Discuss the effects on firms of cutting prices in an oligopolistic market

Edexcel A-Level Economics Paper 3 June 2019 Extract

In Extract A, lines 15–16, it was suggested that some firms may respond to the advertising ban by cutting the prices of their products.

Using game theory and the information provided in Figure 1 and Extract A, discuss the effects on firms of cutting prices in an oligopolistic market.

Paragraph 1

1. one effect of cutting prices is that it would start a price war
2. firms are interdependent
3. this means that when one firm sees another firm cutting prices,
4. they would also reduce prices to avoid losing market share.
5. for example, the payoff matrix shows that if one firm sets a high price whilst the other firm sets a low price, they make a very low amount of profit.

Evaluation

1. however, a price war is not rational in an oligopolistic market
2. the firm who lowers prices first gains only a small amount of revenue
3. after all firms lower prices, all firms make less supernormal profits.

Paragraph 2

1. another impact of firms cutting prices is that lower prices increase barriers to entry.
2. some of the existing firms may make a loss if they have to lower prices to maintain market share.
3. this means they have to shut down, especially if average costs are higher than average revenue in the long-run.
4. this means firms like Walkers and KP have increased monopoly power, and they have the power to charge higher prices.
5. Figure 1 mentions that Walkers has a market share of 55.3%.
6. they can also increase output and exploit economies of scale, making it even harder or other firms to compete.

Evaluation

1. however, lower prices and the advertising ban may make it easier for smaller firms to grow and increase market share.
2. for example, firms like Walkers would not be banned from advertising so customers are forced to look around at all the options.
3. firms would rely on other forms of non-price competition such as taste or customer service.
4. Extract A Line 11 questions 'how firms in the market adapt their behaviour in response to the ban'.
5. this allows other firms to grow, even if they have a small advertising budget.

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