Chapter 15 - Monopolistic competition, Oligopoly and contestable markets Flashcards

Question

Why does a price war take place and what is an example of it?

Answer 1

In the early 2000s, a price war broke out in the UK tabloid newspaper market. It was initiated by the Daily Express, but the main protagonists were the Daily Mirror and The Sun, which joined in after a couple of weeks. The Mirror cut its price from 32p to 20p, and The Sun from 30p to 20p. Their reading of the situation was that the Mirror had not expected The Sun to follow the price cut. Three weeks after the Mirror's price cut, it put its price back up again — followed by The Sun. Analysts and observers commented that the only gainers had been the readers, who had enjoyed three weeks of lower prices. Why should firms act in this way? The Mirror argued that it was trying to re-brand itself, and capture new readers who would continue to read the paper even after the price returned to its normal level. This may hint at the reason for a price war — to affect the long-run equilibrium of the market. The Sun's retaliation was a natural defensive response to an aggressive move. Why initiate a price war? In some cases a price war may be initiated as a strategy to drive a weaker competitor out of the market altogether. The motivation then is clear, especially if the initiator of the price war ends up with a monopoly or near-monopoly position in the market. It could be argued that this represents an attempt to maximise profits in the long run by establishing a monopoly position. Price wars may also be initiated by firms wishing to break into a market. For example, the discount stores Aldi and Lidl launched low-price offers on their range of products in an attempt to compete with UK supermarkets.

Answer 2

An anticompetitive strategy in which a firm sets price below average variable cost in an attempt to force a rival or rivals out of the market and achieve market dominance.

Answer 3

So-called predatory pricing is illegal in many countries, including in the UK and the USA. It should be noted that, in order to declare an action illegal, it is necessary to define that action very carefully — otherwise it will not be possible to prove the case in the courts. In the case of predatory pricing, the legal definition is based on economic analysis. Remember that if a firm fails to cover average variable costs, its strategy should be to close down immediately, as it would be better off doing so. The courts have backed this theory, and state that a pricing strategy should be interpreted as being predatory if the price is set below average variable costs, as the only motive for remaining in business while making such losses must be to drive competitors out of business and achieve market dominance. This is known as the Areeda-Turner principle (after the case in which it was first argued in the USA). On the face of it, consumers have much to gain from such strategies through the resulting lower prices. However, a predator that is successful in driving out the opposition is likely to recoup its losses by putting prices back up to profit-maximising levels thereafter, so the benefit to consumers is short lived. Entry deterrence by the threat of predatory pricing: In some cases, the very threat of predatory pricing may be sufficient to deter entry by new firms, if the threat is a credible one. In other words, the existing firms need to convince potential entrants that they, the existing firms, will find it in their best interests to fight a price war, otherwise the entrants will not believe the threat. The existing firms could do this by making it known that they have surplus capacity, so that they would be able to increase output very quickly in order to drive down the price. Whether entry will be deterred by such means may depend in part on the characteristics of the potential entrant. After all, a new firm may reckon that if the existing firm finds it worth sacrificing profits in the short run, the rewards of dominating the market must be worth fighting for. It may therefore decide to sacrifice short-term profit in order to enter the market — especially if it is diversifying from other markets and has resources at its disposal. The winner will then be the firm that can last the longest. But, clearly, this is potentially very damaging for all concerned.

Answer 4

An associated but less extreme strategy is limit pricing. This assumes that the incumbent firm has some sort of cost advantage over potential entrants: for example, economies of scale. The graph shows a firm facing a downward-sloping demand curve, and so having some influence over the price of its product. If the firm is maximising profits, it is setting output at Q0 and price at P0. As average revenue is comfortably above average cost at this price, the firm is making healthy supernormal profits. Suppose that the natural barriers to entry in this industry are weak. The supernormal profits will be attractive to potential entrants. Given the cost conditions, the incumbent firm is enjoying the benefit of economies of scale, although producing below the minimum efficient scale. If a new firm joins the market, producing on a relatively small scale, say at Q1, the impact on the market can be analysed as follows. The immediate effect is on price, as now the amount Q0 + Q1 is being produced, pushing price down to P2. The new firm (producing Q1) is just covering average cost, so is making normal profits and feeling justified in having joined the market. The original firm is still making supernormal profits but at a lower level than before. The entry of the new firm has competed away part of the original firm's supernormal profits. One way in which the firm could have guarded against entry is by charging a lower price than P0 to begin with. For example, if it had set output at Q0 + Q1 and price at P2, then a new entrant joining the market would have pushed the price down to a level below P2, and without the benefit of economies of scale would have made losses and exited the market. In any case, if the existing firm has been in the market for some time, it will have gone through a process of learning by doing, and therefore will have a lower average cost curve than the potential entrant. This makes it more likely that limit pricing can be used. So, by setting a price below the profit-maximising level, the original firm is able to maintain its market position in the longer run. This could be a reason for avoiding making too high a level of supernormal profits in the short run, in order to make profits in the longer term. Notice that such a strategy need not be carried out by a monopolist but could also occur in an oligopoly, where existing firms may jointly seek to protect their market against potential entry.

