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Answers to short answer and extended response questions

Dear colleagues,

Once again I take a firm stance in saying that the following 110 pages of answers are not the answers —nor are questions the questions. Both are in fact my own and in spite of my earnest attempts to phraseboth questions and answers along mainstream IB lines, most of you will probably do a better job than Iin outlining answers to any number of questions. Such is life. I must also point out that there is no official IB recognition, support or endorsement of either thebook itself or the questions/answers in this document. Everything — good, bad and ugly — herein is myown merit or fault. In a similar issue, you will notice that I have not attempted to set grade boundaries or individualmarks in the answers. This is best left to you and your professionalism — not to mention that it wouldalso be rather presumptuous of me to set such boundaries/marks. I hope that you will have use for these answers (I dearly want to use quotation marks, i.e. answersas they are in fact more suggestions than anything else) in your day to day teaching. I would gladly seeany errors/omissions and such pointed out; please write to me at matt.mcgee@helsingborg.se and Iwill get back to you. Finally, I beg you to respect the intellectual property rights attached to this document. I ask that youdo not upload and/or send digital or hard copies of any part of this document without permission fromIBID Press or myself.

Yours,

Matt McGee

Section 1 — Introduction to economics

Short answer questions (10 marks each)

1. Use a PPF to explain the trade-offs that all economies face.Basic answer: All countries must construct some sort of system whereby output, allocation anddistribution of goods is decided. In the process, of solving the basic economic problem there willalways be a trade-off (i.e. an opportunity cost) since resources are limited and our (societal) wants areinfinite. This trade-off can be illustrated diagrammatically via the PPF.

Possible points:• definition/outline of the basic economic problem, i.e. what/how and for whom to produce• statement to the effect that wants are infinite while resources are finite• leading to choices having to be made, i.e. guns or butter• relevant assumptions; only two goods — say capital & consumer goods, closed economy, the

economy is on the PPF (rather important), all factors not equally re-applicable — leading toincreasing opportunity costs (or diminishing returns)

• using the PPF correctly as an illustrative tool, e.g. cost of one unit of capital• showing possible diminishing returns and/or rising opportunity costs• that the trade-off is not limited to modern economies or poor economies but to all

economies in all times

Diagram(-s): PPF diagram — preferably an outward bending PPF, which is a bit more realistic andalso illustrates diminishing returns and/or increasing opportunity costs.

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Note: Full marks should not be given for answers which do not specifically link the concept of a trade-off to points along the PPF, i.e. some form of opportunity cost must be clearly seen in the diagram andreferred to in the text.

2. A country s choice between the production of education and nuclear submarines is an issue ofopportunity cost. Explain the issue using a PPF.Basic answer: Resources are limited while wants are infinite and the choices made lead to opportunitycosts — defined as the next-best alternative given up. The PPF illustrates the opportunity cost in themovement along the PPF; an increase in submarines has an opportunity cost of an amount ofeducation since societal resources are limited.

Possible points:• definition of opportunity cost as giving up the next-best alternative• stating the premise of wants being infinite while resources are finite• assumptions of PPF; only two goods — say capital & consumer goods, closed economy, the

economy is on the PPF (rather important)• pointing out that the economy is assumed to be maximally efficient and thus on the PPF• no increase in output of submarines is possible without foregoing an amount of education• possibly that all factors are not equally re-applicable — leading to increasing opportunity costs

(or diminishing returns)• using numeric examples in the diagram, showing concretely the opportunity costs of

producing one more submarine• using the concept of cost ratios, e.g. one submarine costs 2 million school hours

Diagram(-s): PPF — outward bending version preferably

Note: Again, for full marks, there should be a clear link between a movement along in the PPFdiagram and resulting opportunity costs. This should be commented on in the text.

3. Why is the concept of scarcity relevant to both LDC s and MDC s?Basic answer: All societies throughout time have wrestled with the basic economic conundrum ofhaving wants that cannot be met. Assuming that wants are endless but that economic resources arescarce means that all economies will have to deal with the issue of scarcity, i.e. that all wants simplycannot be fulfilled and that choices will have to be made.

Possible points:• defining scarcity, e.g. too many wants and not enough resources to fulfil all of them• definition of LDC and MDC in terms of ability to fulfil basic needs of citizens• sound iteration on basic economic problem• linking this to all societies — ancient/modern/rich/poor — since it is basically the nature of our

wants that differ and nothing else• reallocating scarce resources ultimately results in diminishing returns• using a PPF to illustrate that scarcity leads to trade-offs

Diagram(-s): PPF — and possibly showing how a shift outward for a MDC will still mean that scarceresources result in a trade-off (assuming that the economy is on the PPF).

Note: It is important that the answer clearly identifies that scarcity means that economic resources arebeing used, and that this is just as pertinent in developed as developing countries.

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4. Explain opportunity costs using a PPF where investment goods is on one axis andconsumption goods on the other.Basic answer: Again, a good definition of opportunity costs linked to the notion of limited societalresources is the answer. Assuming two bundles of goods — capital and consumption goods — andmaximum efficiency in the economy being attained (the economy is producing on the PPF), then anyincrease in the production of investment goods will of course mean an opportunity cost in terms ofquantity of consumption goods given up.

Possible points:• definition of opportunity costs• assumptions of PPF; only two goods — capital & consumer goods, closed economy, the

economy is on the PPF (rather important)• scarcity of resources• and how this leads to opportunity costs in terms of foregone output when these limited

resources are re-allocated• diminishing returns and/or rising opportunity costs, based on• outward-bending PPF and the premise of economic resources not all being equally re-

applicable• that there is an intertemporal issue; giving up a quantity of consumer goods now in order to

produce more capital goods means a possibility of more consumer goods in the future — theopportunity costs of the future consumption is present consumption

Diagram(-s): PPF

Note: Again, it is important that the answer specifically refers to some form of units in the PPFdiagram showing that increased output of one good results in foregone output of the other good, i.e. anopportunity cost.

5.Explain whether or not GDP is a good measurement of development.Basic answer: GDP — national income — is not a de facto measurement of development but an indicator— or at least strongly correlated. GDP is a quantitative variable while development is a qualitativevariable — and thus includes a number of measurement such as access to basic sanitation/water/healthcare; living standards such as in basic education; social choice and freedom such as democracy and therule of law. The basic answer is that while GDP in fact indicates the level of development, they are notone and the same.

Possible points:• a main problem is in defining development — becomes normative rather than positive• good use of a composite index, such as the HDI, to define development• GDP does not show what is produced (guns or butter)• GDP is an average — even when given in per capita form — and will not show the distribution

of income• GDP in nominal form will not show purchasing power parity• other issues such as environmental degradation, personal freedom, crime rates, gender

equality etc, are not shown in GDP• yet the fact remains that GDP is still strongly correlated to development — and thus a key

indictor

Diagram(-s): PPF could compare two countries with identical total output but with differentcomposition, i.e. guns and butter. The Lorenz curve (HL) could be used to illustrate inequality inincome distribution.

Note: Students all too often get off on a track where national incomes of different countries arecompared, rather than GDP and development.6. Use a PPF to explain the difference between actual and potential growth.

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Basic answer: The PPF shows possible output, taking into consideration all factors of production — butde facto output is shown by a point on or within the PPF. Actual growth means that the pointmoves outwards, while potential growth is illustrated by an outward shift in the PPF.

Possible points:• correct PPF with fully labelled axes• definition of growth as an increase in GDP• definition of potential growth as any increase in the quality or quantity of factors of production

(education, training, higher population )• concrete examples showing links between, say, education and higher potential output• showing that increased focus on education will increase potential output — and ultimately lead

to increased de facto (= actual) output• illustration where increased output of capital shifts the PPF and possibly increases future

output

Diagram(-s): PPF (can be enhanced by AD/AS diagram showing how supply-side policies might serveto increase productivity and thus expand the PPF and real output)

Note: Be wary of confusion amongst students here. Often there is a lack of distinction betweenincreased productivity and factors and actually utilising them in production.

7. How might one assess if a country in experiencing both growth and development?Basic answer: This is a matter of defining clearly both growth and development; growth is an increasein GDP (over a time period) while development deals with wider issues such as living standards andquality of life.

Possible points:• definition of growth (increase in GDP during a time period)

o discussion on real and nominalo per capita incomeo purchasing power parity adjusted income

• definition of development, indicatorso qualitative issue wider than simple GDP or GDP per capitao standard of living, income/wealth distributiono empowerment, choice and freedom

• outlining ways of measuring development indicators such aso life expectancyo infant mortalityo use of Gini coefficient, Lorenz curve (HL)o any number of indicators showing standard of living, i.e. telephones per capita,

average number of doctors per 1,000 citizens etc• reference to composite indicators of development such as the HDI

Diagram(-s): Lorenz curve (HL).

Note: It is important that the student does not simply list indicators/measurement, but also clarifiesways of assessing growth and development.

8. What is the role of profits in a market economy?Basic answer: Profits act as an incentive to producers and potential entrepreneurs, and also as a signalto both that resources might be re-allocated advantageously. Profits also enable (re-)investment,innovation, R&D, incomes and provide a taxable base.

Possible points:

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• definition of profit (HL might well go beyond simple revenue minus costs and outlineeconomic profit)

• how profits signal to producers and possible re-allocation takes place• the incentive for producers to produce• discussion of the role of personal gain in a market based system• profits provide firms with investment and R&D resources• profits are a form of income (possible reference to income method of national income

accounting) and thus form• a taxable base, which in turn• enables transfer payments and goods and services in kind

Diagram(-s): S/D diagram might be used to show re-allocation. Unit cost picture might be used (atHL) to show supernormal profit and how firms would seek market entry, thus re-allocating resources.

Note: One often sees a degree of woofle here — many answers are too vague in drawing links betweenprofits and incentives, reallocation and the signalling issue to firms. High marks should not beawarded if mainstream economic terminology is not used.

Extended response questions

1. a) Planning is something that planned economies need - not market economies . Commenton this from the viewpoint of an economist. (10 marks)Basic answer: The statement is in fact not entirely correct; all economies use various degrees ofplanning — it is more a question of degree. Outline of planned economy as a system where the basiceconomic problem is solved by central planning can be contrasted with a competitive (free market)economy. A strong answer would then explain how in fact most economies are mixed economies, witha degree of (central) state planning.

Possible points:• outline of a planned economy

o output and pricing decisions are made centrallyo resource allocation in planned economyo output targets

• outline of competitive (market) economyo supply and demand functiono role of price mechanismo individual decisions the basis for resource allocation

• examples of planning in market economieso census taking by government in order to plan ahead for school enrolment, road

building, infrastructure etco regional support, subsidies etc which intervene on pure market forces in resource

allocation• reference to planning necessity in developing countries as being perhaps necessarily higher

than in developed countries• discussion on degree of market planning in mixed economies — real world examples should be

used

Diagram(-s): S/D diagram may be used to show price mechanism and re-allocation issues.

Note: Students are often weak on pointing out that planning is most assuredly not limited toplanned/command economic systems. Reward students who are able to link theory to real lifeexamples.

b) What problems might a planned (command) economy encounter in moving towards a marketsystem? (15 marks)

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Basic answer: The central answer pivots around the seeming inefficiency (or built-in inefficiency) ofplanned economies, and how this has resulted in a painful transition to market systems. The structuralreadjustment of many of the Central and Eastern Europe and Former Soviet Union (CEEFSU)economies was marked by depreciating currencies, high unemployment, rampant inflation and fallinggrowth rates (or even falling output).

Possible points:• falling growth rates or falling output as the economy adjusts to a competitive market system• inflation — the liberation of the price mechanism often means that prices surge upwards• often towards the black market equilibrium price• collapse of state run enterprises as market forces increase competition• inflation and overvalued exchange rates can cause depreciation of currency when subjected to

market forces on currency markets• higher unemployment

o when state enterprises no longer guarantee jobso higher efficiency and productivity means that demand for labour fallso increased imports can cost domestic jobso loss of export revenue when currency depreciates

• increasing income inequality• barter economies, black markets, corruption• capital flight

Diagram(-s): S/D diagram to show effects of removing maximum prices. S/D for currency to show theeffects on an overvalued currency which is adjusted by market forces.Note: Real world examples used well to illustrate issues should be rewarded.

2. a) Distinguish between development and growth. (10 marks)Basic answer: Both concepts should be defined and exemplified in some depth — not only indescriptive terms but in specific examples and measurements.

Possible points:• definition of growth (increase in GDP during a time period)

o discussion on real and nominalo per capita incomeo purchasing power parity adjusted income

• definition of development, indicatorso qualitative issue wider than simple GDP or GDP per capitao standard of living, income/wealth distributiono empowerment, choice and freedom

• outlining ways of measuring development indicators such aso life expectancyo infant mortalityo use of Gini coefficient, Lorenz curve (HL)o any number of indicators showing standard of living, i.e. telephones per capita,

average number of doctors per 1,000 citizens etc• reference to composite indicators of development such as the HDI

Diagram(-s): AS-AD diagram to show growth/real income. Lorenz curve (and Gini coefficient) toshow income equality (HL).

Note: A relatively straightforward question which nonetheless should be addressed using quite specificeconomic terminology and concepts.b) Why and how are economists attempting to create more accurate measurements ofdevelopment? (15 marks)

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Basic answer: The why part is simply because of the difficulties built-in to the concept ofdevelopment — it is a very wide (rather subjective) and non-quantitative concept. In order to increasethe measurability, economists increasingly look at (quantifiable) variables which are related to, i.e.show causality with, development. Often these measurements take the form of composite indices.

Possible points:• why

o difficulties in defining and thus measuring developmento correlation between income and development, but there are other aspectso many development issues are not shown in a single indicator such as GDPo other weaknesses of GDP as a measure of development; does not show purchasing

power or what is produced etco the social (non-economic) dimension of development, i.e. quality of life, participation

in society, freedom, choices etc• how

o looking at correlation between various indicators in developed and developingcountries, such as crime rates, ability to vote, pollution levels and other forms ofenvironmental degradation etc

o defining living standards and quality of life in as quantifiable terms as possible, forexample

roads per 1,000 citizens availability of culture access to water amount of time it takes to earn minimum subsistence income growth rates referenced to LR sustainability

o constructing composite indices, such as HDI Human Suffering Index Gender Related Development Index Environmental Impact Index

• problems of measuring development, such as definitional problems (poverty) andaccounting/measurability problems (statistical unreliability and negative externalities)

Diagram(-s):

Note: While credit should be given to creative indices, care should be taken that the links todevelopment should be made clear, i.e. why is number of girls in secondary education an indicator ofdevelopment?

3. a) How would you go about comparing the welfare of citizens in different countries? (10marks)Basic answer: This is a very open-ended question and there should be any number of constructiveanswers available — yet all should be centred on the definition/outline of welfare. Any of themainstream standard of living indicators should merit points.

Possible points:• definition of welfare

o as the ability of citizens to enjoy freedoms of choice and political freedomso consumption capability and variety — across a broad section of societyo access to educationo availability of cultureo availability of employmento entrepreneurial freedomo individual rights —legal and politicalo independence and freedom of speech

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o access to nature, clean air and outdoors• any number of measurable variables will enable a comparison, for example

o voter registration, party registrationo income per capita (at PPP)o proportion of girls in secondary education proportion of children in primary

educationo amount of theatres, libraries, culture centres per capitao percentage of teenagers unemployedo number of private newspapers/radio channelso number of women in local municipal councilo whether basic democratic freedoms are guaranteed in law — and enforced/upheldo number of national parks, pollution levels

• composite indices such as the HDI, Corruption Index, Environment Impact Index• any concrete example of how welfare can be measured and compared should be awarded

Diagram(-s):

Note: Due to the breadth of the question, students should be given some leeway in their use ofexamples — as long as the examples are concrete and the variables are measurable.

b) Assess whether market economies have been more successful than planned economies inproviding welfare for citizens. (15 marks)Basic answer: The student is expected to outline some of the basic issues of welfare in the planned andmarket economies and subsequently submit a reasoned answer as to which has been most successful inmeeting the goals . A standard answer — but a good one nonetheless — would put forward thatplanned economies have been successful in general in the provision of merit and public goods, andhave also been able to minimise income inequality. On the other hand, planned economiesenvironmental record has been poor, as has the ability to provide consumption goods for theircitizenry. Market economies have had remarkable success in output, growth and general purchasingpower, but have in a number of notable cases been less successful in terms of income equality (albeitat far higher income levels than in planned economies) and the provision of merit and public goods forthe general populace.

Possible points:• possible successes in planned economies

o income distributiono general equityo focusing resources in narrow areas, for example medicinal research in the former

USSRo providing basic necessitieso providing basic education and housing for a large proportion of the populationo providing jobs

• possible failures in planned economieso environmental aspectso providing democratic institutionso providing consumer goods and generally meeting the demands of citizens for

consumption itemso resource allocation, as set prices and set outputs never matched demand (the classic

queues of the planned economies were the result of prices being to low)o producing goods of high quality — military goods all too often being the exceptiono use of resources — there were often high levels of waste in productiono creating growth

• possible successes in market economieso attaining high (real) growth rateso enabling democratic institutions, and personal freedoms

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o producing high quality goods to meet the demands of citizenso high productivity and incomes have meant increased living standardso innovation and R&Do allocating resources efficiently

• possible failures in market economieso the provision of merit and public goods for all has in some notable cases been lackingo income distributiono consumerism and unnecessary products become a lifestyle

• discussion on whether free markets, capitalist systems and individualistic societies benefit thestrong and able while disadvantaging the weak

• discussion to the effect that economic growth, productivity increases and liberal democraticgovernment enables welfare increases

Diagram(-s): Lorenz curve (HL) to show/compare income distribution.

Note: Quite obviously, the list is incomplete and can be largely misleading due to sweepinggeneralising. This can be partially countermanded by reference to real world examples — at the risk ofusing anecdotal evidence as a way of underscoring an argument. Students who actually summarise andassess should get higher marks than those who simply account for a number of comparative points.

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Section 2.1 — Markets

Short answer questions (10 marks each)

1. What actions could a government take in order to keep the price above market equilibrium?Basic answer: There are four basic possibilities here; 1) minimum price; 2) a tax on the good; 3) anyform of price support scheme involving government purchasing of the good; and 4) governmentcontrols limiting supply. Any of these should be illustrated using a S/D diagram.

Possible points:• definition of market equilibrium, i.e. S = D• S/D diagram illustrating how the price could be kept above equilibrium

o minimum price — and perhaps commenting on how the excess supply is dealt with(e.g. repurchasing scheme)

o tax — shifting supply curve to the left, creating a price above free market priceo government purchasing — perhaps in reference to government stockpiling in the

context of a government run buffer stock schemeo government controls — shifting supply curve left

• other possibilities include curtailing market entry, nationalisation of an industry to lowerexternalities, trade barriers

Diagram(-s): Essential that the S/D diagrams clearly illustrate market equilibrium and that thecommentary addresses how the price is kept above this level. Buffer stock scheme and price corridoralso a possibility.

Note: High marks should be earned for any one exhaustive example, or two examples in less depth.

2. A government attempts to alleviate a lack of housing by putting a ceiling on rents. Use adiagram to explain the possible outcome of this action.Basic answer: A ceiling on rents will have the same outcome as a maximum price on the market forrental housing. The possible outcome in this case will be to limit quantity supplied and increasequantity demanded — creating an excess in demand and possible second-hand (parallel) market.

Possible points:• premise of ceiling price being below equilibrium and thus equivalent to a maximum price• diagram showing effect of minimum price — clearly illustrating excess demand• area showing possible secondary (black) market and black market price (see page 123 and also

page 173)• the LR possibilities of suppliers removing housing from market in order to use it for

alternatives, e.g. businesses or storageo effects on PESo increase in excess demand

• possibility that housing authorities react by creating a queuing system to counter black market

Diagram(-s): Basic S/D diagram showing ceiling price below market equilibrium.

Note: Diagrams here should be neat and well incorporated into the accompanying text. Any referenceto black market and excess demand should be clearly pointed out in the diagram.

3. How might governments use buffer stocks to stabilise prices?Basic answer: Define/outline a buffer stock scheme briefly as a method for government (in this case)to warehouse (stock) goods for shorter periods of time when the market price tends to go below a

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desired level — and then releasing quantities from stocks when the market price tends above a setceiling price.

Possible points:• definition of buffer stock as market intervention method undertaken by a group of suppliers or

government to keep the LR market price stable ( between a floor and a ceiling )• pointing out that the good needs to be storable — often agricultural goods, e.g. grain• using a SR supply curve and demand curve to show how the buffering agency (here,

government) can adjust the market price by removing from the market or increasing supplyfrom warehouse

• commenting and/or illustrating what might cause the market price to move outside the desiredcorridor (shift in supply or demand)

• comments on additional costs of administration, warehousing etc• difficulties for government in controlling market supply due to

o open markets and possibilities of importso cheaters i.e. non-aligned producers can affect market priceo expensive for governmento government might end up with large surplus of unsold stocks (reference to dumping)

• comment to the effect that many governments in OECD countries have abandoned bufferstock schemes in later years as surpluses become increasingly criticised

Diagram(-s): Absolutely essential that a supply and demand diagram is used — and perhaps also acorridor diagram (page 130).

Note: Very important that the answer uses the diagram and refers clearly to shifts in supply/demandand the market intervention forces used by the buffer stock scheme.

4. Use a supply and demand diagram to help explain how a city council might help to decreasetraffic congestion in the city during weekends.Basic answer: The issue here is for the city council to solve the problem of too many vehicles in agiven area during a given period of time. There is scope here for ingenuity in the answer, but basicallya good answer would point to lowering demand during weekends by increasing the availability ofsubstitutes and/or raising the price of driving/parking in the city.

Possible points:• pointing out that demand occurs during a peak period• and that perhaps one could increase demand during off-peak periods — say by lowering

parking prices• lowering demand during weekends

o toll booths at city limitso creating viable and attractive substitutes, for example by increasing bus runs and/or

lowering the price of public transportationo creating parking houses outside city limits with free buses into the city centre

• other solutions in lowering demand, for example every other weekend only odd numberlicense plates in the city

• increased road tax• any plausible example of how weekend driving in the city might be decreased

Diagram(-s): The S/D diagram should show how any given suggestion will shift demand for inner-citydriving to the left.

Note: Allow reasonable scope for imaginative solutions here — as long as there is realistic plausibility.

5. Show the possible outcome of setting a minimum wage for under-eighteens.

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Basic answer: A minimum wage on labour has the same effect as a minimum price on goods; excesssupply of labour, which in this case results in an increase in unemployment. As the issue dealsspecifically with labour market newcomers, there is the distinct possibility that demand for moreexperienced labour results.

Possible points:• definition and illustration of minimum wage — clearly set above market equilibrium• outlining resulting increase in unemployment• commenting on how more experienced labour might be more demanded — assuming that the

market labour rate is lower than the minimum price for under-eighteens• showing increased demand for over-eighteens in a diagram• discussion on other possible side effects, such as black market labour to avoid minimum wage

— where employers could split the labour tax savings between themselves

Diagram(-s): S/D showing minimum price and resulting excess supply of under-eighteens on labourmarket. Another S/D diagram showing a concomitant increase in demand for more experienced labour.

Note: However neat and correct the text and supporting diagram, full marks should not be given foranswers which completely neglect the fact that we are dealing with only a portion of the labour marketand not the entire market.

6. Why would the weekly price of rental scooters in a holiday resort vary over the course of ayear?Basic answer: The expected response here is that seasonality is the main cause of variations in demandover a year; more tourists during high season will lead to an increase in the demand for goods andservices associated with tourism, e.g. scooters. It is also possible (probable?) that suppliers will adjustin anticipation of increased demand, thereby causing a change in supply also.

Possible points:• increased demand during high season leading to an increase in the weekly rental price• relatively inelastic supply on a weekly basis, as suppliers might have difficulties in acquiring

more scooters in the SR• shift in demand curve to the right during high season• shift of demand curve to the left during off-season• possibility that PED decreases during high season (accompanying a shift right of demand

curve)• explanation that other factors might influence demand, for example bad weather, natural

disasters, preferences and resorts becoming fashionable, other (substitute) goods e.g. otherresorts, increased advertising by tour providers, change of income for holiday makers etc

• influence of the price of complements such as petrol and insurance• possibility of price discrimination (HL), i.e. use of price competition during off season• possibility that the price variation is actually minimal, as suppliers prepare for high season by

stocking up on a supply of scooters — thereby increasing supply to meet the surge in demand• links between higher costs for scooter providers in high season as general price levels tend to

rise and thus increase factor costs

Diagram(-s): S/D diagram clearly labelling P and Q axes — using a currency and a time frame (here;per week). HL might use MC to show increasing factor costs during high season.

Note: Higher marks should be rewarded for students who incorporate solid economic terminology intheir answer, e.g. substitute goods, complements, derived demand, non-price determinants etc.Students who clearly explain why the price may indeed not fluctuate due to suppliers propensity toeven-out price fluctuations over the course of a year (to avoid insecurity and badwill amongstcustomers) should be rewarded.

