Theme 6 II D: Firms and Decisions

Describe Firms may wish to maximise profits but are unable to do so due to lack of information

1. Firms may wish to maximise profits but are unable to do so due to lack of information

• Firms do not know their exact revenue and cost functions because they operate in a dynamic environment (demand and cost conditions change continuously over time)

• Firms unable to maximise profits as they are unable to accurately estimate the MR and MC due to unavailable or imperfect information

• Difficult for firms to estimate their demand curves because of the difficulty of estimating the actions and reactions of other firms and their effects

• Even in stable conditions, firms do not have precise information about price elasticities

• In such situations, firms may resort to simpler pricing models such as cost-plus pricing

  • Firms put a mark-up on top of the average cost of their goods and adjust the mark-up based on how well the goods are selling to arrive at a selling price

• Firms may also aim for profit satisficing, rather than profit-maximising, due to a lack of precise information

• Constraints of changing price in price sticky oligopoly 

Describe firms have other goals and do not aim to maximise profits in the short run

1. Firms have other goals and do not aim to maximise profits in the short run

• A firm may possess profit-maximising or alterfnative objectives which would form the basis for firms in deciding what strategy they should pursue in accordance with their objective

• If a firm prioritises short-run profits:

  • Utilise pricing strategies to maximise profits such as producing where MC=MR or practising price discrimination

  • Use non-price strategies to increase demand or reduce price elasticity of demand for its goods and to reduce costs 

• If a firm prioritises long-run profits:

  • Engage in strategies to drive its competitors out of the market or to deter new firms from entering

  • Such strategies would mean sacrificing some short run profits in exchange for higher profits or greater market dominance in future

Describe 5 general alternative objectives and their strategies

Define and describe predatory pricing (how it will increase profits LR)

• Predatory pricing (Def.): attempt by a firm to undercut its competitors by lowering its price in order to drive its competitors out of business 

• Firms are willing to charge a price that is below their own AC and earn subnormal profits temporarily in hopes of driving out their competitors and recuperating their losses in the future by charging higher prices

• Assuming AC of both firms is the same, all firms will make losses 

• Smaller competing firms (who make normal profits at prevailing market price) will make subnormal profits if they try to match the price or suffer a fall in demand for their product -> If the subnormal profit persists, they will exit the market in the long run

• If predatory pricing is successful: the firm would then be able to increase its market share and market power as its competitors leave the market -> raise prices to increase profits in the long term

• If it is unsuccessful: firms earn subnormal profits which they are unable to sustain and exit the market in the long run

Describe the trigger for predatory pricing

• Triggered by poor business conditions (economic downturn or recession) where the overall market demand is declining for the industry

• One of the firms will most probably have to initiate a price cut to clear its stock, which may spark off a price war -> use the recession as an ideal opportunity to force its rivals into bankruptcy 

• In a price war, all firms would suffer lower profits as prices are slashed

• Firms with lower costs or deeper reserves from past profits earned are better able to survive a price war as they can sustain losses for a longer period of time and outlast their competitors

Describe impact of predatory pricing on other firms and consumers

Other firms	Incumbent firms charge a price under competitors’ AC -> competitors will see a fall in demand -> fall in profits Competitors may react by lowering their price as well -> competitors suffer subnormal profits and will exit in the long run. If a price war occurs, all of them will suffer from a fall in profits
Consumers	SR Price war leads to lower prices and an increase in output. LR  Remaining firms with higher market share would charge higher prices as compared to before the price war -> reduces CS and consumer welfare

Describe impact of predatory pricing on governments

Government objectives

SR Price war would lower prices and increase output towards the allocative efficient level Firms’ supernormal profits are eroded and consumers benefit from lower prices, leading to a more equitable distribution of goods and services LR  If predatory pricing successfully enables a firm to establish a monopoly -> worsen allocative efficiency and equity as the monopoly would set its price even higher than the initial level

