EJC Econs N2023 H2 EQ3 - students

Suggested answer for 2023 A-Level Paper 2 Question 3 A firm’s decisions and strategies are influenced by the level of competition in the industry. Its decisions and strategies might also be affected by consumers’ cognitive biases and concerns about the environment. (a) Explain why a firm considers the level of competition in the industry when making decisions about the price and output level of its product. [10] (b) If markets fail due to a lack of competition, discuss whether consumers will be disadvantaged and what might be the most appropriate form of government intervention. [15] Part (a) - Question Analysis Approach Command Word Explain Question Type Cause and effect Start point Level of competition End Point Price and output decisions Content and Context Content • Level of competition  market structure  perfect competition, monopolistic competition, oligopoly, monopoly • Price and output decision  marginalist principle Context None Introduction State essay approach: A firm will aim to maximize profits when making decisions using the marginalist principle, producing at the output where marginal revenue (MR) equals marginal costs (MC). The level of competition determines the market structure the firm is in and the amount of market power it has. The market structure also affect whether a firm needs to consider the impact of rival’s reaction when deciding its pricing and output decision. Point 1: How high degree of competition affect pricing and output decision • A perfectly competitive (PC) firm faces high degree of competition as there are many small firms selling homogeneous products in the market due to the lack of barriers to entry. • As such, a PC firm has no market power and is a price taker due to its small market share. It follows the market price, P which is determined by the market demand and supply and faces a perfectly price elastic demand curve as shown in figure 1. Any attempt to increase price will result in quantity demanded falling to zero as consumers will switch to the many substitutes available. The firm has also no incentive to lower price as it can sell as much as it wants at the existing price. • At P, the PC firm will produce at Qfirm where MR = MC to maximise its profits. o If the firm were to produce Q1 unit, the MR (the extra revenue from selling one more unit) is greater than the MC (the extra cost of producing that additional unit). Producing this additional unit will benefit the firm as the extra unit will add to its total profits. o By producing an output greater than Qe output level (e.g., Q2,), the MC (the extra cost of producing one more unit) is greater than the MR (the extra revenue from selling that

additional unit. Hence, doing so will not benefit the firm and in fact will lead to lower profits. Point 2: How low degree of competition affect pricing and output decision • On the other hand, a monopolist faces low degree of competition as there are strong barriers to entry to prevent new firms from entering. For example, patent allows pharmaceutical companies such as Pfizer to be the sole producer for new drugs that they have created. • A monopolist thus faces a downward-sloping demand curve as shown in figure 2 due to its high market share and demand is relatively price inelastic due to a lack of strong substitutes. • To maximise profits, the monopolist will produce at Qm where MR = MC and set a price of Pm. • An oligopoly is another market structure faced with low level of competition. It is characterized by a few dominant firms, each holding significant market share due to strong barrier of entry. For example, Singapore’s telecommunications (telco) market is dominated by four firms - SingTel, Starhub, M1 and MyRepublic. Figure 1: Price and Output of a PC Firm Revenue, Cost, Price MC DD = AR = MR = P Quantity E Pe Qe 0 Q1 MR > MC Q2 MR < MC Qm Output D=AR MC MR Revenue & Cost ($) Figure 2: Price and Output of a Monopolist Pm

• As such, o ligopolistic firms are mutually interdependent . This means that one firm’s behaviour greatly affects its rivals. Consequently , the rival firms are likely to react to any action by the oligopolistic firm, and the oligopolistic firm must consider those reactions every time it makes a decision. Oligopolistic firms hence must make decisions carefully in anticipation of what rivals could do. • For example, in a competitive oligopoly, price rigidity occurs due to high rival consciousness. This means prices of goods and services are often observed to remain relatively stable as rival firms will match each other’s price reductions but not price increases. o If SingTel decides to lower its prices below existing market price, this will increase their quantity demanded (sales volume). However, Starhub would react and likely match SingTel’s price reduction to retain their significant market share. Therefore, it is unlikely SingTel would reduce price due to Starhub’s reaction and start a price war. o I f SingTel decides to increase its price, the quantity demanded will decline. Starhub has no incentive to match the price increase as their market share would increase at the expense of SingTel as Singtel’s customer switch to a cheaper alternative. Therefore, it is unlikely that SingTel would increase price to earn high profits. • On the other hand, a monopolistic competitive firm such as Koi, which sells bubble tea, can make pricing and output decision independently. This is because there are many small firms in monopolistic competition selling slightly differentiated products due to weak barriers of entry. Hence each monopolistic competitive firm holds an insignificant market share and t he price and output decision of one firm is unlikely to have a significant effect on the price and output decisions of other firms within the market. Conclusion In conclusion, the level of competition ultimately affects the ability of a firm to set price independently through affecting its market share and market power. The lower the level of competition, the more market power it has and the higher the ability to set higher prices as demand is more price inelastic. 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 why a firm considers the level of competition in the industry when making decisions about the price and output level of its product • clear and accurate explanation of price and output decision of firms in different market structure with appropriate diagrams • supported with relevant examples 8-10 L2 Uneven display of AO1, AO2 and AO3 skills: For an answer that shows under-developed explanation of why a firm considers the level of competition in the industry when making decisions about the price and output level of its product • lacks depth of analysis (i.e. , limited effective use of relevant economic analysis such as the different market structure or gaps in diagrammatic analysis such as using a single profit -maximising diagram to explain the price and output decision for firms regardless of the level of competition) • l acks scope (i.e only explain pricing decision) • lacks relevant examples 5-7

L1 Limited display of AO1 and AO2 skills: For an answer that shows limited knowledge of why a firm considers the level of competition in the industry when making decisions about the price and output level of its product • listing of points, unexplained statements, or descriptive response • many conceptual errors (i.e., using