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7. Explain the factors which would affect the price of a good.Basic answer: While there is a very long list of determinants, the basic issue is for the student toexplain and illustrate how shifts in demand and/or supply will affect the market price. It is importantthat rote-memorised factors are not simply tossed in, but founded on examples. For example, the priceof other goods will affect the price of a good — a fall in the price of DVD rentals might decreasedemand for purchasing DVDs, which could ultimately lower the price of purchasing DVDs.

Possible points:• change in demand

o price of complements/substituteso change in incomeo preferenceso any non-price variable

• change in supplyo change in price/availability/efficiency of factorso other non-price variables

• for various examples of market intervention, e.g. taxes/subsidies

Diagram(-s): S/D diagram showing clearly how the price changes due to a change in demand and/orsupply.

Note: Earning higher marks should be based on clarity of example and how well the diagram isreferred to.

8. Explain consumer sovereignty and why it might not be that extensive in real life.Basic answer: There are a number of definitions here but all centre around how consumers will haveinfluence on firms output and pricing decisions, and thus affect resource allocation. In reality, therewill be a number of reasons why consumers influence will be lower — due to imperfect marketsprimarily.

Possible points:• definition of consumer sovereignty• use of S/D model to show how changes in consumption patterns influence firms output and

price• consumer and supplier surplus to show optimal resource allocation• relevant assumptions such as perfect knowledge/information, homogenous goods, competitive

outcome (price competition)• reasons for partial lack of consumer sovereignty

o imperfect markets, e.g. monopolies, oligopolies, monopolistic competitiono non-price competition — possible collusion, advertising/marketingo less than perfect market knowledge and information on the part of consumers

( bounded rationality for example)o market intervention and/or control — government monopolies, taxes, minimum

prices etc

Diagram(-s): S/D model (shift in demand, consumer and supplier surplus, effects of marketintervention such as taxes/price controls); (HL) any model from theory of the firm showing howpowerful firms might be able to disregard effective market demand and set lower output (and higherprice) than on a competitive market.

Note: Students are often hazy in defining consumer sovereignty, often confusing the concept withconsumer choice. Reserve top marks for answers which clearly explain the link between consumerspreferences and (effective) demand and the quantity/quality/price of the goods on the market.

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9. A major sporting event sets the price of tickets such that a great number of people are notable to get hold of tickets. What might the outcome of this be? Use a diagram to support youranswer.Basic answer: The issue revolves around an excess in demand (price is too low ) and possible blackmarket arising as a cause of this.

Possible points:• standard S/D diagram correctly labelled showing how the price basically results in a

maximum price which should be shown as a horizontal line below equilibrium• pointing out the excess demand between where the maximum price hits the supply curve

and the demand curve• using a completely inelastic supply curve with corresponding explanation that there are a finite

number of seats so quantity supplied is not correlated to price• showing and commenting on the possible arising of a black market• comments to the effect that a queuing system (in situ — i.e. first come, first served) might have

alleviated the problem of a black market

Diagram(-s): S/D diagram (see page 124 & 125)

Note: This is a fairly straightforward question, but better answers will incorporate the diagram into theexplanatory body of text well.

10. Government raises the taxes on car ownership. Explain the possible market outcomes of sucha decision.Basic answer: As this is a tax paid by owners, and thus not levied indirectly via suppliers in sellingcars, one can expect a decrease in the demand for cars and an increase in demand for possiblesubstitutes. (Basically, the ownership tax might be regarded as a complement to car ownership.) Onecould also expect a decrease in demand for complement goods for cars, such as gasoline, insurance,servicing, etc.

Possible points:• explanation of how an ownership tax would decrease demand for cars• explanation of possible increase in substitutes such as public transportation• possibility of decrease in demand for complements to cars

Diagram(-s): S/D diagram showing shift in demand curve.

Note: A tricky question, since this is not a tax on expenditure but ownership.

Extended response questions

SL1. a) What do economists mean by markets ? (10 marks)Basic answer: A sound definition of markets should encompass the concept of willing buyers andwilling sellers who are in contact with each other — creating a market.

Possible points:• definition of markets, e.g. buyers and seller in contact with each other• outline of producers/suppliers ability and willingness to put goods on the market• ditto for effective demand• excess supply/demand• definition of supply and demand• illustration using supply and demand curves• explanation of the price mechanism; signalling, incentives and rationing function• exemplifying markets, i.e. labour market, stock market, goods market

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• the overall issue of markets as being a method to establish quantity, quality and price of goods• reference to how markets solve the basic economic problem

Diagram(-s): Basic supply and demand diagram.

Note: It is amazing how often students neglect basic definitions in theoretical questions. Full marksshould not be given for answers which do not use core concepts such as the price mechanism and thebasic economic problem.

b) Are markets the best way of solving the basic economic problem? Justify your answer. (15marks)Basic answer: The core of the economic problem ( who, what, for whom ) is something all societiesmust address. Planned economies solve it by central price and output setting, while market economiessolve it by the price mechanism. Both systems have their basic flaws. Another issue is that of marketfailure, and how society addresses this.

Possible points:• definition of basic economic problem• how markets address this issue• resource allocation with reference to S/D diagram• assumptions of a competitive market• contrasting the above with a planned system• market failure

o externalities (demerit goods, pollution)o missing markets (merit and public goods)o imperfect competition (monopolies, oligopolies)

• how market failure causes misallocation of resources• solutions to market failure, i.e. taxes on negative externalities, government provision of merit

goods, regulation of monopolies

Diagram(-s): S/D diagram to illustrate market forces and allocation, MSB/MSC diagram to illustrateexternalities and/or public/merit/demerit goods, HL might use monopoly diagram to illustrateshortcomings of a market system.

Note: Answers have a tendency to become opinionated and/or dogmatic — which is perfectly alright aslong as the viewpoint is backed up by sensible use of economic concepts and theory.

2. a) How would the price mechanism decide resource allocation in a competitive (free) market?(10 marks)Basic answer: The main issue it to explain how the price mechanism has a signalling, rationing andincentives function for the actors on a competitive market, creating equilibrium on the market andallocating resources in different markets.

Possible points:• definition of market economy• definition of the price mechanism — rationing/incentives/signalling function• how resources are allocated in accordance with the price mechanism — use of S/D diagram

essential• example of how increased demand for a good might re-allocate resources from another sector• optimal resource allocation; S = D, P = MC (HL), consumer surplus (outside the syllabus)

Diagram(-s): S/D, perfectly competitive market diagram showing P = MC (HL) and possible consumerand supplier surplus

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Note: Answers often use planned economies to contrast the allocative efficiency of the perfectlycompetitive market — good examples merit marks.

b) Examine how the above would apply to non-renewable resources such as oil.Basic answer: This has general applicability to any competitive market. The issue here is that potentialsupply has a finite limit and that ever-lower reserves of oil mean scarcity higher price incentivefor suppliers to find additional reserves. It also means that the rationing function will kick in; higherprice consumers will decrease quantity demanded and look for substitutes.

Possible points:• the price of such resources is determined by market forces, e.g. supply and demand• discussion of substitutability in the SR and the issue of PED• use of S/D model to show

o increasing income/wealth in developing nations will add to demando depletion of known reserves will ultimately lower supplyo the price of oil can be expected to riseo higher market prices will serve as a signal to producers to seek out new oil fields,

and/or increase pumping in existing (more costly) fields — LR increase in supplypotentially

o increased R&D spending by producers on technology to enable finding new fieldso incentive for oil users to become more efficient in their use — for example car

manufacturerso consumers will look at substitutes — and as demand for such increase so too will

supply ultimately (incentive for suppliers to supply substitutes)• failure of the market mechanism

o real (societal) cost of oil use is higher than private costs, i.e. externalitieso externalities in the use of more oilo increased pollution as dirtier oil is refinedo the issue of time-inconsistent pricing behaviour — the market price today does not

reflect future scarcity of the good

Diagram(-s): S/D diagrams; MSC & MPC showing externalities.

Note: There are numerous possibilities here, but credit answers which develop a clear and sound lineof reasoning in use of S/D model to show possible outcomes.

HL3. a) Explain how a government might use buffer stocks to even-out price fluctuations. (10marks)Basic answer: Define the basic function of a buffer stock scheme and illustrate this with a S/D diagramand possibly the price corridor diagram (page 130).

Possible points:• definition of buffer stock as a method to use market force to

o keep prices relatively stableo keep prices at a desired level

• characteristics of buffer stock schemeo storable goodo often commodities/agricultural goods

• the market mechanism used by the scheme, i.e. adjusting supply in order to change marketprice

• illustration of the buffer (warehousing) mechanism using S/D diagram• illustrating LR ceiling/floor — corridor

Diagram(-s): S/D diagram and possibly LR price corridor .

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Note: Many teachers also illustrate price fluctuations be shifting demand — not only supply asexemplified on page 130.

b) What are the costs and difficulties of such an operation? (15 marks)Basic answer: The direct costs are administrative, cooperative and storage costs, while the societalcosts include misallocation, oversupply and waste. Buffer stocks have been increasingly abandonedfor a number of reasons, mainly dealing with costs, political pressure, large unwanted stocks andincreasing criticism of the bad incentive effect perpetuating oversupply of goods.

Possible points:• direct costs to buffer stock scheme

o administrative costso storage costso opportunity costs of storing goods and oversupplying

• indirect — societal — costso opportunity costs of using taxpayer monies to run the schemeo allocative losses arising from overproductiono possible dumping of excess stocks on other markets

• difficulties in operating buffer stock schemeso difficult to foresee price fluctuations and act in timeo goods need to be storableo possibility of certain suppliers cheating and selling above/below agreed-upon price

• criticism of buffer stocks causing oversupply and waste

Diagram(-s):

Note: Most students will be able to identify direct costs of administration, etc, but many are hazy onsocietal and allocative issues.

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Section 2.2 — Elasticities

Short answer questions (10 marks each)

1. How do economists use the theory of income elasticity of demand to distinguish betweendifferent types of goods?Basic answer: Define income elasticity — use formula — and identify different types of goods withdifferent traits, such as normal, inferior and, I hate to say it, Giffen goods.

Possible points:• definition and formula for yED• explanation of yED, relative change in quantity demanded due to a relative change in

income• explanation of relevance of negative or positive value of yED• identifying different types of goods

o normal goods (positive value)o inferior goods (negative value)o Giffen good (negative value)

• use of diagrammatic illustration to show correlation between increasing income and quantitydemanded of good

• using real world examples to illustrate (good luck on Giffen goods)

Diagram(-s): Diagram illustrating correlation between income and quantity demanded.

Note: Anyone coming up with an example of a Giffen good should be pointed out to the NobelCommittee.

2. What determines whether the supply of a product is price elastic or price inelastic?Basic answer: After a basic (formulaic) definition of PES, a good answer will go through — andexplain — possible factors, such as number of producers, barriers to entry, time period, availability ofproducer substitutes etc.

Possible points:• formulaic expression of PES• definition of PES, e.g. ability and willingness of producers to put more on the market at

higher prices• factors affecting PES

o number of producerso type of market, i.e. monopoly, PCM etco barriers to entryo availability of vital raw materialso time frame involvedo access to intellectual property, e.g. production processes and patent rightso availability of producer substituteso switching costs of producerso ability to hold stocks (i.e. storage capabilities)o legal restrictions on market entry, for example nuclear fuelso available excess capacity for producers

• using real world examples to back up rote-learned points

Diagram(-s): Simple supply curve(-s) underlining the differences between examples given.

Note: Highest marks should go to answers which clearly link a PES factor with a good example.

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3. A business person believes that halving her prices will double her revenue. Explain why thismight not happen.Basic answer: There are a number of ways this can be illustrated, and demand curves are involved inall of them. Define revenue (P x Q) and show this in a demand curve — perhaps using a total revenuecurve under the S/D diagram using an equidistant Q-axis. Point out that TR is maximised where PEDis equal to one, and that any movement away from this will in fact lower revenue. One can also useexamples along the elastic portion of the demand curve, showing how halving the price mightincrease revenue but not double it.

Possible points:• definition of TR as P x Q• illustrating TR in S/D diagram• using TR diagram to show total revenue along a linear demand curve• using examples of lowering the price at any point under unitary elastic point to show that in

fact TR falls• other examples showing that while increasing, TR might not double• illustrating that, in fact, in order for revenue to double, demand would have to be highly elastic

Diagram(-s): S/D diagram, TR diagram.

Note: Give marks readily to students who squarely address the issue, showing definitively that cuttingprice in half will not necessarily double revenue.

4. A government imposes an indirect tax on the supply of a good with zero price elasticity ofdemand. Using a diagram, explain why consumers, not producers, could in the end pay this tax.(HL only)Basic answer: Define indirect tax and utilise a S/D diagram to show how the incidence of tax. Asdemand is zero elastic (vertical), the shift left of the supply curve will raise the price by the sameamount as the tax — hence, consumer will bear the entire burden of tax.

Possible points:• definition of an indirect (expenditure) tax• definition/illustration of zero PED• definition of incidence of tax• explanation of why an indirect tax shifts supply• explanation of incidence of tax using examples — and perhaps an illustrative diagram• clear diagram showing — perhaps numerically — how a tax will shift supply curve upwards by

same amount as tax• and that this tax will raise the price by the same amount• hence, the incidence of tax falls entirely on the consumer• discussion on which goods to tax is not entirely central but a good discussion might merit

points

Diagram(-s): S/D diagram(-s) clearly showing the area of incidence of tax.

Note: Many weak answers jumble up the dotted lines and get the incidence of tax confused.

5. If the coefficient of PES is lower than the coefficient of PED, upon whom will the largestincidence of a producer tax fall? Use diagrams to aid your explanation. (HL only)Question scrapped — too far outside the syllabus.

6. Explain why both the PES and PED tend to be inelastic in the short run for primary goods.Basic answer: PED deals with (primarily) the ability and propensity of consumers to switch to othergoods, which in turn deals with the availability of substitutes, the amount spent on the good and howincome sensitive the good is. Taken together, in the SR, consumers are rather unwilling to switch to

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other goods when it comes to primary commodities, as are firms, which use such goods as factorinputs. PES deals with the availability and ease of switching to supplier substitutes, which in the SR israther difficult for commodity goods — due to seasonality of agricultural goods and the heavyinvestment often seen in mining for minerals.

Possible points:• definitions of PED and PED (formulae!)• explanation of how PED shows the ability and willingness of consumers to switch to other

goods due to a change in price• PES shows the ability/willingness of producers to increase output due to a change in price• examples of goods with low PED and PES, say tomatoes or iron ore• use of time component and lack of substitutes (PED)• discussion of primary goods as a necessity and thus low PED• use of time component and difficulty in switching (PES), i.e. the difficulty in increasing

output in the SR due to season length, ability to stockpile the good, difficulty in increasingcapital to increase output

• discussion of producer substitutes and low PES• discussion of MC of increasing output and how this in fact is the supply curve (HL)

Diagram(-s): Separate supply and demand curves illustrating inelasticity. Possibly a MC curve and the•MC = market supply (HL).

Note: It is often the case that weaker students confuse consumer and producer substitutes, and thus thevariables affecting PED and PES.

Extended response questions

1. a) Using commodities as an example, explain the factors influencing the PES for such goods.(10 marks)Basic answer: The basic determinants of PES are time span involved and the availability of producersubstitutes. Both of these help to outline commodities as having low PES.

Possible points:• definition (formulaic) of PES• explanation of PES; relative change in supply due to relative change in price• time

o agricultural goods will of be seasonalo and non-storableo many such goods will have longer periods between planting and harvesting — coffee

plantings for example will take some 5 years before yielding a crop• availability of producer substitutes

o many agricultural goods take a good deal of time to switch too minerals will have enormous sunk costs and heavy investment, making switching

costs very high• taken together, PES for many commodities will be low

Diagram(-s): Illustrative supply curves showing different elasticities based on time period andavailability of producer substitutes.

Note: Many students confuse supplier and producer substitutes.

b) How does the PED and PES of commodities affect producers in developing countries? (15marks)

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Basic answer: Since both PES and PED are inelastic, there will be marked price fluctuations in the SR.And, due to increasing supply for many commodities and the increasing availability of consumersubstitutes (falling demand for commodities), the movements of increased supply and decreaseddemand lead to falling commodity prices over the LR.

Possible points:• definition of PED (formulaic)• explanation of PED• outlining commodities as having low PED

o few substituteso low proportion of income spent on commodities

• illustration of price fluctuations due to shift in inelastic supply and demand curves• how prices of commodities have fallen over the past 30 years

o increasing use of substitutes (rubber for example)o leading to stagnant/decreased demando dependency of developing countries on commodities means that producers are price

takers — and thus have an incentive to increase output in order to increase revenue,which increases supply and lowers the price

• implications for developing countries dependent on commodity exportso worsening terms of tradeo less export revenueo depreciation of currencyo harder to import vital goods, e.g. capital

• attempts of certain commodity producers to develop buffer stocks and/or cartels (e.g. coffeeand oil)

Diagram(-s): S/D diagram illustrating inelastic supply and demand curves — and shifts which showprice fluctuations in SR and falling commodity prices in LR.

Note: Students often don t quite get around to addressing the issue of how the fluctuations and fallingcommodity prices affect developing countries.

2. a) Explain the factors influencing the value of PED and yED. (10 marks)Basic answer: PED and yED should be defined and then dealt with in terms of determinants. PED isdependent on availability/closeness of substitutes, time frame involved, proportion of income spent ongood. yED depends on whether the good might be considered normal or inferior.

Possible points:• definition of PED and yED (formulaic)• explanation of the terms• determinants of PED

o availability/closeness of substituteso time frame involvedo proportion of income spent on good

• determinants of yEDo normal or inferior good

• any sensible examples of the above• weird stuff; Veblen and Giffen goods

Diagram(-s): Demand curves illustrating various goods. Possibly an illustration of yED using incomeand quantity demanded.

Note: A very straightforward question which should be addressed most rigorously in terms of clearlydefined economic concepts.

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b) Evaluate the importance of knowing PED (note: it reads PES erroneously in the textbook)and yED in firms decision making process. (15 marks)Basic answer: Firms will want to know how consumers will react to a change in price in order tomaximise revenue and profit. A good with few substitutes (inelastic) can fetch a higher price withoutlosing customers. Income elasticity will have influence on how the firm markets the good and towhich category of buyer.

Possible points:• discussion of how a firm would benefit from knowing PED in being able to set revenue

maximising price• ability of firm to price discriminate (HL)• illustrating maximum total revenue using demand curve• how yED would create different demand for goods during phases of the business cycle• discussion of yED and ability of firms to target different income groups• how increased value-added and perceived consumer benefits increase yED and enable firms to

charge higher prices in high-income groups

Diagram(-s): Demand curve (and possibly TR curve) illustrating total revenue. yED and correlationbetween income and quantity demanded.

Note: Students often come up with some surprisingly insightful suggestions here. Reward any goodexample which utilises the concepts correctly.

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Section 2.3 — Theory of the firm

Short answer questions (10 marks each)

1. What will happen to output and price when a profit maximising monopolist instead maximisesrevenue? Use a diagram in your answer.Basic answer: Use the monopoly unit cost diagram to show that the profit-maximising point of output(MC =MR) is always lower than the revenue-maximising point (MR = 0). Thus, a switch fromprofitmax to revmax will increase output and lower the price.

Possible points:• definition of profit-maximisation, MC = MR• clear diagram illustrating profitmax output• definition of revenue, maximum revenue is when PED = 1 — which is where MR = 0 for the

monopolist• show profitmax price and output — and how price falls and output increases when instead

revenue is maximised

Diagram(-s): Unit cost diagram for monopoly.

Note: A relatively simple question, but definitions are often lacking.

2. Explain how diminishing returns differ from diminishing returns to scale.Basic answer: The answer should clearly distinguish between SR (one or more factors are fixed) andLR (where all factors are variable). Diminishing returns (marginal returns) arise in the SR anddiminishing returns to scale in the LR caused by for example efficiency lags in ever-larger firms.

Possible points:• definition of diminishing returns with reference to one or more factors fixed• example of diminishing returns: physical product per unit of labour input (output per unit of

input falling); rising marginal/average costs in unit-cost picture• numerical example of the above, using an increase of a variable factor and concomitant ever-

lower rate of output per unit — keeping one or more factors constant• using AC example where an increase in for example capital (fixed factor) results in lower

average costs in LR• using the enveloping effect of a number of AC curves to create the LRAC curve — NOTE that

it is highly unlikely that a student would penalised for not making a distinction betweenreturns to scale and economies of scale ! (See warning on page 206)

• keeping in mind the point above, referring to LRAC and increasing/constant/decreasingreturns to scale (which are in fact economies of scale)

Diagram(-s): The SR could be illustrated using the MP and AP curves, and/or the MC and AC curves.The issue of LR might be illustrated using SRAC curves and the LRAC curve.

Note: While many students might find it difficult to illustrate the SR and LR using clear numericalexamples, marks should be given for a sound distinction between the two concepts.

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3. How might a firm in an oligopolistic market attempt to increase market share?Basic answer: Operating under the premise there is non-price competition, the firm will resort tomarketing measures, collusion, or merging.

Possible points:• definition of oligopoly; concentration ratio, producer sovereignty• explanation that oligopolies are often non-price competitive and resulting price rigidity• use of kinked demand curve to illustrate price rigidity• explanation of how/why oligopoly firms are interdependent and thus have an incentive to

avoid head-on competition byo collusiono merging

• since oligopoly firms wish to avoid harmful price competition, great effort often goes intoR&D, product enhancement, marketing drives, product differentiation

Diagram(-s): Kinked demand curve.

Note: All too commonly, weaker answers never quite get past forming a cartel to address thisquestion.

4. How do economists differ from accountants in the use of the term profit ?Basic answer: Define accounting profit as revenue minus costs and economic profit as revenueminus costs — which include opportunity costs . The term profit is more correctlyeconomic/abnormal/supernormal profit and should be carefully outlined in an example.

Possible points:• definition of rev and accounting costs• definition/outline of opportunity costs, for example

o foregone interesto foregone wageso risk premium

• accounting costs + opportunity costs = economic costs• using examples to underline the above• definition of normal profit as covering all accounting and opportunity costs• definition of abnormal profit

Diagram(-s): While not directly necessary, a total cost diagram could be used as illustration.

Note: Any reasonable example of opportunity costs which clarifies the difference between accountingprofit and economic profit may result in full marks.

5. Explain how normal profit and abnormal profit differ.Basic answer: Define normal profit (breakeven) — which must include commentary on the inclusion ofopportunity costs. Abnormal profit should be defined as revenue above and beyond economics costs,i.e. a profit above what is necessary to keep the firm in the market in the LR.

Possible points:• definition of normal and abnormal profit

o normal profit; rev — total costs = 0o abnormal profit; rev — total costs > 0

• definition of normal profit as covering all accounting and opportunity costs• noting that total costs include opportunity costs, for example

o foregone interesto foregone wages

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o risk premium• accounting costs + opportunity costs = economic costs• using examples to underline the above

Diagram(-s): A clear unit cost picture, say a PCM firm, is a good illustration of abnormal and normalprofits. Two separate AC curves should be used. Profit per unit or total profit should be clearlyoutlined, either numerically or graphically.

Note: Students all too often forget to include a discussion on the fact that total costs includeopportunity costs.

6. A monopoly is broken into a number of competitive parts. Predict the changes in output andprice which are likely to take place.Basic answer: Making the basic assumptions that, 1) the individual parts of the monopoly will operateas subsidiaries; 2) both are assumed to be profit maximisers; and 3) the monopoly had no benefits ofscale, then the sum of the individual PMC firms MC curves will equal market supply curve — and beidentical to the monopoly s MC curve. Thus a simple monopoly/market diagram (see page 236) willcover this question by showing how the market price will be lower and output higher in thecompetitive market.

Possible points:• definition of monopoly in terms of pricing/output power• assumptions of monopoly and PCM (see above)• diagram showing the unit cost picture of the monopoly• possibly a diagram illustrating an individual PCM firm and also the competitive market• clearly showing price and quantity in the monopoly and ditto for PCM

Diagram(-s): Unit cost monopoly diagram. Possibly the unit cost picture for an individual PCM firmand also the PCM equilibrium.

Note: Students usually have a good grasp of this issue, but messiness and sloppiness in the use ofimportant assumptions and clear diagrams often bring the marks down.

7. Why might an oligopoly be reluctant to change its price?Basic answer: When a few large firms have high total market share and are non-collusive, there is astrong element of interdependency. The norm will be for firms to utilise product differentiation,marketing and such rather than price-competition. The kinked demand curve illustrates how anoligopolistic firm would be reluctant to both raise and lower the price. A collusive oligopoly oftenbreaks down due to cheating , rendering a non-collusive outcome and, again, price rigidity.

