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Question 3

a) Explain how the different features of monopolistic competition and oligopoly affect price and output determination in these market structures. [10]

b) Recession will affect firms in different ways depending, for example, on

what they produce and the market structure in which they operate. Discuss the likely effects of a recession on different firms. [15]

(a)

Explain the different features of monopolistic competition and oligopoly

Explain the price and output is determined by profit-maximizing behaviour of the firm, at MR = MC, where the last unit transacted. Different features of monopolistic competition and oligopoly would affect the price and output determination for firms in the different market structures

Barriers to entry and number of sellers

Barriers to entry for MC firms are usually low while high for oligopolistic firms. MC firms like the hawker food industry have ease of entry and exit because of low start –up cost which means that there are a greater number of firms in the industry, as opposed to oligopolistic firms, like the petrol industry. Because start-up costs are high, and existing firms also institute artificial barriers to entry through the use of price and non-price competition, not many firms can enter the industry resulting in a lower number of firms, and hence higher market power for each firm as they have a higher influence on price as compared to the monopolistic competitive firm.

Effect on DD and MR curve

This means that there are more substitutes for consumers to choose from in the MC industry, leading to a more price elastic DD curve facing each firm. Quantity demanded is thus more responsive to changes in price as consumers can switch easily from one firm to another. In contrast, the oligopolistic firm faces a more price inelastic DD as consumers do not have that many substitute to choose from, resulting in higher market power and hence the power to set prices. DD curve for the oligopolistic firm will be higher, as market DD is spread over less number of firms compared to the MC industry This consequently leads to a steeper and higher MR curve for the firm, and a lower profit-maximising price (P2 > P1 ) and higher profit maximising output. (Q2 > Q1 ).

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Number of sellers leading to presence of rival-consciousness The smaller number of firms in oligopoly also leads to rival-consciousness, where the actions (including price and output set by other firms) other firms. In this light, oligopolistic firms may engage in collusive price setting behaviour where they act as a monopoly and charge even higher prices or engage in limit pricing and price war where they deviate from profit maximizing behaviour and charge prices below profit maximizing level in a bid to drive out other firms who may be less efficient and hence faces a higher marginal cost. Collusive behaviour can sometimes be observed from petrol companies who may align their pump prices to gain higher revenue. This level of interactive behaviour in price and output determination is not seen in monopolistic competitive firms as there is no rival consciousness from the high number of sellers in the market. Each firm would have too little market power and market share to influence market prices and output. Type of good Monopolistic competitive firms usually sell differentiated but similar goods while oligopolistic firms can sell both differentiated as well as homogenous goods. Differentiated goods and characteristics enables the monopolistic competitive firm to have a more price inelastic demand compared to a PC firm, and the firm can thus charge a price higher than marginal cost as consumers are willing to pay for such differences. An oligopoly can choose to exploit the differences in their products in order to gain market share, like the automobile industry for instance. On other hand, it may also be easier to collude if they sell homogenous products like petrol and which also leads to a higher collective price setting ability. Effect on MC curve Oligopolistic firms usually produces good with greater product complexity which may lead to a higher marginal cost than MC firms, which also means the profit maximizing output will be smaller and the prices higher than MC firms.

B MR

P1

Q1 Output

Revenue/Cost

S=MC

O

D=AR B

MR

P2

Q2

Output

Revenue/Cost

S=MC

O

D=AR

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b) Introduction Explain recession –usually accompanied by falling AD and lowering of business outlook. Characterized by fall in domestic consumption and hence investment spending, or fall in demand for exports, which affects firms operating in different market structures. Thus, a recession can impact the DD and MC of a firm, which may have implications on the strategies they employ, depending on what they produce and what market structure they operate in. Body Fall in DD and prices and output With a fall in AD and as consumers tighten their purse strings. Fall in DD for each firm in different industries leading to a fall in DD curve and consequently MR curve (MC vs Oligopoly) , leading to lower prices and lower output as firms re-calibrate their profit maximizing price and output. This is especially so for firms selling goods that are known as “normal” goods, which includes necessities or luxury goods. The degree of the fall in demand thus depends on the income elasticity of the good. The higher the income elasticity of the good, the more the DD will fall. In times of recession, its common to see sales plummeting for many firms and prices revised lower. However this is dependent on the nature of the good produced by the firms. However, if the goods are dubbed as inferior goods, (with the income elasticity of the good assuming a negative value) such as the house brands of many big supermarket chains, the DD for such goods may actually rise in the face of recession and falling incomes, as consumers switch from more expensive goods, resulting in higher revenue for such firms. Fall in profits (MC vs. Oligopoly) With falling revenue as a result of fall in DD, profits margins will be squeezed for both MC and oligopolistic firms. However, as MC firms usually earns normal profit in the long run due to low barriers to entry , a fall in profit may force many firms to sustain subnormal profits, and if P < AVC, some firms may be forced to shut down, leading to a fall in number of firms in the MC industry. Oligopolistic firms with their long-run supernormal profits will be able to withstand the fall in profits to some extent, and still stay in business. Hence firms that are more monopolistic competitive in nature are more likely to fold, as can be seen from many small shops, in particular the newer F and B firms, that go out of business during a recession. Effect on strategies: price and non-price competition (oligopoly) MC firms which may produce lower cost goods may engage in non-price competition to establish a “value for money” image because such goods are regarded as inferior goods. Therefore, during a recession, the DD for goods that may be dubbed as “inferior” may actually increase, hence revenue may increase for an MC firm selling such goods. For oligopolistic firms, a fall in revenue because of lower demand may reduce the incentive to increase product complexity and to engage in price –or non price competition. There may be even be an incentive to engage in collusive behaviour, especially if the firms produce homogenous goods, such as engage in joint marketing of R and D to share the cost.

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However, because each firm is struggling to increase DD at the expense of another firm, recession may result in intensifying of competition to gain market share in the face of falling demand. Firms with deeper pockets may choose to advertise more aggressively to vie for a larger share of the shrinking market by increasing DD and making DD more price inelastic with persuasive advertising, thereby decreasing the cross price elasticity of their products vis-à-vis other products. Some firms may take the opportunity to drive another out of business in the context of poor economic conditions through price competition and may start a price war knowing that their rivals will be unable to match their reduction in prices, thus gaining market share. This will enable surviving firms to raise prices when the economy recovers from recession, while others may be driven out of business Cooperative Behaviour: Merger Another possibility is that oligopolistic firms may engage in cooperative behaviour such as mergers to cut costs and serve on duplicate overheads or exploit EOS, the firms will be able to better withstand the fall in profits. However the success of this may depend on what the firm produces, and the extent to which they can exploit EOS that comes with increased scale of production. Synthesis The damage that a recession can do to firms depends in a large part on the market structure they operate in and the type of good they produce , depending on whether these goods are in nature normal luxury, necessities or inferior goods. As most firms produces normal goods, they will likely suffer from a fall in DD and revenue, therefore their survival depends largely on the strategies employed to keep afloat, monopolistic competitive firms may choose to intensify and increase their product differentiation while oligopolistic firms may decide to engage in cooperative or competitive behaviour depending on the circumstances and their expected pay-offs for the strategic action.