AJC Prelims 2013

AJC Prelims 2013

AJC 2013 Suggested Answers

Question 3
In Singapore, there are many small home interior design firms in the industry. With low startup costs, these firms, such as Meng Design, usually market themselves as providing exclusive designs or affordable services. On the other hand, in the budget airline industry, Jetstar and Tiger Airways often offer lower-priced tickets.

a) Explain why some firms remain small. [10]

b) Discuss if Jetstar’s and Meng Design’s strategies are due to the characteristics of the industry they are in. [15]

There are many reasons why some firms remain small and this can be explained by both demand and supply-side reasons. Demand-side reasons can include the need for personalised services as well as consumers’ preference for variety and individuality. Supply-side reasons can include the nature of production processes as well as the need for flexibility in fast-changing environment. This essay will elaborate on these reasons to explain why some firms remain small.

On the demand side, one reason is that some firms may offer services where personalised attention is an important element. Such firms include hair-dressing salons and dental clinics. Since personalised services are required, the demand for labour per unit of output produced is relatively high and it is difficult for firms to mass produce. Hence, these firms tend to remain small in the industry.

Another demand-side reason is that some firms may be selling products or services that require wider variety and greater degree of individuality to appeal to consumers. Such firms include designer fashion shops and home interior designers like Meng Design. These firms have to constantly differentiate their products by coming up with a wide variety of designs to ensure that their products remain unique to their firm. This means that such firms cannot engage in mass production since by doing so, its products will lose the sense of uniqueness and individuality, which are important elements in these fields. Hence, firms each produce a relatively low level of output in relation to market size, explaining why some firms remain small.

On the supply side, one main reason why firms choose to remain small is highly associated with the law of diminishing marginal returns (LDMR) in the short run as well as diseconomies of scale (DisEOS) setting in at a relatively low level of output in the long run.

LDMR states that as more and more variable factors of production are employed when at least one factor is fixed in quantity, the marginal returns of an additional unit of factor inputs will at some point begin to diminish. For example, a tailoring shop can increase the quantity supplied of their tailor-made clothes by employing more tailors and assistance. However, since the size of the shop is of a fixed size, having increasingly more tailors and assistants will eventually lead to overcrowding in the shop, leading to lower efficiency in the production process. The marginal returns of each additional unit of labour employed will start to diminish and total costs will increase faster than the total output, affecting the profits of the shop (assuming constant prices). This is one of the reasons why firms may choose to remain small.

In the long run, all factors of production are variable. Due to the complex nature of production processes, some firms selling products like custom-made cards may experience DisEOS at a relatively low level of output. This is also associated with the personalised services factor explained above. The Minimum Efficient Scale (MES) of such goods is low in relation to market size, hence such firms would choose to remain small before DisEOS sets in, allowing them to keep costs down and remain competitive.

Another supply-side reason is the need for flexibility and quick response to changing taste and preferences of consumers. For example, fashion shops and home interior design firms may need to quickly adapt to changing taste and preferences of consumers and alter their production processes to suit their needs. They may hence see the need to remain small, since small firms generally possess greater ability to detect changes in market conditions and have greater flexibility in modifying their production processes. Thus, such firms may choose to remain small to remain viable in a fast-changing environment.

The abovementioned reasons hence explain why some firms remain small.

b) Discuss if Jetstar’s and Meng Design’s strategies are due to the characteristics of the industry they are in. [15]

Regardless of the industries that firms fall in, all of them engage in different strategies to help them achieve their aims; mainly to profit maximise. It is important to clearly identify the type of industries that Meng Design and Jetstar belong to in order to determine if their strategies are indeed due to the characteristics of their industries.

The home interior design firms like Meng Design is likely to fall under a monopolistic competition (MC) industry. The preamble stated that there are many small home interior design firms in the industry which is in sync with one of the main characteristics of the MC industry – having a large number of sellers. Secondly, as each designer firm tend to offer designs and concepts unique to their firm, the products sold by these firms are likely to be differentiated, in both actual and perceived qualities, fulfilling another characteristic of an MC industry. Thirdly, the preamble also stated that these firms face low start-up costs, indicating low barriers to entry into the industry. Hence, home designing firms like Meng Design is likely to fall under a MC industry due to the characteristic they exhibit.

With low barriers to entry, new entrants can easily enter the industry and compete away any supernormal profits that firms are earning in the short run (SR), thus firms in the MC industry earn only normal profits in the long run (LR). Existing firms would hence have the incentive to engage in non-price competition, with the aim of earning supernormal profits in the short run. By marketing itself as a firm that provides exclusive design and affordable services, Meng Design is trying to differentiate itself from its competitors through non-price strategies. This helps strengthen the perceived quality of their products from the perspective of consumers, hence increasing the demand for their design products. At the same time, these non-price differentiation strategies will also make their products appear less substitutable from rival firms’ products, making the demand more price inelastic.

