TPJC Economics / 2008 / H2 Preliminary Examination / Paper 2 4

Suggested Approach
Essay Question 1

The new S$12 million FairPrice Xtra hypermarket, at Ang Mo Kio Hub,
offers a wider range of goods than the typical FairPrice supermarket, and
includes new lines like electronic products and fashion wear.

(a) Explain how the scale of a firm influences its costs. [10]

(b) Assess the relevance of price elasticity of demand, income elasticity
of demand, cross elasticity of demand to the supermarkets in
Singapore. [15]

Part (a)

Introduction
A firm refers to a business unit which employs productive resources to produce
goods and services. Scale of firm is characterised by the amount of capital outlay
/ fixed assets, employment size and the levels of output / market share. In
Singapore, the employment size of the Small Medium Enterprises does not
exceed 200 workers and fixed assets not exceeding S$15 million.

Development
As a firm increases its scale of production, it is able to enjoy cost advantages -
internal economies of scale. Internal Economies of Scale are lower unit cost
achieved by a firm when it expands its output or enlarges its scale of production.
The internal EOS arises within the firm as a result of its own expansion and are
independent of the size and expansion of the industry.

Internal Economies of Scale (require to explain only two)
1. Marketing / Commercial Economies
A large firm buys its raw materials in bulk and large discount are often
offered by the suppliers. Instead of buying from the wholesaler, the large
firm can buy directly from the producer. For example, a supermarket can
obtain its meat, egg supplies, vegetables and fruits directly from the farms
at a discount while an independent stall at the wet market may have to
obtain his supplies from the wholesaler.

In selling a large volume of output, the firm may be able to use more
expensive but more cost-effective advertising. In other words, advertising
cost will be spread out. A firm such as NTUC Fairprice supermarket with a
nationwide market can afford to advertise in the papers, etc, to bring its
product to the notice of potential buyers whereas a small firm may not
have the capacity to advertise. Though such firms may spend large sums
on advertising, their advertising costs per unit sold may be well below
those of a small firm.

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Advertising costs can spread over a large volume of sales. Moreover, the
large firm can save on advertising costs as the same advertisement helps
to promote its range of products and not just one product.


2. Administrative / Managerial Economies
As the scale of a firm increases, specialists can be employed to manage
the firm. In other words, division of labour can be introduced into tasks of
management. Different experts can be employed to take charge of
planning, production, accounting, sales promotion and personnel
management. Efficiency in management thus can reduce unit costs in
large firms.

3. Financial Economies
A large firm is often able to obtain finance more easily or on better terms
than a smaller firm. Its larger assets and greater selling potential provides
banks with greater security and makes it possible for them to provide
loans at lower rates of interest. The larger firm can also raise substantial
capital through public issue of shares.

4. Risk- bearing Economies
Large firms are in a better position to spread risks. Furthermore, large
firms have greater opportunities for reducing risk through the
diversification of markets or products. Thus, if sales drop in one market, a
large firm can still rely on sales in other markets to compensate for the
loss or if one product becomes unpopular, the firm can make up for the
loss from its sale of other products. In the case of FairPrice Xtra
hypermarket, it offers a wide range of goods and includes new lines like
electronic products and fashion wear.

Diseconomies of Scale (require to explain only one)
When a firm enlarges its scale beyond the minimum efficient scale, it may
experience diseconomies of scale where the unit cost increase.

1. Management problem
As a firm continues to expand, coordination and control become more
difficult. Communication becomes a time-consuming process, so that
decisions are inevitably delayed. In addition, communication in a large firm
tends to be one way; i.e., a superior will pass on to his subordinates
something to do without discussing the matter with them. One-way
communication often leads to ill-feeling and misunderstanding.


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2. Financial Problems
When a firm is very large, it requires a lot of capital to finance further
expansion. It may be possible for the firm to obtain such finance only from
sources which charges increasingly higher rates of interest.

3. Marketing Problems
When a firm becomes too large, it will experience difficulties in finding
sufficient demand for the commodity it produces. After a certain point is
reached, expansion of the existing market can be achieved only by huge
expenditure on advertising and publicity.

