[2023 AP] 2022 A Level H2 Economics

Suggested Answers to Paper 2 EQ1

[2023 AP] Essay Question 1:

Economists usually begin their analysis of decision-making by firms by assuming
that the objective of a firm is to maximise its profit. In reality, however, there are
many different objectives that a firm might adopt.
(a) Explain the likely effects on a firm’s price and output when its objective changes
from profit maximisation to profit satisficing.
(b) Discuss the most appropriate strategy that a firm could adopt if its objective
was to reduce the competition that it faces.
Suggested Answer:
Part (a)

Introduction:
[Definition] Profits = Total revenue – total cost.

All firms ultimately, or traditionally, aim to maximise profits. However, in reality, firms do
not necessarily set price and output at profit-maximising levels and may set price and
output at profit satisficing levels, due to lack of information or violation of the ceteris
paribus assumption, or unwanted attention from the government.
Body/ Development:

Topic sentence: For firms to maximise profit, they would produce and set prices where
Marginal Cost is equivalent to Marginal Revenue (MC=MR), and where MC cuts MR
from below.

Explain with economic analysis:

MC is the change in total cost as a result of producing an additional unit of output. It
shows the extra cost of producing an additional unit of output. On the other hand, MR
is the additional revenue gained by selling one more unit of output. Assuming that the
firm is a large, dominant firm, Figure 1 shows the profit-maximising price and output,
ceteris paribus.

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[2023 AP] 2022 A Level H2 Economics
Suggested Answers to Paper 2 EQ1

If the firm produces OQa where MR > MC, then producing the last unit of output adds
more to revenue than to cost. This implies that the firm should increase its output till Q1
where MR = MC. Hence the total profit of the firm could be increased by producing
another unit of output.

Conversely, if the firm produces OQb where MR < MC, then producing the last unit of
output adds more to cost than to revenue. This implies that the firm should reduce its
output till Q1 where MR = MC. Total profit could be increased if the last unit of output
were not produced.
Thus, profit (area P1ABC) is maximised when the firm produces OQ1 where MC = MR
provided MC cuts MR from below.

Topic sentence: The firm’s price may rise and output may fall when its objective
changes from profit maximisation to profit satisficing.

Explain with economic analysis:

Rather than trying to maximise profits, firms may aim to profit satisfice where managers
aim for a profit level that will keep shareholders happy. This may be because they are
reluctant to accept the increased risks and pressures associated with fiercely
competitive policies, or because they are seeking to satisfy not only shareholders but
also other stakeholders such as workers, consumers, suppliers, the local community
and environmentalists. These groups may have different objectives: consumers want
low prices and high quality; workers want high wages, job satisfaction and security;
suppliers want a high price; the local community want employment but an absence of
congestion; and environmental groups want a clean environment and the conservation
of flora and fauna.

For example, rather than trying to maximise profits, firms may aim to profit satisfice
when managers prize a positive work environment and employer-employee
relationships over profit-maximisation. In such a case, a manager, instead of sacking
underperforming workers and go through the difficulty of firing workers in the process
creating a bad feeling in the workplace, may continue to employ them. All these will
subsequently raise the MC and AC for the firm. The firm will then produce at a higher
price of P2 and a lower output of Q2 where MC = MR provided MC cuts MR from below
as seen in Figure 2. It will also reduce profits in the short run from area P1ABC to area
P2C2CD. Although profits are lower than what the firm could have earned if it had
chosen to maximise profits, the strategy keeps employees happy and still makes
enough profits to keep shareholders satisfied. The same analysis could apply to firms
which choose more costly but environmentally friendly production methods in line with
beliefs rooted in sustainable living and are quite satisfied with lower profits of P2C2CD
which are sufficient to keep shareholders and stakeholders satisfied. An example would
be H&M, which has pledged to become 100% climate positive by 2040 by using
renewable energy and increasing energy efficiency in all its operations, including
making a commitment to make the first two tiers of its supply chain climate neutral by
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2030. H&M has also pledged to use 100% recycled or sustainable materials by 2030,
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a pledge that is also evident in IKEA.

