2026 ACJC H2 Econs Paper 2 Q3 Prelim ANS

2026 H2 Economics Preliminary Exam Question 3 To support firms facing rising operational costs, the government can provide two distinct measures: a rental subsidy or a wage subsidy to help firms remain in business. (a) Explain how the short-run price and output decisions of a profit-maximising firm would change if it received a rental subsidy compared to when it received a wage subsidy. [10] (b) Discuss the most appropriate strategy that a monopolistically competitive firm, operating in the short run, could adopt to remain in business when government subsidies are removed. [15] Suggested Approach Question Requirements: ● Requirement 1: Explain how a rental subsidy affects the firm's short-run price and output decisions. ● Requirement 2: Explain how a wage subsidy affects the firm's short-run price and output decisions. Introduction A firm operating in the short-run will bear at least one fixed cost and variable costs. Total fixed costs are costs that do not vary with output and are incurred even when output is zero. Variable costs on the other hand vary with output produced. As output increases, the total variable cost increases too. Rental cost is considered a fixed cost for a firm and wage cost is considered a variable cost for a firm. Requirement 1: Effect of a Rental Subsidy on Short-Run Price and Output Establish a firm’s price and output decision. ● A profit-maximising firm will produce at an output level where its marginal revenue (MR) equals its marginal costs (MC) according to the marginalist principle. ● Marginal revenue is the addition to total revenue from the production of an additional unit of good and marginal cost is the addition to total cost for producing that additional unit of good. ● If MR exceeds MC, each additional unit produced adds more to revenue than it does to cost, so the firm can increase its total profit by expanding output. Conversely, if MC exceeds MR, each additional unit costs more to produce than it earns, so the firm should reduce output to avoid eroding its profits. It is only at the point where MR = MC that marginal profit is zero and total profit is at its maximum. ● The firm having decided on its profit-maximising output will then decide on the price according to the willingness and ability of consumers to purchase, that is the market demand. Effect of Rental cost on AC and MC ● rental cost is a fixed cost because the rental contract over a period for the space and the rent paid is the same whatever the level of output is, even when it is not producing any output. ● For example, a bubble-tea shop, it must pay shop rental whether the shop is open or not for the day or for the month

● rental subsidy reduces the firm's rental expenditure - a reduction in fixed costs ● firm's Total Fixed Cost (TFC) will decrease hence its Average Fixed Cost (AFC) decreases too ● As AC = AFC + AVC, this causes the Average Cost (AC) to decrease but has no impact on marginal cost ● since rental cost is a fixed cost, it does not change with output and MC is the additional cost of producing one more unit of output, a rental subsidy does not affect the firm's Marginal Cost (MC) and therefore has no impact on MC Explain why there is no change in price and output decision ● before receiving a rental subsidy, the firm’s price and output decision is at price OP 0 and output at OQ 0 where MC 0 =MR 0 ● profit-maximising condition is MC = MR, and neither the MC nor the MR is changed by the wage subsidy, the firm's profit-maximising output remains unchanged at Q ₁ and the price charged by the firm, will also remain unchanged at P ₁ . ● therefore, a rental subsidy does not change the firm's short-run price or output decisions. ● the firm continues to produce the same quantity at the same price. ● the benefit of the rental subsidy is instead reflected in a lower AC, which increases the firm's profit (or reduces its losses) at the existing equilibrium. Requirement 2: Effect of a Wage Subsidy on Short-Run Price and Output Effect of Wage cost on AC and MC ● wage cost is a variable cost because when a firm wants to increase output, it will need to hire more workers or pay existing workers for more hours, which increases its total wage cost and if output falls, the firm will reduce the number of workers or hours worked, decreasing the total wage costs ● for example, the bubble-tea shop sees an increase in demand for their tea through online orders, the firm will increase the number of cups of bubble tea it produces, it needs to hire more staff to fulfil the increased orders ● wage subsidy (subsidy per worker) reduces the firm's total wage cost - a reduction in total variable cost for every level of output which in turn reduces both the Average Variable Cost (AVC) and the Average Cost (AC). ● unlike a rental subsidy, a wage subsidy does affect the firm's Marginal Cost (MC) as a reduction in wage costs lowers the additional cost of producing an additional unit of output. This causes the MC to decrease at every output level.

● With a lower MC, MC 1 and no change in the demand for the firm’s good, there will be no changes to the average and marginal revenue earned by the firm ● when the firm receives a wage subsidy, the firm is not maximizing their profit if it continues to produce at the original profit-maximising output (without wage subsidy), OQ 0 . ● At output OQ 0 , marginal revenue now exceeds the new (lower) marginal cost, MC 1 , which means that each additional unit produced adds more to revenue than to cost. The profit-maximising firm will therefore increase its output until the new MC 1 equals MR at a higher output level OQ 1 ● The change in the firm’s output decision will have a change in its pricing decision too. ● With the change in decision to increase its output after receiving a wage subsidy, the price that the firm decides to sell