TJC 2021 Q1

Faced with a drastic drop in revenue due to the Covid-19 safe distancing measures, some food
and beverage (F&B) owners have succumbed to the challenges. In an attempt to stay afloat,
eateries have employed strategies such as food delivery as well as reducing staff.

(a) Explain why some firms shut down due to the pandemic while other firms remain in the
market with subnormal profits. [10]
(b) Discuss the strategies that firms may use to remain in business amidst the challenges
brought about by Covid-19. [15]

Part (a)

Introduction

During Covid-19 pandemic, most firms faced a reduction in total profits and some possibly made
subnormal profits, making them vulnerable to closure. In the short run, whilst some firms shut down,
others continue to remain in the market even though they making subnormal profits. This essay shall
explain why firms continue to operate, and explain the shutdown condition which a firm uses as a guide to
whether or not to shut down during the pandemic.

Body

R1: Explain the condition for continuing operations when a firm earns subnormal profits in the
short run.

Profit of a firm is obtained from Total Revenue (TR) less (minus) Total Cost (TC). A subnormal profit is
made when TR of a firm is larger than its TC. In the short run, a firm incurs both fixed and variable costs.

Fixed cost does not vary with output produced and it is incurred even when there is no production. Such
costs are payable even when a firm shuts down its operation. Examples of fixed costs in a F&B firm
include rental payments for the shop space, payments for machines and fire insurance etc.

Variable cost varies with output produced and it is not incurred by a firm when it shuts down or ceases
operation. Examples of such costs include wages and expenses for raw materials needed in production.

To slow the spread of Covid-19, the government imposes various restrictions, for example, social
distancing to reduce social contact which reduces the demand of F&B firms, as people are more cautious
about eating and dining out. This may result in a fall in the demand or average revenue (AR) of the firm
such that now it is below its average cost (AC) curve resulting in a subnormal profit of C2abP as shown in
Figure 1 below.
From Figure 1, the firm is earning subnormal profit (C2abP) as average cost (AC) is greater than AR at the
profit maximising output Q2. However, the firm AR is higher than its average variable cost (AVC).

In the short run, even though a firm is earning subnormal profit, but if its average revenue exceeds its
AVC (AR>AVC), it means that it can cover its variable cost and some of its fixed cost, it will choose to
remain in production. This is because by continuing production, the additional cost that will be incurred is
AVC and not the fixed cost because fixed cost does not vary with the level of output, but nonetheless
need to be paid even if it shuts down. At the same time, by continuing operation, the firm will still earn
revenue from the sale of its products (TR).

If the firm chooses to produce at the profit maximising output, it will incur a loss of C2abP which is smaller
than the area C2acC1, as part of the fixed cost (PbcC1) can be covered by TR from sale of output Q2. Thus
under this circumstance, the firm will continue to operate in the market when it earns subnormal profit in
the short run.

[note that the diagram above are optional as diagrams for shutdown conditions are not required in current
syllabus. However, the analytical explanation accompanying the above diagrams are the same as per our
notes, and are thus relevant and useful to be aware of them.

There are alternative ways to explain why a firm chooses to be still in the market when it earns subnormal
profit in the short run. The firm could have accumulated supernormal profits in the past and may be able
to offset current losses, hence they will not shut down. Usually such firms are likely to be oligopolies or
monopoly for these are large firms that could earn supernormal profits in the long run. Nonetheless, the
firm must be anticipating the recovery in demand for its product and will eventually earn normal or
supernormal profits in the future for it will not be worthwhile for not shutting down or exit the market when
it earns subnormal profit].

R2: Explain the shutdown condition when a firm earns subnormal profits in the short run.

Conversely, in the short run, if a firm is earning subnormal profit but the firm’s revenue is unable to cover
its variable costs, (AR<AVC), it will not remain in the market and should shut down.
In the short run, if the firm is unable to earn enough revenue to even cover the AVC, the firm will shut
down. Should a firm choose to shut down, it will have an operating loss that is equal to its total fixed cost,
which will be incurred even if output is zero.