Describe limitation of predatory pricing

• Imperfect information -> main firm may be unable to lower prices sufficiently, such that the lower price is below the rival firm's average cost 

• Other firms still able to match the lower prices to prevent loss of market share while still making normal profits -> other firms will survive without shutting down -> strategy is ineffective 

• Evaluation: Extent to which a firm has imperfect information depends on type of market structure. In oligopoly, there is heavy degree of imperfect info -> greater uncertainty regarding rival’s cost and limitation is more severe 

Define and describe limiting pricing

• (Def.): Limit price is the minimum price that an incumbent firm can charge in order to make an acceptable level of profit whilst also deterring entry of new firms in the market

• Firms can charge the limit price that is below the short run profit maximising price but above the average cost (to make normal profits at least)

• Firms who wish to enter the industry when the oligopolist sets the profit maximising price of P1 can successfully do so if they produce at a relatively small scale of output Qa

• At Qa, the new firm's average cost will be equal to P1-> earns normal profits and is able to survive

• BUT, a threat of entry of a new firm will cause an oligopolist to opt to produce at Q2 and charge a lower price of P2 instead of P1 -> total profits are not maximised

• New firms would have to produce Qb to achieve sufficient economies of scale so as to compete (can charge a price of P2 and survive)

• There is greater risk involved in starting out with a larger scale of operation -> artificial BOE 

NOTE: 

1. Limit pricing - reduce price below AC of new entrants (Create artificial BOE) 

2. Predatory pricing - reduce price below AC of current rivals (firms assume AC of rival firms is same as theirs) (To kick out current firms to gain market share)

Explain how advertising deter potential entrants from entering market

• Advertising creates strong brand loyalty 

• Deter potential entrants as consumers would be less likely to purchase the new entrant’s product since they are unfamiliar with the new product 

• Entrants would then potentially face the need to spend extensively on advertising in order to get consumers to try their product, which deters new firms from entering the market 

• Advertising creates a barrier to entry by raising market penetration costs (through costly mass media advertising) -> raise AC

• Without advertising, the cost structure of the firm is illustrated by LRAC1

• A larger incumbent firm produces at output Q2 with average cost being C2 while a potential entrant may decide to enter the market at a smaller scale producing output Q1 but with a higher average cost of C1

• If the incumbent firms were to engage in massive mass media advertising -> shift LRAC1 to LRAC2 for all incumbent and new entrants as they all have to engage in advertising to attract customers

• Explain shape of graph: 

  • At low levels of output: LRAC2 is much higher than LRAC1 because advertising costs are spread over very little output

  • At high level of output: LRAC2 converges towards LRAC1 because the contribution of advertising cost to average costs becomes less significant as it is spread over a greater of output 

• After advertising, the incumbent firm producing output of Q2 will now have average cost of C4, a potential entrant intending to produce output of Q1 has an average cost of C3

• The cost difference between a larger incumbent firm and a smaller potential entrant has increased from C1C2 to C3C4 

• Smaller potential entrant will find it more difficult to compete against the larger incumbent firm because it has a higher cost disadvantage -> deter potential entrants from entering the market
  

Describe impact of advertising on other firms, consumers and governments

Other firms	Higher entry cost reduces contestability of market and raises market power of incumbent firm  The extent of this impact of entry deterrence on potential entrants depends on whether new firms are able to utilise better technology to reduce their costs or to innovate and come up with a product that closer suits consumers’ tastes
Consumers	Lower prices from limit pricing OR increased CS from product innovation Entry deterrence may also prevent firms with higher quality products from entering the market, -> loss of potential improvement in consumer welfare
Government objectives	Entry deterrence deter potential entrants with newer and better technology/products -> hindering DE as the potential technological improvements that these entrants offered did not materialise Harms AE and PE

Describe revenue maximisation

• Clue: Firm A is mainly run by the manager, who aims to maximize revenue instead of profits due to his commision-based rewards

• At MR = 0, no additional unit will lead to higher revenue