Possible points:• definition of oligopoly• reference to four- or five-firm concentration ratio• outlining collusive and non-collusive oligopolies• use of game theory, Nash equilibrium, to explain price rigidity• explanation of how a collusive oligopoly (cartel) might fix prices, creating loyalty amongst

complying firms and disinclination to change prices outside the collusive agreement• that collusive agreements are subject to cheating by firms and that this ultimately leads to a

non-collusive outcome• using the kinked-demand curve to explain reluctance of firms to change prices

Diagram(-s): Kinked demand curve (with or without the MR curve included)Note: Beware of faulty diagrams here. Students often misalign or draw the curves incorrectly.8. Discuss reasons why a monopoly could produce more output at a lower price than acompetitive market.

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Basic answer: Three basic reasons arise: 1) the monopoly could enjoy benefits of scale; 2) themonopoly could be predatory pricing (setting P = AC = AR); and 3) there could be a naturalmonopoly.

Possible points:• outline of a monopoly enjoying benefits of scale

o diagram illustrating benefits of scaleo comparing the monopoly to PCM (page 238)

• predatory pricing in monopolyo how monopoly can use the price weapon to kill off rivalso diagrammatic illustration of this (page 237)

• natural monopolyo definition of natural monopoly — it should be clear that a natural monopoly will have

both benefits of scale and very high (initial) fixed costso illustration of pricing possibilities in natural monopoly vs PCM (page 239)o examples of natural monopolies

• any real world example with merit should earn marks• other possibilities, such as a government monopoly willing to run at societal optimum and

accept losses, or a monopoly which has earned abnormal profits previously might seek todissuade entrants by setting a price which potential entrants cannot meet

Diagram(-s): See pages 237 — 239.

Note: Any one of these — explained in depth — should be able to earn full marks.

9. Why might a perfectly competitive market firm be willing to run at a loss in the short run?Basic answer: The assumptions of a PCM firm should be outlined in order to conclude that the PCMfirm is a price-taker — and cannot influence the market, either in terms of output or price. Using theunit cost picture, it should be made clear that ATC = AR is the breakeven level of output, and that thefirm will incur losses if the price is below ATC (see page 223). However, as long as the firm iscovering some of the fixed costs (any price above AVC in diagram), it might be willing to stay in themarket for the SR — since losses will be higher if it leaves the market as all fixed costs will remain.

Possible points:• assumptions of the PCM firm• diagram illustrating MC, ATC, AVC etc (see page 223)• breakeven point illustrated and elucidated• clearly illustrating and commenting on losses at price level below ATC• clear explanation — referring to diagram — of how the firm would make an even greater loss by

leaving the market at any price level above AVC• reference to shutdown point at P = AVC• discussion on how the PCM firm might ride out the storm , i.e. live on previous abnormal

profits, put effort into R&D/cost-cutting in order to lower MC and AC and return to normalprofits

• sunk costs as a partial explanation of why firms stay in loss-making markets

Diagram(-s): The shut-down and break-even price diagram on page 223.

Note: While many students have a solid grasp of this issue, they often get lost in this diagram. Awardgood iteration which might not always refer to a correct point in the diagram.

10. Explain the difference between productive and allocative ( economic ) efficiency.

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Basic answer: Productive efficiency shows whether firms are optimising their use of factor inputs(output at AC minimum) while allocative efficiency shows whether resources are being utilised in theright areas (P = MC).

Possible points:• definition of productive efficiency, e.g. output at AC minimum• explanation to the effect that this shows that all factors (fixed and variable) are being utilised

to the utmost efficiency when average costs are at the lowest point• definition of allocative efficiency, e.g. P = MC• explanation that allocative efficiency means that welfare is maximised — the firm is producing

the last possible unit since the market price means that there is a demand for it at that price• illustrating both concepts using a unit cost picture (PCM)• contrasting optimal efficiency using a unit cost picture for a monopoly• discussion/comparison on monopoly vs PCM and productive/allocative efficiency• using S/D model to show consumer/supplier surplus (outside the syllabus)

Diagram(-s): Unit cost pictures for PCM and monopoly, S/D curve showing consumer/supplier surplus(outside syllabus).

Note: Expect weaker answers to neglect the basic definitions, i.e. ACmin and P = MC.

11. Explain how consumers might benefit from the existence of monopolies.Basic answer: While the standard issue of monopolies having higher prices and lower output thatcompetitive markets might often hold true, there are three main notable exceptions: 1) Naturalmonopolies; 2) monopolies which have large benefits of scale; and 3) large abnormal profits re-invested in R&D and innovation.

Possible points:• natural monopoly

o definition of natural monopoly — it should be clear that a natural monopoly will haveboth benefits of scale and very high (initial) fixed costs

o illustration of pricing possibilities in natural monopoly vs PCM (page 239)o examples of natural monopolies

• outline of a monopoly enjoying benefits of scaleo diagram illustrating benefits of scaleo comparing the monopoly to PCM (page 238)

• possibility of large abnormal profits used in R&D/product innovation• reference to Schumpeter and creative destruction• other possibilities, such as a government monopoly willing to run at societal optimum and

accept losses, or a monopoly which is in fact setting the price closer to the real costs, i.e. theMSC (see page 283)

• use of consumer and supplier surplus (not in syllabus)• any real world example with merit should earn marks

Diagram(-s): See diagrams on page 238, 239, 283.

Note: My experience is that many students feel uncomfortable with the concept that a monopoly infact might be more beneficial is some respects than competitive markets, and a good many studentssimply refer to abnormal profits and possibilities of R&D .

12. Explain how/why profits from a monopoly are likely to be different from those inmonopolistic competition.

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Basic answer: It is important to have the most basic assumptions down for both market types; themonopoly does not fear market entry as there are barriers to entry, but the monopolisticallycompetitive firm faces many competitors with differentiated products. The monopoly can thus earnabnormal profits even in the LR but the monopolistically competitive firm (assuming perfectknowledge and information) will face a number of competitors offering similar or better products.

Possible points:• comparing the assumptions of a monopoly and a monopolistically competitive firm• a firm in monopolistic competition will use heavy marketing to differentiate products from

other firms• outlining monopolistic competition using examples — explaining why there is an element of

both monopoly and competition• there is a higher degree of substitutability for goods offered in monopolistic competition• monopoly diagram illustrating abnormal profits — even in the LR• diagram illustrating monopolistically competitive firm• explanation why a firm in monopolistic competition ultimately only earns a normal profit, i.e.

that P = AR = AC (see figure 2.3.47, page 244)

Diagram(-s): Standard unit cost picture for monopoly (page 234) and monopolistic competition (page244).

Note: The diagram showing normal profit in monopolistic competition is a bit tricky for studentsunder stress. A solid explanation should make up for minor errors in the diagram.

13. In talking with three fellow passengers on a train, you discover that you have all paiddifferent prices for the same journey. Explain how this could be.Basic answer: These passengers have been subjected to price discrimination. The explanation hereshould start with stating that only firms which have a degree of market power can price discriminate,and then outline the preconditions for price discrimination. A clear diagram — showing, in this case,how total output is priced at three different levels — is essential.

Possible points:• definition of price discrimination• pre-conditions for successful price discrimination

o identifiable groupso having different PEDo which are separable, i.e. re-selling can be limited

• discussion of various ways to price discriminate, i.e. time, age, income etc• diagram showing how total output (at MC = MR, assuming profitmax firm) will be divided

into three distinct groups• explanation that total output sets the floor for AC — and that selling at different prices will

add to total profit• clearly showing (graphically or numerically) how multi-pricing adds to profit• diagrams illustrating different PED in different groups

Diagram(-s): Diagram showing multi-price monopoly (page 263) and possible different marketsegments (page 262).

Note: Common error here is that students set output at MC = D, i.e. they assume a perfectly price-discrimination monopoly but don t explain this. Another common mistake is that the shaded originalabnormal profit square for a single-price monopoly is wrong — often the shaded area goes down towhere MC = MR rather than stopping at AC.

Extended response questions

1. a) Why do so many international markets tend towards oligopolist structure? (10 marks)

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Basic answer: A number of incentives exist for firms to become international firms; benefits of scale,new markets, spread of technology, access to factor markets, and simply getting a feel for tastes andpreferences on other markets.

Possible points:• definition of oligopoly — few and large firms with market power• basic assumptions of oligopoly• attraction of international markets for firms

o benefits of scale (LRAC diagram)o new markets — increased revenue/profitso spread of technology — firms will gain technological edge by merging or acquiring

other firmso international firms will have access to foreign capital and lower cost factors of

productiono input from foreign markets can benefit the firm elsewhere, i.e. new tastes and

preferences can allow the firm to transfer this knowledge to other markets• real world examples, i.e. soft drinks, sport shoes• discussion of globalisation and how large firms are able to gain from liberalised capital and

factor markets• increasing globalisation — smaller world — has led to streamlining of tastes and convergence

in living standards in many countries, which paves the way for large multinational firms• examples of small countries with very large oligopolistic firms, for example Philips, IKEA etc

Diagram(-s): LRAC curve.

Note: Perhaps the most important aspect here is that firms will have possibly enormous benefits ofscale in operating on the international market. This is perhaps the

b) What are the possible consequences of this? (15 marks)Basic answer: There are a number of possible issues arising from increasingly oligopolisticinternational market structures, and many of them find nourishment in the on-going globalisationdebate.

Possible points:• marketing efforts for firms can increasingly depend on common social/cultural

denominators in many countries, i.e. will not have to tweak products as much to fit localtastes and preferences

• there are possibly a number of positive effectso lower costs for firmso lower prices for consumerso spread of technology/innovationso increased tradeo better resource allocation

• possible negative effectso danger of global monopoly-like market structures, as benefits of scale for increasingly

large firms eject smaller — local — firms from the marketo international firms will have an increasing degree of economic and political powero multinationals can hide profits, avoid labour laws, disregard the environment (see

race to the bottom argument)o firms may increasingly seek out lower-cost labour around the globe, putting smaller

countries in a position of dependency• any reasonable consequence, squarely linked to international oligopolistic market structure,

should merit marks

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Diagram(-s):

Note: A rather open-ended question which should bring a variety of answers. Marks should beawarded on basis of reasonable links to oligopolies operating internationally.

2. a) Explain what economies of scale are and why they have become increasingly common inlater years. (10 marks)Basic answer: The answer should broadly outline internal and external economies of scale and thenfocus on how deregulation and open — market based — economies have arisen during the past 30 or soyears, coupled to trade deregulation and globalisation.

Possible points:• basic definition of economies of scale — increase in fixed factors, but output increases at a

proportionately higher rate than unit costs• internal economies of scale

o technical economies of scale — spreading of fixed costs, better use of capitalo managerial economies of scale — higher efficiency in firms production units via

specialisationo purchasing economies — bulk buying, good customer priceso marketing economies of scale — benefits of having broad brand-name recognitiono financial economies of scale — larger asset base for security in loans, lower interest

• external economies of scale — growth of industry will benefit all firms in the industry• diagram illustrating LRAC and enveloping effect (page 205)• reasons why scale economies have grown

o increased market opennesso trade deregulationo deregulation of international capital marketso lower transport costs have made large scale operations cost-efficiento convergence of consumer tastes in an ever-smaller world

Diagram(-s): SRAC and enveloping effect of LRAC curve (page 205).

Note: Note that economies of scale refers to firms — nothing else. Students sometimes shift intomacroeconomics here and start writing about countries.

b) In spite of this, many small firms still exist. What possible reasons do you see for theirsuccess? (15 marks)Basic answer: The answer is to be found in local preferences which might not be met by larger firms —and the fact that many markets simply will not have benefits of scale available.

Possible points:• local preferences which are not met by large firms• possibility that larger firms simply do not find local/specialised markets profitable• niche markets will not be subject to scale economies• many services, such as hairstyling and automobile repairs, don t lend themselves easily to

scale economies• closeness to the market is an advantage of smaller firms• smaller firms might also be faster in adapting to local conditions• many customers feel a degree of loyalty to local providers• service/maintenance/complaints might be easier when dealing with a small local firm• there is increasing opposition to large conglomerates

Diagram(-s):

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Note: There are of course other possible answers, yet the core issue must deal with why smaller firmsare able to carve out a place for themselves side-by-side with very large potential entrants.

3. a) What main features are found in oligopolies? (10 marks)Basic answer: The key here is that firms will be few and large, thus having considerable market power.There is also an incentive to collude, and in the absence of collusion firms will be heavilyinterdependent.

Possible points:• assumptions of oligopoly• four or five firm concentration ratio• frequently there are benefits of scale to be had• mergers, take-overs and buy-outs are common• incentive to collude, i.e. build cartels

o collusion not limited to price or output — possible to divide markets or limit entrantso collusion is most often illegalo collusion often short-lived, as cheating is a strong incentiveo overt and tacit collusiono price leader

• non-collusive oligopolieso non-collusive outcome results often in price rigidityo firms are heavily interdependent and reluctant to engage in head-on competitiono non-price competition may result in both new and better goods — or at least the

marketing effort will enhance perceived quality• use of game theory to show effects of cheating in collusive oligopoly• kinked demand curve to illustrate why prices tend to be rigid in the LR• non-price competition, possibility of price wars• heavy branding and advertising commonplace due to non-price competition

Diagram(-s): LRAC, kinked demand curve.

Note: Students might confuse features with assumptions , which misses the main point of thequestion.

b) Explain how oligopolies can work both for and against consumers. (15 marks)Basic answer: Oligopolies market power can of course work against consumers — since price-settingand any form of collusion will lower consumer welfare. Yet it is also the fact that many oligopolies infact have to act in accordance with market demand basics and are thus to a certain extent competitive.

Possible points:• against

o firms might colludeo higher prices would result from collusiono increasing market ratio on market in fact moves towards monopoly structureo even in non-collusive oligopolies one might expect competition to be limitedo entrants are dissuaded which lowers competition

• other issues might include the wastefulness of advertising; power of large firms ininternational markets; dangers of streamlined consumerism and decline of local firms

• foro non-price competition is an incentive for firms to come up with better/new goodso product innovation and R&D due to abnormal profitso lower costs due to scale benefits can be passed on to consumerso wide brand recognition would be an incentive for firm to keep quality high

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• other issues might include the on-going process of product differentiation; the high profile ofmultinational firms means that they would want to be seen as good corporate citizens ,consumers would feel secure in brands, knowing that they could rely on the quality no matterwhere the good was purchased

Diagram(-s):

Note: Many students are quite awake here, and are able to give a good number of relevant argumentsfor/against oligopolies.

4. a) What are the main assumptions made in the model of perfect competition and contestablemarkets? (10 marks)Basic answer: The main issue is the difference between the two sets of assumption; in contestablemarket theory, goods can be both homogeneous and differentiated and no exit barriers exist.

Possible points:• assumptions of the perfectly competitive market

o no barriers to entryo perfect knowledge and informationo homogeneous goodo large number of firms — no firm is large enough to affect market supply/priceo the firm is a profit maximiser

• assumptions of contestable marketso no barriers to entryo perfect knowledge and informationo the firm is a profit maximisero one or many firmso homogeneous or differentiated goodo zero exit barriers

Diagram(-s): See below.

Note: Many students will include diagrams and explanations of why/how the firm will make a normalprofit etc — yet this is not asked for in this part but the next!

b) Examine the relevance of the above assumptions in explaining market outcome in terms ofquantity, price and efficiency. (15 marks)Basic answer: Each set of assumptions must be clearly shown to have bearing on the market outcomein the PCM and contestable market.

Possible points:• perfectly competitive market

o as there are many firms and none can influence the market, the firm can sell all itproduces

o output is set at MC = MR, i.e. profitmax point of outputo the firm is too small to influence the market, thus is a price-takero since there is perfect knowledge/info, any abnormal profit will attract entrantso and since no entry barriers exist, this will increase supply and dissolve the abnormal

profito thus, in LR, the PCM firm will operate where P = MR = MC = AC = AR = Do diagrammatic illustration of the above — perhaps with the unit cost diagram for a PCM

firm side-by-side with a PCM diagram (pages 221, 222, 227)o PCM firm is thus both productively efficient (output is at ACmin) and allocatively

efficient (P = MC)• contestable market

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o since there is a degree of market power for firm(-s) in contestable markets, there ispricing and output power

o as no entry barriers exist (to speak of ) firms might expect market entry if the make anabnormal profit (keeping in mind here that there is perfect knowledge andinformation)

o there are also zero exit barriers — highly important here — so firms could adopt a hit-and-run strategy of entering the market, soaking up abnormal profits for a limitedtime and then exiting

o there is thus an incentive for incumbent firms to dissuade potential entrantso this can be done by operating at a level where all incumbent firms set price and output

so as to make only a normal profito diagram illustrating the above (page 259)o contestable market firm is therefore — just as the PCM firm — both productively

efficient (output is at ACmin) and allocatively efficient (P = MC)

Diagram(-s): PCM firm and market compared (page 227) and the contestable market equilibriumdiagram (page 259).

Note: It is impossible to fit all the above points in, but full marks may be given for answers whichclearly outline two assumptions relevant in explaining how market equilibrium is arrived at.

5. a) What is a natural monopoly and how could it be superior to a competitive market inproviding goods? (10 marks)Basic answer: Define natural monopoly as a situation where the benefits of scale an fixed costs are sohigh that it is impossible to fully exploit them. A diagram illustrating falling (or constant) MC and ACshould be used to show that a natural monopoly could indeed be superior to the competitive market.

Possible points:• definition of natural monopoly

o benefits of scaleo high fixed costs

• relevant assumptions; profit maximiser — or breakeven/social benefit max• examples of natural monopoly, i.e. telecom, gas works, train service etc• clear diagram showing how AC and MC are falling — or constant — throughout the span of the

demand curve (page 239)• use diagram to illustrate

o how a duopoly would have a higher priceo that indeed a PCM outcome would mean a far higher priceo possibility of AC-pricing and even MC-pricing

• reference to public/merit goods and social pricing• real world examples showing how ludicrous it would be to insist on PCM in providing goods,

i.e. 240 separate gas pipes into your house , 24 parallel train tracks , 9 bridges side-by-side etc

Diagram(-s): A basic diagram showing decreasing/constant AC and MC — and how the price wouldindeed be higher for this particular good (page 239).

Note: It is possible to use only the MC curve in the diagram — and it can well be constant (horizontal).

b) Explain why goods provided by natural monopolies are often publicly owned. (15 marks)Basic answer: A good question — and I m not quite sure if anyone has an answer. It would seem thatmost natural monopolies come with high MSB and also that society has deemed these goods far tosocietally important to be owned/operated by private interests. Thus, water, gas, sewage, publictransportation, telecom etc, is often wholly in the hands of government or local municipal ownership— or at least control.

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Possible points:• definition of public and merit goods• examples of such goods, e.g. public utilities and the like• how in fact the high fixed costs might dissuade private firms from market entry• use of MSB (and diagrammatic illustration) to explain benefits to society• possibility of social pricing

o setting price at ACo covering losses by subsidies and/or price discrimination

• risk of letting private ownership control such goods• possibility that many such goods have come to be regarded as public utilities , i.e. there are

political reasons for keeping them under public control• reference to real world examples of privatisation and the relative failures here — say the train

system in the UK and electricity in California, US• any reasonable reason

Diagram(-s): Natural monopoly diagram (page 239).

Note: Any well commented issue which uses economic terms/concepts should merit marks.

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Section 3.4 — Demand and supply-side policies

Short answer questions (10 marks each)

1. Explain the link between the rate of interest and inflation.Basic answer: Interest can be defined as the price of money — more expensive money will lead tofew loans, higher saving and hence lower investment and consumption. This will have a dampeningeffect on AD and thus inflation.

Possible points:• interest defined as both the price of money• and the rate of return on deposits• inflation defined as general increase in price level — CPI/RPI/GDP deflator• higher interest rates will increase the cost of borrowing

o firms will decrease investmento household will hold off on big-ticket consumptiono savings will increase, as the opportunity cost of spending has gone up

• use of investment schedule to show effects of increased interest• definition of C, I, S in terms of AD• use of AS-AD model to show decrease in AD (or better; lower rate of increase in AD — see

page 387)• clearly linking r AD I• explanation to the effect that price level will not decrease, but rather rate of inflation• possible to use the transmission mechanism (page 436)

Diagram(-s): Investment schedule, AS-AD.

Note: A straightforward question. Students should take care to clearly link interest with ADcomponents (and the leakage of S) and thus the price level.

2. Using the AD/AS model, explain how an increase in government spending would affect aneconomy.Basic answer: To fully address this question, it should be made clear that G is a component of AD.And, while not correlated to the price level, any increase in G will shift AD to the right, increasingGDPreal and possibly increasing the price level (GDP deflator).

Possible points:• defining G as a component of AD• possible reference to expenditure (in national income accounting)• clear diagram showing AD, AS and possibly LRAS• referring to C, I, G, X, and M in AD• defining G as expenditure, not transfer payments• possible reference to deficit spending, demand management, reflationary policies• clearly showing in the diagram how an increase in G shifts AD to the right• increasing GDPreal• and (depending on shape of AS curve) increasing the price level

Diagram(-s): AS-AD model.

Note: Full marks should not be given for diagrams which are not well-labelled and show dotted linesreferring to increase in output and price level.

3. Why might stimulatory fiscal policy have no (long run) effect on national income?

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Basic answer: This is squarely in the camp of monetarist/classical theory. Define stimulatory policiesas an increase in G, decrease in T, and show clearly how this will affect component parts of AD,which shifts right — beyond LRAS. The monetarist/classical view is that this will lead to a bidding upof wages and factor prices, which then shifts AS to the left — back to LRAS and the full employmentlevel of output.

Possible points:• definition of stimulatory fiscal policies (˘T and/or G)• how decreased leakage (T) affects S, C and I - and thus AD• how G is a component of AD• diagram showing general equilibrium and a shift in AD to the right• monetarist/classical assumptions

o no money illusiono households will know that real incomes have in fact falleno workers bid up wages, firms raise price of factorso the effect is to decrease AS — shifts left

• comments to the effect that according to monetarists, demand-side policies are purelyinflationary in the LR

• reference to demand-pull inflation and possibility of demand-pull spiral• possible crowding out effects (HL)• possible effects on inflation, exchange rates and thus X and M

Diagram(-s): AS-AD diagram (with LRAS), investment schedules (classical juxtaposed withKeynesian) to show possible crowding out.

Note: The entire kit of monetarist assumptions above is not necessary — but the answer must clarifythat the issue of no increase in real output in LR is fundamentally a monetarist issue.

4. Why is it so difficult for government to achieve all macro objectives simultaneously?Basic answer: Define/outline the main macro objectives, i.e. growth, price stability, full employment,external balance (and possibly environmental and equity issues). There are a number of trade-offswhich arise so when a given issue is addressed, such as growth, another set of problems arise, such asinflation.

Possible points:• definition/outline of main macro objectives• specifically showing possible trade-offs, i.e.

o stimulatory policies which increase AD might cause inflationo growth might conflict with full employment as structural and technological change

affects demand for certain labour groups (see sectoral/technological/regionalunemployment), supply-side policies might increase efficiency and createredundancies amongst labour groups

o full employment might also create inflationo growth might increase imports (HL: MPM, and lower multiplicative effects) and

decrease exports due to inflationo growth inflation depreciation of currencyo fiscal stimulus may involve deficit spending and debt, which in turn could have a

negative effect on the exchange rate• use of Phillips curve to show trade-off between inflation and unemployment• other trade-offs might refer to growth environmental issues, or growth distribution of

income• contrasting SR (demand-side) issues with LR (supply-side) issues, for example that there is

perhaps no real conflict between growth and unemployment or growth and inflationDiagram(-s): AS-AD, LRAS to show supply-side issues, Phillips curve, labour market diagram toshow effect of stimulatory policies.

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Note: A good rendition of two basic trade-offs should be able to earn full marks.

5. Explain how automatic (fiscal) stabilisers may help to lower fluctuations in the business cycle.Basic answer: Definition of automatic stabilisers as built-in to the system in terms of transferpayments (unemployment/welfare benefits) and a progressive taxation system. Illustrate the effects onAD during phases of the business cycle.

Possible points:• definition of automatic stabilisers

o transfer payments help to bolster falling incomes during recessionary periods, boostsAD

o marginal tax rates mean higher average taxes during boom periods, has a dampeningeffect on AD

• linking AD to change in transfer payments and marginal tax rates• illustrating the above in a diagram• showing in business cycle when these stabilising effects kick in• for iteration to the effect that these stabilisers do not decrease/increase AD but dampen/boost

the rate of increase/decrease• discussion of possible lags in the stabilising effects• illustrating the moderation of business cycle swings

Diagram(-s): AS-AD model, business cycle.

Note: There are other, more complex, ways to show the business cycle using AS. However, this is notnecessary really.

6. How might monetary policy be used to influence economic activity?Basic answer: Define monetary policy as a change in interest rates (and/or the supply of money andpossibly credit controls — not part of syllabus) to dampen or stimulate AD and thus output — and ofteninflation/disinflation/deflation.

Possible points:• definition of monetary policy

o changing central bank interest rateso changing the supply of moneyo increasing/decreasing credit controls, demands on security for loans etc

• outlining clearly the link between interest and various components of AD (C, I etc) and alsohow saving is affected

• illustrating clearly the effects on ADo lower r decreased S, higher C, I dampening of decrease in AD stimulation

and possible increase in Yo higher r increased S, lower C, I dampening of increase in AD deflating effect

and possible decrease in Y• possible LR effects on AS due to interest rate changes, for example that lower r might increase

I — which in the LR would increase AS• reference to monetarism and focus on monetary policy to steer the economy

Diagram(-s): AS-AD, transmission mechanism diagrams (page 436 — not part of syllabus).