Answer 5

A market in which the existing firm makes only normal profit, as it cannot set a price higher than average cost without attracting entry, owing to the absence of barriers to entry and sunk costs

Answer 6

A contestable market is one in which new firms: - face no barriers to entry or exit - incur no sunk costs in entering the market - have no competitive disadvantage compared with the incumbent firm(s) - have access to the same technology as the incumbent(s - are able to enter and exit rapidly

Answer 7

The incumbent firm cannot set a price that is higher than average cost because, as soon as it does, it will open up the possibility of hit-and-run entry by new firms, which can enter the market and compete away the supernormal profits. The best chance a monopoly would have to prevent entry would be to make sure that the long-run average cost curve is as low as possible (no X-inefficiency), and that it does not set a price above the minimum point of the AC curve. However, if the firm did try to produce at this point, it would not be operating on the demand curve, so new entrants would enter the market to make normal profits. After entry, the market could end up in equilibrium with a number of firms making normal profit, each firm producing at minimum average cost. In this situation, there would be productive and allocative efficiency. However, the theory does not set out how this position could be achieved. For example, suppose a firm has a monopoly on a domestic air route between two destinations. An airline with surplus capacity (i.e. a spare aircraft sitting in a hangar) could enter this route and exit again without incurring sunk costs in response to profits being made by the incumbent firm. This shows how contestability may limit the ability of the incumbent firm to use its market power.

Answer 8

An advantage from society's perspective is that the price will be lower than would be set by a profit-maximising monopolist. Indeed, if the firm sets the price at lowest point of the ATC, new firms may effectively become price-takers, so that entry would continue until the demand at that price is satisfied. Beyond that point, the price would begin to fall, as there would be excess supply. Notice that if the market settles at this price with a number of firms with identical AC curves, then both allocative and productive efficiency would be achieved, as each firm would be operating at the minimum point on their average cost curve at the point at which price equals marginal cost. There is a danger that the authorities may see this argument as meaning that no intervention is needed in contestable markets because allocative and productive efficiency would automatically be achieved. However, this assumes that the conditions for perfect contestability would be met. These are stringent. In particular the requirement that there are no sunk costs may not always be fulfilled. For example, some advertising will be needed to attract customers, which cannot be recouped. In addition, the transition to long-run equilibrium is less clear than with perfect competition, as the theory does not fully explain how new firms will join the market, nor how the final equilibrium is reached. It is also worth being aware that perfectly contestable markets are rare in the real world. An important further point is whether the threat of entry will in fact persuade firms that they cannot set a price above average cost. Perhaps firms will risk making some profit above normal profit and then respond to entry very aggressively if and when it happens.

Answer 9

The growth of the internet has had a significant impact on the contestability of markets and hence on competitiveness. By making information more freely available, the internet has given consumers improved knowledge of market conditions and enabled them to make more informed choices. Furthermore, the growth of online sales has made it much easier for new firms to enter markets. One good example of this is the travel industry. In 2016, UK residents made more than 70 million trips abroad, so this is a significant sector. In the past, many overseas trips, especially holidays, were arranged by high street travel agents. Although there were many retail outlets, the largest chains of travel agents were responsible for a significant market share. The internet has revolutionised this sector, with online firms competing effectively with the established firms, and individual consumers able to make their own travel arrangements much more effectively. This is an example of where increased contestability of a market has resulted in an increase in competitiveness.

Answer 10

Where a firm enters a market to take short-run supernormal profits knowing it can exit without incurring costs