Model essay (b): price cut or differentiation?

What this lesson teaches

• I can explain the strategies firms use to raise revenue or cut unit costs: growth, pricing, price discrimination, innovation, marketing and collusion.

  Syllabus 9570, 2.2.3(a). Firms' Decisions and Strategies: Firms make decisions and engage in pricing, cost and product differentiation strategies aimed at raising revenue and/or lowering unit costs. These include:; growth, diversification and shut-down; price competition; third degree price discrimination; innovation, research and development; marketing; collusion with other firms

• I can judge how a firm's strategy affects efficiency, consumer welfare and other firms.

  Syllabus 9570, 2.2.3(c). Firms' Decisions and Strategies: Impact of firms' decisions and strategies on:; efficiency (allocative, productive and dynamic efficiency); consumer welfare (consumer choice, product quality and consumer surplus); other firms (cost, revenue and profit)

Make a guess

A bubble tea chain faces new rivals. Which strategy is harder for rivals to copy?

1. Building a distinct brand and flavours.
2. Cutting its prices by 10% and keeping them there.
3. Opening longer hours, including late at night.

The answer to part (b)

Introduction

A price cut means lowering the price of each drink to win customers. Product differentiation means making the chain's drinks distinct through new flavours, quality, healthier options or branding. Both aim to raise the chain's profit. This essay argues that differentiation is usually the better strategy for a bubble tea chain. Price cuts make sense only for a chain with a clear cost advantage. The judgement depends on the chain's costs and on how easily rivals can copy each strategy.

Paragraph 2: the case for a price cut

A price cut can win customers because demand for one chain's drinks is price elastic. There are many shops selling close substitutes. So a lower price draws customers from rivals, and the quantity sold rises by a larger proportion than the price falls. Total revenue rises. A large chain may also gain from economies of scale. With many outlets, it can buy tea and tapioca in bulk at lower prices and spread advertising over more sales. So its average cost is below that of small rivals. It can then charge less and still cover AC. Over time, small rivals that cannot cover their costs may leave, and the chain gains market share.

Paragraph 3: the limits of a price cut

However, a price cut is easy to copy. Rivals can match it in a day, so the chain wins far fewer customers than it hoped. Repeated cuts can start a price war, which leaves every firm with lower prices and thinner margins. In the long run the chain earns only normal profit, where price equals average cost, as shown at point a in Figure 2. Cutting price further would push price below AC and cause a loss, unless costs fall too. Customers won by price are also not loyal; they leave when a rival's offer is cheaper.

Paragraph 4: the case for differentiation

Differentiation works by changing demand itself. Suppose the chain launches flavours that rivals do not offer, uses better ingredients and promotes lower-sugar drinks. Nutri-Grade labels now apply to freshly prepared drinks in Singapore, and the least healthy drinks must show a C or D grade. So a lower-sugar range can stand out. In Figure 2, if customers value these features, demand shifts right from AR0 to AR1. Demand also becomes less elastic, because customers see fewer close substitutes for the chain's drinks. The chain produces Q1, where MR1 equals MC, and charges a higher price, P1. Although marketing and design costs shift AC up to AC1, price rises by more, so the chain earns the shaded supernormal profit.

Paragraph 5: the limits of differentiation

Differentiation is costly and its success is uncertain. New flavours, branding and better ingredients must be paid for whether or not customers like them. If demand does not rise enough, the higher AC simply cuts profit. Barriers to entry are also low, so rivals can copy a popular flavour within weeks. Once they do, the chain's AR shifts back left and becomes more elastic again, and the extra profit lasts only a short time.

Paragraph 6: evaluation

The better strategy depends first on the chain's cost position. A large chain with economies of scale can survive a price war that small rivals cannot. A typical chain has no such cost advantage, and for it a price cut just starts a fight it cannot win. It depends second on how easily rivals copy. A price can be matched at once, and a single new flavour within weeks. A trusted brand and consistent quality take years to copy. So differentiation that builds a lasting brand gives the chain a profit that price cuts cannot. In a market with many rivals and easy entry, this makes differentiation the stronger choice.

Conclusion

A bubble tea chain facing new rivals should generally differentiate rather than cut prices. Differentiation can shift its demand right and make it less elastic, so it can earn supernormal profit even after paying for marketing. A price cut suits only a chain whose costs are clearly lower than its rivals'. The strongest approach builds a brand customers trust, perhaps with targeted discounts for loyal members.

Margin notes: how each paragraph scores

Introduction

Defines both strategies, takes a stand and names two criteria for the judgement (cost position, ease of copying).

Paragraph 2

Price elasticity explains why revenue rises, and economies of scale explain why a large chain can still cover AC. It does not stop at revenue: profit needs costs too.

Paragraph 3

The limits use oligopoly-style reactions and the long-run normal-profit position from part (a). The link between the two parts shows understanding, not memorised points.

Paragraph 4

L3 analysis on Figure 2: AR shifts and becomes less elastic, AC rises, and the new MR = MC point and profit area are all explained. Nutri-Grade gives real Singapore context.

Paragraph 5

Balances the thesis: cost risk and imitation, both tied to the low barriers explained in part (a).

Paragraph 6

E3: two well-explained judgements on the chain's costs and on how easily rivals copy. Each weighs the two strategies against each other.

Conclusion

A direct answer with a condition (unless costs are clearly lower) and a practical recommendation.

Overall: L3 and E3, 13 to 15 marks

Both strategies analysed with their mechanisms and limits, using a firm diagram. Without a cost-revenue diagram, most mark schemes would hold this essay at L2.

Worked example: A 4-minute plan

Set the stand and the criteria, then give each strategy its case and its limits.

1. Stand: differentiation usually, unless the chain has a clear cost advantage. Criteria: cost position, how easily rivals copy.
2. Price cut: elastic demand, revenue up; works if scale lowers AC. Limits: rivals match, price war, P below AC.
3. Differentiation: Figure 2, AR right and less elastic. Limits: AC rises, copied quickly.
4. Judge: brand and quality are harder to copy than a price; a mix with targeted discounts.

Watch out for this

Demand for bubble tea is price elastic, so cutting prices must raise the chain's profit.

Elastic demand means revenue rises when price falls, but profit also depends on costs. If price falls below average cost, or rivals match the cut, profit falls.

Check your understanding

Why does Figure 2 shift AC up but leave MC unchanged?

1. Each extra cup now needs more expensive ingredients, so the cost per cup rises.
2. Higher demand pushes up average cost, because the chain now produces many more cups.
3. Marketing and design are fixed costs: they do not change with the number of cups sold.