Firm Output Decisions and Strategies When Barriers to Entry Are Lowered

Question

In the era of a sharing economy, technology is used to facilitate the exchange of goods or services between two or more parties, as seen in the case of Airbnb and ride-hailing services. This has lowered barriers to entry and traditional firms are facing new business risks and uncertainties. Some firms have taken the opportunity to increase their output while others have decided to close permanently.

(a) Explain what needs to be considered when a producer makes rational output decisions in view of new business risks and uncertainties. [10]

(b) Discuss different strategies that could be used by traditional firms when barriers to entry are lowered and how their actions might impact other firms and consumers. [15]

Answer

Scope note. Part (b) of this question turns on pricing and non-pricing strategies in an oligopolistic market. The economics is handled here in prose, drawing on the syllabus’s required awareness of market structure and firm strategy. No cost–revenue or limit-pricing diagram is drawn: the 9570 revision removed firm/market-structure equilibrium diagrams from assessment, so the strategic reasoning is presented verbally rather than diagrammatically.

Part (a) [10]

A rational producer chooses output to maximise profit, weighing the marginal benefit and marginal cost of producing each additional unit. Under new business risks and uncertainties, the considerations that shape that decision are the producer’s costs, revenues and expectations.

Costs. A producer weighs both the explicit and implicit costs of production — the monetary outlays on inputs, and the opportunity cost of the resources committed. Where a sharing-economy entrant lowers the market price, a traditional producer must judge whether the price still covers its variable costs; if not, continuing to produce raises losses, and shutting down may be the rational choice.

Revenues and demand. The producer considers the expected revenue from its output, which depends on the demand it faces. Lowered barriers to entry raise the number of competitors and the availability of substitutes, making the firm’s demand more price-elastic and reducing its market share — both of which the producer must factor into its output choice.

Expectations under uncertainty. Because the new entrants make future demand and prices uncertain, the producer’s decision depends on its expectations. A firm optimistic about retaining demand may raise output to capture scale; a firm pessimistic about its competitive position, anticipating sustained losses, may cut output or close. The same external shock therefore rationally produces opposite output decisions across firms, as the preamble observes.

Part (b) [15]

When barriers to entry are lowered, traditional firms — typically operating in competitive oligopolistic markets — can defend their position through pricing strategies (limit pricing) or non-pricing strategies (product differentiation). The stand of this essay is that differentiation is the more effective strategy, and that consumers gain in the short run but may lose in the long run.

Pricing strategy — limit pricing. With entry easier, an incumbent may engage in limit pricing: setting price below the profit-maximising level — below the average cost of potential entrants — so that the profit available to a new firm is too low to justify entry. The incumbent sacrifices some profit in exchange for deterring entrants and preserving market share.

Impact on other firms. Potential entrants face lower attainable profits and are less willing and able to enter. Existing rivals, facing price rigidity in a competitive oligopoly, are pressured to match the lower price, reducing all incumbents’ total profits.

Impact on consumers. Consumers pay a lower average price for the same goods, so consumer surplus rises.

Non-pricing strategy — product differentiation. Alternatively, a firm can use non-pricing strategies, differentiating its product. Artificial differentiation through marketing and advertising shifts consumers’ tastes towards the firm’s product, raising its demand and making it less price-elastic; real differentiation through R&D makes the product genuinely distinct, reducing substitutability and again raising and steepening demand. Either way the firm defends or grows its market share.

Impact on other firms. Differentiation raises rivals’ costs of competing and so raises effective barriers to entry; other firms see their demand, revenue and profits fall.

Impact on consumers. Real differentiation and innovation give consumers greater variety and quality, raising consumer welfare.

Judgement. Among the strategies, differentiation is the more effective. Limit pricing is purely defensive — it can only deter entrants, never raise profit — and in a climate of uncertainty, deliberately underpricing risks triggering retaliation and pushing the firm towards shutdown. Differentiation, by contrast, can raise profit if the firm successfully aligns its product with consumer preferences, and amid pervasive uncertainty rivals may not match it, handing the differentiating firm a durable edge. Between the affected parties, consumers benefit in the short run — lower prices from limit pricing, more variety from differentiation — but may lose in the long run: sustained limit pricing erodes revenue while differentiation raises costs, so in a competitive oligopoly some firms exit and shut down permanently. As the surviving firms’ market share and price-setting power grow, variety falls and prices rise, reducing consumer surplus. The net effect on consumers therefore depends decisively on the time horizon.