Market Structure

TYS 2023
3a)  Explain why a firm considers the level of competition in the industry when making decisions about the price and output level of its product. [10]

Introduction 

All firms are assumed to be profit-maximizing, aiming to produce at the output level where total revenue exceeds total costs by the greatest margin. However, a firm’s ability to determine price and output depends on the level of competition within the industry, which varies across different market structures. In perfect competition, firms are price takers, meaning they have no control over price and must adjust output to maximize profits. In monopolistic and oligopolistic markets, firms have some pricing power, allowing them to set prices strategically while adjusting output. Meanwhile, in a monopoly, a firm faces no direct competition, giving it full control over both price and output. As competition influences a firm’s pricing and output strategies, firms must carefully assess their market structure to make optimal decisions. 

R1: How the Level of Competition Affects a Firm’s Market Share, Output Level, and Pricing Ability (MC vs Monopoly)

To maximize profit, a firm produces where marginal cost (MC) equals marginal revenue (MR). If MC < MR, increasing output raises profits as the additional revenue from selling one more unit exceeds its production cost. Conversely, if MC > MR, producing more reduces profits, as the cost of production exceeds the revenue generated. Thus, firms adjust output to ensure MC = MR, but their ability to set price and control output depends on the level of competition in the industry.

In a monopoly, where a single firm dominates and faces no close substitutes, the firm has high market power, meaning it can restrict output and set a high price, P0, while producing at Q0. The monopolist, facing an inelastic demand curve, AR0, can charge a price significantly above marginal cost (P0 > MC), leading to higher profits but lower consumer surplus. The absence of competition allows a monopolist to dictate pricing and output, ensuring profit maximization without external pressures.

Figure: Monopoly Vs Monopolistic Competition

Conversely, in monopolistic competition, where many firms sell similar but differentiated products, competition limits pricing power. Firms face a more elastic demand curve, AR1, meaning they must offer competitive pricing to attract consumers. Like monopolists, they produce at Q1, where MC = MR, but due to competition, they must set a lower price, P1, to remain profitable. Unlike a monopolist, a firm in monopolistic competition cannot restrict output or raise prices significantly, as consumers can switch to competitors offering substitutes.

Thus, while firms in both structures produce at MC = MR, monopolists can charge higher prices and restrict output due to their market dominance, while firms in monopolistic competition must price more competitively and produce more to attract consumers.

OR

R1: How the Level of Competition Affects a Firm’s Market Share, Output Level, and Pricing Ability (PC vs Monopoly)

To maximize profit, a firm produces at the output level where marginal cost (MC) equals marginal revenue (MR). If MC < MR, the firm can increase production to raise profits, as the additional revenue from selling one more unit exceeds the additional cost of producing it. Conversely, if MC > MR, producing more would reduce profits, as the cost of production exceeds the revenue generated. Thus, firms adjust output to ensure MC = MR, but the extent to which they can set prices and control output depends on the level of competition in the industry, which differs significantly between monopoly and perfect competition. 

In a monopoly, where a single firm dominates the market with no close substitutes, the firm faces little to no competitive pressure, allowing it to set prices above marginal cost and restrict output. Since the monopolist is the only supplier, it faces a downward-sloping demand curve, AR0, meaning that it can raise prices without losing all customers. The monopolist maximizes profit by producing at Q0, where MC = MR, and charging P0, which is significantly above marginal cost (P0 > MC). 

Conversely, in perfect competition, where there are many firms producing identical products, firms have no market power and must accept the market price (P1), which is determined by industry-wide supply and demand. Since each firm is a price taker, its demand curve is perfectly elastic (AR1 = MR = P1), meaning it can sell any quantity at the market price but cannot influence price. Unlike a monopolist, a perfectly competitive firm produces at Q1, where MC = MR = P1, and price is equal to marginal cost (P1 = MC). 

Figure: Monopoly Vs Perfect Competition

Thus, while both monopolies and perfectly competitive firms produce where MC = MR, the key difference lies in pricing power and output levels. A monopolist can charge a higher price and restrict output due to its market dominance, whereas a firm in perfect competition must produce at the market price and cannot influence pricing, making competition a crucial factor in determining price and output decisions.

R2: How the Level of Competition Affects the Degree of Mutual Interdependence and a Firm’s Pricing Decision

The level of competition in an industry also affects the degree of mutual interdependence, influencing how firms adjust pricing and output levels. In an oligopoly, where a few large firms dominate the market, firms are mutually interdependent, meaning each firm’s pricing decision directly influences and is influenced by competitors’ reactions. This creates price rigidity, where firms have little incentive to change prices due to potential losses in revenue.

According to the kinked demand curve theory, an oligopolist faces a demand curve that is elastic (PED > 1) above the kink and inelastic (PED < 1) below the kink. If a firm raises its price, competitors do not follow, as they can gain market share by keeping prices unchanged. This results in a more than proportionate fall in quantity demanded, significantly reducing total revenue. Conversely, if a firm lowers its price, competitors match the price cut to maintain their market share, leading to a less than proportionate increase in quantity demanded. Since total revenue falls in both cases, firms in oligopolies avoid price changes despite fluctuations in marginal costs, resulting in sticky prices.

Due to this high degree of interdependence, firms in oligopolistic markets rely on non-price competition, such as advertising, product differentiation, and brand loyalty, to attract consumers without triggering price wars. However, in more competitive market structures like monopolistic competition, firms face weaker interdependence and greater pricing flexibility. With many firms selling similar but differentiated products, firms act independently in setting prices and frequently adjust them to remain competitive. Unlike oligopolies, these firms do not anticipate direct rival responses, making price competition more common.

Thus, the degree of competition in an industry determines whether firms maintain stable prices (as in oligopolies) or frequently adjust them (as in monopolistic competition).

 Conclusion

A firm must consider the level of competition in the industry when making pricing and output decisions, as it directly affects market share, pricing flexibility, and interdependence with competitors. In low-competition industries like monopolies, firms can set higher prices and restrict output without fear of losing consumers. In monopolistic competition, firms have some pricing power but must adjust output and pricing to attract customers. Meanwhile, in oligopolies, firms are mutually interdependent, leading to price rigidity and reliance on non-price competition. Ultimately, the degree of competition determines whether firms focus on price-setting strategies, output restrictions, or competitive adjustments to maximize profits.