RI Firms Assignment

Y5 H2 Economics 2024 T3W5 Assignment – Firms and Decisions (Part 2) – Post-Mortem 1 Businesses in the UK are still not able to cope with the dual blow of Brexit and Covid -19, and face falling profit levels. Supply disruptions remain a lingering concern, which has driven up prices of many items including petrol and a basic haircut. The Competition and Markets Authority found that high petrol prices could not be solely blamed on global factors and found evidence of weakening competition. Amidst these developments, businesses have taken various measures, with petrol retailers moving towards mergers while barbers are offering attractive discounts on their haircuts. (a) Explain whether the higher petrol price is due to collusion or other factors. [10] (b) Discuss whether lowering prices is the most appropriate strategy for firms in different industries when faced with the above challenges. [15] Part (a) Introduction • Clarify market structure petrol retailer operate in – oligopoly Elaborate briefly. i) High barriers to entry • Firms in the petrol retailing industry tend to face high natural /structural barriers which essentially arises from the differences in production and costs between the incumbents in the petrol retailing industry such as Esso and a potential entrant. These natural barriers to entry include high rental / lease of land particularly in northern parts of UK and central London areas . In addition, infrastructures such as fuel dispensers, submersible pumping systems as well as technology to adopt digitalisation to facilitate payment processes to enhance operational efficiency and improve customer experience incurs very high overhead costs → lack of financial capital/loans prevents firms from entering • Given the large scale of operation of incumbent firms such as BP, Shell and Tesco, they tend to have high minimum efficient scale (MES) of production. As such, they are fully able to exploit available internal economies of scal e to enjoy significant low unit cost of production of their petrol and consequently allowing them to price them at a competitive level. • As a result, potential entrants may find it difficult to compete effectively as they tend to operate on a relatively smaller scale and may not be able to spread the high overhead/startup costs of setting up a petrol station over the output produced, incurring a relatively higher uni t cost of production compared to the incumbent . Therefore, potential entrants may not be able to match the price of their petrol at the same level as the incumbents without incurring losses. This deters the entry of new firms since they are less able to compete on cost and may incur losses due to the significant differences in the cost conditions. ii) Few dominant firms As a result of the high barriers to entry, there are only a few large firms dominating the industry and for example, the 3-firms market concentration is relatively high in the UK. For example, the UK petrol retailing industry may be characterised by 3 dominant firms such as Shell, BP, and Esso. iii) Nature of Product • Differentiated – services? Body: R1: High petrol price due to tacit collusion of petrol retailers. ▪ Due to small number of large firms dominating the industry, there is high degree of mutual interdependence/rival consciousness between the firms. Hence, every action taken by a single firm, for example Esso, will affect the sales and profits of all the other firms such as Tesco, Morrisons, and Shell, triggering a reaction from them to protect their market share.

Y5 H2 Economics 2024 T3W5 Assignment – Firms and Decisions (Part 2) – Post-Mortem 2 ▪ As such, firms in the petrol retailing industry need to consider the rival’s reactions when deciding to set a price for their petrol due to the high degree of mutual interdependence. As a result, there is a strong temptation to collude in the petrol retailing industry to increase profits and reduce the degree of uncertainty that may arise from the incomplete information about the motivation of the rivals , particularly considering the rising costs which could be negatively affecting profitability of these large firms. Furthermore, there signs of weakening competition which may imply firms may be moving further away from behaving competitively to colluding to increase their profits further. ▪ In the petrol retailing industry, firms tend to engage in tacit collusion where smaller firms tend to follow the price set by the market leader who tends to be the dominant firm in the industry with the largest market share. The decision to follow the pric e set by the leader instead of undercutting them arises from the fear that a price war may erupt if they do not keep sync with the leader’s price. As such, they may not be able to compete with the dominant firm with the large supernormal profits and will incur heavy losses if they engage in a price war , exiting the industry. ▪ For example, in the petrol retailing industry, a price set by the dominant firm such as Esso is accepted as the market price by the followers/fringe firms even though the price deviates from their individual profit maximising price and out. Hence, if Esso were to increase the price of petrol in their petrol stations across the UK further (due to changes in cost conditions or any other reason), other firms will also follow suit and increase the prices of petrol at their stations too in a move aligned with the dominant firm . Such coordinated price increase of petrol by retailers in the UK is deemed as the best way of maintaining or even increasing their profits further in view of weakening competition instead of initiating a price war in response to a further hike in price of petrol by Esso. ▪ As a result, the higher petrol prices in the UK could be due to a possible tacit collusion by petrol retailers. ALTERNATIVELY, students can also explain collusion in terms of cartels. ▪ Petrol retailing firms such as Shell, BP, Asda and Tesco can form a cartel to determine the output and price that jointly maximises their profits and hence address the falling profits. ▪ If these petrol retailers form a cartel, they will act like a mon opoly and jointly face a downward sloping demand curve (like a monopolist) and its corresponding MR . Meanwhile, the cartel’s marginal cost curve will be given by the horizontal sum of the individual members’ marginal cost curves. ▪ As such, the cartel's profit ‐maximizing decision is the same as that of a monopolist at P1 and Q1 when the industry’s MR equals the industry’s MC. Consequently, members in the cartel such as Shell, BP and Asda will sell the petrol at the agreed price of P 1 which is higher than their individual profit maximising price of P0. ▪ Meanwhile, the cartel members choose their combined output at the level where their combined marginal revenue equals their combined marginal cost at Q1. Each member will sell an output based on the production quota given by the cartel which is dependent on the individual firm’s market share, and this output will be lower than their profit maximising output which is at Q 0. ▪ Therefore, the higher price of petrol is likely to be due to petrol retailers deviating from individual profit maximisation price to a higher price that maximises the joint profits under a cartel . The Competition and Markets Authority found evidence of weakening competition, suggesting that more petrol retailers are likely to collude to increase profits.

Y5 H2 Economics 2024 T3W5 Assignment – Firms and Decisions (Part 2) – Post-Mortem 3 R2: High petrol prices could be due to rise in average cost of production of petrol retail firms due to Brexit and Covid-19. ▪ Brexit has led to higher COP o With Brexit, petrol retailing firms have faced severe shortage of workers given that they largely