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[2023 AP] 2022 A Level H2 Economics
Suggested Answers to Paper 2 EQ1

Profit satisficing could also see a fall in price and rise in output compared to profit-
maximising. This is particularly evident in sole proprietor mom-and-pop shops (usually
small, independent and family-owned businesses). It is not uncommon for food hawkers
to keep prices low despite hikes in production cost causing MC & AC to rise from AC1
& MC1 to AC2 & MC2 due to rising energy or ingredient prices. In this case price is kept
at P1 instead of rising to P2 if the hawker had been profit-maximising and output
remains at Q1 instead of falling to Q2, causing lower profits of P1AXY instead of P2C2D
– which keeps the hawker satisficed as his customers can continue enjoying his dishes
at affordable prices. Another example is when, for the benefit of society, a non-profit
tuition agency hoping to reach out to and benefit as many underprivileged children as
possible charges its tutees a price that is just enough to cover average cost of tutoring
at PT where AR (=DD) = AC i.e., AC-pricing, choosing to earn normal profit at price PT
& quantity QT rather than maximise profits at P1ABC by charging price P1 and
providing Q1 amount of tuition services.

Such pricing and output behaviour could also be applied to a firm seeking not so much
social good, but longer-term market share dominance. Such a firm might conduct AC-
pricing where AR = AC in the short run, setting a price and output level (PT and QT)
that is respectively lower and higher than that which maximises profits (P1 and Q1) and
be satisfied with lower or even normal profit in the short-run (as opposed to P1ABC1)
in order to maximise sales/growth so as to monopolise the market, charge higher prices
and earn larger profits in the long run.

Y X

PT

QT

Figure 2

One example of profit satisficing that sees price higher and quantity lower than profit-
max; and one where price is lower and quantity higher than profit-max.
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[2023 AP] 2022 A Level H2 Economics
Suggested Answers to Paper 2 EQ1

Conclusion:

Firms can also have other objectives such entry deterrence to prevent the entry of new
firms or aim to increase market share and hence market power via predatory pricing to
reduce the competition that it faces.

Mark Scheme (a):

Level Descriptors Marks
L3 For a response which shows strong economic analysis to explain 8-10
how firms determine price and output when maximising profits
and the impact on price and output when there is change in the
firm objectives changes from profit maximization to profit
satisficing.

L2 For an under-developed explanation. Appropriate economic 5-7

concepts and analysis is used but analysis lacking to address the
change on the impact on price and output when there is change in
the firm objectives changes from profit maximization to profit
satisficing.

L1 For an answer that shows some knowledge of the objectives of 1-4

profit maximisation and profit satisficing.
OR an undeveloped answer that contain inaccuracies.

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[2023 AP] 2022 A Level H2 Economics
Suggested Answers to Paper 2 EQ1

Part (b)

Introduction:

Firms can employ a range of price and non-price strategies to achieve its objective to
reduce the competition that it faces by preventing entry of new firms or increasing its
market share and hence market dominance.

Body/ Development:

Topic Sentence: Firms might be aware of potential entrants into the market. To reduce
the competition that it faces and avoid losing market share to these new entrants,
incumbent firms could decide to focus their non-price and price decisions to reduce
competition as well as deter the entry of new firms.

Candidates just need to choose and explain 2 price and non-price strategies

Requirement #1: Explain how firm can employ non-price strategy – product
development to reduce competition as well as deter the entry of new firms:
In order to reduce competition and prevent new firms from entering the market, existing
firms may adopt strategies such as product development. New firms are deterred from
entering the market as they may not have sufficient capital to invest in producing similar
products. An example would be Uniqlo, which has diversified its clothing range to
include Airism and Heattech series, and more recently, face masks during the COVID-
19 situation. Another example would be Grab which has included new features such as
GrabMart and GrabExpress and a reward system to build brand loyalty in its
application. New firms are deterred from entering the market as they may not have
sufficient capital to invest in producing similar products and hence reduce competition
that the incumbent firm faces. Existing firms which do not have as deep enough pockets
i.e., accumulated profits as Grab and Uniqlo to carry out such product development will
also find themselves losing out in terms of non-price competitiveness to Grab and
Uniqlo.

