N08Q2
Firms’ pricing and output decisions depend on barriers to entry and the behaviour of competitors.
(a) Explain why barriers to entry are a key determinant in firms’ pricing decisions. [10]
(b) Discuss the extent to which the behaviour of firms depends in reality on the actions of their
competitors. [15]
Part (a)
Clarify Barriers to entry; clarify “pricing decisions” – (1) ability to set prices; (2) is it necessary to set
prices to maximise profits in the long run; (3) ability to set more than one set of price for a the same
good for reasons not associated with cost differences (not necessary given the mark allocation);
Classify Barriers to entry
Explain how firms in market structures with no or lack of entry barriers (e.g. PC and MPC) determine
prices  assume objective to max profits
 Note that PC firms cannot set prices, PC firms are price takers because they sell an
insignificant proportion of market share, homogeneous products, perfect knowledge
o PC firms take the market price as given (and the market price is determined by
market demand and market supply)
o PC firms while they cannot set price, they choose the output level that maximises
their profits  they can only make normal profits in the long run due to absence of
entry barriers and hence must maximise profits in order to survive in the industry 
explain how supernormal profits are eroded in the long run with the entry of new firms
into the industry (note that with the entry of new firms, the market supply curve shifts
to the right and the equilibrium price falls till each PC firm can only make normal
profits in the long run)
o Choose an output level that max profits (MC=MR) and then price it accordingly
 MPC firms on the other hand, they are price setters (differentiated products)
o However, in the long run, MPC firms also have to choose an output level and set
prices to maximise its profits and they must maximise their profits in the long run
because of lack of entry barriers  in the long run they can only make normal profits
and hence they must maximise profits in order to survive in the industry  explain
how supernormal profits are eroded in the long run with the entry of new firms (note
that with the entry of new firms, the existing MPC firm’s demand curve/average
revenue curve and marginal revenue curve shifts to the left (and also become more
price elastic in demand with the presence of more substitutes) until at the new
equilibrium, the MPC firm is only making normal profits (the new AR curve is tangent
to the LRAC curve at the profit-maximising output level).
Explain how firms in market structures with high entry barriers (e.g. monopoly and oligopoly)
determine prices
 Profit-max where MR=MC and price is found on the demand curve
 High barriers to entry  supernormal profits can be retained by the individual firms in the long
run (diagram)
 However, since the monopoly and oligopoly is able to retain supernormal profits in the long
run, they can but need not price their product to profit maximise  they can pursue other
objectives (Revenue maximisation (MR=0), profit satisficing motives) (diagram)  more
appropriate for part (b)???
 In market structures with high entry barriers, the higher the entry barriers, the greater the
monopoly power, the greater the ability to price discriminate (which means having the ability
to charge different prices for the same good for reasons not associated with cost differences)
 more appropriate for part (b)
Conclusion: Barriers to entry are a key determinant to pricing decisions of firms as seen in the need
for PC and MPC firms to price their product to max profits 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. But the
ability to set prices depends on also depends on other factors like nature of product.
Wednesday, November 03, 2010 10:03 AM 1
(b)
Pepper your answer with real life examples
Clarify what is meant by behaviour of firms
- Price vs non-price strategies
- Output decisions
- R&D and innovation
Clarify what is meant by “on the actions of their competitors”  mutual interdependency  identify
the market structure where firms exhibit mutual interdependency  oligopoly
Thesis: Yes, behaviour of firms tend to depend on the actions of their competitors
- Competitive model of oligopoly
 Kinked demand curve theory
o Price rigidity
o Preference to engage in non-price competition
 Ability to retain supernormal profits in the long run
means that they have greater ability or more funds to
engage in R&D, advertising on a larger scale, more
fanciful product differentiation and so on
 Price wars  when one firm starts to lower prices, rival firms will
follow suit because if they do not do so, they will lose a substantial
share of their market to the firm that cuts price first  mutual
interdependency + dominant firm
- Collusive model
 Dominant price leader
 Barometric price leader
 Cartel???
Anti-thesis: Not necessary so. Behaviour of firms also depends on other factors
- Other market structures
 Monopolistic competition (MPC)
o Explain characteristics and how and why it affects behaviour
of firm
o MPC firm can practice independent pricing policy because
each firm only sells an insignificant percentage of market
share; MPC firm tends to engage in both price and non-price
competition but the extent to which they can engage in nonprice competition is limited because of the lack of funds (they
only make normal profits in the long run)  the type of nonprice strategies that MPC firms engage in is dependant on
the profits that they make which depends on the existence of
barriers to entry
 Monopoly
o Explain characteristics and how and why it affects behaviour
of firms
o No competition hence not dependent on actions of other
firms  they can maximise profits and earn supernormal
profits in the long run due to high barriers to entry  but they
may not always do so
 Other objectives of the firm determine the behaviour
of monopoly
 Threat of government intervention will influence the
behaviour of monopoly
 Actual government intervention will determine the
behaviour of monopoly
o PC firm
- Contestable markets
 Dominant firms may price the product competitively if barriers to
entry are low
Wednesday, November 03, 2010 10:03 AM 2
o
Yet even if no actual competition, according to theory of
contestability, the presence of potential entrants will cause
the monopoly to behave such that they price their product
competitively
- Ability to price discriminate depends on other factors like whether the market
can be segmented… explain the conditions for price discrimination
Conclusion: Make a stand and explain your stand
Remember to provide real life examples
Wednesday, November 03, 2010 10:03 AM 3