Competition and Vulnerability to Closure in a Recession

Question

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]

Answer

Thesis. This essay argues that, to a large extent, firms in highly competitive industries are more vulnerable to closure in a recession than firms in less competitive ones — though the verdict turns on the cost structure of the firm rather than on competition alone, and several countervailing forces qualify it.

A firm’s closure decision is governed by its shut-down conditions: in the short run it suspends production when total revenue falls below total variable cost ($TR < TVC$), and in the long run it exits when total revenue falls below total cost. A recession lowers national income and so threatens revenue across the board; the question is whose revenue falls furthest relative to their unavoidable costs.

Higher costs under intense competition. Firms facing high levels of competition operate in industries with low barriers to entry and many small rivals, so each produces a small output and reaps only limited economies of scale. Unable to operate at minimum efficient scale, their average cost is, ceteris paribus, higher than that of larger firms in less competitive industries. A given fall in revenue is therefore more likely to push total revenue below total variable cost, triggering short-run shut-down.

Thin profit margins. Low barriers to entry also mean these firms cannot sustain supernormal profit in the long run: any short-run supernormal profit attracts entry, which competes profit back down to normal. Operating on only normal profit, a highly competitive firm has no buffer, so a recessionary fall in demand can readily tip it into subnormal profit and, if revenue falls below variable cost, closure. A firm in a less competitive industry, protected by high barriers and earning supernormal profit, has a cushion to absorb the same shock.

Counter-argument — the income elasticity of what is produced. The relationship is not uniform, because what a firm sells matters as much as how competitive its market is. Highly competitive industries (such as hawker food) often supply necessities or income-inelastic goods, and some are inferior goods with negative income elasticity of demand; less competitive industries (such as a premium restaurant chain) more often supply income-elastic luxuries. In a recession, falling household disposable income raises demand for inferior goods while sharply cutting demand for luxuries. On this channel the revenue of competitive firms can rise even as that of less competitive firms falls — making the latter more, not less, vulnerable. The example of hawker centres versus a high-end chain captures the tension.

Evaluation and judgement. Weighing these forces, highly competitive firms are more vulnerable to a large extent, for two reasons rooted in cost structure rather than demand. First, short-run shut-down depends only on variable cost and revenue. Firms in less competitive industries typically carry large fixed costs and proportionally smaller variable costs, so their revenue rarely falls below variable cost; highly competitive firms, with little fixed cost, have most of their costs as variable, leaving them far closer to the short-run shut-down threshold. Second, less competitive firms are often arms of larger multinationals with operations across geographies, so subnormal profit in one recession-hit market can be offset by profits elsewhere — an option unavailable to a small, single-market competitor.

The income-elasticity counter-argument is real but partial: it depends on the specific goods involved and bears on revenue, whereas the decisive shut-down test is revenue against variable cost, where the competitive firm’s cost structure leaves it most exposed. The reasoned verdict is therefore that firms in highly competitive industries are more vulnerable to closure in a recession to a large extent, with the qualification that the conclusion can reverse for competitive firms selling strongly inferior goods whose demand rises as incomes fall.