Note: Straightforward question — but links between interest rate and AD components need to be quiteclearly illustrated.7. How might a country s Central Bank use monetary policy to stimulate domestic aggregatedemand via exchange rates?Question scrapped — too far outside the syllabus.

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HL only8. How might an accurate value for the multiplier aid a government in setting fiscal policy?Basic answer: Any given multiplier will increase national income at a given rate times the increase ingovernment spending. Knowing that, for example, the value of k is 2, and that 10,000 jobs areexpected to be created for each additional billion in national income, then additional governmentspending of 0.5billion will create the necessary jobs.

Possible points:• definition of multiplier, i.e. k = 1 / MPL

o leakages, S, M, To 1 — MPL = MPCo thus, the lower the leakages, the higher the value of the multiplier

• definition of fiscal policy, e.g. a change in G and/or T• linking G and/or T to the value of the multiplier• using an example of how increased G would increase national income• other issues of having an accurate value of k

o government would have a better calculation of how much deficit spending a givenincrease in national income would entail

o demand-management policies would be far more accurateo inflation rates might be held in checko future tax revenues might be better calculated

Diagram(-s): Well, the ol 45¡ degree diagram is clearly superior at showing the multiplicative effectsof an increase in G — but even the AS-AD diagram can be used to illustrate stimulatory fiscal policy.

Note: It is not necessary to illustrate the multiplicative effects using the 45¡ diagram. However, thebasic principle of repetitive rounds in the circular flow model should in some way be made clear.

9. Explain crowding out and why it may be considered important for policy makers.Basic answer: Crowding out refers to how increased government borrowing (real borrowing!) mightserve to raise interest rates and basically make scarce resources which could be used by firms.Basically, government borrowing crowds out an amount of private investment. There is also amonetarist/classical and Keynesian distinction herein, where the former view a high probability of(complete) crowding out and the latter view the effects as limited. The importance of whethercrowding out takes place has implications for the effectiveness of demand-side policies, and thusserves to underpin the on-going debate between monetarism ( complete or near-complete crowdingout takes place and thereby negates demand-side policies based on government borrowing of funds )and Keynesianism ( only partial crowding out takes place which supports the view that demand-sidepolicies serve to stimulate the economy and increase GDP ).

Possible points:• definition of crowding out as the replacement of private investment by government, if..

o real borrowing takes placeo the economy is at or near full employment (primarily a Keynesian premise)

• the interest rate effect due to government demand for loanable funds• how higher interest would affect private investment• the distinction between monetarist and Keynesian views on the demand for investment (see

investment schedule )• linking interest to investment and thus AD and Y• use of transmission mechanism to show link between interest and GDP• complete, or near complete crowding out (monetarist view)• limited crowding out (Keynesian view)• the implications for government policies on demand management

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Diagram(-s): Market for loanable funds, investment schedule, AD-AS (see page 408).

Note: The top tier answers will manage to incorporate the differing investment schedules (of themonetarist/classical side and the Keynesian side) into policy discussions by linking demand-sidepolicies to the (possible) increase in AD.

Extended response questions

1. a) Carefully distinguish between demand-side policies and supply-side policies. (10marks)Basic answer: The answer should broadly illustrate the general macroeconomic objectives ofgovernments and then carefully outline demand-side policies in terms of fiscal/monetary policies (e.g.stimulating AD); and the micro-policies of supply-side economics such as lowering taxes andtransfer payments (aimed at increasing LRAS).

Possible points:• brief outline of main macro issues, e.g. growth, price stability, employment and external

balance (balance of payments and exchange rate)• definitions of demand-side and supply-side policies• with support of AS-AD model• demand side policies are commonly used to stimulate AD and even-out business-cycle

fluctuations• demand side policies are fiscal policies and monetary policies aimed at influencing AD

o changing taxes on income, expenditure, profitso adjusting government spendingo adjusting interest rates

• supporting the points above using AD-AS model• supply-side policies

o labour policies — reducing union power; cutting back on welfare benefits; abolishingminimum wages; easier hire-and-fire policies etc

o capital — tax breaks for investment and education in firms; lower taxes onprofits/dividends etc

o competition — privatisation and deregulation; subsidies for R&D; trade and generalmarket liberalisation etc

• using AS-AD model incorporating the LRAS curve showing the aim of supply-side policies• any reasonable discussion on the monetarist/classical vs Keynesian viewpoint• relevant reference to SR and LR

Diagram(-s): AS-AD; ASL-ADL; possibly the inverted L-shaped Keynesian AS curve

Note: Students are often able to account for demand- and supply-side policies rather well, but weakerstudents tend to neglect showing more specifically how a given policy affects AS and/or AS and thusthe main macro objectives.

b) What are the main weaknesses of using demand-side policies? (15 marks)Basic answer: The student can either adopt the standpoint of a monetarist/classical economist or viewthe weaknesses from a more empirical standpoint. The main weaknesses can be covered in 1) trade-offs; 2) time lags; and 3) monetarist/classical criticism of demand management.

Possible points:• trade-off issues

o growth and low unemployment often come with inflation

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o government stimulatory policies may come from deficit spending and thus increaseddebt

o growth may result in current account problems (HL; use MPM)o growth and inflation, together with rising imports may lead to downward pressure on

the exchange rate• time lags

o identification lags implementation lags impact lags — might lead to exacerbationof business cycle

• monetarist/classical criticismo demand-side policies have shown to be inflationary (for example, wages-price spiral),

inflation is primarily a monetary issue (reference to demand-pull inflation)o market efficiency is lowered, market signals are distorted and markets do not clear

(primarily labour market)o people are rational — thus any stimulus of AD beyond LRAS (potential output) will be

solely inflationary in the LR as wages are bid up and SRAS shifts left (see diagram3.4.12 I on page 393)

• mentioning that markets have become increasingly open/integrated, which has lessened thedegree to which demand-side policies have a multiplicative effect, as leakages (imports) haveincreased (HL)

Diagram(-s): AS-AD (LRAS necessary); Phillips-curve (and LR Phillips-curve for HL); ADL-ADL

model showing how ADL increases due to fiscal/monetary stimulation, and also how labour marketdoes not clear due to minimum wage and labour market regulation

Note: This question is seldom answered neatly and well-organised — yet most students should be ableto give basic critique of demand-side policies. Most answers should utilise the LRAS curve and thePhillips-curve.

2. a) Why is investment so important in an economy? (10 marks)Basic answer: Define investment as an increase in capital stock and link this to broad macro issues;future output, increase in living standards, tax bases, development issues etc. The PPF may be usedto illustrate de facto output and potential output.

Possible points:• definition of investment as increase in capital stock in the economy during a period of time• effects of investment

o stimulation of ADo increase in output potential — ASo possible supply-side issues, i.e. increasing the LR potential while keeping inflation in

checko productivity and link to real wages and income

• developmental issueso saving often lower than investment, need for foreign investmento transfer of knowledge/technologyo reference to Harrod-Domar and capital output ratio

Diagram(-s): PPF, AS-AD model — utilising LRAS to show supply-side issues and LR potentialoutput.

Note: Most students will have an intuitive grasp of the issue, yet care should be taken not to digressfrom mainstream economic terminology and links between investment and growth/development.

b) Explain the role governments can play in supporting investment levels in the economy. (15marks)

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Basic answer: Government — and the central bank — can influence investment levels through variousforms of tax legislation, open market mechanisms and monetary policy. Linking any viable example toincreased propensity of firms to invest should get marks.

Possible points:• monetary policies

o lowering interest rates would stimulate investmento relaxing credit restrictions to firms which invest

• fiscal policieso tax breaks for firms which re-invest profitso decrease in profit taxeso decrease in capital gains taxes

• legislationo tax holidays for FDIo allowing larger write-offs for firms — which would in fact lower corporate taxes

• market orientated policieso allowing easier entry to financial markets by domestic and foreign playerso encouraging competition in financial markets, for example by privatising national

financial institutions• subsidies

o granting various forms of output subsidies for firms with high investment ratioso subsidising loans for investment — i.e. government backing of loans

Diagram(-s): Investment schedule would illustrate the effect on investment of a decrease in interestrates.

Note: Allow a good degree of inventiveness here — it s amazing what some of these students have readsomewhere. Award marks as long as the suggestion is plausible and clearly linked to increasedinvestment.

3. a) Outline and briefly explain the main macroeconomic objectives of governments. (10marks)Basic answer: The answer should include growth, high employment, price stability and externalbalance (balance of payments and exchange rate). Three additional options are environmental issues,equitable distribution of income and productivity.

Possible points:• definition of macroeconomic issues• growth

o increase in national income per unit of time, a flow concepto enables the economy to improve living standards

• high employmento percentage of labour force employedo shows utilisation of social factor of production

• price stabilityo steady rate of price increase; change in CPI/RPI/GDP deflatoro allows predictability and reliability in the economic environment

• external balanceo balance of payments

equilibrium in foreign sector trade, i.e. exports and importso exchange rate

stability in external value of currency• environmental issues; use of natural resources, impact on environment, sustainability• equitable income distribution; growth without benefiting wider portions of society is non-

developmental

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• productivity; increasing efficiency of factors and thus productive capacity

Diagram(-s): AS-AD model can illustrate growth, price stability and net exports.

Note: One often gets a rather simplistic list of objectives here, yet the question reads explain , whichshould elicit a brief definitional measurement ( change in GDP during a time period ) and a brief lineof reasoning why it is on the list of main macro objectives.

b) Critically examine one of these objectives, and explain why it should be considered the mostimportant of them all. (15 marks)Basic answer: This is a very wide and open-ended question which requires the student to justifyhis/her choice. This calls for the weighing of options in terms of the possible trade-offs of any oneobjective, and a comparison with other objectives in argumentation. The monetarist/classical vsKeynesian debate can also be used in supportive argument.

Possible points:• growth; national income is the foundation of wealth, prosperity and general living standards;

provides tax bases from which to provide public/merit goods and infrastructure; a largercake means that more is available for consumption; the possible trades-off of inflation isworth it and environment can be dealt with ultimately as increased prosperity will provideresources for this

• high employment; people are the most vital resource and should not be squandered due to highsocietal costs of such waste; people with jobs will have opportunities and meaningful lives;high employment enables growth, entrepreneurship, innovation; high employment lowers notonly social costs but has financial benefits in the form of lower transfer payments/benefits andhigher tax revenues for government; possible trade-off of inflation does not negate the greatersocietal benefits of low unemployment

• price stability; reliability and predictability in the economy can be created by keeping inflationunder control; high costs of inflation, i.e. redistributive effects, behavioural distortions, shoeleather and menu costs etc; monetarist theory indicates that strong non-interventionism bygovernment and free markets increase real incomes; macroeconomic policies should focus onprice stability and creating the framework for incentives in production — supply-side policies;possible trade-offs such as unemployment are SR issues — in the LR market forces will havecreated more output and labour markets will clear

• external balance; assuming a small, highly export-oriented and open economy — Hong Kongfor example — it is imperative that the export sector is flourishing, since this creates the bruntof the economic base; export orientation creates jobs, tax bases and income; a stable andreliable exchange rate is absolutely vital in this case; trade-off is possibly that monetary policyfreedom is given up to retain a fixed exchange rate

• environment; students might adopt the stance that in the LR it will not matter what theeconomic system or ranking of macro objectives if it is clearly non-sustainable

• income distribution; one might argue that growth is clearly not optimally socially beneficial ifthe brunt of income/wealth goes to a small powerful minority; equitable distribution of incomehas shown to have both social benefits and economic benefits (in terms of growth rate); thewider concept of development — of which income distribution is part — outweighs simplegrowth or inflation concerns

• productivity; it is possible to philosophise that ever-higher incomes and increasingprosperity in developed countries, together with declining birth rates makes it absolutelyimperative to increase productivity to retain living standards, provide tax bases and thuspublic/merit goods and pensions in the future; productivity can be said to be at the heart ofnational income, as it shows potential real GDP per capita

Diagram(-s): AS-AD model to show trade-offs, e.g. inflation/output/unemployment. Phillips curve(and LR Phillips curve, HL) to show inflation vs unemployment. LRAS to illustrate supply-side issuesand productivity. Labour market diagram to show natural rate of unemployment etc.

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Note: Again, a very wide and open question — and you will in all likelihood get a number of far betteranswers than above from gifted students! Award points not only on the basis of clarity of economicthought but also for validity and skill in argumentation.

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Section 3.6 — Distribution of income

Short answer questions (10 marks each)

1. Why might there be unemployment at the equilibrium level of income?Basic answer: Define and outline equilibrium income; AS = AD in diagram. A very straightforwardmethod would then be to add a LRAS curve to the left of this equilibrium, showing that the economyis at less than full employment. Another version shows general equilibrium (AS=AD=LRAS) butcomments on the fact that full employment in fact entails a degree of unemployment.

Possible points:• definition of equilibrium income in AS-AD diagram• definition of unemployment; percentage of labour force willing and able to work not holding

jobs• use of natural rate of unemployment, i.e. that full employment entails

o structural,o seasonal, ando frictional unemployment

• use of labour market diagram to show the above• that equilibrium might well mean that output is below potential output — at LRAS — and that

this will mean additional unemployment• good reference to real wage and/or cyclical unemployment

Diagram(-s): AS-AD including LRAS to show equilibrium national income. Labour market diagram —which can be linked to AS-AD diagram — to show that equilibrium national income can mean naturalunemployment (at LRAS) and cyclical/real wage unemployment at AS =AD below LRAS.

Note: Many students hurry past a sound definition of equilibrium and cannot get highest marks.

2. Discuss whether inflation or deflation is the more serious problem for an economy.Basic answer: Define both; inflation is a consistent general increase in the price level , whiledeflation is a consistent fall in the general price level , i.e. negative inflation. A good answer willoutline the basic damage to an economy of both, ultimately showing — perhaps — that deflation, whilerarer, can be held by many economists to be the greater of two evils.

Possible points:• definition of inflation, consistent etc• definition of deflation• costs of inflation

o shoe leather, menu costso redistribution effects — fixed income earners lose, borrowers gaino behavioural distortions in the economyo effects on outputo possible break-down of monetary economy (hyperinflation)

• use of LR Phillips curve (HL) to show effects of inflation on economy• effects of deflation

o distinction between benign and malignant deflationo use of AS-AD model to illustrate the aboveo possibility of negative expectations ando malignant inflation and possibility of self-reinforcing feedback loop

• inflation is more damaging; far more common, destroys trust in money and financial system,can take years to correct, see 1922/23 in Germany, Brazil in 1980«s

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• deflation is more damaging; uncommon but when this is the case it is very difficult to get outof a negative feedback loop of falling prices falling demand falling prices — see Japan in1990 s

• use of AS-AD model to illustrate demand-pull , cost-push inflation• illustration of cost-push, demand-pull spirals

Diagram(-s): AS-AD to show inflation and spirals, LR Philips curve (HL).

Note: aas

3. Explain what the natural rate of unemployment is.Basic answer: It is essential here to include a solid definition based on economic concepts. The naturalrate of unemployment is the rate of unemployment which exists when the labour market has cleared —leaving voluntary employment comprised of seasonal, frictional and structural unemployment. Itseems obvious that a basic definition of employment and labour force is necessary here.

Possible points:• concept of full employment, i.e. where all labourers in the labour force who want a job at the

going wage rate are employed• that this in turn is the labour market in equilibrium, i.e. equilibrium unemployment• those who do not accept the going wage rate are voluntarily unemployed• there is always an element of voluntary unemployment and this is the natural rate• difficulties in assessing the natural rate of unemployment; different definitions of the labour

force are possible, part time workers may not be counted, accounting problems such as notregistering at employment agencies and discouraged workers

• that the natural rate of unemployment is not cut in stone but varies over time

Diagram(-s): The basic labour diagram (ASL/ADL) could be used — clearly showing equilibrium andthe natural rate of unemployment between market equilibrium and the TLF.

Note: While it is not absolutely necessary, it is common that stronger students include and refer to thelabour market diagram.

4. Explain how an unexpectedly large increase in the price of oil might affect a non oil exportingcountry.Basic answer: This is something of a classic , dealing with supply-side shocks and the effects on ASand AD. Start off by determining oil as a major factor of production and then use a AS-AD diagram toillustrate the effects on the economy — AS decreases and the possibility of cost-push inflation.Reference to the oil crisis of the 1970 s is highly relevant.

Possible points:• oil as a factor• explanation of the effect on AS of factor prices, i.e. shift to the left• supply-side shock

o falling outputo increase in price levelo stagflation (or slumpflation)

• cost-push inflation as AS decreases further due to bidding up of factor prices and wages• possible reflationary policies undertaken to stimulate AD• possible cost-push spiral• use of Phillips curve (HL: LR Phillips curve)• exemplifying with the stagflationary period of the 1970 s• noting that oil producing countries would in all likelihood benefit from oil price increase

Diagram(-s): AS-AD including LRAS. Phillips curve and LR Phillips curve (HL).

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Note: Reward students who clearly differentiate between a supply-side shock and cost-push inflation.

5. What are the economic and social costs of high inflation levels?Basic answer: High inflation will have serious redistribution costs; create distortions to the economy;reduce international competitiveness; affect the balance of payments and exchange rate; and havenegative effects on growth.

Possible points:• definition of inflation as a sustained general increase in the price level• economic cost include

o higher interest rates and reduced investmento insecurity and lack of predictability; firms will be wary of increasing investment and

consumers might hold of on spendingo shoe leather and menu costso inflation might cause exports to fallo and depreciate the currency

• social costso people on fixed incomes will suffer more than those strong enough to bid up wages in

line with inflationo the poor will suffer more than the financially strong

• redistribution effects — for example, borrowers will gain at the expense of lenders (as the realvalue of debt falls over time when inflation is high)

• extreme inflation (hyperinflation) might lead to a breakdown in the monetary economy,resulting in time-wasteful bartering

Diagram(-s): AS-AD diagram may be used to show inflation, investment schedule may be used toshow how investment falls when interest rises.

Note: Students often produce a list of ills without bothering to explain or elucidate. Clearly highermarks should be reserved for answers which give some depth as to why a certain effect constitutes aneconomic and/or social cost.

6. Discuss the merits of supply-side policies aimed at reducing unemployment.Basic answer: Define supply-side policies as aimed at increasing LR (potential) growth by stimulatinglabour mobility, capital formation and increased competition. Note that supply side policies are LRpolicies.

Possible points:• outline of supply-side policies

o labour policies — reducing union power; cutting back on welfare benefits; abolishingminimum wages; easier hire-and-fire policies etc

o capital — tax breaks for investment and education in firms; lower taxes onprofits/dividends etc

o competition — privatisation and deregulation; subsidies for R&D; trade and generalmarket liberalisation etc

• using AS-AD model incorporating the LRAS curve showing the aim of supply-side policies• clearly showing how AS and LRAS are affected by these policies• use of labour market diagram to show either labour market clearing and/or a decrease in the

natural rate of unemployment• definitions of natural rate of unemployment and real wage unemployment• merits of such policies

o have had a degree of success in the UK and USo have been adopted to some extent in many OECD countries

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o can have severe drawbacks in the SR, i.e. increased unemployment, possible budgetdeficits as taxes are cut, social costs of decreasing social benefits, rise in incomeinequality,

• limitations also include Keynesian criticism; market are imperfect and could take considerabletime to clear, highly politicised issues of whether tax incentives actually work, the long runmight be very long — and painful — indeed

Diagram(-s): AS-AD including LRAS, LR Phillips curve (HL), labour market diagram.

Note: For full marks, some form of assessment must be included — hence the command term meritsin the question.

7. Explain how unemployment could be voluntary or involuntary .Basic answer: A thorough examination of unemployment is the key here. Start of with a definition ofthe labour force and then outline the proportion of the labour force which would be unemployed evenwhen the labour market is in equilibrium — this consists of frictional, seasonal and structuralunemployment. Classical/monetarist theory looks at any unemployment in excess of the natural rate ofunemployment as voluntary — since these labourers are not accepting jobs at the going real wage rate.Keynesians, on the other hand, view this as involuntary, or demand deficient.

Possible points:• definition of labour force, e.g. proportion of population between 16 and 65 considered

economically active• voluntary unemployment is the monetarist/classical view that any unemployment above the

natural rate of unemployment is voluntaryo the labour market has not clearedo the real wage level is too higho labourers voluntarily decline jobs since at the going real wage rate, there is far higher

demand for jobs than there is supply• involuntary unemployment means that the labour market has not cleared, i.e. unemployment is

above the natural rate of unemploymento this could be demand-deficient in nature — ADL has fallen and wages are sticky

and/or labour markets are generally immobileo it could be argued to be real wage unemployment — real wages are too high,

disenabling labour market clearing• use of labour market diagram to illustrate voluntary and involuntary levels of unemployment• reference to natural rate of unemployment• use of AS-AD and LRAS model to illustrate natural rate of unemployment, i.e. full

employment level of output

Diagram(-s): Labour market diagram, AS-AD including LRAS in order to show full employment levelof output.

Note: One often sees answers hinging upon a rather sad line of argumentation; voluntaryunemployment is the result of unemployment and social benefits being too high . This can be largelydiscounted unless placed in the proper context of monetarism and supply-side policies aimed atcreating market clearing.

8. The government of a less developed country decides to reduce the extent of income and wealthinequality. What methods could the government use to achieve its goal?Basic answer: The answer is centred around redistribution issues — governments can influence netdisposable income and wealth in a number of ways. Taxes on income, wealth, expenditure and importscan be adjusted to decrease the burden on the poor. Transfer payments and benefits in kind are ways ofredistributing incomes.

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Possible points:• wealth equality; redistribution via land re-distribution schemes, nationalisation and taxes on

wealth• income redistribution can possibly be aided by shifting the weight of tax bases from basic

necessities to income elastic and luxury goods, by increasing income tax progression,minimum wage policies, increased goods and services in kind, increased transfer payments(benefits), increased spending on merit goods etc.

• relevant discussion on the limits to such governments schemes such as tax evasion, capitalflight, increased use of parallel markets, lack of government funds to implement increasedtransfers etc

• use of Lorenz curve/Gini coefficient (a bit peripheral but illustrative)

Diagram(-s): Inward-shifting Lorenz curve to illustrate improved distribution of income.

Note: Students often spin off into an answer dealing with why income and wealth inequality should bereduced rather than how.

HL only9. How could knowledge as to the shape of the Philips curve benefit governments?Basic answer: The Phillips curve illustrates the possible trade-off between inflation and unemployment— while the LR Phillips curve (expectations augmented in monetarist terminology) shows that thetrade-off is at best temporary. This has some profound implications for economic policy in terms offocus on demand-management or supply-side policies.

Possible points:• use of Phillips curve to show trade-off• underlining the above by using an AS-AD model as support (see page 441)• demand-side

o the Phillips curve shows a trade-offo presents a menu of possibilities for governmento clear correlation between demand stimulation and unemployment

• monetarist/supply-sideo people/firms do not suffer from money-illusiono thus the fall in real income will be noticedo and firms will increase factor prices and households will bid up wageso in time, AS will shift left, back to equilibrium and the economy will adapt to higher

inflation expectations• any viable points in the monetarist-Keynesian debate, e.g. causes of inflation, market

interventionism or not, market clearing issues, SR vs LR etc• making clear that knowledge of whether the Phillips curve is a SR version or if indeed a LR

version exists will have direct implications for fiscal and monetary policy

Diagram(-s): AS-AD, SR and LR Phillips curve.

Note: Full marks should not be given to answers which are limited to an itemisation of demand-sideand supply-side views of the Phillips curve — a clear reference must be made to the effects on policymaking.

Extended response questions

1. a) What are the main causes of unemployment? (10 marks)

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Basic answer: Two main paths are available; demand-deficient unemployment and real wageunemployment. After defining unemployment (percentage of the workforce not holding a job), relativedepth should be given to these two main rubrics.

Possible points:• demand-deficient unemployment

o reference to business cycle (cyclical unemployment)o derived demand for labouro illustrating increase in unemployment in labour market diagram, shift left of ADL

o possibility of downward stickiness of labouro primary cause is low AD in the economy

• real wage unemploymento market for labour does not clear due to market imperfectionso unwillingness/inability of labourers to accept going real wage rate results in voluntary

unemploymento causes include trade union power, minimum wages, high social and welfare benefits

• natural rate of unemployment, i.e. frictional, seasonal, sectoral unemployment• other possible issues

o restructuring of the economy, for example in transitional economieso dependency on a narrow range of goods for which demand has fallen — for example in

many developing countries

Diagram(-s): Labour market diagrams illustrating natural rate of unemployment, demand-deficientunemployment and real wage unemployment. AS-AD model to illustrate derived demand for labour,natural rate of unemployment.