The increase in demand will eventually lead to higher supernormal profits for these home interior design firms. However, these supernormal profits can only be maintained in the short run due to the low barriers to entry into the industry. Hence, firms in a monopolistically competitive industry more commonly engage in non-price product differentiation strategies to capture supernormal profits in the SR. Hence, it can be argued that the strategies Meng Design implemented were due to the characteristic of the monopolistically competitive home interior design industry it is in.

Conversely, there are also grounds to argue otherwise – that the strategies undertaken by Meng Design is not entirely due to the characteristic of the industry it is in, instead it could be due to other economic conditions. Take for instance a period of economic recession, Meng Design could have made the decision to market its products as affordable, in order to package its products as value-for-money. This would help maintain their pool of consumers even in times of recession. Similarly, during times of economic boom, there is an increase in the income of consumers, and demand for luxurious goods will increase by more than proportionate. By marketing its products as exclusive, Meng Design in injecting a luxury element into their products, making their products appear to be more upmarket. The demand for their products will also become more income elastic, meaning that a rise in income will lead to a more than proportionate increase in the demand. This will result in a large increase in revenue and eventually increasing profits for the firm. This illustrates that firms like Meng Design could be implementing strategies to tackle changing economic situations, instead of merely doing so due to the characteristics of the industry they are in.

Unlike the home interior design industry, the budget airline firms like Jetstar is likely to fall in an oligopolistic industry. The industry is made up of few major players, like Jetstar and Tiger Airways, indicating that each firm has significant market power in the industry. Furthermore, the products offered by each firm are highly substitutable, as most of them offer similar products in terms of their services and the routes offered. This also means that firms in this industry are very mutually interdependent in their pricing an output decisions; a firm’s action can have major impact on their rivals and vice versa. In addition, there are large fixed costs involved in the establishment of a new firm in the industry, such as costs involved in planes purchasing, operational and maintenance. This suggests that there are high barriers to entry into the industry and existing firms can hence maintain their supernormal profits even in the long run.

The mutually interdependence of firms in the industry can serve as a plausible explanation as to why Jetstar decided to offer low price tickets. The preamble stated that other firms like Tiger airways also offer low price tickets, this action of Jetstar could thus be in response to actions of its rival firms that have reduced ticket prices. As explained earlier, the products sold by firms in the industry are highly substitutable, this means that the cross elasticity of demand (XED) for Jetstar’s budget tickets is highly positive with that of rival firms. In the case where rival firms like Tiger Airways reduce the price of their tickets, the demand for Jetstar’s tickets will fall by more than proportionate as a large proportion of their consumers will switch to purchase from Tiger Airways. Hence, Jetstar will tend to follow the actions that rival firms have undertaken in order to prevent the loss of market share and profits. Hence, the strategies of Jetstar could be indeed due to the characteristics of the industry like mutual interdependence between firms.

However, the strategies of Jetstar could be due to other reasons instead. There are many complementary goods offered by firms in the budget airline industry, such as tour packages, car rental services and inflight dining and products. These products have highly negative cross elasticity of demand with budget air tickets. By offering low price tickets, or reducing the prices of these tickets, Jetstar can increase the quantity demanded of their air tickets, and at the same time, increase the demand for the complementary goods that they offer. Hence, even if Jetstar experience a fall in revenue from lowering the ticket prices, the extra sales revenue generated from their sales of complementary goods will eventually lead to an overall increase in their sales revenue and profits.

In conclusion, it is difficult to completely determine if the firms’ strategies are indeed due to the characteristic of the industry they are in. This is because a firm may adopt various strategies due to a wide variety of reasons, be it due to characteristics of the industry, prevailing economic conditions or other factors. For example, firms could implement certain strategies to help them tackle changing economic conditions, like a sudden recession in the economy, or change in taste and preferences unfavourable to the demand of their products. These reasons could however be mistaken to be associated with the characteristics of the industry these firms are in.

It is possible to use the time period to help determine the reasons for the strategies implemented. In the short run, economic conditions could be more volatile and dynamic, firms’ decision would then revolve around the need to meet the changing income levels, or demand and supply of their goods, in order to increase their survivability in the market. For example, if there is a sudden change in taste and preferences unfavourable to their products, the demand for these products will fall. Firms would then have to focus their decision making and find ways to increase the demand for their products, by marketing and promotional strategies for instance. On the other hand, in the long run, external shocks average out and there is less volatility involved, it is then highly possible that firms’ decision making as well as price and non-price strategies could be attributed to the characteristics of the industry.