EJC Econs N2022 H2 EQ1

Suggested answer for 2022 A-Level Paper 2 Question 1 Economists usually begin their analysis of decision -making by firms by assuming that the objectives of a firm is to maximise their profit. In reality, however, there are many different objectives that a firm might adopt. a) Explain the likely effects on a f irm’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) - Question Analysis Approach Command Word Explain Question Type Cause and effect Start point Objective of firm End Point Price and output Content and Context Content • Marginalist principle • Profit satisficing Context None Introduction State essay approach: Traditional economic theory suggest that r ational producers will seek to maximize profits when making decisions using the marginalist principle. However, a firm may only seek to achieve a level of profits that is satisfactory, instead of the maximum level possible due to various factors such as imperfect information. Body Point 1: Explaining a profit-maximizing firm’s price and output level • A firm, such as Apple, will produce up to a point where marginal revenue (MR) equals to marginal costs (MC) to maximize profits. • Marginal revenue is the additional revenue gained from selling an additional unit of Apple product such as iPhone, and revenue is obtained by price multiplied by quantity. • Marginal cost is the additional cost incurred from producing an additional unit of Apple product, which include wages paid to workers and manufacturing costs such as costs of raw material for the different components of iPhone and costs of machinery to assemble the iPhone. • With reference to Figure 1, if Apple produces iPhone only up to Q1 where MR > MC, his profits can be increased by producing additional unit of iPhone as it will add more to his revenue than the costs. Hence, to maximize profits, a rational producer will increase production until MR = MC at Qm. • On the other hand, if Apple produces iPhone at Qs where MC > MR, the additional production has decreased its overall profits. Thus, to maximise profits, Apple should decrease production until MR = MC at Qm.

• The Marginalist principle states that an economic agent should pursue an activity up to the point where Marginal Benefit (MB) = MC. Thus, at Qm where MR = MC, there is no incentive for the producer to either increase or reduce production hence the profit-maximising firm will produce at the output Qm, with a price of P m, earning a supernormal profit of area PmEDCm. Body Point 2: Explaining a profit-satisficing firm’s price and output level • Profit-satisficing behaviour arises due to the separation of ownership and management. While the owners wish to maximum profits, the employees (managers and workers) might aim for a minimum level of profit that is just enough to satisfy the owners (and shareholders) rather than maximise profits. • Managers might not have perfect information about the firm’s costs and revenue to produce at the point where MR = MC too especially in a fast -paced business environment where business conditions are ever changing. For example, during the COVID -19 pandemic, surviving in challenging conditions bec ame the primary objective for many firms, instead of profit maximising. • When a firm changes its objective from profit maximisation to profit satisficing , it usually involves setting lower prices in a bid to increase revenue & market share. Hence the firm might set the price at Ps instead of Pm and selling at output Qs . This results in a satisfactory level of supernormal profits of area PsFGCs, which is smaller than area PmEDCm. • However, it must be noted that there is no unique price and output that a firm will set when its objective is profit satisficing. It depends on the minimum requirement set by the owner/shareholders and how much information is available. It also depends on the threat of competition. The greater the threat of potential competition, the lower the price the fir m will set to deter entry. Figure 1: Price and Output of a Firm E F AC Pm MC DD = AR MR 0 Q1 Qm Qs Quantity Price, Revenue, Cost Cm Cs Ps G D

Conclusion In conclusion, a firm’s price will likely decrease, while output will likely increase when its objective changes from profit maximisation to profit satisficing. Mark Scheme Level Knowledge, Understanding, Application, Analysis Marks L3 Full display of AO1, AO2 and AO3 skills: For an answer that shows well-developed explanation of the pricing and output level of both profit-maximizing and profit-satisficing firms. • clear and accurate explanation of marginalist principle with an appropriate diagram • supported with relevant examples 8-10 L2 Uneven display of AO1, AO2 and AO3 skills: For an answer that shows under-developed explanation of the pricing and output level of profit-maximizing and profit-satisficing firms. • lacks depth of analysis (i.e. , limited effective use of relevant economic analysis or gaps in diagrammatic analysis) • lacks scope in explaining either profit-maximizing or profit-satisficing firms • lacks relevant examples 5-7 L1 Limited display of AO1 and AO2 skills: For an answer that shows limited knowledge of how a firm make price and output decision based on its objective. • listing of points, unexplained statements, or descriptive response • many conceptual errors (i.e., using total benefit/costs instead or marginal costs/benefit when explaining marginalist principle , confusion between profit satisficing and revenue maximization , using DD/SS instead of a firm’s diagram) • irrelevant response such as on market failure or price mechanism • smattering of points 1-4

Part (b) - Question Analysis Approach Command Word Discuss → balanced answer + evaluation Question Type Most appropriate strategy → strategy comparison and evaluation Start point appropriate strategy End Point Reduce competition Content and Context Content Strategies to reduce competition Context None Introduction State essay approach: A firm may aim for alternative objectives such as profit satisficing when competition is high in the industry. Hence, the firm may employ strategies such as predatory pricing and acquisition to reduce competition in the short run and change objective back to profit maximization after competition level has been reduced. Body Point 1: Explain how predatory pricing can reduce competition level • Predatory pricing is practised through pricing the firm’s good below its AC to drive out competitors. Figure 2: Predatory pricing to reduce competition • Instead of selling at the profit-maximising price PM, the firm that practises predatory pricing will now sell its good at a price below AC, for example at price PP. This ensure that rivals with higher cost condition will not be able to survive as the fall in price will result in a fall in demand for the rival’s product which is a substitute . The fall in demand will result in a fall in total revenue, and a fall in profits level, ceteris paribus. If the fall in demand results in AR< AC, the rival firm will make subnormal profit and shut down in the short run if AR<AVC. • For example, Grab would give attractive discounts to attract Uber user s while suffering subnormal profits. • By driving out existing competitors, the firm can increase demand for their own products and reduce price elasticity of demand ( PED) due to less substitutes available. Once existing AC PM AR = DD MR Quantity QM Revenue, Cost, Price AC MC PP 0 Qp

competitors leave the industry, the firm will then raise prices back