The importance of entry and to deter entry in case of firms in different market structures - Essay Example

?Thesis ment: The importance of entry and to deter entry in case of firms in different market structures. Introduction The word “competitive” means ‘not monopolies’. A market structure that does fails to satisfy the postulations of perfect competition is regarded as the market of imperfect competition. This type of market does not operate under the guidelines of perfect competition. In this type of market structure a firm has the potential to impact upon the prices (Kitchener, 2001, p. 3). In spite the products being close substitutes, they can be differentiated and advertising and branding plays a major role in this type of market structure. A large number of sellers participate in the market (Economics, n.d.). The market structure is characterized by freedom of entry and exit. Monopolistic competition along with oligopoly constitutes the structure of imperfect competition. Firms that are imperfectly competitive offer many products (Krcilkova, n.d. p. 1). The products are offered at administered prices. The price changes are costly and slower. The prime prediction of the theory of monopolistic competition is that firms will produce at the level where marginal cost equals marginal revenue in the short run. However in the long run, the firms will operate at zero profit levels and the demand curve will be tangential to the average total cost curve (Central Washington University, 2003). Importance of entry barriers The first thing that a firm needs is to enter a market of competition. Barriers to entry exist in almost every type of competition except in cases of cartel. One needs to account for the barriers to entry while examining the dominance of a firm as well as in determining whether some kind of conduct from the part of the firm can deter entry for other firms from participating in the market. It is also necessary in assessing the competitive effects of the mergers. Suppose a merger is inclined to increase concentration to a certain point where the agencies of the competition are actually involved about the effects of anti competitive policies. In such cases the barriers to entry matters greatly as competition will not get hampered if there is easy access for the firms to enter in the market. It is also important to establish barriers to entry as it is necessary to prove that in monopoly a firm enjoying a high percentage of market shares can translate it into market power (ORGANISATION FOR ECONOMIC CO-OPERATION AND DEVELOPMENT, 2007, p. 1). Both Walmart and Loblaw are engaged in same type of business activities. They will engage themselves in activities that will prevent entry of competitors. If the two competitors compete between themselves they will end up in creating barriers that will not enable themselves to diversify their business. In fact this will not be desirable outcome from the firms’ point of view and consumers’ welfare will get affected (Carlton, 2005, p.9). Strategies used by firms to deter entry The incumbent firm can involve itself in three types of strategies to deter entry. They are: Limit Pricing, Predatory pricing and capacity expansion. The strategy of limit pricing is illegal in many countries. A limit price is a strategy mainly used by the monopolists to deter entry. They used to set a price that would be faced by the entrant on entry into the market until the existing firm did not act to decrease the output. The limit price is generally set at a level which is less than the average cost of production. It can also be set at the level where entry is just not profitable. This discourages the new entrants (Roberts and Milgrom, 1982, p. 444). The second strategy is used by the incumbent by charging a price that is low relative to the price of the other products before the entry takes place. Often it appears that other firms who initially were not in the market of a certain product express their opinion to enter the market. It is the price of the product that influences their decisions. The already existing firms in the market can discourage the new entrants by charging a low price for the products. Thus the potential entrants can be ignored and their consumer base will not be affected. If the potential entrants find it unsustainable to continue to operate in the market, they tend to move out of the business which provides a wider consumer base for the existing firms. Then the incumbent can raise the prices of the product and exploit the market power (ORGANISATION FOR ECONOMIC CO-OPERATION AND DEVELOPMENT, 1989, p. 7). When a potential entrant has complete information about the already existing firms then the strategy of excess capacity comes into the picture. The incumbent can easily flood the market by increasing output. Walmart can decrease the price of the offered products at such a level which make impossible for Loblaw to reach. Therefore, Walmart can enjoy market power and will be able to set the price according to their wish. Any of the competitors can set the price at a level that will not allow the other to enter in the market for that product. They can advertise their brands which can drive consumers to their shops. Branding and advertisement are the two most successful measures to promote business. They can also offer some discounts on particular products (Indira Gandhi National Open University, n.d., p. 2). Economics of product differentiation and its role in competition Two or more products that essentially satisfy the needs of the consumers with slight difference are known as product differentiation. The similar products serve the same purpose of the consumers. Product differentiation is the characteristic of monopolistic competition. In the case of Walmart and Loblaw, both firms are engaged in retail business. So they offer almost the same type of product. Except discounts and product variety, the other measure that can be used by the competitors is product differentiation. The same type of product can be served just by changing the taste slightly (HOLCOMBE, 2009, p. 17). Suppose a firm provides a soft drink. The