Note: It should be fully possible to get full marks be exploring either of the main theoreticalstandpoints in depth.

b) How might governments lower the natural rate of unemployment? (15 marks)Basic answer: An easy way to organise the answer is to divide possible solutions into two broadgroups; interventionist and market (supply-side) solutions. Interventionism should not be limited tosimple demand-management but include interventionist supply-side suggestions. Market solutions arefirmly centred around monetarist/classical thinking, i.e. supply-side policies.

Possible points:• clear definition of the natural rate of unemployment as the unemployment which exists when

the labour market has cleared• interventionist solutions

o demand management; increase the demand for labour by stimulating the economy —via interest rates and/or fiscal policies

o interventionist supply-side possibilities include labour market programs for retrainingand education; grants and subsidies to firms to hire; tax incentives to firms investingin retraining/education of labour etc

• market based solutionso lowering social/unemployment benefitso decreasing income taxeso relaxing hire and fire legislation to increase labour mobility

• illustration of natural rate of unemployment in diagramo showing shift in ASL to the righto possible shift of ADL to the right

• any reasonable suggestion which clearly addresses the issue of getting more members of thelabour force to offer their services on the labour market

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Diagram(-s): Labour market diagram.

Note: Answers frequently address the issue of how to remove labour market imperfections, i.e. how tohelp the labour market to clear. The question, however, deals with decreasing the natural rate ofunemployment.

2. a) Examine whether full employment is possible to attain. (10 marks)Basic answer: Define full employment as the rate which exists when labour markets have cleared —leaving structural, seasonal and frictional unemployment. The question can be addressed from both aKeynesian side and a monetarist/classical side. Keynesians would claim that sufficient demand in theeconomy would create full employment, while monetarist/classical theory claims this would lead toinflation — instead, supply-side measure should be implemented.

Possible points:• definition of full employment• use of labour market diagram to illustrate• possibly the Phillips curve (HL)• Keynesian arguments

o increasing AD will increase the demand for labouro as ADL shifts right, unemployment falls

• monetarist/classical argumentso unemployment level is above the natural rate of unemployment due to market

imperfectionso reduce market imperfections — e.g. union power, minimum wage etc — and the market

will clear• possible convergence and agreement; most economists would agree that supply-side policies

do indeed reduce unemployment in the long term

Diagram(-s): AS-AD model, labour market diagram, Phillips curve (HL).

Note: In referring to the Keynesian side of the argument, the inverted L shaped AS curve may beused.

b) What possible social and economic costs might arise in trying to attain full employment? (15marks)Basic answer: In terms of Keynesian demand-side policies, there might be inflation, governmentdeficit spending, loss of international competitiveness and depreciation of the exchange rate. On themonetarist/classical side, one might see increased unemployment (in the medium term), social costsdue to lower social benefits, de-skilling of the workforce, and increased inequality in society as thepoorest groups take the brunt of the costs of structural change.

Possible points:• possible consequences of Keynesian demand-management policies

o inflation (and decreased AS in LR according to monetarist/classical side)o loss of international competitivenesso depreciation of currencyo deficit spending, government debt

• ditto for monetarist/classical supply-side policieso increased unemploymento social cost of unemploymento social costs of lower social benefitso income inequality

• other possibilities; trade barriers might be used to save jobs, which would render welfarelosses to society; resources might be misallocated in saving jobs in sunset industries

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Diagram(-s): AS-AD model.

Note: Good answers will refer to real world examples, such as the massive government deficits duringthe Reagan period in the US, and the stop-go cycles in the UK during the 1960 s and 70 s.

3. a) What are the causes of inflation? (10 marks)Basic answer: Define inflation as a steady increase in the general price level. Then, there are, well, twoand a half basic reasons: 1) demand-pull inflation; 2) cost-push inflation and; 2.5) demand-pullinflation caused by excess money supply.

Possible points:• definition of inflation• cost-push inflation

o factor costs increase ando fuel bidding up of wageso illustration of cost-push inflation in AS-AD model

• demand-pull inflationo a demand-side shock increases ADo and households/firms act in anticipation of higher prices, which causes further

increase in ADo illustration of demand-pull inflation in AS-AD model

• excess money supplyo an increase in the supply of money above and beyond the LR potential of output will

be inflationaryo illustration of excess monetary growth using transmission mechanism (page 436)

• other reasons; imported inflation when a main trading partner has inflation it is possible forthe imports from them to raise the price level (depending on rigidity of exchange rate systemand the PED for imports)

Diagram(-s): AS-AD model, transmission mechanism (not part of syllabus, page 436)

Note: Any two reasons, well illustrated/commented, should be able to get full marks.

b) Explain how monetary and fiscal policies can be used to alleviate (= lessen) different types ofinflation. (15 marks)Basic answer: Define monetary and fiscal policies and show how these policies might decreaseinflation rates caused by demand-pull, cost-push and excess money supply. Problems such asdecreased AD during cost-push inflation should be brought up, and the SR and LR issues of thesepolicies implementation and effect should be given some consideration.

Possible points:• definition of monetary policy• definition of fiscal policy• applied to demand-pull inflation

o raising interest rates affect on AD; increased S, lower C and I possibly a higher exchange rate which in turn would lower X and increase M

o increased taxes and/or lower G takes some time to implement and take effect

• applied to cost-push inflationo both increased interest rates and lower G/higher T would affect cost-push inflation,

yeto while both monetary and fiscal policies might lower inflation during cost-push times,

the effects would be an even greater level of unemployment as AD shifts left

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• applied to excess monetary growth• illustrating effects using AS-AD model• use of investment schedule to illustrate effects of interest rate increase• other possibilities

o imported inflation might be combated by devaluing the currency (or possibly bylowering tariffs — which is in reality a bit far-fetched)

o supply-side policies might be enacted to deal with cost push inflation — yet these areof such long term nature that in fact the problem would not be addressed

Diagram(-s): AS-AD model, investment schedule.

Note: A rather tricky question, as the student must show insight into the basic problem of dealing withcost-push inflation.

4. a) How could government change its tax system in order to shift more of the overall taxburden from the poor to the rich?Basic answer: The core issue here is to tweak the tax bases — primarily income, expenditure, profitsand perhaps tariffs — in favour of poorer groups. Income taxes can be made more progressive;expenditure taxes can be shifted from basic necessities to more income elastic goods; profit taxes canbe increased; and tariffs can be shifted away from imports purchased by low-income households tomore luxury oriented items.

Possible points:• outline of key taxable bases; income tax, expenditure tax (e.g. VAT), corporate (profit) tax

and tariffs on imports (tariffs)• income tax

o can be made more progressiveo the minimum required level of taxable income can be increased

• expenditure taxo goods with high yED can be taxed moreo lower tax on basic necessitieso low yED goods — inferior goods — taxed lesso various forms of luxury taxes can be implemented

• corporate taxo lower corporate tax on smaller businesseso and shift tax base to larger businesses

• capital gains taxo increased capital gains tax (tax on, for example, selling shares or property at a profit)

will hit primarily the well-off• property taxes

o an increase in property taxes — land, housing and even cruise ships — will affect thewell off far more than the poor

• tariffso shift tariffs from basic necessities to luxury imports

Diagram(-s): Progressive tax curve.Note: There is wider scope than illustrated above — award marks for reasonable and logicalsuggestions.b) Analyse why the government might wish to do this and the possible effects of the tax changes.Basic answer: The answer is primarily that an evening-out of incomes in society has shown to haveboth growth and developmental effects. More equitable distribution of income lowers a number ofsocial ills, such as crime, alcoholism, corruption etc. Simultaneously, better income distributionenables better and more borrowers (and thus more businesses) and a wider spread of social goods suchas education and health care — both of which are pro-growth and pro-development.

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Possible points:• reasons for redesigning of tax bases

o better distribution of incomeo spread of social goodso increasing participation and contribution to society

• effects of better income distribution and spread of social goodso wider spread of wealth enables more borrowers and thus entrepreneurso lower crime rateso lower social costs such as drug addiction, prostitution, alcoholismo fairness in society lessens civil tensions between upper and lower income groups

• fairer income distribution has been shown to be pro-growth and pro-developmental• other effects: lower levels of corruption and nepotism; less favouritism amongst a small elite;

wider recruitment of ability in those who have been able to gain education

Diagram(-s):

Note: Shifting tax bases to target certain societal aspects — here, evening-out of income — is often atricky issue for students.

HL only5. a) Is there a trade-off between inflation and unemployment? (10 marks)Basic answer: This is another classic question, and is designed to elicit a discussion on the basicKeynesian-monetarist debate. The Keynesian side posits that policies can indeed be used to stimulatedemand — demand-side policies — and that markets are imperfect and thus need priming . Theopposing view, from the monetarist/classical side, argues that any intervention by government aimedat stimulating demand beyond the full employment level of output (i.e. LRAS) will be purelyinflationary — the trade-off is a SR issue.

Possible points:• outline of inflation and unemployment — and why they are related

o use the AS-AD diagram to illustrate how an increase in ADo would decrease unemploymento but increase the price level (see figure 3.5.22, page 443)

• yes, there is a trade-offo reference to the Keynesian premise that disequilibrium unemployment is primarily

demand-deficiento solution is to stimulate demand (fiscally for the most part), i.e. ADo use the SR Phillips curve to illustrate how an increase in AD will cause a movement

along the Phillips curve (page 443 again)• maybe, but only in the SR, according to the monetarist/classical side

o people/firms do not suffer from money-illusiono thus the increase in AD will result in a fall in real incomeo and firms will increase factor prices and households will bid up wageso in time, AS will shift left, back to equilibrium and the economy will adapt to higher

inflation expectationso thus, there is no trade-off in the LRo this is shown in the LR Phillips curve (page 444)

• empirical evidenceo evidence suggests that a trade-off existed during the 1960 so additional evidence shows a break-down of the Phillips curve relationship during

the 1970 s

Diagram(-s): AS-AD model, SR and LR Phillips curve.

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Note: This is a most important question, as it is at the heart of the Keynesian-monetarist debate. Moststudents should be able to get reasonable marks here.

b) What are the implications of your answer in terms of economic policies aimed at growth? (15marks)Basic answer: The implications are as simple as they are hotly debated; Keynesian policies have beenadopted by the political left while monetarist/classical policy prescriptions have been supported by thepolitical right. The existence of an inflation-unemployment trade-off suggests that demand-sidepolicies should have a degree of success in lowering unemployment — at the cost of higher inflationlevels. The implication of a LR Phillips curve is that demand-fuelled growth is temporary at best,leading only to higher inflation in the LR.

Possible points:• implications of there being a trade-off

o demand-management can be used to regulate the economyo fiscal stimulation has an effect on unemploymento to a certain degree, the economy is able to choose a maximum level of inflation in

combating unemployment• implications of no trade-off

o demand-management does not solve the problem of unemploymento inflation becomes a problem when economy is stimulated via demand-side policieso there is a natural rate of unemployment which cannot be dealt with using demand-side

policieso the solution lies in supply-side policies; increase LRAS and inflation is kept in check

while the natural rate of unemployment falls• natural rate of unemployment; illustrating that unemployment will hover around a given rate

regardless of demand stimulation — any increase in AD which is not upheld by the LRpotential (LRAS) of the economy will ultimate result in the natural rate of unemployment butat a higher price level

• possible convergence; increasingly, the debate has had a degree of convergence, in thateconomists of demand-side persuasion agree that it is indeed sound policy to also increaseoutput potential in the economy — AS — yet disagree that this necessarily means a marketbased solution

Diagram(-s): SR and LR Phillips curve, AD-AS model.

Note: Students often fall into the trap or repeating themselves here, and accounting for whether there isa trade-off or not. The task, however, is to clarify how the two sides use their theoretical bases toprescribe economic policies.

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Section 4.2 — Free trade and protectionism

Short answer questions (10 marks each)

1. How might a country improve its comparative advantage in producing manufactured goods?(Note: error in the book; not by but in .)Basic answer: Definition of comparative advantage and illustration either graphically or in a table.Specialisation, investment and labour capital are the main ways in which a country might enhance andimprove its comparative advantage.

Possible points:• definition of comparative advantage

o a country has a lower opportunity cost than a trade partner in the production of a goodo assumptions of comparative advantage and PPFso use of PPFs to illustrateo divergent PPFs and cost ratios show possible terms of trade

• investmento increased investment via

government grants, tax breaks and incentives foreign investment possible reference to capital output ratio

• specialisationo increased specialisation move the economy along a learning curveo scale benefits possible

• labour capitalo education, training, experience will all increase productivityo wider implications of development in enhancing comparative advantage

Diagram(-s): PPF, cost ratio diagram.

Note: Common mistake is to confuse comparative with absolute advantage.

2. Explain how a country might use trade barriers in order to improve the current account inthe balance of payments.Basic answer: Definition of current account in terms of visible and invisible trade plus transfers.Definition/outline of barriers to trade. Keeping price, quantity and revenue/spending clearly separate,examples can be drawn showing how decreasing the ratio of export revenue to import spending willimprove the current account.

Possible points:• definition —and illustration — of current account

o visible trade balanceo invisible trade balanceo net transfers

• definition and examples of trade barrierso tariffso non-tariff barriers, e.g. quotas, subsidies, anti-dumping etco hidden or covert trade barriers, e.g. spurious health and safety regulations

• devaluation of currency (not directly a trade barrier, but should merit marks)• illustration of tariffs/quotas in the standard trade diagram• clear examples of how increased price of imports decrease in quantity of imports

decrease in import spending and thus improvement in current account• differentiating clearly between price/quantity/revenue of exports• same for imports

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• HL: possible exceptionso Marshall-Lerner conditiono J-curve effecto a bit peripheral but a bit relevant — dangers of trade barriers

risk of reciprocal barriers by trade partners, which to a certain extent negateexport gains of original protectionist country

devaluation by trade partners

Diagram(-s): Trade diagrams showing tariffs/quotas, J-curve.

Note: Students who simply refer to increase in exports.. without bothering to differentiate betweenexport price/quantity/revenue should not be awarded full marks.

3. Trade is much freer today since tariffs have fallen drastically in the past 50 years. Discussthis statement.Basic answer: In defining free trade one soon arrives at the conclusion that while yes, visible (tariff)barriers have fallen considerably and trade has increased , there are a good many other types ofbarriers to trade which have replaced the more traditional ones. Trade is in fact still in many respectssubject to barriers.

Possible points:• definition of free trade — i.e. that foreign providers are not in any way disadvantages over

domestic providers of goods (beyond perhaps physical distance and transport costs)• outline of barriers of more traditional type, i.e. tariffs, quotas, VERs etc.• reference to WTO rules banning several types• example of MFA quota system ending in 2005• discussion of increases in trade during past 20 or so years• however, many other forms of de facto barriers have replaced the visible trade barriers

o subsidies to domestic producers (look up Airbus vs Boeing !)o spurious barriers — examples of health and safety regulationso anti-dumping tariffso government favouritismo environmental standardso labour standardso administrative barrierso the monumental increase in REAs/FTAs which creates an advantage for members

over non-members (and is exempt from MFN clause)

Diagram(-s): Trade diagrams showing tariffs/quotas.

Note: Well-versed students will come up with any number of viable examples not on the list above —award according to relevance and merit.

4. Explain why subsidies to domestic firms act as a trade barrier.Basic answer: A trade barrier is broadly defined as any market intervention whereby the ratio of priceof exports to price of imports goes down. Thus, a subsidy will lower the domestic price of goods —ceteris paribus — and unfairly advantage domestic producers over foreign.

Possible points:• definition of a trade barrier• definition and illustration of a subsidy

o use of S/D diagram; S shifts righto adding in Pworld, i.e. trade diagram, showing how quantity of imports decreaseso possibility of export subsidies

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• how developing countries are severely disadvantaged here — since a) they often cannot meetthese subsidies, and b) their own markets can be dumped upon by foreign subsidisedproducers

Diagram(-s): Trade diagram illustrating the change in imports. Possibly a trade diagram showingexport subsidies (not part of syllabus, see page 508)

Note: A straightforward question which needs to be addressed using a clear and well-commenteddiagram.

5. How can trade barriers for agricultural goods in developed countries affect developingcountries?Basic answer: Define trade barriers as decreasing the ratio of price of exports to price of imports andillustrate how barriers to trade serve to limit developing countries exports to developed countries —and even how developed countries can destroy domestic markets in developing countries

Possible points:• definition of barriers to trade• examples of barriers to trade

o tariffso non-tariff barriers; quotas, regulations, health/safety barriers etco subsidies

• examples of developed country trade barriers specifically affecting developing countrieso domestic subsidies in developed countries disadvantage producers in developing

countrieso tariffs and quotas for a number of goods still existo illustration of tariffs/quotas in trade diagramo comments to the effect that effective tariff levels are in fact much higher than visible

tariffso comments to the effect that tariffs are often higher in developed countries on goods

with higher value-added (processed goods) than on low value-added (unprocessed)goods

o examples such as raw (green) coffee and processed coffeeo subsidies in developed nations can create excess supply which can be dumped on

developing countries — perhaps destroying domestic markets• increasing number of REAs/FTAs serve as barriers to trade for non-members — and it is

notable that the strongest REAs/FTAs are in the developed world• the highest trade barriers often exist for the very goods in which developing countries have a

comparative advantageo textileso agricultural goodso specific examples; sugar market in EU

Diagram(-s): Trade diagram showing subsidies/tariffs.

Note: Full marks can be given for any one example done in depth.

6. What factors might influence the competitiveness of a firm competing in export markets?Basic answer: There is wide scope here, where any good answer will address the fact that internationalcompetitiveness is a matter of relative price and quality of domestic goods compared to othercountries goods.Possible points:

• a country s focus on comparative (or even absolute) advantage in the production of goods• increased specialisation in conjunction with the above• exchange rates — with possible reference to terms of trade

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• international business cycle will have an influence on the demand for key factor inputs such assteel

• innovation, R&D etc• domestic subsidies can lower costs for export firms• inflation rates (i.e. relative inflation rates compared to other exporters)• productivity and efficiency in the economy — for example supply-side policies might lower

domestic prices and make the economy more competitive• low interest rates and increased capital could increase productivity — as could FDI• enhancing human capital via education and training• lower costs due to economies of scale

Diagram(-s): Divergent PPFs for two countries and how increased specialisation and focus onproducts in which the home economy has a comparative/absolute advantage; standard trade diagram(see page 486) can illustrate how a country might shift domestic supply to the right and create anexportable surplus; the LRAC curve (HL) together with the world supply can illustrate how increasedcapital can lower AC and enable benefits of scale; investment schedule together with AS-AD diagramcan illustrate the competitive effects of supply-side policies.

Note: There is, as mentioned above, wide scope for good answers. Marks should be awarded on thebasis of how well the student shows a concrete link between, for example, increased investment inhuman capital and the competitive gains internationally.

7. Use a diagram to illustrate how a tariff causes resource misallocation.Basic answer: Use the standard trade diagram — Sdomestic, Ddomestic, Sworld — and then shiftSworld upwards to show a tariff. The trapezium (see page 487) shows the loss of domesticconsumer surplus, and the two triangles (B and D, figure 4.2.2, page 487) show green loss and netloss of consumer surplus respectively. Together, this is the allocative loss of a tariff.

Possible points:• definition of resource misallocation• clear trade diagram showing domestic supply /demand and world supply• adding a tariff — shift world supply upwards• the trapezium shows the loss of consumer surplus and (in reading order)

o A) gain in domestic supplier surplus ( captured from consumers)o B) green loss to societyo C) tax revenue to govto D) net loss of consumer surplus

• triangles B) and D) together show the allocative loss, i.e. the deadweight loss to society• for explanation to the effect that less efficient producers end up taking over a proportion of

output, which is clearly societally suboptimal

Diagram(-s): Standard trade diagram.

Note: Yes, consumer and supplier surplus is outside the syllabus — but it would be very difficult tooutline allocative failure in this context without the use of these concepts.

Extended response questions

1. a) What is meant by dumping ? (10 marks)Basic answer: Dumping is when a producing country dumps goods on foreign markets at a pricelower than either the price on the home market or below the cost (HL: marginal cost) of production.Common examples are subsidised industries in developed countries which then dump excess supplyon developing countries.

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Possible points:• definition of dumping

o goods are sold on a foreign market at a price below the home country priceo goods are sold at below cost of productiono HL: goods are sold at below MC

• examples of dumpingo developed countries dumping agricultural goods on developing countrieso use of examples of goods, often in agricultureo examples, say EU and North Africao accusations from US that both EU and Chinese firms are selling goods at below cost

in US market• debate on dumping

o whether subsidies pervert the actual costs of production, enabling producers to sell atwhat looks like an above-cost price but in fact is not

o tax relief and other benefits can be used to lower costs for firms, enabling them to sellat unfairly competitive prices abroad

Diagram(-s):

Note: Better answers will include a sound definition and clear real world examples.

b) Why have anti-dumping tariffs become so common and how might manufacturers in low costcountries defend themselves against dumping accusations? (15 marks)Basic answer: Define anti-dumping tariff as a tax levied on imports to bring the price of these importsup and reflect the true cost of production. Anti-dumping tariffs have become common for three mainreasons: 1) they are allowed according to WTO rules; 2) it is almost impossible in many cases for anoffending nation to prove that the real costs are lower than the foreign sales price; and 3) the mainanti-dumper is the US — where any fines levied on offending foreign firms go to the US firms whichhave lodged a complaint. The issue of how low cost countries might defend themselves againstdumping accusations is, well, difficult, to say the least. The most efficient way would probably be tohave a very open book system, where all costs/subsidies are made available to foreign market courts— yet the process of counter-claims by offending companies is both time-consuming and expensive.

Possible points:• definition of anti-dumping tariff

o tariff is added to goods to reflect true cost of productiono almost impossible to establish — and thus in many cases in all likelihood unfair

• reasons for them becoming commono the WTO has granted such tariffs an exceptiono very difficult to prove one way or anothero the proceeds of anti-dumping tariffs in the US go to injured party , i.e. domestic US

firm which lodged the original dumping complaint• problems for low cost countries

o burden of proof somehow seems to lie on producerso low cost countries are exactly that — wages and other factors are often far lower than

in developed countries, which leads to allegations of unfair low-cost wages by firmsin developed world countries

• possible solutions for low cost countrieso open book policy to show real costs and eventual tax benefits and/or subsidies (the

problem being that such figures are often sensitive and would not be disclosed forcompetitive reasons)

o low cost countries could band together and establish an office/organisation wherefirms subjected to anti-dumping tariffs could ask for legal assistance

o have the WTO or other international body act as arbiter (judge) in controversieso other possibilities

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• other issues

Diagram(-s): Trade diagram to show effect of anti-dumping tariff.

Note: The possible solutions are a tricky issue. Allow for wide discussion here, as long as it isrelevant.

2. a) What are the possible advantages of free trade? (10 marks)Basic answer: Define free trade and then briefly comment on a list of possible advantages, clarifyinghow/why such an advantage might rise.

Possible points:• firms

o specialisation and increased use of comparative advantageo possibility of benefits of scaleo spread and knowledge of technology — production gainso spread of skills and labour capitalo access to new/wider markets

• consumerso increased choice, i.e. varietyo lower priceso overall consumer welfare (consumer surplus — outside of syllabus) in lower prices and

increased consumptiono increase in standard of living

• society in generalo political issues; cooperation, peace-dividendo improved global resource allocationo growth via exports

• other points; possible improvement in environment due to better resource allocation,possibilities of growth in developing countries

Diagram(-s): PPFs showing comparative/absolute advantage and increased consumption possibilities(CPF). AS-AD showing growth due to exports.

Note: Good answers will cover a few points in illustrative depth, or shallower but more issues.

b) In light of these advantages, why do so many barriers to trade exist? (15 marks)Basic answer: Define barriers to trade and exemplify why countries might be tempted to use them.Common examples would be employment argument, safety/health reasons, environmental issues,labour and working standards, tax revenue, hinder dumping, regional support reasons, domesticstrategic arguments, and developing infant industries.

Possible points:• employment

o save jobs in domestic industrieso protect domestic industries from unfair competition, e.g. low-cost labour goods

• safety/health reasonso safeguard domestic society against harmful productso examples; FDA in the US or any national agency charged with consumer protection

• environmento regulations against goods using valuable and limited resources, e.g. hardwoods from

diminishing rainforests, ivory from elephants etco ban on goods which do not meet certain production standards, e.g. goods using CFCs

in productiono regulations on minimum standards of emissions in production

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• labour/work standardso argument of fairness/solidarity in buying goods from sweatshop firms (often

MNCs) in developing countries• tax revenue

o tariffs will generate government revenueso particularly in countries with scanty domestic tax bases, e.g. developing countries

• anti-dumpingo countries should be allowed to protect domestic producers from unfairly subsidised

goods and/or goods sold at below cost (or domestic price) abroad• regional policies

o subsidies can be used to preserve traditions, way of life and support certain regionsand products

o cultural considerations in line with the above• strategic arguments

o nations have a duty to citizens to have a degree of broad production capacity in caseof war/blockade/conflict

• infant industry argumento developing nations need to have protection — for a period of time — in order to develop

domestic industries which initially cannot compete with far more efficientinternational firms (which might enjoy benefits of scale)

Diagram(-s): Trade diagrams to show how imports are limited (tariffs and/or subsidies) and how taxrevenue is created. The LRAC curve (HL) may be used to illustrate the infant industry argument andmoving along towards scale benefits (page 676).

