HCI H2 ECONS Q3

Q3 In recent years, natural calamities such as floods and earthquakes have caused the cost of raw materials to rise. (a) Distinguish between variable costs and fixed costs and explain whether a rise in these costs will affect a firm’s pricing decision differently. [10] INTRODUCTION Fixed and variable costs are two different types of costs in the short-run production period of a firm. The impact of a rise in these costs on a firm’s pricing decision can be analysed using the cost-revenue framework. BODY Distinguish between fixed & variable costs Distinguish well with definitions and examples: Remember to use words like, ‘on the other hand’ to distinguish the two concepts clearly. Variable Cost Fixed Cost Variable cost refers to cost that varies with output. while fixed cost is cost that does not change with level of output Variable cost is only incurred when production starts. On the other hand, fixed cost is already incurred when production is zero. Note: The 2nd point is often left out. Examples: Cost of energy, raw materials & daily rated workers will change with output. Examples: The initial capital outlay even before production of a single unit. It is a lump sum that needs to be spent on tools and equipment, to buy land, building & infrastructure by business unit before production process can take place. Exemplification details: When a car manufacturer increases the production of cars, they need to buy more raw material like steel and paint, pay more wages for overtime and there will be a rise in utility bills as machines are used more intensely. Thus variable costs increase with more output. And when there is no production, these costs will not be incurred. Exemplification details: When the same car manufacturer increases the production of cars, there will not be changes in the size of the factory or equipment that already exist or purchased when the manufacturing plant was first set up; the costs are already incurred even when production is zero and will not change with more output. Explain how a firm makes its pricing decision Assuming that the firm aims to maximise profits, it will produce an output where its marginal costs (MC) equals its marginal revenue (MR) and set its price on the corresponding point on its average revenue (AR). Price will change when MR or/and MC change. So wh ether a change in VC or FC will change a firm’s pricing decision will depend whether it changes MC. Explain how an  in VC & FC can affect a firm’s pricing decision differently.  An increase in variable costs (VC) will lead to an increase in MC as it is the additional cost arising from an additional output. (MC = TC/Q or MC = TVC / Q).  For example, rising oil prices can lead to an increase in the costs of jet fuel fo r an airline. Jet fuel is a variable cost as it varies with the number of flights conducted by the airline. If there are no flights, jet fuel cost will be zero.

As seen in the figure above, an increase in variable costs will cause the MC to increase from MC 0 to MC1, causing the firm to reduce its profit maximizing output from Q0 to Q1 where MC1 = MR. Hence the firm will increase its price from P0 to P1. Note: It is fine to draw a full diagram with changes in both AC and MC but the focus is not on changes in profit but pricing when MC changes. So to simplify the process, shifting MC will do. An increase in FC such as the cost of advertising on television will not affect the MC of a firm since a change in TFC = 0 and have no impact on TVC. The cost of advertising is fixed as it does not vary with the number of products or services sold by the firm. If the firm does not produce or sell any output, it will still have had incurred the advertising cost. Hence an increase in fixed does not affect the MC of a firm as it does not vary with output. Therefore the profit maximizing output of the firm where MC = MR remains unchanged and the corresponding price is unchanged too. Note: There is no need for a diagram here to score well. Most importantly is the analysis. Hence for firms who are price-setters and face a downward sloping AR and MR, a change in VC and FC affect their pricing decision differently. Explain how an  in VC & FC does not affect a firm’s pricing decision differently. However for a firm in perfect competition, the increase in such costs does not affect their pricing decision differently. Output Price/Revenue/Cost P0 AR MC0 Q0 MR MC1 P1 Q1

As seen in the diagram above, while the increase in MC from MC 0 to MC1 causes the profit maximimising output of a PC firm to fall from Q0 to Q1, its price remains as P0 due to the horizontal AR it faces as a price taker. Similarly as firms in imperfect competition, a change in fixed costs does not affect the MC of a PC firm either and hence its pricing decision remains unchanged. Hence for a PC firm, as it is a price-taker facing a horizontal MR and AR, a change in either variable or fixed costs does not affect their pricing decision. Note: There is no need for a diagram for the analysis here. Just the idea of a price-taker in PC firm, will not change price when there’s a change in VC and FC. Note that technically speaking, if the increase in MC is widespread, the market supply curve (= MC) will fall the market price will increase, leading to an increase in the price of a firm via a change in AR/MR. But this is not within the A Level syllabus. CONCLUSION In conclusion, for a firm facing imperfect competition, an increase in VC will le ad to it increasing its price while an increase in FC will not affect its pricing decision. For a PC fi rm, an increase in either cost s will not affect their pricing decision. However given that a PC rarely exists and most firms face some degree of imperfect completion, the former is more likely to be observed. Output Price/Revenue/Cost P0 MR = AR MC0 Q0 MC1 Q1

Marking Scheme LEVELS DESCRIPTION MARKS 3 L3 (10)  Ability to recognise and explain clearly that the pricing decision is also affected by the type of firm (last mark) L3 (7 to 9)  Ability to recognise and explain clearly that a change in variable costs affects the pricing decision while a change in fixed costs does not.  Well-illustrated and explained diagrams.  Distinguishes clearly the difference between fixed and variable costs.  Shows good understanding of the difference between fixed and variable costs with the use of appropriate examples. 7-10 2  Ability to recognise and explain clearly that a change in variable costs affects the pricing decision while a change in fixed costs does not.  A diagram was drawn but contains minor errors or adequately explained.  Distinguishes clearly the difference between fixed and variable costs but only one contrast was being made.  Lack or poor choice of examples of variable and fixed costs. 5-6 1  Major conceptual errors with little coherent explanations 1-4 (b) Discuss the extent to which a rise in cost of raw materials will result in an oligopolistic firm changing its price in reality. [15] INTRODUCTION The cost of raw materials such as crude oil to an oligopolistic firm such as Esso is a variable cost as it increases as Esso increases the amount of petrol it sells and is not incurred if Esso does not produce any petrol. An oligopolistic firm faces imperfect competition and hence has a downward sloping demand curve. The earlier analysis in 3a) predicts a positive relationship between variable costs and an oligopolisti c firm’s pricing. However that may not happen in reality due to a variety of factors. BODY (1) Kinked Demand Curve/Competitive Behaviour of Rivals Scenario 1: A rising in variable cost will not lead to a rise in price.  In a competitive oligopoly and selling homogeneous product, it is assumed