purpose of the product is same. In order to attract they can just change the packaging system or the taste slightly. Service services also fall in the category of product differentiation. One store can serve the customers with smile while the other just performs the duties. Suppose one of the firms sells shoes of a brand. Customers can afford the shoe from any store, but the store under consideration can keep a different shelf for the shoes according to sizes which will help the customers to find out the correct size. The advantages of product differentiation have been recognized by the neoclassical economists. They are of the opinion that a market characterized by product differentiation does not produce at the lowest point of the average cost curve. However a trade off exists between variety and higher costs. Bertrand Model The assumptions are as follows: The market comprises of two firms-Walmart and Loblaw. Goods are homogeneous and the products satisfy the condition of being perfect substitutes. The firms can set the prices simultaneously and each firm has the marginal cost as constant. The participating firms will set the prices equal to the marginal cost. In other words they will set the prices according to the competitive outcome. The model delivers that the two firms will try to achieve the perfect competitive outcome. Suppose Walmart believes Loblaw would choose a price that will be over and above the price of the monopoly. In that case the best response of Walmart will be to set the price at the price level of the monopoly since profit will be maximized at that point and Loblaw will be driven out of the market. Therefore no firm will be engaged in setting the price above the price that of the monopolist. In equilibrium both Walmart and Loblaw will set the same prices (Machado, n.d.). Now suppose Loblaw sets the price above the price of the monopolist. In this case the best response of Walmart will realize that if it can set the price at lower level it would be able to capture the market as the goods satisfies the second assumption. Therefore the price of the product of Walmart will be price of the monopolist plus the constant factor. If the prices are not in equilibrium both the firms will find it wise to undercut competition and capture the whole market. It must reduce the price level in the process. It will not be possible to attain the equilibrium in that case as in the marginal cost the participating firms will have no incentive to deviate from the price level existing in the equilibrium. The model assumes that one shot game represents a pricing game and this situation is hard to arrive at in the life term of a certain firm. Now suppose each of the participating firms have capacity constraint in the way that even if the demand for the product start to rise, they firms will not be able to match the demand. Again it is assumed that the marginal cost is zero and this provides the researchers to emphasize the decisions on pricing ignoring the marginal gain in profits (Southern Methodist University, n.d.). Cournot Model In the Cournot competition, the participating firms have the potential to choose the optimal quantity simultaneously and not the prices. The assumptions are more or less same as the Bertrand model. Two firms Walmart and Loblaw are taken who produce homogeneous product and choose the optimal quantity to produce simultaneously. The marginal cost is same for both the firms (Crampton, n.d., p. 2). Suppose the output of each of the firm be qi. The price is the dependant of the choices of both the participating firms. The model implies that the choice of one of the firms will affect the choice of the other and ultimately the prices existing in the market will get affected. The residual can be easily derived from the model. The firms will take the residual demand in consideration and each firm will make their choices acting as a monopolist with the motive to maximize their profits. They will set the marginal revenue and marginal cost same. Suppose Walmart decides to sell nothing and then the best thing that will be affordable for Loblaw is to sell at monopoly quantity. Again, if Loblaw decides to produce at the competitive level then the best possible thing for Walmart is to sell nothing (Vanderbilt University, n.d., p. 3). If the choices of the participating firms are plotted a reaction function is derived. The reaction function for the Bertrand model is upward sloping while it is downward sloping for Cournot model. In the Cournot model, greater the degree of the competition among the competitors, the smaller will be the degree of the residual demand. The use of either of the models depends on the adjustment process of the firms on quantity or on prices. If Walmart or Loblaw finds it easier to adjust the quantity to sell, the Bertrand model has the potential to better describe the situation or the strategic choices as decision on the quantity is an immediate consequent of the choices of pricing. The participating firms can also choose the choices sequentially. In such cases it is necessary to merge the models. It may be the case that the capacity and the decision on the pricing are separate. The decision on pricing can be more binding constraint. Then the process of modeling will involve a two staged game where the firms have the potential to work out on the long run decisions before the decisions on the short run. Conclusion If the already existing firms have been able to achieve a strong foothold it is harder for the new potential new entrants to enter into the market. The resources belonging to the incumbent cannot be diverted and the monopolist will erect barriers to entry for the entrants. But monopolies can emerge as the best outcome for some industries where there are substantial economies of scale. Reference ORGANISATION FOR ECONOMIC CO-OPERATION AND DEVELOPMENT, 2007, Competition and Barriers to Entry. [pdf]. Available at: http://www.oecd.org/dataoecd/9/59/37921908.pdf. [Accessed:24th APril, 2012]. Krcilkova, M. n.d. Perfect competition II. Monopolistic competition. [pdf]. 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