However, extensive product development to differentiate its products could result in

higher costs and thus lower profits for the incumbent firm. However, if the product
development is successful in reducing the degree of substitutability of the products (i.e.
fall in XED value) and subsequently making the demand relatively more price inelastic
(i.e. fall in PED value) as the availability of close substitutes falls, the existing firms can
then increase prices and thus total revenue earned, ceteris paribus. Moreover, if the
product development is successful this will lead to a favourable change in tastes &
preference towards the product, thereby making a rise in demand and hence revenue
for its products. Profits thus rise, assuming costs remain constant.
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However, engaging in innovation would incur higher costs for firms, which could, in the
short run, lower profits even further before total revenue rises in the longer run. This
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could even lead to subnormal profits, increasing the risk of closure in the short run.

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[2023 AP] 2022 A Level H2 Economics
Suggested Answers to Paper 2 EQ1

[E/Criterion: Availability of resources / Type of market structure] Firms such as

bubble tea outlets belonging to monopolistically competitive markets which are less
concentrated due to weaker barriers to entry will very likely find themselves in such
situations due to their lack of accumulated profits. As these firms tend to earn normal
profit in the long run, they have hardly any reserves to withstand losses, increasing their
risk of closure in the short run from such product development. In fact, it is even
questionable whether firms in more competitive markets are able to carry out such
product development to reduce competition, since they lack the financial reserves and
are therefore only capable of small scale, cosmetic non-price competition in the form of
product differentiation such as selling unusual concoctions or offering special drinks on
certain days of the week – strategies which could be easily copied and so might be less
effective in reducing competition.

Requirement #2: Explain how firm can employ price strategy – such as predatory
pricing to induce exit of firms and so reduce competition:
In an attempt to increase the firm’s market share and hence market power to reduce
the competition that it faces, decisions could be made with the aim of driving rival firms
out of the market.

For example, incumbents like Grab may deliberately make it difficult for the new
entrants like Plum to stay in the online food delivery industry or deter new entrants into
this industry by offering promotions such as a lower minimum order for free delivery
which could be a predatory pricing strategy, since (1) the low price is insufficient to
cover new firms’ average costs due to its much smaller production scale that limits it
from enjoying large internal EOS earn subnormal profits and (2) its high AVC is likely
to exceed its low AR given its limited consumer base as it is a new firm that has yet
gain consumers’ trust and confidence in its food delivery services new entrant has to
shut down and should the losses persist into the long term, it will exit the industry,
evidenced from food delivery start-up Plum’s exit from the online food delivery industry.

Firm engaging in predatory pricing involves the firm temporarily pricing its product
below its average cost (C1) at P1 (Figure 4) in order to drive new entrants out of
business. The firm will make a loss (i.e. subnormal profits) of area C1P1ba now or in
the short run.

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[2023 AP] 2022 A Level H2 Economics
Suggested Answers to Paper 2 EQ1

Figure 4

Once the predator’s rivals drop out of the market in the long run, the firm’s demand
rises to AR2. It can then restrict output and charges a market dominant price (P2), well
above its production cost (C2). It makes supernormal profit of area P2C2dc. This will
be a profitable strategy if the firm can charge the market dominant price for a long
period to offset the losses it experienced while driving its rivals out of business.

