PJC H2 ECONS P2 Q2

Pioneer Junior College (Economics Department) 1 PJC 2017 H2 Prelim Exam Paper 2 Question: The firm’s decisions and strategies are affected by cost, revenue, and threat from existing and potential competitors. (a) Explain how producers in imperfect markets make rat ional price and output decision based on cost and revenue consideration. [10] (b) Discuss the extent to which the behaviour of firms is in fluenced by the threat of competition. [15] Producers in imperfect market would make rational d ecision of maximising profit by producing at an output where marginal cost is equal to marginal revenue (MC=MR). They would also attempt to price discriminate if they have control over the market t o maximize profits. In the case where they earn subnormal profit, it would also make decisions whet her to shut down or continue production to maximise profit. Producers will aim to produce at the output where MC=MR to maximise profit. In Figure 1, Producers will produce at Q M, where MC = MR to maximise output and sell it at p rice = PM as indicated by the AR (DD) curve. If producers pr oduce at Q 1, which is below profit maximising output, the marg inal revenue is MR 1 while marginal cost is MC 1. This means that the additional revenue is more than additional cost and producers could generate more revenue and profit if they increase output towards Q M. On the other hand, producers produce beyond Q M, for example, Q 2, the marginal cost of producing at Q 2 is MC 2 while marginal revenue is MR 2. This means that producers can reduce cost by reducing it s output, leading to an increase in profits. Hence, producers would decrease its output to increase its profits. At Q M, where MC=MR, producers cannot increase its profits any fu rther by changing its output. Hence, producers will produce at output Q M, and price it at P M to maximise profit. For producers who dominate the market (e.g.: Monopo ly), they could also practice price discrimination to maximise revenue and profit. Price discrimination is the practice of charging di fferent prices for the same product or services for reasons not due to cost differences. It can occur when producers have control of market supply, able to separate the market with little cost and the sep arate markets have different price elasticity of demand. For example, public transport firms are able to cha rge a lower price for students and elderly, where their demand is price elastic (due to high proporti on of income spent). This would allow public transport companies to earn higher revenue as the l owering of price will result in a more proportionate increase in quantity demanded, leadin g to an increase in total revenue. On the other hand, they will be able to charge a higher price fo r working adults as their demand is price inelastic (due to low proportion of income spent on public tr ansportation). Hence the increase in price will result in a less than proportionate fall in quantity demanded, leading to an increase in total revenue. Hence, producers could price discriminate by chargi ng different prices at profit maximising output in markets with different price elasticity of demand t o increase total revenue and hence maximise profits. In the case where the producer is earning subnormal profit when they are producing at profit maximising output, firms would need to decide whether to shut down or continue production. Fig 1: Profit maximising output

Pioneer Junior College (Economics Department) 2 Producers will shut down when the price is less than average variable cost of production. From Fig 2, at profit maximising output Q M, price is P M. Even though the firm is earning subnormal profit (AC M> PM), price is more than average variable cost (P M>AVC M). Hence the producer will continue production as the revenue earned could be used to offset the fixed cost. Fig 2: Producer continue operation Fig 3: Producer decides to shutdown However, if the average variable cost at profit max imising output is more than price (seen in Fig 3, where P M < AVC M at Q M), the revenue earned from production is not enough to cover the variable cost. Hence, producers will choose to stop production to minimise loss. Thus, if producers earn subnormal profit when they produce at MC = MR, they would decide to continue production only when P M > AVC M at profit maximising output. Thus producers will make a rational decision to pro duce at MC=MR to maximise profit and price its goods as indicated by its AR. However, its pricing decision may vary if they could price discriminate. They would also consider shutting down production if they earn subnormal profit.

Pioneer Junior College (Economics Department) 3 b) Discuss the extent to which the behaviour of firms is influenced by the threat of competition. [15] Firms will normally engage in price and non-price strategies (behaviours) in order to maximise profits. While the behaviour of some firms in oligopoly and monopolistic competitive industries is influenced by the level of threat of competition in the market, there are also other factors that influence the behaviour of firms as the profit level of firms and alternative aims of firms. As such, the extent of which the threat of existing and potential competition influence the behaviour of the firms depends on whether which factor has greater significance of it. Threat of competition could influence the behaviour of firms in an oligopoly market. With a few large dominant firms in an oligopoly mar ket (e.g: telecommunication firms in Singapore), they are subjected to existing and potential threat of competition since the government deregulate the industry. Hence, they exhibit mutual interdepen dency as the action of one firm would affect others. In light of competition, they would avoid changing their prices. This is because if a firm increases its price, their rivals would not follow suit, which could result in a more than proportiona te fall in quantity demanded, resulting in a fall in t otal revenue and profit, ceteris paribus. If a firm reduces its price, the rivals would follow suit, wh ich could result in a less than proportionate incre ase in quantity demanded, causing total revenue and profit to fall, ceteris paribus. As a result, in light of competition, Singtel, M1 a nd Starhub would usually avoid price competition. Instead, they would engage in non-price competition such as improving connectivity island wide, varying the amount of mobile data given to subscrib ers, to increase their demand and quantity, leading to an increase in total revenue and profit. Hence, oligopoly firms in light of threat of competition, would avoid changing prices and instead focus on non-pricing strategies to increase total revenue and profit. However, even with threat of competition, oligopoli stic firm may still engage in pricing competition t o achieve alternative aims. Instead of aiming to achieve profit maximisation, f irms in oligopoly would use pricing strategies or predatory pricing strategies in order to increase market share. This strategy could be used in attempt to establish market dominance in the industry in th e short run. In Singapore’s telecommunication industry, there was a price war in 2016, where Sing tel, M1 and Starhub reduced its monthly subscription plans to gain more market share in the industry even if it means that they would see a fall in total revenue in the short run. This behaviour might be influenced by alternative aims of firms (market share dominance). However, the underlying reason for this behaviou