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Discuss the relative significance of input cost, consumer incomes and market concentration in influencing firms’ pricing decisions in your country. [25]

Introduction
Firms in most industries in Singapore face an imperfect market condition and the pricing behaviours are usually based on the notion of profit maximization. However, such pricing behaviours are affected by many variables, such as those mentioned in this question, which are the input cost, consumer incomes and market concentration ratio.

Main body

1. Explain what is meant by an imperfect market condition

In the imperfect market structure, the firms are under the conditions where there is imperfect market information about price and production condition and immobility of resources where some firms may not be able to access certain resources. In this imperfect market condition, the firms in the respective types of industries will be classified as the monopolistic competitive, oligopolistic or monopolistic market structure where the forms of market structure is classified based on the number of firms in the industry, the nature of the product, the degree of barriers to entry to the industry. The characteristics of the market structure will affect the nature of competition and pricing behavior. As the firms in the imperfect market structures have some form of market power, their demand curve (marginal revenue and average revenue) will be downward sloping, indicating that these firms are price-setters.

2. Explain what is meant by profit maximization

All the firms in the three types of market structures will abide to the notion of profit maximisation to determine the price and output level unless it is regulated by the government or the firms have other aims in mind. Thus, the firms will abide to the notion of profit maximization in setting price and output which is at the level of output where marginal revenue (MR) is equal to the marginal cost (MC) as the firm will increase production when MR is greater than MC since additional net profit is attained or decrease production when MR is less than MC where additional loss is incurred, implying the production equilibrium is attained when the marginal revenue is equal to marginal cost and there is maximization of net profit.

Economics Tuition - Economicsfocus - Market Structure - Diagram 1

As seen from the diagram, it can be observed that MR and AR are downward-sloping while MC is upward-sloping as there is high rate of utilization of resources. The production equilibrium is set at the quantity level Q0 while the price level is at P0.

3. Explain how input cost will affect pricing decision of firms

At this production level, the firm’s pricing decision is attained and it is influenced by the factors stated in the requirement of the question. The input cost, in terms of variable and fixed costs will affect the pricing decision differently. The rise in variable input cost will lead to an increase in the marginal cost and this will cause a rise in the price and a fall in quantity as production equilibrium based on profit maximization level will be attained at the lower level of quantity of production. As for the fixed input cost, it will only raise the average cost and this will not affect the production equilibrium as the average fixed cost will not cause a change in the marginal cost. Thus, the price and output decision remains the same level but the level of profit for the firms will decrease.

4. Explain how income level will affect pricing decision of firms

As for the rise in income level, it will affect the marginal and average revenue as it raises the purchasing power of the consumers but it will depend on whether it is a normal or inferior good. For normal goods which are goods that occupy a large proportion of income spent on the goods, the rise in income will lead to a rightward shift of the MR and AR and this will cause the price to rise as the production equilibrium where MR is equal to MC is set at a level higher than the original level. As for inferior goods, which are goods that occupy a small proportion of income spent on the goods, the rise in income will lead to a leftward shift of the MR and AR and this will cause the price to fall as the production equilibrium where MR is equal to MC is set at a level lower than the original production level.

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5. Explain how market concentration ratio will affect pricing decisions of firms

Lastly, the market concentration ratio will reflect the size of market share of the firms and this will determine the types of market structure the firm is operating in. It will also reflect the degree of barriers to entry which will influence the degree of market power possessed by the firms. By virtue of the degree of market power, the slope of the MR and AR will be shaped to be price-elastic or price-inelastic and this will determine whether the firm can set higher or lower price level.

6. Explain how market concentration ratio affects firms in the monopolistic competitive market

For the firms with low market concentration ratio as in the monopolistic competitive market, the firm will have lower barriers to entry which shapes it to have lower market share. The MR and AR will be price-elastic and this will influence the production equilibrium based on profit maximization to set at a lower price level and the quantity to be at a higher level. As for market with high concentration ratio, the firms will have higher degree of market power as there is high barrier to entry and this will shape MR and AR to be price-inelastic as seen in monopolistic and oligopolistic forms of market structures. Consequently, price level will be high while the output level is low.

7. Explain how pricing decisions are determined for firms in the oligopolistic market structure based on high market concentration ratio

However, firms in the oligopolistic market structure will be affected in other ways too. For those firms which are collusive, the firms may set their price as close as the price set by the industry based on barometric structure, price leadership or others to reduce market unpredictability so as to raise market power to conduct consumer exploitation. As for the non-collusive oligopolistic firms, they will experience price rigidity due to the high degree of mutual interdependency where price is set high but the firms will not adjust independently as there is no given advantage to raise or lower price.

8. Evaluate the significance of the variables stated in the question

Given all these understanding of the pricing behavior under the influence of the factors stated, the market concentration ratio is more significant in influencing the pricing decision. The income and input cost have a similar impact on the pricing decision of the firms in different types of market structures but the market concentration ratio will be a key influence on how the market structure is formed. This implies that the knowledge of the influence of the market concentration ratio in determine pricing decision is imperative.

Conclusion
In sum, the identified factors of influence will be significant when the firms based their pricing decision on the notion of profit maximization but these factors will not be as influential under the circumstances when the firms operates under the regulation of the government or decides to set price level based on other aims of the firm.

Simon Ng

Founder, JC Economics & General Paper Tutor at Economics Focus
JC Economics Tutor Simon Ng of Economics Focus has been teaching A Level Economics and A Level General Paper since 2003. Simon set up Economics Focus to assist students in their pursuit of academic excellence at the examination by providing economics tuition for H1 and H2 students. JC1 and JC2 students are inspired by Simon's clear teaching methods that enabled them to comprehend economics terms and concepts. Simon developed the Rational Thinking methodology to aid students to excel in their JC economics essays and CSQs.