Differing objectives and policies of firms (3)
Resources |
Revision Questions |
Economics
Login to see all questions
Click on a question to view the answer
1.
The following diagram illustrates a firm operating in a market with a large incumbent firm. The demand curve is shown as DD, and the incumbent firm’s MC curve is shown as MC1. The firm’s MC curve is MC2. Assume the firm is entering the market. Draw a diagram to illustrate the limit pricing strategy and explain how this strategy affects the incumbent firm’s profitability. (12 marks)
Diagram: The diagram should show the following:
- Demand Curve (DD): A downward sloping demand curve.
- Incumbent Firm's MC Curve (MC1): An upward sloping MC curve representing the incumbent's marginal cost.
- Entrant Firm's MC Curve (MC2): A relatively low MC curve, positioned below the incumbent's MC1. This represents the entrant's lower costs.
- Price (P): The market price is determined by the intersection of DD and MC1.
- Quantity (Q): The market quantity is determined by the intersection of DD and MC1.
- Entrant's Output (Qe): The entrant produces a quantity (Qe) such that their MC2 intersects the demand curve at the same price (P) as the incumbent. This is the limit point.
- Incumbent's Output (Qi): The incumbent's output (Qi) is the quantity where their MC1 intersects the demand curve (DD).
Explanation of Impact on Incumbent Profitability:
- Reduced Incentive to Enter: Limit pricing deters the entrant from entering the market. The entrant chooses a quantity (Qe) where their marginal cost is equal to the market price. This means the entrant is only making a normal profit (zero economic profit).
- Incumbent's Profit Reduction: The incumbent's profit is reduced because the entrant's presence, even at a limited scale, forces the incumbent to lower their price to maintain market share. The incumbent's output is lower (Qi) than it would have been without the limit pricing.
- Long-Run Implications: In the long run, the incumbent may be forced to respond with lower prices and potentially reduced output, leading to lower overall profitability. The limit pricing strategy effectively restricts the entrant's potential profits and protects the incumbent's existing market share, but at the cost of potentially lower overall market output.
2.
(a) Define predatory pricing.
(b) Explain why a firm might engage in predatory pricing.
(a) Definition: Predatory pricing occurs when a firm sets its price below its average total cost (ATC) with the intention of driving competitors out of the market and then raising prices once the competition is eliminated. This is a form of anti-competitive behaviour.
(b) Reasons for engaging in predatory pricing:
- Gaining Market Share: The primary goal is to gain a significant market share, often in an oligopolistic market.
- Eliminating Competitors: By driving rivals out of business, the predatory firm reduces competition and increases its profitability.
- Creating Barriers to Entry: A strong market position built through predatory pricing can deter new firms from entering the market.
- Profit Maximization (Long-Term): While initially incurring losses, the firm anticipates higher profits in the long run due to reduced competition.
3.
Consider a market where a new firm is considering entering. The existing firm has a cost advantage. Using a diagram, explain how the new firm might use limit pricing to deter entry. Discuss the potential consequences of limit pricing for both the incumbent and the potential entrant. (12 marks)
Diagram: The diagram should show the following:
- Demand Curve (DD): A downward sloping demand curve.
- Incumbent Firm's MC Curve (MC1): An upward sloping MC curve representing the incumbent's marginal cost.
- New Firm's MC Curve (MC2): A relatively low MC curve, positioned below the incumbent's MC1. This represents the new firm's lower costs.
- Price (P): The market price is determined by the intersection of DD and MC1.
- Quantity (Q): The market quantity is determined by the intersection of DD and MC1.
- New Firm's Output (Qe): The new firm produces a quantity (Qe) such that their MC2 intersects the demand curve at the same price (P) as the incumbent. This is the limit point.
- Incumbent's Output (Qi): The incumbent's output (Qi) is the quantity where their MC1 intersects the demand curve (DD).
Explanation of Limit Pricing Strategy: The new firm chooses a quantity (Qe) where its marginal cost is equal to the market price (P). This means the new firm is only making a normal profit (zero economic profit). The incumbent firm is deterred from entering the market because it anticipates that the new firm will aggressively compete on price, leading to lower profits for the incumbent. The incumbent's output is reduced as it tries to maintain its market share.
Consequences for the Incumbent:
- Reduced Market Share: The incumbent's market share will be reduced as the new firm captures a portion of the market.
- Lower Profits: The incumbent's profits will be lower as a result of the reduced market share and increased competition.
- Potential for Price Wars: If the incumbent is unable to effectively respond to the new firm's limit pricing strategy, it may be forced to lower its own prices, leading to a price war.
Consequences for the New Firm:
- Limited Profit Potential: The new firm's profit potential will be limited because it is only making a normal profit.
- Risk of Incumbent Response: The new firm faces the risk of an aggressive response from the incumbent, which could lead to losses.
- Market Entry: The new firm successfully enters the market, gaining a foothold and potentially growing its market share over time.