However, this means that the firm employing predatory pricing would be earning
subnormal profits/making losses in the short run.
[E/Criterion: Availability of resources]: The viability of the strategy is dependent on
the ability of the firm to recoup its short run losses in the long run. This strategy will only
work and ensure profitability if Grab can charge the monopoly price for a long period to
offset the losses it experienced while driving its rivals out of business. Otherwise, if the
firm continues to earn subnormal profits in the long run, they may end up having to shut
down since AR<AC. Therefore Grab will need to ensure they have the ability to recoup
their losses in the long run if they decide to pursue this objective. In this instance, Grab,
being an established firm, and having enjoyed supernormal profits as the dominant firm,
is likely to have deep enough pockets due to accumulated supernormal profits, to
withstand these losses. This is unlike newcomers which have yet to make any profit
and so will likely shut down and exit the industry.

Moreover, being an established firm serving a sizeable proportion of the market, Grab
is likely to enjoy much lower unit cost due to internal economies of scale compared to
newcomers – this means Grab is able to charge a much lower price than newcomers
to inflict huge losses on them and increase the likelihood of them shutting down and
exiting the industry.
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Other possible strategies: Mergers & acquisitions, limit pricing

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Conclusion:

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[2023 AP] 2022 A Level H2 Economics
Suggested Answers to Paper 2 EQ1

Whether the strategy to reduce competition is appropriate depends on the following

criterion:

[Criterion]: Time Period

In the short run, it would be appropriate for the firms to reduce the competition it faces
by predatory pricing. However, predatory pricing leads to subnormal profits which are
strategies that can only be applied for a short time and not sustainable in the long run.
This may even lead to firms shutting down if they do not have enough supernormal
profits to fund these strategies. Hence, employing non-price strategy of product
innovation would be a more appropriate long-term policy.

[Criterion]: Government intervention

The appropriateness of the strategy depends on whether the government will actively
intervene to protect consumers’ welfare. This is because if firms employ predatory
pricing to drive out rival firms to increase the market share and charge high price to
earn high profits, governments may step in to intervene to prevent exploitation of
consumers. As such, to reduce unwanted attention from the government, predatory
pricing would be the least appropriate policy to reduce the competition that the firm
faces. For instance, Competition & Consumer Commission of Singapore (CCCS)
imposes anti-trust laws to prevent anti-competitive behaviour of firms as predatory
pricing is considered an abusive tactic/dominant undertaking and is against the law.

Mark Scheme (b):

Level Knowledge, Application, Understanding & Analysis Marks

Well-developed and balanced analysis with good scope and depth
L3 that clearly analyses both price- and non-price strategies to reduce 8-10
competition that a firm faces.
For an underdeveloped answer
• that does not have sufficient scope; explains only price or non-
L2 price strategies OR 5-7
• lacks a clear explanation of how the various strategies reduce
competition that a firm face
For an answer that shows some knowledge of the various strategies
L1 1-4
that can be employed to reduce the competition that a firm face.
Evaluation
For a well substantiated evaluative judgement on the
appropriateness of the strategy that firms can employ to reduce the
E3 competition that they face with a summative conclusion on whether 5
price or non-price strategies are most appropriate using a specified
criterion.
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For an answer that makes some attempt at an evaluation on the

E2 most appropriate strategy that firms can employ to reduce the 3-4
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[2023 AP] 2022 A Level H2 Economics
Suggested Answers to Paper 2 EQ1

competition that they face but is underdeveloped or lacking a

summative conclusion.
For an answer that gives an unsupported evaluative statement(s)
E1 1-2
that addresses the question.

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[2023 AP] 2022 A Level H2 Economics
Suggested Answers to Paper 2 EQ1

MY REFLECTION/LEARNING POINTS FROM EQ1

After reviewing the suggested answers to EQ1, here are my…

2 reflection/learning point with respect to SKILLS:

2 reflection/learning point with respect to CONTENT:

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[2023 AP] 2022 A Level H2 Economics
Suggested Answers to Paper 2 EQ1

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[2023 AP] 2022 A Level H2 Economics
Suggested Answers to Paper 2 EQ1

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