IJC H2 ECONS Essay Q2 SuggestedSolution

IJC 2014 H2 Prelim 2 Paper Question 2 As the growth of online shopping cont inue, shoppers are focused on purchasing electronics, books, music, apparel and s porting goods. On the other hand, food and beverages, supermarkets, luxury fashion and healthcare tend to be less affected by the shift towards online retail and continued to perform well. (a) Explain how economies of scale determi ne the type of market structure in different industries. [10] Suggested Outline:  Define economies of scale, minimum effici ent scale. Explain that the extent of economies of scale reaped by firms determine the size of firms and hence the type of market structure.  Firm where MES is small relative to industry demand means that the optimal size of the firm is small and thus there are many small siz ed firms in the industry. These firms will experience lowest average costs at a low level of output only and are thus remain small in size. For exam ple, fashion boutique and barber shop. Hence, such industries are likely to ex ist in monopolistic competition where there is a large number of small firms.  Firm where MES is large relative to industry demand means there may be room for only one or a few large sized firms. T hese industries tend to have high capital cost and is more likely to exploit technical economies of scale. Examples of such industries include telecommunication, public utilities and aircraft production. In these industries, there is no possibility of com petition from withi n the country. Even if a firm were large enough to produc e the whole output of the industry in the country, it would still not be lar ge enough to experience the full potential economies of scale. As a result, the LRAC curve falls continuously over the entire output range sufficient to supply th e entire market. Such industries are likely to be oligopolistic, with a few lar ge firms dominating the market. In the extreme case, with only one firm in the market it might exist as a monopoly.  In some industries, the firms’ LRAC curve may have a horizontal portion due to constant returns to scale. These firms can enjoy lowest average costs over a range of output. It is possible for small and large firms to be equally cost efficient and co-exist in the same industry. For exam ple, in the retail industry, there exist small grocery stores and lar ge supermarkets. Hence fi rms in these industries can be either oligopolistic (e.g. superma rket chains) or monopolistic competitive (e.g. grocery stores).

Marking Descriptor Level Descriptor Marks L3 Clear attempt to address question. Well-developed analysis of how economies of scale determine the size of firms, number of firms and market structure in different industries with the good use of relevant examples. 7-10 L2 Some attempt to address question. Less developed analysis of how economies of scale determine the size of firms, number of firms and market structure in diffe rent industries. Answer is generally descriptive or lacking in scope in terms of type market structures considered and examples. 5-6 L1 Answer mostly irrelevant or co ntains only a few valid points made incidentally without any attempt to address question. 1-4

(b) Discuss how far the market structure of the firms in different retail industries will affect their profitability when faced with the growth in online shopping. [ 1 5 ] Suggested Outline: With growth in online shopping, the retail industries are impacted in different ways Growth in online shopping  greater competition for exis ting traditional firms due to more producers in the market Extent to which existing traditional firms ’ profits are affected depends on market structure firms operate in  Retail industries with monopol istic competitive features E.g. fashion boutiques Lack of excess profits due to freedom of entry and exit industry Growth in online shopping  fall in demand  some firms might be making subnormal profits eventually  exit the industry in the long run  Retail industries with oligopolistic features E.g. supermarkets Able to maintain supernormal profits due to substantial barriers to entry which prevent firms from entering Growth in online shopping  falling demand  fall in revenue but might still be able to maintain supernormal profits if reduction in revenue is not drastic In comparison, the impact might be more favourable for online retail industries Growth in online shopping  rising demand as consumer s switch to online retail firms which are substitutes of traditional retail firms Extent to which it favours these industries might also depend on the market structure firms operate in  Retail industries with oligopolistic features E.g. large internet firms Ability to maintain high barriers to entry  prevent new firms from entering  supernormal profits can be maintained in the long run Greater ability to use super normal profits to innovate, differentiate, advertise  raise barriers in the industry  raising market power and profits further  Retail industries with monopol istic competitive features E.g. blog shops Growth in online shopping rising demand  rising revenue  rise in profits  supernormal profits earned in the short run However, monopolistic competitive i ndustries have freedom of entry and exit of firms  attract new firms into the industry  fall in demand and demand becoming more elastic with presence of more substitutes  supernormal profits competed away  normal profits earned in the long run Market structure is not the only factor a ffecting firms’ profitability. When faced with growth in online shopping, firms’ profitability can be dependent on other factors: (i) Ability of firms to adop t competitive strategies:  Product Differentiation

When faced with growth in online s hopping, if retailers are able to differentiate their products in terms of range, designs and quality, they may be able to make their products less s ubstitutable and thus the demand for their products becomes more price inelas tic. With that, su ch retailers may be able to earn higher profits  Firms changing strategy by tapping on growth potential in online shopping, especially for those products experience favourable growth in sales online, such as some products like electronics, books, music, apparel and sporting goods (ii) Nature of product  Products that are highly specialised, requiring more personalised service less likely to be impacted by growth in online shopping E.g. in the market for food and beverage, apparels, consumers with greater affluence and purchasing pow er often places a high premium and value on variety, personalized services and choices such as unique dining experience or high- end luxury fashion serving a niche market  Goods that are perishable and have mo re limited shelf lif e, e.g. those in supermarkets, profitability less impacted by the growth in online shopping Conclusion: Market structure of firms in retail industrie s can affect their profitability when faced with growth in online shopping to some ex tent, but other fact ors like competitive strategies that firms adopt and nature of product migh t prove to be important affecting their profitability as well Marking Descriptor Level Descriptor Marks L3 Clear attempt to address question. A balanced discussion with well-developed analysis of ho w market structure and other relevant factors can affect re tail firms’ profitability when faced with growth in online shopping. 9-11 L2 Some attempt to address question. Less balanced and developed analysis of how market structure and other relevant factors can affect retail firms’ profitability when faced with growth in online shopping. 6-8 L1 Answer mostly irrelevant or contains only a few