NYJC H2 ECONS Q2

Question 2 a) Explain how the level of competition influences firms’ price and output decisions. 10m b) Assess whether a firm’s behaviour is always dependent on the actions of its rivals. 15m a) Explain how the level of competition influences firms’ price and output decisions. 1. Intro : Level of Competition and Market Structure Level of competition is determined by the presence of barriers to entry - Barriers to entry refer to any impediment that prevents new firms from comp eting on an equal basis with existing firms in an industry. Identify PC as a market structure that has no BTE and hence high level of competition. The higher the barriers the lower the level of competition faced by the firms. Barriers to entry determine the degree of competition faced by firms in an industry and hence the degree to which they can influence price and output decisions. Identify monopoly as a market structure that has high BTE and hence low levels of competition. Assume that firms operate under profit maximisatio n motive. 2. Explain how high levels of competition affects firms’ pricing and output decisions In a perfectly competitive market - no barriers to entry - existing firms are unable to stop new firms from entering the market - no restrictions on existing firms leaving the market - no single firm has the market power to influence the market price of the product –product is identical - each firm is a price taker eg shares of listed companies in the stock markets….. Figure 1a above, shows how the intersection between the market demand and supply curves of a perfectly competitive market determines the eq uilibrium price P 0, and output Q 0. Each firm in the perfectly competitive market will then take the market price P0, as each firm in the perfectly competitive market is a price taker. The demand curve faced by each firm is thus perfectly price elastic (see Figure 1b). Each firm will then produce at its profit-maximising output, Q 2, where marginal revenue (MR 0) cuts the marginal cost (MC) curves. Here, the perfectly competitive firm is initially earning supernormal profits ,area P 0ABC. High competition, no barriers to entry, potential profit s entice new entrants into the industry leading to a shift in the market supply curve to it s right, lowering its market price as a result.

The price of the perfectly competitive firm will thus follow the price determined by the market. The output however will be determined by the indivi dual firm depending on its cost curves set. The firm will eventually earn normal profits. 2: Explain how no competition affect firms’ pricing and output decisions On the other end of the spectrum, where there is no competition due to high barriers to entry a monopoly will develop. A monopoly is one in which there exists only a single firm in the market. There is no competition as a result of the high barriers that can be classified into two categories, namely natural barriers to entry and ar tificial barriers to entry. The greater the natural barriers present the greater the firm’s ability to set a higher price. As the monopolist is the only producer it is the in dustry. The monopolist’s demand curve is also the market demand curve and is relatively pric e inelastic since it is the sole seller of a good with no close substitutes. To maximise profit or minimise losses, the monopolist will produce at an output where MR = MC. In the short run, the monopolist can be in equi librium earning supernormal profits, normal profits or subnormal profits. Figure 2 shows a monopolist making supernormal profits where he will produce at the profit-maximising output, MR=MC, such that output is at Q e and price is at P e. The supernormal profit is indicated by area P eABC. Since there are high barriers to entry for new firm s, a monopolist’s short-run profits will not be competed away in the long run. Unlike the perfectly competitive firm, the monopolist can continue to sell Q e at price P e and continue to earn supernormal profits even in the long run. The monopolist can price his product higher and continu e to earn supernormal profits for a longer period of time if his barriers to entry are natural ones than if they are artificially put up. 3. Compare the price and output determination in a mar ket structure with different levels of competition Assuming that there are identical cost structure, m arkets with different levels of competition would have different price and output levels. A monopolist would have a higher price and a lower output as compared to a PC market. (Draw the diagram). Figure 2 : Monopolist earning supernormal profits

- However it is not always true that low levels of co mpetition enables firms to dictate its price and output. In the case of Oligopoly, under the non-collusive model, firms tend not to change their price due to the characteristics of mutual in terdependence (briefly explain). Similarly under the price leadership model, firms do not inde pendently determine their prices as well as their output levels (briefly explain). Conclusion Barriers to entry is a key determinant to pricing and output decisions, as seen in the need for firms in perfect competition and monopolistic competition to price their product to maximise profits, so as to achieve normal profits in the long run in order to survive in the industry, but there is no need to do so for monopoly and oligopoly. High natural barriers to entry allow the monopolist to maintain its price and output so as to continue earning supernormal pr ofits. However, firms under the perfectly competitive market that are earning supernormal profits will face a lower price and a smaller output as more firms join the market due to the presence of high competition and freedom of entry and exit. Level Descriptors Marks L3 Developed explanation of how barriers to entry can cause firms to make differing pricing and output decisions for different market structure types. 8-10 L2 Un der -developed explanation of how barriers to entry can cause firms to make differing pricing and output decisions of at least 2 types of market structure types. 5-7 L1 A general discussion of only one type of market structure and its determination of price and output decision 1-4

b) Assess whether a firm’s behaviour is always dependent on the actions of its rivals. Rivals can be defined as a person, thing or firm competing with another for the same objective or for superiority in the same field of activity. Firms (including businesses and corporations) exist and make decisions to maximize profits. Firms interact with the market to determine pricing and demand and then allocate resources according to models that look to maximize net profits. In an oligopoly, the firm exhibit mutual interdependence which means that one firm’s action will have a significant impact on the other firms and the other firms will respond accordingly. Assuming that the firms are profit-maximising, their behavior may be influenced by their rivals’ actions and other factors. The extent to which the behaviour of firms depend in reality on the actions of their rivals can be discussed with reference to the concepts of market structure, strategic interdependence, government intervention/regulation and the alternative objectives of firms. 1: The behaviour of firms depends, in reality, closely, on the actions of their rivals This is true for an oligopolistic industry whereby firms exhibit mutual interdependence where a few firms account for a large market share, with strong barriers to entry and producing homogeneous or differentiated good or service, firms are mutually interdependent. This means that the main dominant firms have a very high degree of rival consciousness. Firms will consider the reactions of