However, if the firm chooses to remain operating, with a P<AVC, the firm will suffer even greater losses of
AVC + AFC. Hence, in order to minimise losses, the firm will choose to shut down instead.

Conclusion

In the short run, for firms earning subnormal profits, the decision to shut down or not, depends on whether
the firm’s AR is above the AVC, and that it can offset some parts of AFC. A firm may leave the industry
after shutdown when it earns subnormal profit going forward into the long run if its P is less than AC
(P<AC).

Mark Scheme [from source]

L For a well-developed answer that: 8 – 10

3
● employs good use of economic theory to analyse how Covid-19’s safe distancing
measures have resulted in subnormal profits (supported with a diagram); and
● explains the shut-down condition and uses rigorous economic analysis to explain the two
situations (P>AVC and P<AVC)

L For an under-developed answer that: 5–7

2
● analyses only one of the two situations in the question; and/or
● did not support analysis with revenue OR costs analysis OR
o Did not provide an explanation as to how subnormal profits arise due to the pandemic;
and/or
● did not provide any application to real-world context.

L For answer that is largely descriptive and have limited application of economic concepts, and/or 1–4
1 contains serious conceptual errors.
(b) Discuss the strategies that firms may use to remain in business amidst the challenges
brought about by Covid-19. [15]

Introduction

To remain in business, firms would have to consider strategies that could tackle falling demand to
increase revenue and those that could reduce costs of production. This essay shall be using the
examples of firms in the F&B industry to discuss the types of strategies to adopt and their effectiveness to
survive the Covid-19 pandemic.

Body

R1: Explain strategies to adopt by firms to increase demand and revenue (AR and MR)

Product diversification through innovation allows the firm to enter new markets and generate new sources
of revenue. By providing a wider range of products, the firm is able to cater to the different needs of
consumers and therefore earn higher revenue and profits as a whole. Here product differentiation

During the pandemic, this is especially useful when the firm’s usual sources of revenue may be impacted
by Covid-19 restrictions such as social distancing (reducing the number of seats to create space) and no
dining out during Circuit Breaker in 2020. Hence restaurants are not able to depend on their usual means
of profiting from the sales from dining in. As such, restaurants started to pivot towards food delivery
services or takeaways, taking advantage of existing platforms such as GrabFood, FoodPanda or
OddleEats, to cater to customers who still wish to patronise the restaurant despite the restrictions.

When the firm chooses to diversify into the food delivery or takeaway market, the firm is able to cushion
the fall in AR and MR or even see an increase in overall demand. From Figure 2, with diversification,
instead of AR falling to AR2, AR may only fall to AR3 instead, hence resulting in a fall in profits (still
profitable, albeit smaller profits).

[note that such product innovation is different from vertical and conglomerate integration
mentioned in our notes. Here due to exigencies of the situation, i.e. during Covid-19 pandemic
with its many restrictions, innovative ideas and strategies must be initiated to differentiate the
firm’s products or offerings to remain in business, unlike normal times where vertical and
conglomerate integration are adopted to diversify for expansion and growth].
Furthermore, in the long run, such diversification can help the firm spread risks, especially with the ever
changing Covid-19 restrictions. It may also increase its overall brand loyalty, and increase long run profits.

Product diversification also includes product differentiation. A firm seeks to differentiate its product from
its rivals. By differentiating its product, the firm can potentially enjoy greater market share and market
power by catering more to the needs of consumers. The aim of product differentiation is to further develop
or highlight the differences between the products of the firm and its rivals.

F&B firms can carry out advertisements by engaging social media influencers on Instagram to conduct
promotional campaigns. This will help to create brand loyalty and to appeal to consumers when they see
their favourite celebrities endorsing a certain product.