Note: Any four examples done in depth should be able to earn top marks.

3. a) Identify the ways in which an economy can limit imports. (10 marks)Basic answer: This should not be limited to a list of trade barriers, but include a brief iteration on howimports are limited.

Possible points:• examples of barriers to trade

o tariffso non-tariff barriers; quotas, regulations, health/safety barriers, buy domestic policies

in local and national government, strategic argument etco subsidies

• other ways in which to limit importso ban (extreme, but US-Cuba is an example)o devaluation of domestic currencyo non-convertibility of domestic currency

• showing how these barriers and policies can limit importso domestic subsidies give domestic producers a cost advantage over foreign producers

(use trade diagram)o tariffs and quotas limit imports (use trade diagram)o effect of non-tariff barriers in limiting importso how a devalued currency adjusts the external value of the currency — creating an

incentive to buy domestically instead (expenditure-switching)• increasing number of REAs/FTAs serve as barriers to trade for non-members — and it is

notable that the strongest REAs/FTAs are in the developed world

Diagram(-s): Trade diagram to show effects of tariffs, quotas, subsidies in limiting imports.

Note: There is a long list of possible ways to limit imports. Leeway should be granted, but examplesshould be relevant and realistic. Good examples merit marks of course.

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b) Argument for and against such policies. (15 marks)Basic answer: This is a huge question, and any two pro et con examples should be able to getmaximum marks. The main issues lie in whether the barriers to trade are in fact more costly to societythan not implementing them. Each given example of import limitation could be granted a brief pro etcon — in spite of any argumentative stance taken by the student. Alternatively, a good answer mightpick to argue for/against different policies in total. The key is to render solid economic arguments insupport of the line of argument taken.

Possible points:• limiting imports is generally negative

o less choice for consumerso higher priceso decrease in consumption and lower living standardso less consumer welfare (consumer surplus lost — use trade diagram)o domestic firms grow lazy/uncompetitive behind protectionist wallso forward-linkage effects can increase domestic price of goods and decrease the

international competitiveness of domestic firmso limits possibilities of trade — and thus utilising comparative advantage, benefits of

scale etco misallocation (use trade diagram to show deadweight loss)o environmental costs of producing goods better left to more efficient producers

• there are viable points for an economy to limit importso infant industry argument — protect fledgling industries, allow them to get up to scaleo limit harmful goodso strategic argumento possible government revenue from tariffso protection of domestic labour market against unfair competitiono anti-dumping argumento improve current account in balance of payments

• assessing the costs and benefits of the points above, i.e. is there a net societal gain in saving10,000 jobs in the steel industry when this is offset against higher domestic steel prices forsteel-using industries — i.e. what is the real cost of each job?

• other issueso the increase in free trade has improved relations between countries ( peace

dividend ); possibility of reciprocal trade barriers and trade war; declining relations ofnations in trade dispute; there is ample evidence that trade is not a zero sum gameand that jobs are in fact not saved in the LR

o developing countries must be allowed to protect themselves from highly efficientinternational firms — just like the present developed nations did once; increasing tradeliberalisation can lead to global entities which empower themselves at the expense ofsmall domestic firms — and even governments

Diagram(-s): PPFs/ CPFs showing increased consumption possibilities (CPF). Trade diagram showingeffects of tariffs etc.

Note: Good real world examples — and there are many — should be amply rewarded.

4. a) Distinguish between the terms of trade and the balance of trade for a country. (10 marks)Basic answer: A basic definition of each is a good start; terms of trade can be defined as the averageprice of a country s basket of export goods in relation to the average price of a country s basket ofimport goods. (HL: use index of terms of trade, i.e. IndexflP X/IndexflPM x 100). The balance of tradeis the total amount of export revenue minus import spending.

Possible points:

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• definition of terms of tradeo the amount of a given amount of export goods necessary to buy a given amount of

import goodso barter or commodity terms of trade, i.e. quantity of Volvos per quantity of Toyotaso index of terms of trade (HL); index of the average price of exports over an index of

the average price of imports time one hundred (IndexflP X/IndexflPM x 100)o explanation that a change in the price of either the domestic and/or imported good will

change the terms of trade• definition of trade balance

o price of exports times quantity of exports equals export revenueo price of imports times quantity of imports equals imports spendingo export revenue minus import spending equals the (visible) trade balanceo explanation that a change in either price or quantity (ceteris paribus) of exports or

imports will change revenue/spending, and thus the trade balance• trade balance in context, i.e. the current account and the balance of payments

Diagram(-s):

Note: A seemingly straightforward question, but an alarming number of students falter in definingbasic concepts.

b) How might a country use trade barriers and the exchange rate to affect both the terms oftrade and balance of trade? (15 marks)Basic answer: Definition and outline of possible barriers to trade, for example tariffs, quotas,subsidies etc. They should, however, be picked in accordance with the ability to change the ratiobetween export and import prices — as this is the central theme. The answer should clearly identifyhow an increase in the price of imports 1) would change the terms of trade (ceteris paribus) and thus 2)possibly improve the trade balance — depending on whether import expenditure in fact decreases or not(HL: refer to Marshall-Lerner condition).

Possible points:• definition of trade barriers

o and how these would serve to raise the price of importso thus decreasing importso illustration using trade diagram to show increase in price, decrease in importso stating that an increase in the price of imports has the effect of worsening the terms of

trade• reference to expenditure-switching• example of effects on trade balance

o price of imports riseso how this could lead to lower imports (HL should include either Marshall-Lerner

condition or J-curve effect)o that imports are a negative component in the trade balanceo thus the trade balance should improve when imports fall

• definition of the exchange rate — price of domestic currency in terms of a trade partner scurrency

• use of the exchange rate to affect the terms of trade and trade balanceo a devaluation/depreciation of the currency (ceteris paribus) will decrease the terms of

tradeo a lower exchange rate will raise the price of importso and lower the price of exportso leading (possibly — HL should include Marshall-Lerner condition and/or J-curve) to an

increase in exports and export revenueo and a decrease in imports and import spendingo thus, the terms of trade have fallen and the trade balance has improved

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Diagram(-s): Trade diagram to illustrate the effects of trade barriers. Possibly J-curve.

Note: All too often students are hazy on the issue of whether an improvement in the terms of trade canactually be bad — i.e. worsen the current account.

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Section 4.6 — Exchange rates

Short answer questions (10 marks each)

1. Using a suitable diagram, explain how a change in a country s imports and exports can affectthe exchange rate.Basic answer: The main task here is to make clear that the causal flows move from the change inexports/imports to a change in the exchange rate. Using a S/D diagram, a good answer will state thederived-demand issue involved in currencies, and then illustrate how an increase in demand forHome s export goods will increase the demand for Home s currency. Concomitantly, if Home sdemand for imports increases, there will be an increase in the supply of the Home currency — as this isused to buy foreign currencies need for imports.

Possible points:• outline of exchange rate as the price of Home currency in terms of another (or trade-weighted

basket of currencies• the derived demand for a currency, i.e. that the demand for a country s goods and services is a

main determinant of the exchange rate• assumption of a floating exchange rate• S/D diagram illustrating initial equilibrium• change in (the demand for) exports

o an increase in demand for Home s goodso can cause an increase in the demand for Home s currencyo demand curve for Home currency shifts right, price of currency rises — i.e. the Home

currency appreciates• change in (the demand for) imports

o an increase in Home s demand for importso causes Home to buy more foreign currencyo supply of Home currency on currency market increaseso supply curve for home currency shifts right, price of currency falls — i.e. the home

currency depreciates• comments on possible time lags in the mechanism outlined above• possibility of intervention purchasing/selling by central bank

Diagram(-s): S/D diagram for currency.

Note: A very common failing of students is to simply put P on the Y-axis rather than P in terms of$US .

2. Why might a country have difficulty in attaining full employment whilst keeping a currentaccount surplus?Basic answer: Define full employment and illustrate using an AS-AD diagram. Define current accountsurplus, i.e. sum of visible and invisible trade balance is positive. Assume that attaining fullemployment necessitates the use of demand-side policies. There are thus two main effects possible onthe current account: 1) the stimulatory effects on AD increase national income — and thus there is anincrease in general spending, some of which will go to imports (HL: MPM); and 2) increased ADmight well lead to inflation, and since the relative prices have now changed in favour of foreigncountries, imports might increase and exports decrease. Both of these effects work in the samedirection, namely a worsening of the current account.

Possible points:• definition of full employment and illustration in AS-AD model (use LRAS curve)• define current account and surplus (use of examples encouraged)

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• outline possible policies to attain full employmento outline of demand-side policieso illustration of less that full employment — AD curve to the left of general equilibriumo fiscal and monetary policies which would increase ADo showing how such policies would increase C, I and shift AD to the righto comment on the increase in incomeo and higher price level

• the effect on current account of the aboveo increase in spending due to income effect might lead to increased demand for importso higher price level might decrease exports (as prices relative to foreign sector have

changed) and increase importso taken together, the effect of increased AD might cause a worsening of the current

account• possibility that in fact supply-side policies could have the opposite effect; increased AS might

bring the economy to full employment and lower the price level, thus making the economymore competitive internationally

Diagram(-s): AS-AD model to show full employment, shift in AD.

Note: Albeit infrequently done, a student addressing the question by criticising the entire premise byusing supply-side arguments should be able to get full marks.

3. Using a diagram, explain how a country can peg (fix) its currency to another currency.Basic answer: Definition of a pegged/fixed currency should centre around how the central bank usesthe currency market mechanism — buying and selling its own currency — to set the exchange rate in theLR. Using a S/D diagram, show how the corridor of the exchange rate can be set and then how thecentral bank can intervene to stop the exchange rate from exceeding the floor or ceiling.

Possible points:• definition of a pegged currency; a country sets the external value of its currency in terms of

another currency and keeps it set by buying/selling its own currency to keep it at this rate• S/D diagram showing the price of a currency in terms of the — pegged — currency• possibly a diagram showing hypothetical LR fluctuations (see page 569)• illustrating the corridor within which the pegged currency is allowed to fluctuate• how the central bank keeps the peg (illustrated in the diagram)

o when there is a tendency for the exchange rate to exceed the ceiling, the central banksells home currency — shown by an increase in supply and a return to within theboundaries of the ceiling

o when there is a tendency for the exchange rate to go below the floor, the central bankbuys home currency (using foreign reserves) — shown by an increase in demand and areturn to within the boundaries of the floor

• additional tools of the central bank; changing the interest rate, borrowing from IMF• issues which affect government policies

o trade-off in terms of domestic freedom in monetary policyo limits to fiscal policy, as the pegging country cannot risk large deficits and debt which

would exert a negative influence on the exchange rateo large foreign currency reserves are necessary in case of speculation against the

currency

Diagram(-s): S/D diagram for currency.

Note: Often students switch things around by stating that as the central bank sells its currency, thedemand for other currencies increases .

4. Explain why a country s currency might appreciate.

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Basic answer: Assuming a floating exchange rate, the main issue here is to outline the factorsinfluencing the supply and demand for a given currency — having stated that the (external) value of acurrency is of course set in terms of another currency.

Possible points:• for assumption of floating/fixed exchange rate• issues which influence demand for the home currency, i.e. the derived demand for domestic

goods and services by foreigners, investment (portfolio and direct) demand by foreigners,relative rate of return on saving (interest rates), intervention purchasing of the home currencyby the central bank, speculative buying by foreign speculators

• issues influencing the supply of the home currency, i.e. change in import demand, change inFDI abroad, change in foreign interest rates, speculative selling of the home currency,intervention selling of home currency by central bank, change in relative inflation rates

• mentioning that there are a number of LR issues influencing the exchange rate; governmentdeficits/debt, current account deficits, supply-side issues (which in turn influence productivityand relative inflation), increasing focus on R&D/comparative advantage etc to increasecompetitiveness and hence demand for goods and thus currency

• diagram showing specifically the market for a currency and how demand would be affected bysome of the variables listed above — shifting the demand curve and concomitant appreciationor depreciation (note that it is important that the diagram shows P of in USD or such)

• ditto for supply of currency in separate diagram• viable and clear examples of how the exchange rate changes in line with changes in

supply/demand

Diagram(-s): Two diagrams should be used; one to show shift in demand and one to show a shift insupply of the home currency. Both should then be commented on to make clear how the exchange rateis influenced.

Note: This is a wide question with many possible angles of attack. Students should be amply rewardedeither for dealing with a few issues in depth (say, one good example of a change in demand and onefor supply) or a number of issues where there is still a basic explanation linked to a correct diagram.

5. Analyse the possible effects of speculation on exchange rates.Basic answer: The core answer is that the expectations element of foreign currency traders/speculatorsmight cause an increase/decrease in the supply/demand for a currency, causing a depreciation orappreciation of the exchange rate. One might refer to a self-fulfilling prophecy .

Possible points:• definition of speculation in currencies as betting on the appreciation/depreciation of a given

currency — good answers will refer to expectations and/or marginal returns as a reason forspeculation

• example of speculation — such as a currency trader buying a currency in a country where theinterest rates is expected to rise

• using S/D diagrams to show the effects of speculationo if speculators fear a fall in the exchange rate for the $US, they will sell off the dollar

and supply of the $US will increaseo if speculators expect an increase in the exchange rate for the $US, they will buy the

dollar and demand for the $US will increase• self-fulfilling prophecy (expectations-based feedback loop) — if many currency speculators

feel that a currency is overvalued and act upon it (by borrowing large amounts of the currencyand then immediately trading it in for another currency ˘_S for the currency), it is possiblethat this speculation creates the very situation which was expected

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Diagram(-s): S/D diagram for a given currency. Important that price is given as Rate of £ in orsomething like this.

Note: Often weak answers will confuse the causal flows here, i.e. write about how exchange ratechanges might lead to speculation. This does not address the question.

6. The central bank in a country raises interest rates. How might this affect this country scurrency and balance of payments?Basic answer: A rise in the interest rate might have a SR effects on the Home economy; as globalinvestors/speculators shift their portfolios to increase the weight of Home currency (higher SR rate ofreturn for investors/speculators), the demand for Home currency will increase — thus appreciating theHome currency. In the LR, the monies flowing into the capital account (+), might create outflows incurrent account (-). A higher exchange rate may also exacerbate the balance of paymentsdisequilibrium by creating more imports to Home and lowering exports.

Possible points:• explanation how interest rates attract foreign deposits

o use of interest rate differentials or relative interest rates or rate of return ondeposits

• use of S/D diagram to explain effects on exchange rate• definition/outline of balance of payments (both current and capital account)• explanation of money inflows on capital account• possibly creating outflows in current account in LR• linking appreciation of Home currency to increased imports• and decreased exports• both of which worsen current account

Diagram(-s): S/D diagram for currency.

Note: Award ample marks to students who clearly see that there are two effects on the balance ofpayments; 1) SR inflows in capital account and thus possible LR outflows in current account; and 2)LR worsening in current account caused by the LR appreciation of the currency and decreased exportsand increased imports.

Extended response questions

1. a) Examine the factors that influence a country s exchange rate. (10 marks)Basic answer: Assuming and define a floating exchange rate, the main issue here is to outline thefactors influencing the supply and demand for a given currency — having stated that the (external)value of a currency is of course set in terms of another currency.

Possible points:• for assumption and definition of floating/fixed exchange rate• issues which influence demand for the home currency

o derived demand for domestic goods and services by foreignerso investment (portfolio and direct) demand by foreignerso relative rate of return on saving (interest rates)o intervention purchasing of the home currency by the central banko speculative buying by foreign speculators

• issues influencing the supply of the home currencyo change in import demand — an increase in imports will increase the supply of the

home currency

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o change in FDI/portfolio investment going abroad — and increase will increase thesupply of the home currency

o change in foreign interest rateso speculative selling of the home currencyo intervention buying/selling of home currency by central banko change in relative inflation rates

• mentioning that there are a number of LR issues influencing the exchange rateo government deficits/debto current account deficitso supply-side issues (which in turn influence productivity and relative inflation)o increasing focus on R&D/comparative advantage etc to increase competitiveness and

hence demand for goods and thus currency• diagram showing specifically the market for a currency and how demand would be affected by

some of the variables listed above — shifting the demand curve and concomitant appreciationor depreciation (note that it is important that the diagram shows P of in USD or such)

• ditto for supply of currency• viable and clear examples of how the exchange rate changes in line with changes in

supply/demand

Diagram(-s): Two diagrams should be used; one to show shift in demand and one to show a shift insupply of the home currency. Both should then be commented on to make clear how the exchange rateis influenced.

Note: Full marks should be possible for clear answer dealing with two variables which affect demandand two affecting supply for a currency.

b) How might a change in the exchange rate affect the domestic economy of the country? (15marks)Basic answer: A change in the exchange rate — ceteris paribus — will alter relative prices betweentrading countries. The answer should (one again) be clear on the price of the currency, the price ofexports, quantity of exports and export revenue. Clear links to the domestic economy should be seen,i.e. X and M as components of AD. A good example will then outline how a fall in the exchange ratecould increase exports and export revenue, thus increasing AD — while possibly reducing importspending. References should be made to the main macro objectives.

Possible points:• outline of the impact on export prices due to a depreciation/appreciation of the exchange rate

(same for import prices)• distinction between price/quantity and revenue for exports (same for imports)• description of AD as including X and M• clear diagram of AS and AD• effects of depreciation

o price of home goods fall in the eyes of foreignerso possible increase in exports and increase in export revenueo possible decrease in imports and decrease in import spendingo HL: possible reference to Marshall-Lerner condition and/or J-curveo the effects clearly illustrated in AS-AD model; shift of AD to the righto increase in national income and price level

• effects of appreciationo price of home goods increase for trade partnerso possible decrease in exports and decrease in export revenueo possible increase in imports and import spendingo HL: possible reference to Marshall-Lerner condition and/or J-curveo the effects clearly illustrated in AS-AD model; shift of AD to the lefto decrease in national income and deflationary effect on economy

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• assuming a fixed/pegged currencyo the economy might realign (devalue/revalue) the exchange rateo possible reciprocal/retaliatory effects due to devaluationo downward pressure on the exchange rate might mean that the central bank is forced to

raise interest rates — which would have a deflationary effect on the domestic economy• other issues

o a depreciation and concomitant increase in export demand might in the LR appreciatethe currency and lower exports

o assuming a floating currency, the current account will ultimately balance

Diagram(-s): AS-AD model to show effects on domestic economy. HL: J-curve to show how adepreciation/devaluation might in fact worsen the current account.

Note: A good answer will clearly establish links between the exchange rate and AD.

2. a) Explain the difference between a floating and managed exchange rate. (10 marks)Basic answer: The key distinction here is that a floating exchange rate is set by market forces, i.e.supply and demand. A managed exchange rate — defined perhaps as an adjustable peg or simplypegged exchange rate regime — will see how the rate is set by central bank policy and upheld byintervention purchasing/selling of the domestic currency.

Possible points:• definition of fixed exchange rate; rate set by central bank and upheld by intervention

purchasing/selling of domestic currency• definition of floating exchange rate; rate is set by market forces• use of S/D diagram to outline floating currency, for example

o Increase in demand for the US dollar:_ _ US exports of goods/services_ _ in foreign investment in US_ _ in US interest rates_ _ in US inflation rate_ speculative buying of US dollar_ US central bank buys dollars (note; causes a decrease in foreign reserves)

Decrease in demand for the US dollar:_ _ US exports of goods/services_ _ in foreign investment in US_ _ in US interest rates_ _ in US inflation rate

• definition of managed exchange rate; rate is set by central bank (illustrated in the diagram)o when there is a tendency for the exchange rate to exceed the ceiling, the central bank

sells home currency — shown by an increase in supply and a return to within theboundaries of the ceiling

o when there is a tendency for the exchange rate to go below the floor, the central bankbuys home currency (using foreign reserves) — shown by an increase in demand and areturn to within the boundaries of the floor

• other issues; the central bank can also use interest rates to change demand for the domesticcurrency — which means giving up interest rates as a domestic monetary policy tool

Diagram(-s): S/D diagram for currencies — clearly outlining the price of the home currency in termsof another/basket of currencies . The fixed exchange rate corridor (page 569) may be used forfurther illustration.

Note: This question is usually well addressed — main weakness probably being sloppiness inadequately labelling diagrams.

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b) Discuss the advantages and disadvantages in having a managed exchange rate regime. (15marks)Basic answer: Well, this is actually only a HL question, but the list below should in part be included inSL sections.

Possible points:Advantages of a managed/fixed exchange rate

• predictability and certaintyo fixed exchange rates make it easier for importers and exporters to calculate earningso costs, revenues and profit margins are clear and predictableo this creates an incentive for firms to invest and households to engage in

entrepreneurial activity.• exchange rate stability encourages trade

o when exporters and importers can be sure of tomorrow s exchange rate and futureprofits it is easier to plan business

o international stability in exchange rates lowers barriers to partaking in internationaltrade and thus increases trade.

• fiscal/monetary discipline domesticallyo the central bank will have to use limited foreign reserves to adjust the exchange rate,

governments in fixed exchange rate regimes will keep inflation and deficits to aminimum in order to avoid depleting the reserves. This limits inflationary fiscal andmonetary policies.

o countries within a fixed exchange rate system will not be able to run up large currentaccount deficits in the long term. Stimulating aggregate demand leads to increasedimports and inflation — both of which will create net outflows in current account. Acurrent account deficit means that more domestic currency is hitting the internationalmarket which will exert downward force on the exchange rate.

• less risk of speculationo since the exchange rate is fixed there is little or no element of speculation in

currencies, since there is little movement in the rates.

Disadvantages of a managed/fixed exchange rate• loss of domestic monetary policy freedom

o when a country commits to keeping a certain exchange rate, the central bank will havelimited freedom in setting interest rates in order to influence the domestic economy.Interest is one of the tools which a central bank can use to keep a peg towards anothercurrency, since higher interest rates attract foreign funds and thus increased demandfor the domestic currency. Since the priority of the central bank must be to keep theexchange rate steady there is little room to set interest rates in order to stimulate ordeflate the domestic economy. There is a trade-off between having a fixed exchangerate and being able to set domestic monetary policy.

• need of large foreign reserves ( war chest )o to maintain a fixed exchange rate, the central bank will need ample foreign reserves

for market intervention. Even if this war chest is never used, there must be reservesenough to dissuade speculators from attacking the currency.

• possibility of increased unemploymento if a country runs the risk of continued current account deficits, subsequent downward

pressure on the currency will create an incentive to raise interest rates to increasedemand for the domestic currency. Government spending might also be cut todecrease imports. Both policies will have a negative effect on aggregate demand andthus employment.

• possibility of imported inflationo when prices rise in trade partner economies relative to the domestic economy, there is

a risk that firms and households will simply have to pay more for imported materialsand goods.

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Diagram(-s):

Note: The list above is quite extensive — exhausting you might say — and top marks should be allowedfor answers which address a couple of advantages and a couple of disadvantages in depth.

3. a) Account for the difficulties in establishing a common currency amongst 10 countries. (10marks) Note: HL question.Basic answer: This can be answered by linking to the problems faced by EMU members. The basicproblem is one of convergence; when countries take the step to permanently align (and a singlecurrency is pretty permanently aligned) their currencies, having different growth rates, inflation rates,unemployment etc will make it very difficult to have a well-functioning common economic policy —especially in monetary policy.

Possible points:• difficulty in setting initial rates — member countries might wish to keep a certain cost

advantage over other members• resistance to having monetary and even fiscal policy power in the hands of a supra-bank and

supra-government respectivelyo a common currency means a common interest rate — thus members will give up the

ability to use monetary policy to affect ADo increased economic integration will entail even fiscal limits (the Stability and Growth

Pact of the EMU)• convergence issues, i.e. members might have widely divergent economic fundamentals

o interest rates must convergeo inflation must be roughly the same in member countrieso government deficit and debt cannot be widely disparate in member countries

• other issues; political and perhaps nationalistic issues, where citizens feel loss of politicalpower and loss of identity;

Diagram(-s): Possibly two separated AS-AD diagrams showing different AD curves in relation toLRAS to illustrate the difficulty in having a one size fits all monetary policy for common currencymembers which have divergent growth rates and/or inflation rates.

Note: The question only asks for difficulties in establishing a common currency — not maintaining.

b) Discuss the costs and benefits of establishing a common currency. (15 marks)Basic answer: So, there is a convergence issue in setting up the common currency — and there willalso be a convergence problem in maintaining it — commonly called the asymmetry problem. There arealso the economic and political costs of giving up domestic policy freedoms. In spite of this, there arenumerous benefits in having a single currency for an area which is economically integrated.

