage in non-price competition instead of price competition. For example, telecommunications companies in Singapore do not undercut one another. Instead, they engage in non-price competition through product development and product promotion.

The behaviour of oligopolistic firms may be consistent with the objective of profit maximisation as they practise third-degree price discrimination when the necessary conditions are met. Third-degree price discrimination is the practice of charging different prices for the same good in different markets. For example, cinema operators charge different prices for the same movies to different groups of consumers. To practise third-degree price discrimination, a firm which has price-setting ability must be able to identify at least two distinct markets which differ in terms of their price elasticities of demand. In addition, it must be able to prevent consumers in the lower-priced market from reselling the good to consumers in the higher-priced market which is known as arbitrage prevention. Suppose that a good is sold in two different markets, market A and market B, at two different prices. Under third-degree price discrimination, profit will be maximised when the marginal revenue in market A (MRA), the marginal revenue in market B (MRB) and the marginal cost (MC) are equal. If MRA is not equal to MRB, profit can be increased by selling less of the good in the market with the lower MR and more of the good in the market with the higher MR. If MC is not equal to MRA and MRB, profit can be increased by changing the output level. The firm will charge a higher price in the market with the lower price elasticity of demand and a lower price in the market with the higher price elasticity of demand. In reality, oligopolistic firms practise third-degree price discrimination when the necessary conditions are met. For example, the price elasticity of demand for cinema movies is lower for adults due to their higher level of income and hence smaller proportion of income spent on the good compared to students. Therefore, cinema operators in Singapore charge a higher price to adults and a lower price to students for the same movie on weekdays.

The behaviour of oligopolistic firms may be consistent with the objective of profit maximisation as they typically engage in research and development. Firms are likely to experience an increase in profit if they engage in research and development. Research and development will lead to product innovations and process innovations. Product innovations will lead to higher product quality and better product features which will lead to higher demand and lower price elasticity of demand resulting in higher total revenue. Process innovations will lead to a better production technology which will lead to higher labour productivity resulting in lower total variable cost. Although total fixed cost will rise due to the cost of research and development, the increase is likely to be more than offset by the rise in total revenue and the fall in total variable cost resulting in an increase in profit. In reality, oligopolistic firms typically engage in research and development. For example, smartphone producers as such Apple and Samsung constantly engage in research and development to improve the quality and the features of their products.

The behaviour of oligopolistic firms may not be consistent with the objective of profit maximisation due to tacit collusion in the form of dominant firm price leadership. In dominant firm price leadership, the dominant firm which is the firm with the largest market share is the price leader and the rest of the firms are the price followers. The price leader will set the price and the price followers will take the price set by the price leader. The price followers will also follow any price increase or decrease by the price leader. Typically, the price leader will set the price which maximises its profit. However, as the price leader will reap more economies of scale than the followers due to its large scale of production as a result of its larger market share, the price which will maximise the profit of the price leader will not maximise the profits of the price followers. The price followers will take the price set by the price leader due to the fear of a price war rather than to maximise profit.

The behaviour of oligopolistic firms may not be consistent with the objective of profit maximisation as they may be pursuing other objectives such as market share maximisation, sales revenue maximisation and long-run profit maximisation. For example, if a firm is a new entrant, it may want to maximise market share to compete with the incumbent firms. In this case, although profit will not be maximised, the larger market share may ensure the survival of the new entrant. For example, when StarHub entered the telecommunications market in Singapore in 2000, it charged prices lower than those charged by the incumbent firms, namely SingTel and M1. The objective of StarHub was to induce mobile phone users to switch mobile network service providers so that it could capture sufficient market share to compete with SingTel and M1. To maximise market share, a firm should produce the output level where price is equal to average cost, assuming it wants to make at least normal profit.

Diagram

In the above diagram, market share is maximised at QMS where price (P) is equal to average cost (AC), assuming the firm wants to make at least normal profit. Beyond this output level, price is lower than average cost and hence a loss will be incurred.

Evaluation

In the final analysis, it is important for an oligopolistic firm to pursue the objective of profit maximisation in the long run, if not in the short run. An oligopolistic firm that pursues the objective of market share maximisation or sales revenue maximisation instead of profit maximisation in the long run is unlikely to have the financial ability to expand its scale of production to reap more economies of scale. This is likely to put its long-term survival in jeopardy as it is likely to constrain its ability to increase its cost-competitiveness and hence price-competitiveness. Furthermore, an unprofitable oligopolistic firm is likely to have difficulty in raising funds at a favourable rate as financial institutions and investors are likely to consider the firm a high default risk. This is likely to further constrain its ability to increase its cost-competitiveness and hence price-competitiveness. However, unlike a private oligopolistic firm, the objective of a state-owned oligopolistic firm need not be profit maximisation. Indeed, for a state-owned oligopolistic firm that produces an essential good or service, such as healthcare, the objective should be to ensure the affordability of the good as high prices of essential goods and services are likely to cause hardship for the people, especially low income households. For a state-owned oligopolistic firm that produces a non-essential good and service, the objective should be to maximise the welfare of society as failure to do so will lead to a loss of social welfare. This can be done by producing the allocatively efficient output level where the marginal social benefit is equal to the marginal social cost.

The question will be discussed in economics tuition by the Principal Economics Tutor in greater detail.

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