PJC H2 ECONS P1 Suggested Ans Markers Report

PIONEER JUNIOR COLLEGE (ECONOMICS DEPARTMENT) 1 PJC 2016 H2 Paper 1 Prelim Exam Suggested Answers Question 1: Supermarket Shake Up (a) (i) Explain how real GDP growth can be calculated from the data in Table 1. [1] Suggested answer: Real GDP growth is calculated by subtracting the inflation rate from nominal GDP growth. Real GDP growth = Nominal GDP growth – Inflation Rate (a) (ii) State how the level of real GDP has changed from 2011 to 2013. [1] Suggested answer: The level of real GDP has fallen / decreased from 2011 to 2013. (b) Account for the surge in Aldi’s sales revenue using the concepts of price and income elasticity of demand. [4] Suggested answer: Explanation of how PED accounts for rising Revenue 2 marks Aldi’s groceries (own label, etc) are price elastic in demand (PED>1) due to the availability substitutes / high proportion of income spent on groceries as many consumers have low income during recession / austerity. As Aldi cuts prices, quantity demanded rises more than proportionately thus total revenue (PXQ) rises and surges. Explanation of how YED accounts for rising Revenue 2 marks The economic downturn shows incomes are falling, and Aldi’s goods are inferior goods (own label), thus YED<0 and fall in income leads to rise in demand/Qty demanded, this boosts total revenue too (assuming price remains constant). (c) Comment on whether the pricing behavior of firms in the supermarket price war is in alignment to traditional economic theory. [6] Suggested answer: The firms in the supermarket industry operate in a competitive oligopolistic market structure. There are few dominant firms in the market and each is interdependence in their behavior to the other. According to the traditional economic theory on price rigidity, prices in the market tend to be rigid. As a result, firms in a competitive oligopoly market tend to compete via non-price competition than price competition. According to the theory of price rigidity, when a firm increases his price, his rival firms will not follow suit. This will cause the firm to have a fall in quantity demanded by more than proportionate and his total revenue will fall. Thus, the profit maximizing firm will choose not increase his price. In the same way, if the firm lowers his price, his rival firms will also reduce their prices. Consequently, the firm will have a rise in his quantity demanded by less than proportionate and his total revenue will fall. Thus, the firm will again choose not to reduce his price. This interdependence behavior of the competitive oligopoly explains why firms in this industry do not usually compete via prices. However, as seen in the extract 1, when Aldi reduced its price, the other supermarkets like Tesco, Morrisons, Asda and Sainsbury also cut their prices. This is not aligned with price rigidity as espouses in the theory. However, in the short run, firms may occasionally choose to compete using price as they are maximizing market share (for long term gain) at the expense of their short term profits.

PIONEER JUNIOR COLLEGE (ECONOMICS DEPARTMENT) 2 The firms may be willing to earn subnormal profits in the short run as long as they are able to protect / expand their customer base. Overtime, the smaller supermarkets that are not able to survive the price competition will exit the industry, leaving the entire market to the few surviving supermarkets. By then, the supermarket can raise their prices and make supernormal profits again. The price war can be considered to be short term adjustments by firms. In the long run, the behavior of the firm is still in alignment with the price rigidity theory as price war is unsustainable. Price will remain rigid in the long run. (d) Discuss the factors that supermarkets should consider in deciding whether to develop their online sales presence. [8] Suggested Answer All supermarkets seek to maximize their profits (i.e. total revenue - total costs). When deciding whether to develop their online sale presence, the supermarkets will weigh their revenue gain against the cost incurred, taking into account any constraints they may face (eg in terms of fundings) and any unintended consequence from the external environment of the firm. By having an online sales presence, supermarkets can increase their market share by reaching out to customers not in the proximity of their brick-and-motor stores. Sales demand can also be from overseas, allowi ng potential for rapid growth, rising the supermarket’s demand in the future. AR and MR both shift rightwards, increase total revenue. In addition, by leveraging on technology, supermarket gain insights into their customer’s needs and better cater their product ranges to the customers. Customers can select their groceries anytime at any place and compare prices for different brands. This improved shopping experience can increase cu stomers’ loyalty to the supermarket involved, reducing the supermarket’s price el asticity of demand(PED), reducing its cross elasticity of demand (CED)with respect to a rival supermarket and increase demand for the supermarket. When PED is reduced, the supermarket can increase the prices of its groceries, quantity demanded will fall less t han proportionately and total revenue can rise. With a fall in CED, the supermarket will experience a smaller fall in the demand for its groceries by less than proportionate when the rival supermarket reduces its price. This is especially important in times of future price war situations. In the context of falling income, customers in UK are shifting to online stores in an attempt to buy possible cheaper goods available. The revolution in food retailing has seen shifted taste and preference of customers towards shopping online. Supermarket that fail to develop their online sale presence may lose these customers that have shift their shopping online eventually. Thus, in an attempt to protect their market share and reduce the potential fall in total revenue, supermarkets have little choice but to start an online presence. However, there is uncertainty that the investment to build an online presence can increase total revenue. Online presence intensify competition for the supermarket as their competitors now stretch to any online grocery stores in the world or even the third parties selling groceries. In addition, the increase in sales revenue from the online stores can stem from a fall sales from the same group of cust omers from the brick-and-motor stores. Thus, demand and total revenue may not rise with an additional channel for sales. By having online presence, the supermarkets can reduce their fixed and variable costs as supermarkets can reduce their fixed and variable costs from expensive retail premises and customer-facing staff. In addition, supermarket can utilise its existi ng warehouse, logistic systems and related personnel to enjoy techni cal economies of scale and reduce its average cost of production. This allows the supermarket to move along the falling arm of its LRAC.

PIONEER JUNIOR COLLEGE (ECONOMICS DEPARTMENT) 3 With an addition sales channel, there could be problems arising in communication and overstaffing problem in some departments. This will cause diseconomies of scale and increase the average cost. The eventual impact on the average costs depends largely on how the supermarket reorganizes itself with the new department on online sales. In addition, supermarket will incur additional costs related to having a new online sale platform. Some of these may include costs in starting an internet platform and security systems etc. In the context of falling profits for many years, supermarket like Morrison may have problem coming up with these additional funds to invest in the online presence. In deciding if the supermarket should develop their online sa