Possible points:• possible costs

o restriction of monetary policyo loss of political powero increased integration might render a fiscal straightjacket , i.e. diminished freedom

for member governments in setting taxes and government spendingo asymmetry problem; thus far in the EMU, there has been great divergence in growth

rates, inflation and unemployment in member countries — yet there is still a single rateof interest which definitely does not fit all members

o possibility of trade diversion (HL)o finally, an argument I personally have heard in a number of EMU countries; firms

take advantage of the jump to a different currency unit by raising prices — androunding all prices upwards

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• possible benefitso possibility of trade creation within the currency uniono price transparency as all prices will be in a common unito greater competition, lower prices, consumer welfare increaseo lower transaction costs for firms in dealing with foreign firmso increased trade might lead to benefits of scale for member firms

• other issues; there is an on-going debate as to whether a currency union basically sets thescene for inevitable economic/social integration — that a single currency forces a singlemonetary policy, increases coordination of fiscal policies, and leads to further integrationalong the lines of converging taxes, welfare benefits, common borders etc

Diagram(-s): Possibly trade diagrams showing trade creation and diversion — noting that thesediagrams are not core syllabus illustrations (page 534).

Note: These are the main issues, yet any other reasonable issues should render marks. Any four issueswell developed should be able to get top marks.

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Section 4.8 — Terms of trade

Short answer questions (10 marks each)

1. A current account deficit damages the domestic economy. Discuss.Basic answer: The question is aimed at eliciting points which support and refute this statement. Definecurrent account and current account deficit — i.e. that the sum of visible and invisible trade balances isnegative. In support, possible arguments are that a current account deficit entails a capital accountsurplus — which in turn could mean borrowing and increased foreign debt burden; speculative inflows;poor use of capital inflows; and domestic speculation with concomitant asset bubbles. In refuting thestatement, possible arguments might be that capital account inflows create jobs and increase the capitalbase; foreign firms are simply allocating funds to a vibrant economy yielding higher rate of return; andthat under a floating exchange rate the balance of payments will automatically correct itself.

Possible points:• explanation that current account entails a capital account surplus• iteration on possible reasons for, and sources of capital account inflows• not particularly damaging

o if the corresponding inflows are investment inflows rather than SR and/or speculativeo if capital inflows — such as FDI — are used productively in the economyo linking FDI/portfolio investment to increased demand for labour, increased outputo the deficit — and corresponding inflows to capital account — are due to a strong,

growing economy with the result that large amounts of foreign investment flow ino no real problem as long as foreign investors are willing to invest and thus finance the

current account deficito if the current account deficit simply reflects increasing incomes for the home

economyo if the current account deficit in relation to GDP or total trade is relatively smallo that the current account will automatically correct itself under a floating exchange rate

regime• damages the economy

o if the capital account inflows are due to borrowing debt burden country becomes vulnerable to international interest rate hikes increased debt burden due to exchange rate depreciation

o the capital account inflows are speculative possible effects on speculative bubbles in the economy possible depreciation of exchange rate financing the deficit may run down foreign reserves

o the capital account inflows are squandered or become capital flighto foreign investors see the growing current account deficit and decrease investmento the inflows can create inflation and domestic speculation (see Thailand 1997)

• any real world examples, e.g. USA ( not a problem ), Ireland ( massive increase in GNP dueto foreign capital ) and Thailand/Indonesia/Malaysia in 1997/98 ( South East Asianmeltdown )

Diagram(-s): AS-AD model to show effects of FDI, increasing demand and inflation, and the effects

Note: As long as the answer addresses a few issues on either side in depth, full points should bepossible.

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2. Explain how a country which is experiencing a boom in the domestic economy might see thecurrent account go into a deficit.Basic answer: Definition of boom period as heightened growth commonly associated with anincrease in AD. Definition of current account as inflows/outflows in the economy created by trade andtransfers. The question asks for the student to link AD — and possible inflationary gap — to an increasein import spending and/or a decrease in export revenue.

Possible points:• definition of current account; visible and invisible trade balances plus net transfers• definition of boom with reference to business cycle

o assumption that AD has increasedo possible inflationary gap

• definition of current account deficit, i.e. outflows are greater than inflows on currentaccount

o and that this may be caused by a trade deficito reference to invisibles (services, net tourism, repatriated profits, interest )

• high domestic growth causing increased importso reference to income effecto possible bottlenecks in domestic supplyo marginal propensity to import (HL)

• use of AD-AS model to show increased AD — beyond LRAS possibly• increased domestic inflation, lowering exports and export revenue

o but there is a possibility that export revenue does not fall due to Marshall-Lernercondition (HL)

• clear explanation of how increased import spending and decreased export revenue affects thecurrent account

Diagram(-s): AS-AD model showing increase in AD, possible reference to inflationary gap.

Note: Links between exports and imports as being components of AD and current account should bemade clear.

3. How might a country s exchange rate influence the balance of payments?Basic answer: Definition of the exchange rate; price of domestic currency in another (basket of)currency (currencies). Definition and outline of the balance of payments; current account (trade andtransfers) and capital account (net flows of investment, deposits etc). The link between a country sexchange rate and balance of payments is primarily to be found in current account; the currency alsoaffects the price of goods and services for foreigners, thus a lower/higher price of the currency willaffect demand for goods and services itemised under export revenue and import spending in thecurrent account.

Possible points:• definition of exchange rate; price of home currency in terms of another (or basket of

currencies)• definition/outline (and perhaps a simple illustrative figure) of balance of payments; current

account consists of visible and invisible trade plus net transfers; capital account consists of netflows due to foreign investment, deposits, speculation, loans and foreign reserves

• assuming a floating exchange rateo a depreciation will lower the domestic price of goods and serviceso exports increase, imports decreaseo and this possibly increases import revenue and decreases import spendingo depending on Marshall-Lerner condition and/or J-curve effect (HL)o thus there would be an improvement in current account

• possibilities under a fixed/pegged exchange rate regime

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o a downward force on the exchange rate would force the central bank to use the foreigncurrency reserves to purchase the home currency — this would be an inflow to capitalaccount and a depletion of foreign reserves

• other possibilities; possible that an ever stronger currency in fact attracts net investment(inflow on capital account) which may cause subsequent outflows in current account

Diagram(-s): S/D for currency.

Note: The link must be made quite clear between the exchange rate price of exports (in foreigneyes), price of imports (domestic eyes) quantity of exports/imports export revenue/importspending current account and balance of payments.

4. How might deteriorating terms of trade improve the current account in the balance ofpayments?Basic answer: Define and exemplify terms of trade (ratio: price of exports over price of imports) andclarify that a deterioration of the terms of trade means that export prices have fallen relative to importprices — leading possibly to increased exports (and export revenue) and decreased imports (importspending). As the current account is basically made up of the balance of exports minus imports, theabove would lead to an improvement in current account.

Possible points:• definition of terms of trade; price of exports over price of imports• terms of trade index (HL)• example of (commodity or barter) terms of trade, for example the Japanese terms of trade

might be tonnes of bananas per exported Honda Civic• properly outlining deteriorating , i.e. that the Japanese terms of trade worsen when the price

of the Honda Civic falls (ceteris paribus) — less bananas are received• that the price differential can be caused by both relative prices (exporting and importing

nations price level) and exchange rate movements• clearly linking deteriorated terms of trade to both imports and exports

o lower price of exports higher quantity exported higher export revenueo higher price of imports lower quantity imported lower import spending

• clear account/illustration of current account, including visible and invisible trade balanceswith examples of the latter (repatriated profits/interest, transfers)

• simple numerical example showing clearly a change in terms of trade, export revenue/importspending, trade balance and current account balance (improvement)

• HL: using caveats in the Marshall-Lerner condition and/or J-curve effect to show that it is infact not entirely certain that a deterioration in the terms of trade will lead to an improvement incurrent account

Diagram(-s): J-curve.

Note: I usually generously reward students who manage to show a clear link in some way betweenterms of trade price of X/M quantity of X/M X/M revenue or spending current account.However, I demand that there is a clear distinction between price/quantity/revenue(spending) when itcomes to exports and imports. Also, I highly reward HL students who take the path of criticising thequestion entirely using Marshall-Lerner and/or J-curve.

5. An appreciation of the exchange rate is always beneficial to an economy . Discuss.Basic answer: Not quite; in defining the exchange rate and that an appreciation will render exportsdearer to foreigners and imports dearer to domestic citizens, there are a number of possible benefitsbut also disadvantages. Benefits include increased purchasing power for households, lower importedfactor prices for firms and forward linkage effects, increased standard of living perhaps, a wider rangeof goods and travel possibilities, decrease in real foreign debt etc. Possible negative effects are

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decreased exports and increased imports with implications for the balance of payments and possiblecurrency speculation.

Possible points:• definition of the exchange rate as price of domestic currency in terms of trade partners

currencies• noting that appreciation entails a floating currency• positive aspects of appreciation

o increased consumption possibilities for domestic citizenso enhanced choice and array of goods, standard of living increaseo lower factor prices for domestic firmso forward linkage effects on domestic production and possibly increased international

competitivenesso decrease in (real) foreign debt

• negative aspects of appreciationo price of exports (in foreign eyes) has increased leading possibly to a decrease in

exports and export revenueo implications for current account and balance of paymentso increased imports may decrease ADo loss of jobs in export sector

• additional issues; a stronger currency might cause expectations-based speculative buying ofthe domestic currency, driving up currency further; speculative inflows might cause asset-price escalation, i.e. a bubble economy

Diagram(-s): S/D diagram for currency to illustrate speculation. AS-AD diagram to illustrate negativeeffects on AD.

Note: A good answer might deal with several points in broad sweeps or a few points in some detail.

HL

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6. Why might a devaluation of a country s currency not necessarily improve the current accountin the short run?Basic answer: Devaluation (intentional downward adjustment of a fixed exchange rate) is commonlyexpected to increase quantity of exports as the price of exports has decreased. This might notnecessarily lead to an increase in export revenue for two primary (overlapping) reasons; 1) theMarshal-Lerner condition; and 2) the J-curve effect.

Possible points:• definition of devaluation as a re-setting of the exchange rate for a currency in a fixed exchange

rate regime• definition of the current account as sum of net flows of export and import spending in visible

and invisible trade accounts• explanation/illustration of the norm , i.e. that a lower exchange rate would decrease export

prices, increase import prices• however

o Marshall-Lerner condition; only if the sum of PED for exports and PED for imports ismore than one, will a devaluation improve current account

o J-curve effect; consumers might take time to adjust purchasing behaviour to a higherprice levels of imports, and firms can be locked into fixed currency contracts — bothcould in fact mean that the current account would worsen in the SR (also hinges uponthe fact that some import goods might be highly demand inelastic)

• possibility that the economy is highly dependent on imported factors for domestic productionwhich is primarily exported — a devaluation would have serious forward linkage effects andcould in fact diminish the economies international competitiveness and thus decrease exportrevenue (case in point is England during late 1990 s)

Diagram(-s): J-curve.

Note: A solid explanation of the link between the exchange rate and export revenue/import spending,together with correct use of either the Marshall-Lerner condition or J-curve effect should get highmarks.

Extended response questions

1. a) What problems might arise for a country running a current account deficit? (10 marks)Basic answer: Define current account in terms of visible and invisible balances and then proceed toexplain how this might be a problem in the SR/LR.

Possible points:• define balance of payments and current account deficit (it should be clear that there is an

inflow on capital account• there could be a number of SR effects;

o running down foreign reserveso building a speculative bubble (remember, there is a capital account surplus — which

may be speculative)o outflows of currency in speculative anticipation of a fall in the exchange rateo increased loans from abroad to enable import expenditure

• then there are some LR effects;o depreciation of exchange rateo increased foreign debto higher interest rates on future loans as a risk premium for lenderso possibility of increased interest rates in order to continue to attract foreign investmento high level of FDI might cause increased outflow of repatriated profitso risk that foreign capital starts to dry up

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• there is also the possibility of reversed causality, i.e. that the current account deficit is indeedcaused by decreased competitiveness, higher inflation

Diagram(-s): S/D diagram for currencies illustrating speculative outflows of currency and depreciationfor example. AS-AD diagrams illustrating the effects of increasing imports and/or decreasing exports,i.e. a decrease in AD.

Note: Students often confuse the current account deficit with the budget deficit.

b) How might the deficit be reduced? (15 marks)Basic answer: The answer lies primarily in increasing exports and/or decreasing imports. A wide rangeof possibilities present themselves here.

Possible points:• trade barriers — tariffs, quotas etc• devaluation (assuming fixed exchange rates)• export oriented policies, e.g. government subsidies and tax benefits to exporters etc• supply-side policies aimed at increased competitiveness and lower relative inflation• HL: reference to expenditure switching (for example domestic subsidies and/or tariffs) and

expenditure reducing (deflationary policies which lower income and thus imports — refer toMPM)

Diagram(-s): Trade diagram showing effect of tariffs/subsidies; S/D diagram showing increaseddemand for export goods; AS-AD diagram showing effect of supply-side policies.

Note: For higher marks students must be able to explain how any given policy will have a positiveeffect on the current account — simple rote-learned description should not give highest marks.

2. a) Distinguish between the terms of trade and the balance of trade . (10 marks)Basic answer: Basic definition of the terms of trade as the average price of exports in relation to theaverage price of imports — and exemplifying using some form of export and import basket. Thebalance of trade is defined as the total export revenue minus total import spending (in the visible tradeaccount).

Possible points:• definition of terms of trade; flPX /flPM

• HL: terms of trade index; index of flPX / index of flPM x 100• use of example, i.e. basket of goods or bananas per Volvo• reference to barter or commodity terms of trade• explanation to the effect that the terms of trade can be altered by a change in export/import

prices and/or a change in the exchange rate• definition of trade balance; sum of export revenue minus sum of import revenue• including the invisible trade balance• putting the trade balance in the wider context of the balance of payments

Diagram(-s):

Note: While a straightforward question, the distinction between the two needs to be clearly outlinedvia correct definitions and good examples.

b) How might both be affected by a fall in the country s exchange rate? (15 marks)Basic answer: Define the exchange rate; price of domestic currency in terms of another (or basket ofcurrencies). Clearly illustrate how the exchange rate changes the price of home s exports in the eyes of

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trade partners, and how the price imports changes for domestic citizens. This could affect the tradebalance. The terms of trade change when the price of exports and imports change — thus, adepreciation of the currency will cause a deterioration in the terms of trade but possible an increase inexport revenue and a decrease in import spending which improves the trade balance

Possible points:• definition of exchange rate; price of domestic currency in terms of another currency (or basket

of currencies)• outlining possible links between the two concepts

o a depreciation of the currency would mean a fall in the terms of tradeo this might serve to increase exports and/or decrease importso and an increase in export revenue and/or a fall in import spending, thus improving

trade balance• effect on trade balance of depreciation

o depreciation of currency increased exports increased export revenue improvement in balance of trade

• effect on terms of trade of depreciationo exchange rate decreases fall in the ratio between export and import prices (ceteris

paribus) deterioration in terms of trade• other examples, for example

o lower domestic inflation relative to trade partners increase in exports and decreasein imports improvement in trade balance

Diagram(-s):

Note: Higher scores are often for answers which exemplify and illustrate changes in the terms of tradeand trade balance.

3. a) Explain how a country might have a consistent current account deficit for longer periods.(10 marks)Basic answer: By first defining/outlining the current account and overall balance of payments, a goodanswer will be able to make clear that the only way a country can persistently run a current accountdeficit is by having a capital account surplus. The answer lies squarely in how/why money is flowinginto the capital account.

Possible points:• explanation that outflows are greater than inflows on current account• and that this may be caused by a trade deficit• reference to invisibles (repatriated profits, interest )• reference to deterioration of the terms of trade and imports being demand inelastic• high domestic growth for longer periods causing increased imports (HL: MPM)• and causing domestic inflation, lowering exports• decreased competitiveness causing exports to falter• overvalued currency• current account deficit must be balanced by inflows on capital account

o loanso speculative inflowso FDI and portfolio investment

• reference to real life examples such as the US current account deficit during most of the 1980sand 1990s

Diagram(-s):

Note: Highest marks should be given to students who clearly outline the balance of payments and areable to identify solid reasons how a current account deficit can be sustained.

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b) Is this necessarily a serious problem? (15 marks)Basic answer: Well, yes and no. A good answer will might lean in either direction but give room for acounterargument.

Possible points:• explanation that current account entails a capital account surplus• iteration on possible reasons for, and sources of capital account inflows• not a serious problem

o if the corresponding inflows are investment inflows rather than SR and/or speculativeo if capital inflows — such as FDI — are used productively in the economyo linking FDI/portfolio investment to increased demand for labour, increased outputo the deficit — and corresponding inflows to capital account — are due to a strong,

growing economy with the result that large amounts of foreign investment flow ino no real problem as long as foreign investors are willing to invest and thus finance the

current account deficito if the current account deficit simply reflects increasing incomes for the home

economyo if the current account deficit in relation to GDP or total trade is relatively smallo that the current account will automatically correct itself under a floating exchange rate

regime• a serious problem

o if the capital account inflows are due to borrowing debt burden country becomes vulnerable to international interest rate hikes

o the capital account inflows are speculative possible effects on speculative bubbles in the economy possible depreciation of exchange rate financing the deficit may run down foreign reserves

o the capital account inflows are squandered or become capital flighto foreign investors see the growing current account deficit and decrease investmento the inflows can create inflation and domestic speculation (see Thailand 1997)

• any real world examples, e.g. USA ( not a problem ) and Thailand/Indonesia/Malaysia in1997/98 ( South East Asian meltdown )

Diagram(-s): AS-AD model to show effects of FDI, increasing demand and inflation, and the effectsof a speculative (inflationary) economy.

Note: For full marks there has to be an element of evaluation; the student should include a discussionon why/how the deficit does or does not represent a serious problem. Real world references which arerelevant and clearly linked to argumentative stance should be amply rewarded.

HL4. a) Explain how a floating exchange rate works and the variables which affect the rate. (10marks)Basic answer: Define a floating exchange rate as the price of a currency (in terms of another or basketof currencies) being determined by market forces, i.e. supply and demand of the currency. Using twoS/D diagrams, illustrate and exemplify such market forces — all the while clearly referring to thediagram.

Possible points:• definition of floating exchange rate; the price of the home currency is determined by demand

for and supply of the currency — i.e. the price of the home currency will be set in terms of howmuch of another currency is needed to by one unit of home currency

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• clearly noting that in a floating regime, a fall in the external value of the currency isdepreciation while a rise in the external value is an appreciation

• issues which influence demand for the home currencyo the derived demand for domestic goods and services by foreignerso investment (portfolio and direct) demand by foreignerso relative rate of return on saving (interest rates)o intervention purchasing of the home currency by the central bank (possible reference

to dirty float )o speculative buying by foreign speculators

• issues influencing the supply of the home currencyo change in import demando change in FDI abroado change in foreign interest rateso speculative selling of the home currencyo intervention selling of home currency by central banko change in relative inflation rates

• viable and clear examples of how the exchange rate changes in line with changes insupply/demand, for example

o a fall in home s inflation rate relative to trade partners (= fall in relative inflationrates) increased demand for home s exports increased demand for home scurrency appreciation of home exchange rate

o higher corporate taxes in home lower demand for FDI from foreigners demand for home currency falls

depreciation of home currency it is plausible that even home firms will seek out higher net rate of return by

diverting investment abroad increased outflows of FDI abroad increasein the supply of home currency depreciation of home currency

• mentioning that there are a number of LR issues influencing the exchange rate; governmentdeficits/debt, current account deficits, supply-side issues (which in turn influence productivityand relative inflation), increasing focus on R&D/comparative advantage etc to increasecompetitiveness and hence demand for goods and thus currency

• important that the diagram shows P of in USD or such

Diagram(-s): Two S/D diagrams should be used; one to show shift in demand and one to show a shiftin supply of the home currency. Both should then be commented on to make clear how the exchangerate is influenced.

Note: This is a wide question with many possible angles of attack. Students should be amply rewardedeither for dealing with a few issues in depth (say, one good example of a change in demand and onefor supply) or a number of issues where there is still a basic explanation linked to a correct diagram.

b) Why might exchange rates ultimately reflect the relative prices of traded goods in tradingcountries? (15 marks)Basic answer: This centres around PPP theory of exchange rates, which deals with the LR effects onexchange rate adjustments. Underlying is the concept of the law of one price.

Possible points:• definition of relative prices; in trading goods, two countries will have an exchange rate and a

domestic price on the good — relative prices basically means the cost of a shirt in one countryrelative the exchange rate based cost in a trading country

• example of relative price priceso home s shirt costs $30 and foreign s shirt costs 60o the exchange rate is $1 = 1.5o the relative price means that

home citizens pay $30 for domestic shirts and $40 for foreign s shirts

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foreign citizens pay 60 for domestic shirts and 45 for home s shirts (i.e.they could get 1.25 shirts by buying imports instead of domestic shirts)

• law of one price states that — barring market imperfections and using some assumptions(below) — goods will ultimately have the same price

• assumptionso homogeneous goodso no transport costso no trade barrierso no transaction costs (e.g. commission on currency exchange)o floating exchange rate

• the relative price of a shirt in the example above shows that shirts are cheaper in home that inforeign, thus

o foreign citizens will increase imports of shirts from home increase in the supply of depreciation of the

o foreign citizens demand for the $ will increase appreciation of the $• example of how arbitrage (re-selling) will have the same effect as above• conclusion that — assuming that the prices of shirts in each country remain the same — the

exchange rate will ultimately even-out , i.e. a shirt in both countries will cost the same• example of the above; the depreciates and the $ appreciates until the exchange rate shows

that a $30 equals a 60 shirt — the exchange rate is $1 = 2 (or 1 = $0.5)• thus PPP theory predicts that a change in relative prices — via inflation — acts as a LR force in

setting exchange rateso example of this; assuming an exchange rate of $1 = 2, an increase in (relative)

inflation in home ($) will lower demand for home s shirts and increase imports fromforeign — this will ultimately readjust the exchange rate to reflect relative prices (thehome $ will depreciate and the foreign will appreciate)

• criticism of PPP theoryo assumptions do not hold up in realityo many goods are non-traded goods (for example services)o inconclusive evidence of PPP theory holding up in reality — even in neighbouring

countries in Europe

Diagram(-s): S/D diagram(-s) for currency (currencies).

Note: A difficult question, where a clear answer addressing the basic issue of relative prices and howthis would cause changes in exports/imports and affect exchange rates should be rewarded. Any wellexemplified answer which takes a counter-stance and states that exchange rates will not in fact reflectrelative prices can earn full marks.

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Section 5.5 — Evaluation of growth and development strategies

Short answer questions (10 marks each)

1. Why is human capital so important in the development process?Basic answer: Define human capital in terms of (the sum of) education/training/experience/literacy etc, and clearly show how this will expand an economy s growth and development potential— i.e. provision of tax bases public/merit goods health care re-investment etc.

Possible points:• definition of human capital and development• how increased human capital provides economic growth income tax bases enhanced

ability for infrastructure/merit- and public goods• increased income higher savings and investment• reference to Harrod-Domar model and the effects of both higher savings ratio and increased

productivity• using real examples of the strong statistical link between human capital and economic growth,

i.e. South Korea, Singapore, Taiwan• human capital and entrepreneurial spirit• the spin-off effects of having higher human capital; ability to incorporate foreign

technology, skills and production methods• the attractiveness of human capital to foreign investors

Diagram(-s): AS-AD model may be used to show growth, PPF to show increase in both de facto andpotential output.

Note: As so often is the case in development questions, students have a tendency to be vague andanecdotal here. Highest marks should go to students who are able to clearly link enhanced humancapital to growth/development.

2. What barriers to economic growth can be explained using the Harrod-Domar model?Basic answer: Definition and outline of the Harrod-Domar model; growth in national income =savings ratio over the capital output ratio. This is put as g = s / k. Explain the implication of the modeland then outline various impediments to its implementation in real life in developing countries. Notethat the question necessarily leads to a degree of spin-off in that the basis of the Harrod-Domarequation provides a starting point for discussion of limits to its viability.

Possible points:• definition of economic growth, i.e. increase of national income for a given time period• definition of Harrod-Domar model; g = s / k

o s = savings ratio is the proportion of income saved in the economy (s x Y = S)o k = capital output ratio, capital per unit of outputo thus, growth will occur when s increases (noting that this leads to higher saving, S, in

the economy, and assuming that S = I)o and/or growth will occur when k decreases (a fall in the rate of capital per unit of

output means increased productivity)o noting that both capital and output are in monetary units

• lack of financial institutions inhibit saving• poverty and low income levels mean that the propensity of households to save will be low

(HL: low MPS)• reference to the poverty cycle of low growth low savings low investment low

growth• capital flight hampers efficient domestic allocation of investment resources• other issues implicit in the Harrod-Domar equation

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o saving gap due to low domestic savings in developing counties, i.e. insufficientfunds for investment level

o can be filled by foreign loans and/or foreign investmento risk of foreign debt burden, dependency on foreign capital

Diagram(-s):

Note: As long as the answer refers to issues pertinent to variables included in the Harrod-Domarmodel, marks should be considered.