External EOS(required to explain only one)
Large as well as small scale firms are able to enjoy external economies of scale.
External EOS are cost savings enjoyed by individual firms as a result of the
expansion of the industry as a whole. These economies are independent of the
firms own output and are outside the control of the firm. External economies are
possible to an industry as a whole when most of the firms in a particular line of
production comprising the industry are concentrated in one area, i.e. when
localization of industry occurs.

1. Economies of Concentration
These are mutual benefits to be derived when the firms in a particular
industry are concentrated together and the industry expands.

Development of infrastructure & marketing facilities
When an industry is first set up in a new area, transport, amenities (like
water, electricity, telephone facilities) and marketing facilities (for the
purchase of materials and sale of the product, specialized warehousing
and banking) may not be well developed. With the entry of firms leading to
expansion of the industry, it is possible for transport and marketing
facilities to be developed. Thus, individual firms need not build their own
road system and generator. This will help to cut down unit cost of
production. For example, in Singapore, the Ang Mo Kio Hub or IMM
building housed a large number of retail outlets including supermarkets
which enjoy the well-developed transportation (MRT and SBS Transit) and
other amenities.

2. Economies of Information
The development of the industry often leads to the development of
research facilities to improve the existing production techniques and the
publication of specialist journals. It becomes possible to set up research
associations which will carry out research work on behalf of individual
firms and publish the results for all firms to use. Such researches are of
enormous advantage to the industry as a whole but far too expensive for a
single firm to undertake unaided.


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Conclusion
In conclusion, the large scale production enjoys internal EOS as AC decreases.
However, when a firm enlarges its scale beyond the minimum efficient scale, it
may experience diseconomies of scale where the unit cost increase (AC
increases). The external EOS are enjoyed by both the small and large scale
firms. Besides cost advantages, the scale of the firms also influences its revenue.
Firms must be large enough to capture a bigger market share and therefore able
to exert market power to set prices or output in order to increase its revenue.

Part (b)

Introduction
Supermarkets, like all other business organizations, conduct their day-to-day
business with the aim of maximizing their profits, ie. Revenue Cost. The use of
the 3 concepts of elasticity of demand helps the supermarkets to maximise its
TR. Some supermarkets may see growth maximising and expansion of market
share as their long term objectives.

Development
Explain how each concept may be relevant to the supermarkets seeking to max
TR

1. Price Elasticity of Demand
Usefulness
Ep measures the degree of responsiveness of the quantity demanded
of a good with respect to its price changes, ceteris paribus. It is useful
in helping the firm to determine the price that should be set to
maximize its TR.

Application
Most of the items sold one supermarket are available in other
supermarkets. Examples, rice, meat, ice cream, daily essentials etc.
Due to the availability of substitutes, we shall consider the case of Ep >
1. In this case, the supermarket should decrease price to maximize
TR. (diagram). A fall in price will lead to a more than proportionate
increase in quantity demanded, therefore increasing its TR.

Supermarkets should make its demand more price-inelastic so as to
increase price and capture more revenue. This can be done through
branding, promoting customer loyalty through discount privileges, link
points etc.

2. Cross Elasticity of Demand
Usefulness
EAB measures the degree of responsiveness of quantity demanded of
good A to a change in the price of good B, a related good, ceteris

TPJC Economics / 2008 / H2 Preliminary Examination / Paper 2 8
paribus. It is useful in helping the supermarket to decide what
strategies they should adopt in response to a price change of a related
good (substitutes or complements) in order to maximise its total
revenue.

Application
If EAB high & positive (due to availability of substitutes)
Supermarkets need to take note of rivals pricing policies & strategies.
In the short run, if their rivals reduce price, supermarkets might have to
follow so that demand will not fall drastically. In the long run, in order to
reduce the degree of substitutability, supermarkets should differentiate
its product from rivals. E.g. creating unique services like delivery

EAB high & negative. Strong complements like salad and
seasoning.
Supermarkets can offer bundled packages at attractive prices to
increase customer base

3. Income Elasticity of Demand
Usefulness
Ey measures the degree of responsiveness of quantity demanded of a
good to a change in the income, ceteris paribus. It is useful in helping
the firm to determine its strategies and what to stock up in different
economic situations in order to maximise its total revenue.

