Firms' Decisions and Strategies

• In markets with weak BTE, price competition is fierce as firms engage in tit-for-tat price wars, in turn causing prices to be so low that they are just sufficient to cover the LRAC, and the firm earns normal profit in the long run.
• In markets with strong BTE, price competition is negligible, as a result, firms are able to retain supernormal profits in the long run, and are able to employ strategic pricing strategies as strategic BTEs in the market.
• Firms can tap on human's cognitive biases to improve the effectiveness of their pricing strategies, such as:

  • Sunk cost fallacy
  • Loss aversion
  • Saliency bias
• In the short run, effects of price competition would benefit consumers, as price wars lower prices, in turn increasing consumer surplus. As a result, consumer welfare improves.
• In the long run, effects of price competition would harm consumer welfare, as firms are able to charge higher prices in the aftermath of price wars, as well as limiting the choices for consumers as rival firms leave the market.
• Price competition would lead to a higher markup of P over MC, resulting in a loss of allocative efficiency.
• Price competition could lead to productive efficiency from society's perspective, assuming that the inital output was below the MES, as expansion of the scale of production allows the firm to enjoy internal economies of scale.
• Price competition could lead to productive inefficiency from the society's perspective, assuming that the initial output was above the MES, as expansion of the scale of production would result in internal diseconomies of scale.
• Price competition could lead to productive inefficiency from the firm's perspective as higher long-run profits for the remaining firms could lead to x-inefficiency.
• Price competition worsens equity due to higher prices and higher long-run profits for the remaining firms.
• Strategic Pricing Behaviours in oligopoly markets include:

  • Price wars
  • Limit pricing
  • Predatory pricing
  • Price rigidity
  • Collusion
• Limit pricing refers to the pricing by incumbent firms to deter or inhibit entry or the expansion of new firms.
• Predatory pricing refers to the deliberate strategy of driving out competitors of the market by setting very low prices.
• Price rigidity occurs when the competition is so intense that firms have little room to change prices for fear of loss of market share and sales. This results in stable prices as firms maintain a mutual interdependence between one another.
• Collusion occurs when oligopolies agree on prices, market share, advertising expenditure to limit competition between themselves.
• Conditions for explicit collusion:

  • Number of members cannot be too numerous
  • Members must have control of a large market share
  • Product has to be homogeneous and costs similar
  • A member must be a dominant firm
• Limitations of explicit collusion:

  • Inherently unstable due to incentive to cheat and earn greater profits
  • Illegal
• Implicit pricing is the behaviour of firms to set their prices according the the price set by the price leader.
• Types of price leaders:

  • Dominant firm
  • Low-cost price leader
  • Barometric price leader
• Limitations of implicit collusion:

  • Only the price leader maximises its profit
  • Indirect signals may be distorted and misinterpreted
• Price discrimination is defined as the selling of the same good at different prices for reasons not associated with differences in cost of production.
• Conditions for price discrimination:

  • The firm must be a price setter
  • PED must differ between groups
  • Firm must have the ability to separate the markets at low or no cost
• Effectiveness of price discrimination depends on:

  • How successful the firm is in preventing resale or bypassing the different prices
  • Utilisation of cognitive biases
  • Data to set prices optimally
• Price discrimination would lead to higher profits if successful.
• Price discrimination may feel inequitable, but some consumers may be able to afford the good when it is set at a lower price.
• When a firm uses price discrimination, consumers with a more price inelastic demand are charged with a higher price, which represents a loss of consumer surplus. The converse is true with consumers with a more price elastic demand.
• Effects of price discrimination on efficiency:

  • Allocative efficiency: Depends on PED
  • Productive efficiency from society's POV: Depends on initial output
  • Productive efficiency from firm's POV: Worsens
  • Dynamic efficiency: Improves
• Types of non-price strategies:

  • Real differences, such as:
  • Product quality
  • Conditions of sale
  • Imaginary differences
• Product differentiation is a process used by firms to distinguish their products from the products of rival firms.
• Product differentiation increases a firm's profits by:

  • Increasing demand
  • Making PED more inelastic
  • Reducing the degree of substitutability of its goods with rival firm's goods
• Cost of non-price strategies:

  • Advertising cost adds to the firm's fixed cost
  • Depending on the specific nature of product innovation, it could raise fixed cost or both fixed and variable costs
• Non-price strategies are uncertain as they:

  • Depend on consumers' receptiveness to the changes introduced
  • R&D efforts may not necessarily yield significant benefits
  • Depends on rivals' responses