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Qn2 - Comment on the strategies available to a profit maximising firm in an imperfectly competitive market. by Mind Map: Qn2 - Comment on the strategies available to a
profit maximising firm in an imperfectly
competitive market.
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Qn2 - Comment on the strategies available to a profit maximising firm in an imperfectly competitive market.

Pricing and output strategy

Price-setter due to market power

Face downward sloping DD=AR (will not lose all its customers if it raises prices)

MR is half of DD=AR since it has to lower price of all previous units when selling the additional unit

Profit maximising output is where MC=MR (< socially optimal level of output where MC=DD=MB)

Output is restricted and prices are higher

Net welfare loss to society, inefficient

Advertising

Basis:

Imperfect information

Products have different qualities/attributes

Intensity depends on:

Consumer vs Industrial

Durable vs Non-Durable

Market Structure

How:

increase & make more inelastic the DD for the good(s) offered

via persuasion/informing consumers on the superior quality of the good

Effects:

(firm) increases market power, consumers switch to the advertising firm's good(s) due to the belief of their superiority, creates first-mover advantage, conferring barriers to entry due to brand loyalty

(economy +ve) reduce consumer ignorance, improve allocation of resources due to imperfect info (reduce search/transaction cost)

(economy -ve) distorts consumer choice; wastage of resources (expensive advertising)

(economy -ve) firms simply pass on the costs of advertising to consumers

Evaluation:

Effectiveness is limited if other competing firms are advertising as aggressively as well, With sales and market share relatively unchanged for each firms, all the firms would have effectively wasted the resources used for advertising., But all the firms would still choose to advertise because them not doing so when others do would likely hurt them significantly (prisoners dilemma -> rationality leads to inefficient outcome)

Firms cannot just rely on advertising alone in the short-run, Advertising may gain the firm initial customers/support in the short run but if the quality of the good is not desirable, customers will switch to substitutes and by word-of-mouth & reviews, advertisement(s) by the firm will become less convincing, especially for experience goods (judgment of quality before actual consumption - trust involved), Firms need to ensure the quality of the goods/services at least matches the standards promised in the advertisement and their competitors (i.e - product innovation)

Innovation

Basis:

Imperfect Information, slows/prevent imitation, allows for a period of supernormal profits

Austrian perspective, entrepreneurs actively seeking to improve their position, possibly continue earning (more) or start earning supernormal profits

Evolutionary perspective, only react to the environment (i.e - change), only if survival is threatened

How:

invention, generation of a new idea, through R&D (uses resources)

innovation, application of invention in practical use, occurs only when entrepreneur feels it's worthwhile to commercialise

Effects:

(firm) improve the quality of the goods/services relative to competitors, increase DD for its products, DD becomes more inelastic, greater market share & revenue

(firm) lower the MC of production with more efficient/cheaper production inputs/methods, more price-competitive than rivals/competitors, earn more profits than competitors, more likely to survive a price war with rival(s) -oligopoly

(economy +ve) improvement in society's welfare, lower prices and/or higher quality goods/services, however, there will be trade-off between current and future welfare (resources channeled to R&D)

(economy -ve) might promote monopoly power (lower welfare), can be argued that bigger firms have the larger capacity to innovate, smaller firms increasingly lose out as bigger firms produce "innovative" goods and its own become outdated, small firms cannot survive => exit, in reality: reverse is true. i.e. monopoly power is eroded BECAUSE of innovation. (e.g. Pfizer and Lederle & their market share in UK market for broad spectrum antibiotics , also Glaxo's Zantac for anti-ulcer drugs)

Evaluation:

Freeman and Pavitt findings/theory, firm size vs innovative activity = inverse U-relationship, small = no capacity, medium to moderately large = innovate most, large(st) = little innovation activity, Reasons, over-introduction of "new" products may harm a monopoly's already successful product's performance (no competition, wasteful to innovate to compete with their own product), Time-cost trade-off and Fast-Second Strategy, with competition, firms innovate quickly to capture maximum profits before competitors/imitators move in, dominant firms invent actively but choose to delay the innovation phase & let the smaller firms take the risk to implement the innovation first, when small firms are successful, the dominant firm move quickly to imitate and catch-up & supplant the small firm, Example, Gillette hung back from stainless razor blade in 1950s till smaller firm came out & tested market

Patents, Fast-Second Strategy might not very applicable with intellectual property rights like patents in place

Non-cooperative Strategic Behaviour

Predatory Pricing

How it works, lower prices & increase output, drive rivals out & scare off potential entrants, raise prices once rivals exit, incur short term loss for long term gains

Effects, acquire market share, increase profits, SR: consumers enjoy lower prices, LR: consumers pay higher prices

Evaluation, Will only work if firm can survive longer with low prices (credible threat), i.e - larger firms with significant EOS (low cost), Can hurt the firm very significantly if rivals are not significantly less cost-efficient, risk involved as exact cost conditions of other firms likely to be unknown, but can infer from rough gauges like pricing history and number of outlets/production quarters, Example, 1880s-1900s: Tobacco Trust acquired 40 rivals via predatory pricing

Raising rival's cost

How it works, direct method (sabotage), British Airways vs Virgin Atlantic Airways 1993, indirect methods, raise switching costs, Internet Explorer vs. Netscape, raising prices of inputs/FOPs, i.e deliberately buying up for FOPs to hinder the rival firm in acquiring FOPs

Effects, raise costs => rival firms become less competitive and may be forced to shut down, especially so if it's dominant vs small firm, increase in market power for sabotaging firm

Evaluation, such a strategy might be too aggressive to be applicable to every/many firms, might receive consumer backlash if their actions are publicized (resulting in loss of support for product => fall in DD) -especially sabotage, raising switching costs also hurt your own firm (i.e - consumers may have wanted to switch from rival to yours), unless the firm is already the dominant firm and stands to lose more from their own consumers switching over than vice-versa, susceptible to retaliation by the rival firm & costs incurred on both sides could be large, legal/governmental regulations and implications

Conclusion/Evaluation

Firm Level

Choice of strategy depends largely on the context of the firm, Nature of product, Market Dominance/Share, Its own cost-efficiency

Can be seen that non-cooperative strategies may incur large costs even if they are successful, From a firm's perspective, it might be easier/more efficient to collude & work together, However, problem of Games Theory and behavioural economics will surface (i.e - cheating), But because of long-term interaction between firms (reiterated games), cheating can be curbed and collusion may work out, Note that collusion will likely work only in the case of an oligopoly (number of "players")

Macroeconomic Level

Many strategies employable by such imperfect competition firms are inefficient and detrimental to the economic welfare of the larger economy

Based on principle of homoeconomicus - each firm is 'selfish' and wants to maximize its own utility (profits)

And this is the reason why many countries implement anti-trust laws to regulate the behaviour/actions of such firms for the betterment of the macroeconomy