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2009 ACJG Prelim Exam Econ H2 Essav Question 2 Firms' pricing and output decisions are primarily determined by their cost conditions. Gomment. t25l lntroduction Most firms seek to profit maximize. The profit maximizing output is attained at the output level where marginal revenue (MR) and marginal cost (MC) meets. (i.e. MR=MC) A firm's cost conditions (i.e. MC) determine a firm's pricing and output decisions. Bodv Thesis: Explain how a firm's cost conditions determines its price and output a) A firm's marginal cost curve determines its price and output CosUrevenu At the profit maximizing output, price is determined by the AR curve. A larger firm enjoys internal EOS and hence has a lower MC curve than a smaller firm. Figure 1 shows that a larger firm produces at a higher output and lower price than a smaller firm. (i.e. P,>Pr-, Q,_>Q.) The larger firm with substantial cost savings may pass on the savings to consumers in the form of a lower price. This shows that a larger firm with lower MC curve can afford to charge a price that is lower than that of a smaller firm. Anti-thesis: Explain how there are other factors (i.e. demand conditions) that determine a firm's pricing and output decisions. Strength of market power determines the level and steepness of the demand curve of the firm The higher the barriers to entry, the fewer number of firms in the industry, the more market power a firm has and the higher and more price inelastic is the demand curve. A higher and steeper demand curve enables firms to charge a higher price. Cost /revenue Qe Qa 1.L

2009 ACJC Prelim Qns 2

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Page 1: 2009 ACJC Prelim Qns 2

2009 ACJG Prelim Exam Econ H2 Essav Question 2Firms' pricing and output decisions are primarily determined by their cost conditions. Gomment.t25l

lntroductionMost firms seek to profit maximize. The profit maximizing output is attained at the output level wheremarginal revenue (MR) and marginal cost (MC) meets. (i.e. MR=MC) A firm's cost conditions (i.e. MC)determine a firm's pricing and output decisions.

Bodv

Thesis: Explain how a firm's cost conditions determines its price and outputa) A firm's marginal cost curve determines its price and output

CosUrevenu

At the profit maximizing output, price is determined by the AR curve.

A larger firm enjoys internal EOS and hence has a lower MC curve than a smaller firm. Figure 1 showsthat a larger firm produces at a higher output and lower price than a smaller firm. (i.e. P,>Pr-, Q,_>Q.) Thelarger firm with substantial cost savings may pass on the savings to consumers in the form of a lowerprice. This shows that a larger firm with lower MC curve can afford to charge a price that is lower thanthat of a smaller firm.

Anti-thesis: Explain how there are other factors (i.e. demand conditions) that determine a firm's pricingand output decisions.

Strength of market power determines the level and steepness of the demand curve of the firm

The higher the barriers to entry, the fewer number of firms in the industry, the more market power a firmhas and the higher and more price inelastic is the demand curve. A higher and steeper demand curveenables firms to charge a higher price.

Cost/revenue

Qe Qa

1.L

Page 2: 2009 ACJC Prelim Qns 2

The demand curve of a larger firm (i.e. firm A) with higher market power is relatively higher and moreprice inelastic than that of a smaller firm (i.e. firm B) with lower market power. At the profit-maximizingoutput (i.e. MR=MC), the firm A is able to charge a price higher (i.e. Ps>P6) and an output higher (i.e.Qn>Qe) than firm B. (Assuming that the MC of both firms is the same.)

a) Price discriminationA firm may choose to price its products to maximize profits by practicing price discrimination ratherthan determine the price by its cost conditions.

A firm must meet certain conditions before they can price discriminate. Separable market. Different price elasticities of demand between markets. Resale of product is not possible

b) Price collusionFirms (i.e. oligopolies) may decide to collude and behave as a collective monopoly. When firmsdecide to act like a monopoly, they enjoy a higher market power and hence their demand curve ismore price inelastic.

, c) lnterdependence between firms in pricing decisions+ When a firm reduces its price, rivals are likely to follow to prevent a fall in their market power. When afirm raises its price, rivals are unlikely to follow as they gain in market power. This usually occurs inmarkets where firms sell products, which are close substitutes of each other.

d) Predatory pricing in the short runFirms in an attempt to capture a larger market share may decide to charge a price lower than its costprice to drive out other competitors in the short run.

e) Dumping in overseas market: Firms with excess capacity may sell these surpluses in overseasmarket at a price lower than marginal cost or unit cost in home country.

f) Government regulation: Government may impose pricing regulation on firms to protect theinterest of consumers. Some pricing regulations include marginal cost (MC) and average cost(AC) pricing

g) Alternative objectives of firms: Sales revenue maximization and Satisfactory performance setby firms

ConclusionWhen a firm's cost conditions change, firm usually react to the cost changes by changing its price.However, cost conditions are not primarily the reason that determines a firm's pricing and outputdecisions.

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