Application
Ey is positive
During economic boom or end of the year where most people receive
their bonus, the supermarket could advertise more aggressively the
luxury goods which are income elastic (Ey > 1). Examples are
organic and premium food items. This is because during periods of
increasing income, the demand for luxury goods will increase by more
than proportionate. By exploiting on the higher Ey, the supermarkets
could increase its TR thus increasing its profits, ceteris paribus.

At the same time, supermarkets need not stock up too much income
inelastic goods (Ey <1) such as daily essentials as the increase in
demand is less than proportionate to the increase in income. There is
afterall physiological limit to how many loaves of bread and rice one
can consume even for someone very wealthy. Instead, the additional
income is more likely to be spent on manufactures like electronic
products and fashion wear.

Implication on growth and sales
Relying on the sale of staple items like bread and rice means that
supermarkets will see only very slow growth in the demand for their

TPJC Economics / 2008 / H2 Preliminary Examination / Paper 2 9
products as consumers income rise. By diversifying, offering a wider
range of goods and includes new lines like electronic products and
fashion wear, supermarkets can benefit from exploiting their higher
income elasticity of demand and experience a more rapid growth in
demand and sales revenue.

In Singapore, some supermarkets exploit the high Ey by setting up
premium outlets in high income residential area that supply premium
food items to meet the demands of the high income group.

Ey is negative
Supermarket could promote inferior goods (some house brands)
during periods of decreasing income (recession, increase in tax rates).


Evaluate the relevance of the 3 concepts and its limitations
All the 3 concepts of elasticity of demand are relevant to the supermarkets to a
certain extent. The concept of price elasticity of demand can be considered as
useful in that it explains the price rigidity of supermarkets as oligopolistic firms
which are mutually interdependent. As a result, supermarkets may be hesitant to
increase or decrease the price of its products, they may instead follow the price
set by the most dominant firm in the industry. Cross elasticity of demand is also
useful as there are several supermarkets in the industry. Each supermarket is
watchful over the strategies that their rival supermarkets are engaging in. They
will tend react accordingly so as not to lose their customers. Income elasticity of
demand is especially useful in the long run where the economic situation and
income of the consumers changes. By offering a wide range of goods also
serves to meet the changing consumer patterns resulting from rising affluence,
the focus here is, therefore, on income rather than price as a determinant of
demand.

However, there are limitations with using elasticity concepts.

Difficulty in estimating elasticity values
Firstly, it is the ability to gather accurate data for analysis. Furthermore, precise
figures might not be so readily available and even if they were, historical trends
may not be adequate to correctly predict future ones. A normal good today might
be an inferior good tomorrow. The data therefore must not be obsolete as the
economy and preferences are not static but dynamic.

Ceteris Paribus assumption does not hold
Secondly, there are other factors that might be taking place concurrently, thus
influencing the outcome predicted using the elasticity concepts. For example,
even if there is a reduction in price for a price elastic good, its revenue may end
up falling if other factors (eg. a change in taste and preference) cause the

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demand to fall at the same time. The assumption of ceteris paribus is rarely true
in real life and so elasticity estimates may be unreliable.

Elasticity values explain the effect on Demand & TR but did consider TC
Thirdly, demand elasticity concepts are only useful in explaining the changes in
demand and revenue. The long term survival of a firm however depends on its
profits. In other words, supermarkets must also keep a close watch on their costs
especially as it expands its scale.

Conclusion
In the short run, the supermarkets may still use the 3 elasticity concepts to
increase its total revenue although there are limitations. Supermarkets being
oligipolistic firms, in the long run, they may be concerned with building up barriers
to entry to increase their market share to increase their profits. By offering a wide
range of products, supermarkets position themselves as a one-stop shopping
place which provides convenience for customers, which enables them to capture
a wider market thus increasing their profits. At the same time, they are
maximising the use of their floor space, thus lower average cost. In so doing,
they are building barriers to entry preventing new firms from entering into the
industry.