2013 DHS H2 EC P1 Ans Scheme

1 Case Study Question 1 - Answer and Mark Scheme: (a) Compare the trends in wine and beer consumption between 2008 and 2011.  Consumption of beer in the USA has always been higher than the consumption of wine. [1m]  US consumption of beer as a percentage of those who drink fell from 2008 to 2011, while that for wine increased during the same period. [1m] Note: Answers that state “US beer consumption fell from 2008 to 2011 while that for wine increased” will be marked incorrect as the values are percentage NOT absolute figures.                                                                                       [2] (b) (i) Using a relevant elasticity concept, explain why the Americans are turning towards wine consumption. Identify the relevant elasticity concept [1m]: Beer and wine both being alcoholic drinks are close substitutes in consumption, with cross elasticity of demand being more than 1. Reasoning [1m]: As evident from extract 1, “beer prices are rising faster than Consumer Price Index.” As beer price increases, by law of demand it will lead to a fall in quantity demanded, ceteris paribus. Although there is no change in absolute price of wine, its relative price becomes lower. Consumers who were previously consuming beer will switch over to consume wine, thus increasing the demand for wine. [2] (ii) With the aid of diagrams, explain the impact of a rise in demand for corn-based ethanol on the price of US beer. Corn-based ethanol and barley are in competitive supply [1m]  Both corn and barley are in competitive supply, as they required the same factor of productions, such as land and fertilizers. An increase in demand for corn-based ethanol will increase the derived demand for corn from D 0 to D 1 in fig 1(a), signaling a rise in price of corn. Farmers will increasingly shift towards planting more corn and increasing the quantity supplied of corn from Q 0 to Q 1. This will result in fall in supply of barley, from S0 to S1 in fig 1(b).  Evidence from Extract 2: “barley could become increasingly scarcer” [4]

2 Explanation of the price-adjustment process with diagrams [2m]  The fall in supply of barley will create a shortage at the initial equilibrium price, P0 in Fig 1(b)  Consumers who strongly want to consume barley will be willing and able to pay a price higher than current equilibrium price. Producers observing such behavior of consumers (prices are increasing) are more willing and able to increase the quantity of barley supplied. However, as prices increase, some consumers whose utility of consuming barley is not maximized at price higher than equilibrium price will decide to leave the market. Thus as prices of barley rises, quantity demanded falls. This process will continue and stop when the demand and new supply of barley meets each other at the higher equilibrium price, P 1. Increase in price of barley, increases the cost of production of beer, thus resulting in a rise in price of beer [1m]  Increase in price of barley, will increase the cost of production of beer, as “the beer industry is the leading user of malting barley, an essential component of the brewing process”, evident from Extract 2.  With increase in cost of production, producer will decrease the quantity supplied of beer at each and every price level, reducing the supply of beer.  This will result in a shortage and price of beer will go up to clear the market.  The new equilibrium price of beer will rise up to P 1 from P0. Overall, an increase in demand for corn-based ethanol will increase the price of US beer. (c) (i) Describe the type of market structure operating in the US brewing industry. Identify the market [1m]: Oligopoly (or, duopoly) Use Table 1 as evidence [1m]: Market is concentrated in the hands of few firms, such as AB-InBev and MillerCoors, owning approxiamtely 79.5 % market share. [2]

3 (ii) With reference to the data where appropriate, discuss whether market concentration or cost of raw materials is the key factor in influencing US brewer’s pricing decision. 1. Explain how market concentration affect firm’s pricing decision /g3 As identified in c(i), the alcohol industry is a highly concentrated market exhibiting strategic interdependence in oligopolies, i.e. the actions of a major firm in the oligopoly typically cause reactions by the other firms in the industry. Oligopolists pricing decisions may be undertaken for strategic reasons, independent of input cost. A) The Kinked Demand Curve Model With a rise in input cost, firms in the alcohol industry may not raise prices. Firms, looking to protect and maintain their market share, are unlikely to match another’s price increase but may match a price fall. For example, if one firm lowers its price, other firms will lower their price in order to remain competitive. This will cancel out any potential benefits of a price reduction, as the firm initiating the price cut will not be able to lure many customers away from his rivals. But if the firm increases its price, rivals firms are unlikely to react because they will gain as customers turn to their products, which are now relatively cheaper. If this theory holds true, then an oligopolist's demand curve will be kinked at the prevailing price – more elastic above the prevailing price but less elastic below the prevailing price. Associated with each demand curve (AR) is its MR. This explains why at the kink of the demand curve, the MR is discontinuous. /g3 /g3 Fig 2: The Kinked Demand Curve explaining price rigidity Since the profit maximising output level is where MR = MC, any MC curve between the upper limit of MC1 and a lower limit of MC0 intersects MR at quantity OQ and price OP. In other words, the oligopoly is reluctant to raise prices even as its marginal cost increases from MC 0 to MC1. This results in price rigidity. Price remains unchanged over a wide range of costs. [8]

4 B) Hedged Pricing Evidence from extract 2: “The rise in production costs will not likely have an effect on larger brewers”. This is because the large firms in the alcohol industry, such as AB-InBev, has high bargaining power to engage in hedged pricing, whereby they form longer contracts with barley producers and thus lock the price of barley. This makes the large firms less susceptible to fluctuations in cost of raw materials. 2. Explain how rise in cost of raw materials will affect firm’s pricing decision As evidence from extract 2, barley prices are increasing due to (i) dismal harvest and (ii) increase in demand for biofuels  both resulting in a fall in supply and hence an increase in price of barley. Barley being an essential component of the brewing process for the beer industry, an increase in price of barley will increase the marginal cost of production of beer, thus shifting the MC curve from MC 0 to MC1. Fig 3: Increase in price due to increase in input cost Explain the adjustment process: /g3 At the original output Q0, MC (aQ0) > MR (bQ0)  the last unit sold adds more to firm’s cost than it does to firm’s revenue  to avoid the loss on the marginal unit of output firm would reduce output  it will continue to cut output up to the point where MR = MC 1 last unit produced adds as much to the firm’s revenue as it does to the firm’s cost and firm’s profits cannot increase further by decreasing production. The new profit-maximising output is at Q 1 and firm charges price P 1, up from the original P0 Evidence from Extract 2: Microbrewers also known as ‘Craft Brewers’ in the U.S, likely will take more of a hit from rise in price of barley. Hence, the only alternative for craft beers to maintain profits is to increase the beer prices.

5 Evaluation 3. Identify and explain the key factor in influencing US brewer’s pricing