VJC H2 ECONS P1 Suggested Answers

Suggested answers to 2018 VJC H2 Prelims Paper 1 Question 1 a. i) Using Figure 1, compare the change in infant formula milk prices for the periods 2007 to 2014 and 2014 to 2017. Infant formula milk prices increased in both periods. (1) Infant formula milk prices more than doubled from 2007 to 2014; while it rose by only about 10% for 2014 to 2017. (1) [2] ii) Explain whether the data in Figure 2 is able to support the observed change in infant formula milk prices for the period 2007 to 2014. Given the data in Figure 2, there is a positive correlation between rising infant formula milk prices and rising import of infant formula milk in China. (1) This could suggest that China could have been importing from Singapore, leading to an increase in demand creating a shortage there. Hence, the rapid rise in prices of infant formula milk over this period. (1) Figure 2 is insufficient because there is no clear data on the source of the China’s infant formula milk imports. Despite evidence from Extract 1 that Chinese parents were willing to pay double for these products from Singapore, China could have also imported the infant formula milk from other countries like Australia. (2) OR Figure 2 alone is not able to fully support the observed change in infant formula milk prices. In addition, price changes could arise from supply factors and not only from changes in demand. Thus, information on the supply of infant formula milk China and Singapore is needed. The rapid rise in price could have been due to a fall in supply of infant formula milk in Singapore. (2) [4] b. What can you conclude from the evidence in Extract 2 about the price elasticity of demand for infant formula milk powder? From Extract 2, it can be inferred that the demand for infant formula milk powder is likely to be highly price i nelastic given that parents continue to demand infant milk powder due to the perceived lack of close substitutes as they ‘remain loyal’ despite the huge increases in price. (2) Also accept demand for infant formula milk powder is perfectly price inelastic if explained clearly – infant milk powder is the only available substitute for infant milk powder is breast milk. Lack of other close substitute available suggests demand for it is perfectly price inelastic for those who cannot breast feed. [2] c. With reference to the data, justify the market structure for the formula milk market in Singapore. It is an Oligopoly market structure, dominated by a few dominant sellers as seen in Extract 3, where Nestle, Abbott and Mead Johnson constitute 72% of the total market share in Singapore. Such dominance implies strong market power for firms in this industry. (2) [4]

In addition, the high barriers to entry (BTE) is also a characteristic of oligopoly market structure. Extract 3 mentions that such firms aggressively advertise which may result in high brand loyalty for the incumbent firms’ goods. In addition, the heavy investment in R&D in order to develop better and newer products will result in high start-up costs that require new entrants to produce at a higher output level in order to reap the large economies of scale. These strategies create high BTE, limiting the ability of new firms to enter and compete, which in turn gives firms in this industry strong market power. (2) d. Discuss the factors Australian infant formula milk companies are likely to consider when deciding whether to enter the Chinese infant formula milk market. Intro: Assuming that Australian infant formula milk companies aim to maximize profits, they will consider factors that affect their total revenue (TR) as well as total cost (TC) when deciding whether to enter the Chinese market. Body: Australian infant formula milk companies are likely to consider the potential size of the Chinese market as it affects the firm’s revenue. [C, E] Australian firms will be able to capitalize on the reputation of Australia as a producer of high-quality food (Ext 4). This will cause the DD for Australian infant formula milk to rise; particularly following the stigma of infant formula milk scandal (Ext 1); existing consumers may switch to milk powder produced in Australia as a result. This rise in demand will increase the expected revenue for Australian infant formula milk companies. Given the relaxation of China’s one child policy (Ext 4 para 2), there would also be a rise in DD for infant formula milk as more children are born in China, increasing the expected revenue for Australian companies. As Chinese households become affluent (Ext 4 para 2), income and hence their purchasing power increases, enabling them to afford premium infant formula milk, increasing the demand for infant formula milk and the firms’ expected revenue. These factors above are likely to affect the expected demand for Australian infant formula milk and hence the potential size of the infant formula milk market in China, which will in turn impact Australian firms’ expected total revenue. Australian firms are likely to consider the level of barriers to entry of Australian-produced infant formula milk to the Chinese market. Governments can put up artificial barriers to entry in the form of food regulations or import tariffs. The free trade deal between China and Australia will bring about a tariff saving of 15% as it is phased over 4 years (Ext 4). This reduction in tariff will lower the price of Australian-produced infant formula milk in the Chinese market. If the firms pass on the cost savings (from tariff elimination) to consumers, it will result in a fall in the price of Australian infant formula milk. The resulting rise in quantity demanded is likely to be more than proportionate to the fall in price given that demand for Australian infant formula milk is likely to be price elastic (i.e. PED > 1) because of the large number of available substitutes, resulting in higher revenue reaped by the Australian firms. [8]

However, entering the Chinese market may also mean higher cost due to the need to adhere to stricter regulation following the infant formula milk scandal (Ext 4). These measures may increase the administrative cost of importing of Australian-produced infant formula milk as they need to adhere to these regulations. Australian firms may also consider the potential cost savings from reaping EOS by selling in the Chinese infant formula milk market. [C, E] By expanding into the Chinese market, Australian firms will be able to produce a larger output given the size of the Chinese market, enabling it to reap greater economies of scale e.g. marketing economies of scale through the bulk purchases of factor inputs to produce infant milk powder. Increasing economies of scale will enable firms to lower their average cost of production. The rise of internet and e-commerce have also changed tastes & preferences amongst consumers who prefer to buy online instead of physical stores. This will lower the cost of selling in the Chinese market as there is no longer a need to incur significant fixed costs in the form of rentals to set up physical stores to access the Chinese market. Evaluation/Conclusion: In deciding whether to enter the Chinese market, Australian infant milk companies will need to weigh the expected revenue and costs of entering the market. Given that the market is an oligopoly market structure (Ext 3), there is mutual interdependence and rivals’ actions are likely to affect the extent of the changes in revenue and costs, hence firms will also have to consider the perspectives of current incumbent firms. For example, while there may be potential EOS to be reaped in selling to a larger market, the extent of the EOS may be limited given the competition from the numerous sellers in China (Ext 4 para 3). The deep pockets and vast experience of the incumbent firms also sug