Discuss the extent to which firms faced by high levels of competition are more vulnerable to closure in a recession than firms in less competitive industries. [15]
Intro
Firms facing high levels of competition: PC, MC, non-collusive Oligopoly
Firms facing low levels of competition: Collusive Oligopoly, Monopoly
When a firm is more vulnerable to closure, it is more likely to attain the shut down conditions of P<AVC in the short run and P<AC in the long run.
Body
- During a recession, the average consumer's income will fall.
- Due to the decreased purchasing power of the consumer, it makes him less willing and able to purchase normal goods (YED>0). This causes the demand for normal goods to fall.
- However, a recession would increase the willingness of consumers to purchase inferior goods (YED<0), hence the demand for inferior goods will increase.
- In this scenario, a firm which sells inferior goods, such as home-brand products, will face a rightward shift in its AR Curve, regardless of the level of competition it faces.
- The output produced by the firm will increase and the price paid for by the consumer will increase as well.
- More competitive firms who initially earn normal profits will now reap supernormal profits, while less competitive firms continue to retain their supernormal profits in the long run.
- However, should a firm sell normal goods, it will result in a leftward shift of its AR curve, as shown in Figure 1 below.
- For firms facing a higher level of competition, the profit-maximizing output level (MC=MR) will fall from Q0 to Q1, and the price will fall as well. In the short run, the resulting price is lower than SRAC. If P remains below AC in the long run, the firm will shut down.
- On the other hand, for firms facing a lower level of competition, they initially earn supernormal profits in the long run. When the demand for their good decreases, their AR curve will shift leftwards, as illustrated, as illustrated on Figure 2 below. If AR0 shifts to AR1, the resulting price P1 is equal to AC1, the new average cost at the new profit maximizing level of output. The firm will not shut down as it is making normal profits in the long run.
However, should the AR curve shift leftwards by a larger extent than AR1, the firm will definitely make subnormal profits and shut down in the long run. Therefore, for firms facing a lower level of competition, it depends on the extent of fall in demand to determine if they will shut down. Because there is a possibility for firms facing lower competition to not shut down when faced with a fall in demand, they are less vulnerable to closure.
[Fig 1: Rev/Cost/Price Diagram for imperfect market. After leftward shift of AR/MR, P<AC.]
[Fig 2: Rev/Cost/Price Diagram for imperfect market. After leftward shift of AR/MR, P=AC. That means AR1=MR0, AC1=P1.]
- To determine a firm's vulnerability to closure, we can also consider its ability and incentive to innovate.
- Assuming that they produce normal goods and face a fall in demand, engaging in innovation will allows firms to lessen the impact of the fall in demand, or even increase the demand of the normal good.
- PC firms produce homogeneous products and have perfect information. Should they engage in innovation, other PC firms will follow suit as they have the same information on innovation. Thus, PC firms have no incentive to innovate.
- Also, because there are many sellers in a PC industry, super normal profits earned in the short run will be eroded away in the long run when new firms enter and capture a portion of the market share. Ultimately, PC firms can only earn normal profits in the long run, making them unable to engage in innovation, which is costly and unaffordable.
- While MC firms produce differentiated products and have the incentive to make their product more distinctive to increase demand or make the demand more price inelastic, it can only earn normal profits in the long run, and thus only has a low ability to innovate.
- We can then conclude that firms facing higher levels of competition are relatively unable to cushion the fall in demand to increase revenue.
- However, for oligopolies, they are competing with several other dominant firms and hence will seek to capture a larger proportion of the total market share. This provides them with the incentive to innovate.
- Considering that an oligopoly has high entry barriers, there will not be sufficient new firms entering the market to erode the supernormal profits reaped by the oligopolist, in the long run. This gives the oligopolist the ability to engage in innovation as it can bear the high costs of product differentiation.
- Likewise, for monopolies, they may engage in innovation if they feel that their dominant position is being threatened by a potential entrant.
- Also, because they capture the entire market share, they can earn supernormal profits in the long run and thus have sufficient capital to engage in innovation.
- Clearly, firms facing lesser competition have the incentive and ability to innovate, making them more able to improve their products and increase the demand for their products, which will drive the price up. Therefore, they are less vulnerable to closure than firms faced with higher competition.
- We can also consider the size of the firms to determine if they are in a good position to reap internal economies of scale (iEOS).
- For MC and PC firms, they tend to be small and will not capture a large portion of the total market share. On the other hand, oligopolies and monopolies are dominant firms in their industries and they produce a very significant portion of the total market supply.
- Here, we can see that less competitive firms tend to be larger and thus, are in a better position to enjoy iEOS.
- For example, they can reap financial economies. Larger firms have more valuable assets to offer collateral, and in the event that they default the bank loan, the bank can take the collateral as payment. This deems larger firms as low-risk borrowers and the bank will be more willing to offer them loans at lower interest rates, thereby decreasing their cost of borrowing. This puts less competitive firms in a better position to lower their LRAC, making them less likely to meet the long-run shut down condition of P<AC, as compared to smaller firms, who are less able to reap significant cost advantages.
- Hence, firms facing lower levels of competition are less vulnerable to closure than firms facing higher competition.
Anti-thesis
- However, we have to consider the possibility that firms facing lower competition may suffer from increased average costs due to x-inefficiency.
- This is especially so for monopolies. As they are the sole seller in the industry, they may feel that there is no threat of competition.
- Also, because they reap supernormal profits in the long run, they feel that their market share will not be eroded. As a result, they become complacent and have a lax in cost control. At the profit maximizing output level of Q0 on Figure 3, the firm is supposed to incur a LRAC of AC0, but they end up incurring a higher than necessary cost of AC1 instead.
- The firm thus suffers from x-inefficiency as it does not produce on the LRAC, causing them to suffer from productive inefficiency.
[Fig 3: Regular x-inefficiency diagram]
- In the above scenario, the less competitive firm will only shut down if the LRAC increases significantly, to the point that it is higher than P0.
While a firm can be complacent, it is unlikely that it will be so lax on cost- controls to the point that they need to shut down in the long run.
Conclusion
- Considering that more competitive firms are in a worse position than less competitive firms to increase the demand for their product or to lessen the impact of the fall in AR, they will be more likely to reach the shutdown conditions of P<AC.
- Also, because they are less able to reduce LRAC, it makes them more vulnerable to closure during a recession.
- The only way that less competitive firms are more more likely to shut down during a recession is that PC and MC firms produce inferior goods and the oligopolies and monopolies produce normal goods.
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