Ev1:: There may be high costs associated with developing the food takeaway or delivery. In order to
develop new food dishes that travel well during delivery or takeaway/delivery options, firms may have to
conduct research to ensure that the new food dishes are suitable for the new market. Furthermore, F&B
firms may have to conduct market research on delivery prices or spend additional costs to pay the
platforms or merchants to host their F&B business. Hence firms who may be completely new to this
market such as hawker stalls may find this is not a cheap strategy to implement.

For product differentiation, attempts at product differentiation may end up costing more as firms need to
run advertising or promotional campaigns. Furthermore, rival firms may also attempt to imitate or retaliate
with their own promotions or campaigns. This may reduce the effectiveness of the campaign, resulting in
minimal increases in demand.

R2: Explain cost cutting strategies to reduce AC and MC

By engaging in R&D in technology or to improve efficiency in production processes (process innovation),

the firm may be able to lower its average cost of production and therefore earn higher profits. For
example, F&B firms may depend on technology to prepare their food or drinks, so that they may reduce
staffing and cut costs on paying labour wages. Local cafés such as Ratio Café and Lounge have
developed fully automated robots that replace baristas. This allows the firms to reduce costs spent on
wages which may see an increase as Singapore may see a decline in foreign labour due to inaccessibility
from border closures.

This results in a decrease in cost of production, hence both AC and MC decreases. This is shown by a
downward shift of the AC and MC curves from AC0 to AC1 and MC0 to MC1 in Figure 3. As a result, the
profit maximising level of output and price changes from P0 to P1 and Q0 to Q1 respectively. The level of
profits change from subnormal profits of C0abP0 to supernormal profits of P1efC1

Ev2: As with any research and development programme, there are extremely high cost and a low
certainty of outcome. Consumers may also be sceptical of the quality of the coffee brewed by a robot and
may not take to the new innovation, which may lower AR/MR in the long run, negating any potential
increases in profits due to the cost-cutting measures.

The firm may still have to hire a staff to ascertain the quality and taste of the food or drink in order to give
assurance, which may not help to decrease the cost of production eventually.

Conclusion

Owing to the ever-changing nature of Covid-19 pandemic and the challenges that it brings, in the short
run, firms should focus on responding quickly to the changing measures in order to ensure survival by
carrying out product differentiation via advertisements and promotions on social media platforms. This will
help to cushion the fall in revenue due to the changing regulations.

However, F&B firms should also ensure that they carry out process innovation or diversification strategies
in the long run to ensure they keep with and survive with competitions.

On the whole, firms should engage in a combination of strategies that allow them to cut costs as well as
increase revenue.

Mark Scheme [from source]

 L3 For a balanced answer that 8–
● provides a rigorous analysis of at least three different strategies (how it works and the 10
limitations) to increase profits in light of the Covid-19 situation.
● well-contextualised to a chosen market (could be F&B or any other contexts) bringing in
key concerns relevant to the context of strategies that help a firm remain in business
due to the challenges of Covid-19.

L2 For an answer that: 5–7

● lacks sufficient scope; analyses only two strategies OR

● lacks a rigorous analysis of how the strategy works and limitations/unintended consequence of
at least three strategies to address the subnormal profits OR
● an answer that is rigorous but not balanced; analyses only how the strategy works or
limitations/unintended consequence of at least three strategies to address the subnormal
profits OR
● answer lacks application to a real-world context or understanding of the challenges of
Covid-19

L1 For an answer that: 1–4

● For a descriptive answer that mainly stated the different strategies that could be adopted, with
limited or erroneous explanations of how the strategies work and/or their limitations.

Evaluation

E3 For an answer that uses economic analysis to arrive at a well-reasoned judgement on the relative 4–5
appropriateness/effectiveness of the different strategies to address the subnormal profits of firms
and hence how to remain in business in light of the Covid-19 challenges.

E2 For an answer that makes some attempt at a judgement about the relative 2–3
appropriateness/effectiveness of the different strategies to address the subnormal profits of firms
and hence how to remain in business in light of the Covid-19 challenges.

E1 For a largely unexplained judgement that addresses the question of the 1

appropriateness/effectiveness of the different strategies, but is not supported by economic
analysis.