HCI 2022 Econs Suggested Essay Answers (students) updated

Suggested Answers to A Level 2022 H2 Economics (ESSAYS) by Hwa Chong Institution Economics Unit Question 1 Economists usually begin their analysis of decision-making by firms by assuming that the objective of a firm is to maximise its profit. In reality, however, there are many different objectives that a firm might adopt. (a) Explain the likely effects on a firm’s price and output when its objective changes from profit maximisation to profit satisficing. [10] (b) Discuss the most appropriate strategy that a firm could adopt if its objective was to reduce the competition that it faces. [15] Part (a) Introduction Firms are assumed to be profit-maximisers and they will set their price and output according to the profit-maximising condition where MR=MC. However, objectives may change depending on various factors like the contestability of the industry and dynamic economic conditions. A firm may also decide to focus on other objectives such as maximise its sales volume in order to gain market share and as an entry deterrence strategy. R1: Explain why profit maximization requires MC = MR using a price setting diagram In the diagram above, the firm would choose to maximise profits by producing where MR=MC, producing at Qe and pricing at Pe. If the firm produces below Qe, say at Q1 and prices at P1 where MR>MC, the additional revenue gained would be the area ABQeQ1 while the additional cost would be CBQeQ1. Since ABQeQ1>CBQeQ1, a rational firm would be able to gain additional profit by increasing production and moving closer to Qe and Pe. If the firm produces above Qe, say at Q2 and prices at P2 where MR<MC, the additional revenue gained would be the area BEQ2Qe while the additional cost would be BDQ2Qe. Since BEQ2Qe<BDQ2Qe, a rational firm would be able to gain additional profit by decreasing production and moving closer to Qe and Pe. Price/Revenue/Cost ($) MC P1 Pe P2 A B D AR C E MR Qe Output Q1 Q2 0

Suggested Answers to A Level 2022 H2 Economics (ESSAYS) by Hwa Chong Institution Economics Unit R2: Explain why profit satisficing often leads to a lower price and higher output A profit satisficing firm is satisfied with a level of profits as the firm seeks to attain other objectives such as sales volume maximisation or revenue maximisation. A firm seeking a sales volume maximisation strategy would produce as much as it can but it would not go beyond the breakeven output and price of Qv and Pv respectively. At Qv and Pv, TR=TC at PvAQv0. This means that the firm is achieving at least normal profits and is thus able to remain in the industry while at the same time maximising its sales volume. Hence, as a firm changes from a profit maximising strategy to a sales volume maximisation strategy, Pv is larger than Pe and Qv is greater than Qe. However, the firm may revert to the profit maximising price and quantity, Pe and Qe respectively, to maximise profits once higher market share is attained and its demand becomes more price inelastic with greater market power. Mark scheme To score L3 your need to address the two requirements: ● Explain the impact on price and output when a firm profit maximises using the marginalist principle ● Explain how the impact on price and output differs when a firm focuses on another objective other than profit maxisiation. Part (b) Introduction: As analysed in part (a), a firm need not to always choose to profit maximise, and in this instance the focus of an incumbent firm may be to reduce the contestability of a market so as to increase its market share, potentially earning higher profits in the long run. Both price and non-price strategies can be used to reduce competition. Price competition such as limit pricing could be used to deter potential entrants while predatory pricing could be used to drive out existing competitors. Non-price strategies seek to win over consumers from competitors and establish brand loyalty. This essay will discuss the most appropriate strategy a firm could adopt to reduce competition. R1: Pricing strategy to reduce competition (A) Limit pricing: Similar to the profit satisficing diagram in part a, a firm could choose to deliberately charge a price that is lower than its profit maximizing price. Limit pricing is designed to prevent new firms from entering the market rather than by forcing the existing firms out. This strategy involves charging a price that may be only a little above its average cost but could be lower than the estimated average cost of the potential rivals. It is therefore a way of creating an artificial entry barrier. Price/Revenue/Cost ($) MC Pe AC Pv A AR MR Qe Output Qv 0

Suggested Answers to A Level 2022 H2 Economics (ESSAYS) by Hwa Chong Institution Economics Unit From Fig 1 on limit pricing, the firm may decide to sacrifice some short term profits by pricing lower at P2 and selling a higher output (this increases its market share). Total profit is lower - shown by P2BFC2. This new low price P2 is below the estimated average cost of the potential rival firm, and assuming that firms in the market sell at the same price, then the potential rival firm may face the risk of big losses if it enters the market. Ev1A: Limit pricing may not be able to reduce competition due to government intervention Limit pricing is usually deemed as anti-competitive strategy and given that most governments have set up anti-trust laws that prevent the formation of monopolies, there is a possibility the government might step in to halt the tactic. Hence this strategy may prove unsustainable. (B) Predatory pricing Predatory pricing is the practice of charging a very low price with the intent of forcing competitors to leave the market. A sign of predatory pricing is when a company chooses temporarily to sell its product at a loss. This is when the firm is pricing below its marginal costs, doing so the firm is voluntarily making additional losses and presumably the motivation for this is to eliminate its competitors. If the dominant firm can acquire a reputation for predatory pricing, this may help to deter new entry to its market in the future – it works like another way of creating an artificial entry barrier. Ev1B: Predatory pricing rarely proven and invites government intervention Cases of predatory pricing successfully reducing competition is rare. This is because when the dominant firm start to raise prices once its rivals are forced out of the competition, this increases the incentive for other new firms to enter the market. No long-term gain can be reaped from this predatory action. Moreover, the government might step in as the strategy helps to protect powerful market positions, going against the interests of the consumers. R2: Non-price strategy to reduce competition Product Innovation and marketing to create product differentiation and brand loyalty When an incumbent firms is able to successfully carry out production innovation to come up with improved or clearly differentiated products, it will raise the demand for the product and the demand for the product would become relatively more price inelastic. Moreover with marketing, when the firm’s ability to promote the product results in the consumer developing a close association between the product and the brand, it will be increasingly difficult for a new firm to break into that market. The brand name is often established by means of product differentiation, aggressive advertising & attractive after-sales service (e.g. Apple, Microsoft and Panadol). All these will make the product unique to the consumers, increase the demand and reduce the magnitude of price elasticity of demand. Hence, this will reduce contestability in the market, thus reducing competition while helping the incumbent firm to retain its dominant market share. Ev2: Possible limitations of product i