3. Why might economic growth not be compatible with sustainable development?Basic answer: Define economic growth; increase in national income during a time period. Definesustainable development; development that meets the needs of the present without compromisingthe ability of future generations to meet their own needs. The issue of sustainability needselucidation, as there is no generally accepted or universal translation of this excerpt from the 1987Brundtland Report. The possible trade-off between growth and sustainable development deals withresource use, environmental degradation, carrying capacities of our world and the ability of humaningenuity in increasing efficiency/productivity in order to utilise scarcer resources ever better.

Possible points:• definition of economic growth; increase in GDP during given period of time• definition of sustainable development; .meeting the needs of future generations• other definitions; growth that lasts (World Bank)• outline of sustainability

o use of natural resources and a growing populationo environmental degradation, i.e. air pollution, soil erosion, global warming etco carrying capacity of the globe in terms of maximum sustainable LR populationo whether efficiency in resource use is outstripping the decrease in available (finite)

resources• how productivity, growth and sustainability are linked

o sustainability does not actually entail that the same amount of resources remain intactduring growth, but that productivity increases (and technological advances) are suchthat there are sufficient resources to sustain living standards (i.e. that the economicsystem can produce more output with fewer resources and less environmental impact)

• reference to possible trade-off between growth and environment• possible reference to Kuznets curve (outside the syllabus, and hotly debated)

Diagram(-s):

Note: A very hazy question but, alas, all too frequently included in some version in IB exams. It isunlikely that any of the IB examiners would define and outline sustainable development in exactlythe same way.

4. What are the possible negative consequences of economic growth in a developing country?Basic answer: Define economic growth as an increase in GDP during a given time period, and thenillustrate how this might adversely affect a developing country. Main points deal with possibleinflation, income distribution and externalities such as environmental issues.

Possible points:• trade-off issues

o inflation due to increase in ADo balance of payments issues due to growtho growth may have a severe impact on the environment

• societal and cultural changes

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o uprooting of people from traditional lands to make way for urbanised areas, industrialareas, etc

o loss of cultural identity in line with rapid change of society• greater income and wealth inequality

o high growth rates might be spread unevenlyo it is rather clear that trickle down effect has been very limited

• increased urbanisation in dual sector economy• possibility of declining domestic industries due to MNCs• increased dependency on international markets due to heavy export orientation

Diagram(-s): AS-AD to show growth-inflation trade-off.

Note: Most answers will at least refer to the growth-environment trade-off possibility, but for highermarks at least two in-depth examples should be given.

5. Distinguish between the various forms of aid received by developing countries.Basic answer: Here the student must show clearly the difference between grant (donor) aid; reciprocal(tied) aid; bilateral aid; multilateral aid; soft loans; and writing off debt. For higher marks, the studentshould not simply list various types, but be able to give examples and perhaps put into context.

Possible points:• grant aid as a form of gift which comes in various forms, i.e. medicines, catastrophe relief,

experts etc• tied aid as a form of reciprocity — the recipient country commonly pledges various counter-

purchases• bilateral aid — from one country to another• multilateral — from many countries via a central aid agency to many countries• soft loans — loans with longer amortisation period and lower than market interest• debt write-offs — a creditor nation simply erases certain debts

Note: Weaker students might simply iterate various forms, while stronger candidates will be able toexemplify. Full marks may be earned by in-depth examples and outline of two or three types of aid.

6. Evaluate the role of multinational companies in helping developing countries to achieveeconomic growth/development.Basic answer: Define multinational companies (MNCs) as companies having production in more thanone country. Define growth (increase in GDP) and development (increase in standard of living). Somecommon issues for and against MNCs should be developed and their costs/benefits evaluated.

Possible points:• definition of growth; increase in GDP per time period• definition of development; growth and wider spread of income, general increase in standard of

living• positive effects on development of MNCs

o a way to fill the savings gap (possible reference to Harrod-Domar model)o both FDI and portfolio investment in fact creates job opportunitieso and increases the capital stock of the countryo increase in AD and thus GDP (HL: possible multiplicative effects)o subsidiary companies generate possible inward flows of profits from abroado it is possible that MNCs transfer not only capital, but also technology, knowledge and

experience to developing countries• negative effects

o inflow of FDI may cause current account deficito not all capital put to use in LDCs is appropriate

highly capital intensive production does not create many jobs

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capital intensive production does not utilise comparative advantage, i.e.labour

imported capital is often demanding in terms of technological expertise in setup, maintenance and repairs — such services are often imported from abroad

o a number of MNCs have been accused of heavily marketing inappropriate productso a goodly proportion of profits might be repatriated abroad and thus not be re-invested

in the local communityo it is possible for MNCs to avoid a proportion of taxes by, for example, internal pricing

of goods within the companyo very large and powerful MNCs might simply use there power as leverage and

bargaining power in land/rent/tax/labour negotiations with firms/unions/governmentsin developing nations

• other possibilities, for example that MNC presence might create the need for functioninginfrastructure/institutions

Diagram(-s): Possibly AS-AD model to show growth due to investment.

Note: Real world examples should merit marks. Answers which do not attempt to assess points shouldnot be able to earn full marks.

7. Explain how many developing countries became burdened with severe debt problems in the1980 s.Basic answer: The debt problem which became world famous during the Mexican crisis in 1982,had its roots in a number of causal factors, for example: 1) the recent liberation of previous developingnations; 2) the oil crises of 1973/ 74 and 1979/80; 3) massive amounts of petro-dollars floodingliquidity markets in western commercial banks; 4) stagflation of the 1970 s and low demand forinvestment funds; 5) interest rate hikes of early 1980 s.

Possible points:• the oil crisis of 1973/ 74 meant a quadrupling of oil prices

o oil sold in $USo these so-called petro-dollars were often deposited in western commercial bankso abundance of available loanable funds

• stagflation and effects on western economieso low demand for loanable fundso banks sought out new customers — countries, which do not go bankrupt

• many newly liberated countries — ex-colonies — sought access to development capital and werehappy to borrow funds from western commercial banks awash with liquidity

• real interest rates were relatively low• link to cash crops

o colonial heritage of cash crops in many newly liberated countrieso borrowed monies were often directed towards increasing cash crops

• interest rates in early 1980 s increased drastically — one possible reason being that USPresident Reagan raised US rates to stifle inflation

• falling commodity prices continued during 1980 s and 1990 so decreased terms of trade for developing countrieso lower export revenue for commodities and cash crops

• in conclusiono already substantial debt taken on in the 1970 s increased as

interest rates increased many of the loans were dollar denominated and the dollar appreciated as the

US raised interest rates price of commodities fell continuously and so did export revenues for many

developing countries — and several countries defaulted on loans

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o a number of the poorest countries took on new loans — amongst others, from theWorld Bank — to help service previous loans

Diagram(-s): AS-AD model to illustrate stagflation.

Note: Detailed points such as above are not expected, but rather a correct outline of the basic issue ofwhy many developing countries were so deep in debt by the late 1990 s.

8. How have falling commodity prices affected many developing countries?Basic answer: Definition of commodities; raw material such as copper, iron and bauxite; andagricultural goods such as rice and wheat. These prices have been falling more or less continuouslysince the 1970«s, and severely hampering growth/development in developing countries which aredependent on (a rather narrow range) of commodity exports.

Possible points:• definition of commodities; basic goods ( land as a factor of production) which have low

value-added — minerals and agricultural produce• explanation that the commodity price index has fallen for over 30 years• effects on exchange rate• export revenues and export balance• effect on local unemployment• how lower commodity prices might act as an incentive to (price taking) producers in

developing countries to increase output• creating a vicious circle of falling prices of exports deteriorating terms of trade low

PED for commodities fall in export revenue worsening of current account fall inexchange rate falling prices of exports .

• the above has exacerbated the debt situation for developing countries, since a depreciationleads to higher real foreign debt, and also that falling commodity prices mean that more goodshave to be sold in order for the developing country to receive vital foreign currency necessaryto service debt

• any reasonable/viable example of the severe anti-developmental effects on developingcountries as a result of falling commodity prices

Diagram(-s):

Note: Many answers will spin-off into an explanation of why commodity prices have fallen — which isnot central to the question.

9. Discuss whether economic growth leads to an improvement of the environment.Question scrapped — too far outside the syllabus.

10. Why are so many developing countries dual sector economies?Basic answer: Definition of dual sector in terms of a partial shift from traditional/agricultural/subsistence economy to a rural/industrialised/modern economy. As growth and development takeplace, low (and perhaps negative) marginal productivity of labour in the traditional sector willallow/entice the relative abundance of available labour to move to the modern sector (terminology isfound in the Lewis model).

Possible points:• definition of dual economy

o traditional sector based primarily on agriculture and/or subsistence households — largesupply of labour

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o modern sector resulting from industrialisation and manufacturing — increased incomeand productivity in urban sector

• definition of rural and urban• definition/outline of labour force in terms of

o productivity, i.e. marginal productivity of labour low — even negative marginal productivity of labour in traditional sector higher and increasing marginal productivity of labour in modern sector

o supply and demand for labour excess supply of labour in traditional sector increasing demand for labour in modern sector

• migration towards modern sector as increased productivity increases wage levels —urbanisation

• incompletion of migration yields two sectors in the economy• other issues

o shift of (surplus) labour to modern sector has results such as urban unemployment large wage differentials between traditional and modern sector large poor urban population, overcrowding

Diagram(-s):

Note: A good answer would be one which clearly outlines — descriptively — the existence of a modernand traditional sector side-by-side. A thorough description of the marginal productivity of labour is notnecessary.

11. Describe the poverty cycle and suggest how a developing country can break the cycle.Basic answer: The poverty cycle is defined as the trap developing countries can land in; lowincomes low savings low investment low incomes. As for the issue of breaking the cyclethere are a range of possible suggestions, all of which unfortunately encounter any number of otherobstacles.

Possible points:• definition of poverty cycle; low incomes low savings low investment low incomes• further explanation of the links herein; poor countries will have low propensity to save (HL:

MPS) as a large proportion of a meagre income must be spent on basic necessities; this starvesthe financial institutions (e.g. banks) from loanable funds for investment; investment is centralto the concept of economic growth — which leads back to low income

• breaking the cycleo increased use of government funds towards infrastructure and merit/public goods in

order to increase human capitalo micro-credit schemes might make more entrepreneurial capital availableo enforced property rights would give more households the opportunity to use property

as collateral (= security) for loanso freer international movement of capital, allowing foreign investment to fill savings

gapo attracting MNCs to increase both income and investmento changing the tax system to redistribute incomes, which would enable more saving

amongst a wider groupo enforcing legislation against various forms of capital flighto aid and foreign loans might help fill a savings gap

• critique of suggestions above (in the order as above)o government funds are often noticeably lacking — as is good government, stable

political system and tax bases

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o while there are some notable successes here, the scale of such schemes would appear— as yet — to be too small

o again, strong and able government and judiciary systems are a prerequisiteo foreign investors need incentives such as able labour force, distinct and well-enforced

property rights etco multinational companies might result in a one-off investment followed by

repatriation of profits to the mother country (and thus low re-investment)o tax systems are notably weak in many cases — as are the tax bases (low income and a

large parallel market system, unofficial market )o the problem is that it is the wealthy and perhaps the very people in charge of the legal

and judicial system who are primarily responsible for capital flighto aid is not large enough to fill the savings gap (and corruption/mismanagement has

negated proper investment often) and foreign loans need to be paid back

Diagram(-s):

Note: There are many other possibilities — reward sound reasoning and any clear/plausible example.

12. Explain the importance of well-established property rights in the process of development.Basic answer: Definition of property rights should not start and end with owning land andbuildings but have a much wider scope. Property rights encompass also the use of land/buildings inaccordance with contractual rents — and also any resulting output resulting from economic activity.Property rights enable households and entrepreneurs to borrow against both existing ownership deeds(to land or capital) and also future gains such as output and profits. Lack of property rights serve tokeep poorer households powerless and also act as a disincentive to improve use of land and capital.

Possible points:• definition of property rights as both ownership of land/capital/output, but also legal usage

rights obtained contractually• links between property rights and development

o hazy or non-existent property rights diminish investment lack of collateral for loans future gains cannot be used as security for loans farmers on customary land and squatter have little incentive to improve the

quality of this property — lowering any potential value as securityo inability to sell property to others who might use it more productivelyo lack of investment results in

less income lower tax base less government revenue and thus public/merit goods large parallel economy

o often the poorest segments who lose the most from lack of property rights poor entrepreneurs might be forced to borrow from loan sharks at

preposterously high interest rates increased vulnerability of poor at the hands of corrupt officials in

administrative positions• other issues herein; misallocation and wastefulness of unaccountable assets has high

opportunity costs; lack of property rights can result in political powerlessness

Diagram(-s):

Note: Possibly a tricky question, but any reasonable answer which links lack of property rights to lowlevels of entrepreneurship, investment and the vulnerability of poorer sections in society should meritmarks.

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13. Distinguish between growth and development .Basic answer: Growth is quantitative measure (change in nominal or real GDP/GNP) whiledevelopment is a wider and a (subjective) qualitative measure.

Possible points:• definition of growth, i.e. ˘_GDP• development encompasses living standards and welfare in the economy, such as health care,

access to education, level of infrastructure, income/wealth equality, freedoms ofchoice/religion/politics etc

• measures of development includeo percentage of population in absolute/relative poverty (define!)o percentage of women with secondary/tertiary education, proportion of women in

parliamento mean distance to hospital, infant mortality rates, longevityo proportion of population literateo telephones per capita, kms of roads per 1,000 citizenso number of violent crimes per 1,000 citizens,o unemployment rate, voting rightso HDI or any composite development indexo indicators of inequality such as the Lorenz curve and Gini coefficient, Kuznets ratio

(outside the syllabus)o any reasonable way of measuring intangibles such as quality of life (average free

time amongst workers), cultural possibilities (access to theatres/arts ) and so forthshould receive marks

Diagram(-s):

Note: A good answer will not consist simply of a description of development but include more specificmeasures of descriptive variables.

14. Describe stabilisation policies as outlined by the International Monetary Fund (IMF).Basic answer: Define stabilisation policies as basically a list of demands set forward by the IMF to adebtor nation which has seen necessary to reschedule old debt or borrow anew. These demands areaimed at creating macroeconomic stability in the debtor nation; balance of payments stability,decreased government deficit/debt, stability in exchange rate, and generally move towards a free-market economy.

Possible points:• macro objectives

o raise interest rates to combat inflationo implement various forms of supply-side measures to increase growth, decrease

inflation• government debt

o decrease government spendingo increase taxes to balance budgeto restructure debt

• exchange rateo cessation of intervention in currency marketso allow convertibility of currencyo floating exchange rate

• market-based economyo removal of minimum priceso decrease in government subsidieso decrease labour market rigidities

• openness to trade

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o removal/lowering of barriers to tradeo increased openness to FDI and capital movements

• free-market orientation, currency convertibility and openness to trade is aimed at improvingbalance of payments

Diagram(-s): S/D diagram for currency showing over-valued currency and market rate.

Note: Though there is wide-spread and harsh criticism of the IMF s stabilisation policies, this is notasked for here.

15. Outline the possible negative effects of import-substitution policies.Basic answer: Define and outline import-substitution; focus on decreasing domestic reliance onimports by implementing high barriers to trade and channelling government resources towardsspecified domestic industries. The rather dismal results of import-substitution include a strong politicalrather than economic philosophy , focus on domestic champions which decreased competitiveness,failure to identify winning industries, squandered government resources on goods for which therewas no competitive advantage, forward linkage effects and a lack of capital/ skills/ knowledgetransferred from abroad.

Possible points:• definition/outline of import-substitution

o high (infant industry) tariffs on importso funnelling resources towards state-run or heavily state-subsidised industrieso large element of central planning in facto reference to national champions or license Raj of Indiao often attempted in countries with large inner markets

• negative effects hereino tariff protection and subsidies created comfort zones for domestic firms to operate

behind lack of competition and high prices inefficiency in production poor quality goods low productivity

o forward linkage effects higher costs of factors produced domestically raised costs further forward in

production decreased competitiveness internationally

o government decisions as to which industries to sponsor have been notoriously poor —based, as they frequently were, more on political manifests rather than economicreasoning

o few of these chosen industries became winners — and fewer still survived when thestep towards open markets was taken

o lower consumer welfare — less choice, fewer goods, higher prices• general failure of import-substitution

o now pretty much abandoned — possible exceptions are Burma/Myanmar and NorthKorea

o the infancy of infant industry tariffs cold get rather middle-aged in fact• real world examples, e.g. China (until 1980 s) and India (until 1990 s)

Diagram(-s): Trade diagram to show effects of tariffs and subsidies — together, possibly, with theLRAC curve (see page 678).

Note: A careful outline of import-substitution should be demanded.

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16. Discuss whether the success of newly industrialised countries — such as the Asian Tigereconomies — is solely the result of outward oriented policies.Basic answer: Define outward oriented policies; (also referred to as export-orientation or export-ledgrowth) a policy of focusing on goods aimed at the international goods market which has frequentlybeen shown to involve both protectionism and a considerable degree of government planning/intervention/steering. In other words, a good many of the tools used in an import-substitution strategywere in fact used here also.

Possible points:• definition of outward oriented policies — the countries industries are aimed at producing goods

for the international market• characteristics of outward oriented policies

o a degree — and often selectively so — of trade freedom for importso and often a degree of infant-industry protectionismo often liberalised international capital flows to allow inflows of foreign investmento strong focus on competitive advantage — often labour intensive goods (at least

initially)o strong government involvement

subsidies to key sectors and industries tax breaks for investment

• not all successes can be attributed to outward oriented policieso often very strong focus on education and infrastructure — both as a cultural dimension

and government fundingo households in the Tiger economies were for the most part strong savers which enabled

investment• other issues; discussion of cultural factors in the success of Asian Tigers such as the high

status of education and teaching, strong and able governments (which for the most part wereinitially most assuredly non-democratic), relative stability and lack of internal conflicts,geographic issues such as proximity to Japan

Diagram(-s): Trade diagram to show effects of tariffs and subsidies — together, possibly, with theLRAC curve (see page 678).

Note: Full marks should not be possible without using at least one clear example of the limits ofoutward oriented policies in explaining the success of the Tiger economies.

Extended response questions

1. a) How might one measure differences in living standards between less developed anddeveloped countries? (10 marks)Basic answer: This is a very wide question where any clear and relevant measure should merit marks.Definition of standard of living as a wide range of issues — which must then be made measurable !For example, health care is hardly a distinct and measurable variable, but doctors per 1,000citizens is. The way to address this question is thus to not only exemplify with variables which arepart of living standards, but also render them measurable in some way.

Possible points:• defining standard of living

o poverty levelso inequalityo health careo educationo infrastructureo safety

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o opportunities in society• exemplifying ways to measure the above variables

o percentage of population in absolute/relative poverty (define!)o Lorenz curve, percentage of women with secondary/tertiary education, proportion of

women in parliamento mean distance to hospital, infant mortality rates, longevityo proportion of population literateo telephones per capita, kms of roads per 1,000 citizenso number of violent crimes per 1,000 citizens,o unemployment rate, voting rights,

• using the HDI as an example• any reasonable way of measuring intangibles such as quality of life (average free time

amongst workers), cultural possibilities (access to theatres/arts ) and so forth should receivemarks

• other indicators, i.e. Gini coefficient, Kuznets ratio (outside the syllabus)

Diagram(-s): Lorenz curve.

Note: I often give students rather considerable leeway here — as long as they are specific in definitions,and in referring to how any give example of standard of living can be measured.

b) How might developed countries assist less developed countries to increase their livingstandards? (15 marks)Basic answer: Again, a very broad topic with many possibilities. Possible answers include the entiretrade vs aid debate — and virtually any of the development strategies put forward. The key here is toclearly link development strategies to increased living standards in LDCs.

• tradeo developed countries can lower trade barriers for goods such as textiles and agricultural

products for which LDCs have comparative advantageso exceptions (via WTO) to developing countries allowing certain types of infant

industry protection for LDC industrieso fair trade organisations

• increased FDI in developing countries - multinational companies; can help transferknowledge/technology, fill domestic savings gap

• increased aido might help close the savings-investment gapo in line with the above, reference to Harrod-Domar model; increase growth by either

increasing savings (and thus investment) and/or increasing productivity (and thusdecreasing the capital-output ratio)

o aid in the form of expertise, training and educationo assistance in infrastructure and poverty reliefo funds towards socially beneficial projects

• borrowing from international creditors (IMF, World Bank)• writing off loans (often called debt relief) for the most heavily indebted poor countries (HIPC)

Diagram(-s): Trade diagrams showing how decreased barriers to trade would increase imports fromLDCs; AS-AD model to show increases in AD/AS due to increased exports/investment etc; (HL)LRAC curve and world supply showing how a country might enjoy initial (infant industry) protectionenabling the country to gain benefits of scale

Note: Better answers should be able to address the trade vs aid issue in some respect.

2. a) Outline the main features of outward-oriented and inward-oriented development strategies.(10 marks)

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Basic answer: Define outward oriented policies as policies aimed at creating export industries; inward-oriented as focus on decreasing domestic reliance on imports by implementing high barriers to tradeand channelling government resources towards specified domestic industries.

Define and outline import-substitution; The rather dismal results of import-substitution include astrong political rather than economic philosophy , focus on domestic champions which decreasedcompetitiveness, failure to identify winning industries, squandered government resources on goodsfor which there was no competitive advantage, forward linkage effects and a lack of capital/ skills/knowledge transferred from abroad.

Possible points:• definition of outward oriented policies — the countries industries are aimed at producing goods

for the international market• outward oriented strategy

o lower barriers to trade, e.g. tariffs, subsidies etco increased use of international capitalo openness to FDI and portfolio investmento removing restrictions on foreign exchange, i.e. allowing the currency to be convertible

and subject to market forceso focusing on sectors in which the country has comparative advantage (with possible

government support)• definition of inward oriented strategy/import-substitution - focus on decreasing domestic

reliance on imports• inward oriented strategy/import-substitution

o high (infant industry) tariffs on importso funnelling resources towards state-run or heavily state-subsidised industrieso large element of central planning in facto reference to national champions or license Raj of Indiao often attempted in countries with large inner markets

Diagram(-s): Trade diagram to show effects of tariffs and subsidies — together, possibly, with theLRAC curve (see page 678).

Note: A complete list of characteristics is not necessary for full marks.

b) Explain which of the two strategies is most likely to lead to development. (15 marks)Basic answer: Empirically, it seems rather evident that export-orientation has been more successfulthan import-substitution. The main point in putting forth this claim are that export-orientation has ledto rapid growth while import-substitution has in fact been a dismal failure — resulting in the generalabandonment of import-substitution as a main development policy. The however , as there always isin the dismal science, is that numerous specific policies in export-orientation in fact closely mirrorpolicies implemented in import-substitution policies.

Possible points:• general results of export orientation

o focus on key growth industries in which comparative advantages existed has beenbroadly successful

Japan in 1950 s and 1960 s, Korea in 1970 s and 1980 so specialisation enables

benefits of scale firms to move along learning curve

o industrialisation and FDI initial focus on relatively simple industrial goods enabled technological

advances leading to higher level goods increased value-added

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improved productivityo openness to capital markets has enabled open economies to fill domestic savings-

investment gapo broadened production base enabled these economies to move away from commodities

and into higher income elastic goodso generally, the competitive market orientation of export orientation has improved

resource allocationo high export levels have generated much-needed growth

created jobs increased tax bases enabled investment in human capital, merit/public goods

• general results of import-substitutiono tariff protection and subsidies created comfort zones for domestic firms to operate

behind lack of competition and high prices inefficiency in production poor quality goods low productivity

o forward linkage effects higher costs of factors produced domestically raised costs further forward in

production decreased competitiveness internationally

o government decisions as to which industries to sponsor have been notoriously poor —based, as they frequently were, more on political manifests rather than economicreasoning

o few of these chosen industries became winners — and fewer still survived when thestep towards open markets was taken

o lower consumer welfare — less choice, fewer goods, higher priceso general failure of import-substitution

now pretty much abandoned — possible exceptions are Burma/Myanmar andNorth Korea

the infancy of infant industry tariffs could get rather middle-aged in facto real world examples, e.g. China (until 1980 s) and India (until 1990 s)

• other issues; countries which have implemented export orientation policies have in some caseshad any number of accompanying problems; externalities in the form of pollution andenvironmental degradation, speculative inflows of funds which have fuelled bubbleeconomies, harsh labour policies designed in favour of employees, bans on unions, poorlabour rights

Diagram(-s):

Note: A good answer will outline both sides critically and clearly link issues brought up todevelopment.

3. a) What are the various forms of aid a developing country might receive? (10 marks)Basic answer: Here the student must show clearly the difference between grant (donor) aid; reciprocal(tied) aid; bilateral aid; multilateral aid; soft loans; and writing off debt. For higher marks, the studentshould not simply list various types, but be able to give examples and perhaps put into context.

Possible points:• grant aid

o a form of gift which comes in various forms medicines catastrophe relief expertise

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• tied aid as a form of reciprocity — the recipient country commonly pledges various counter-purchases

• bilateral aid — from one country to another• multilateral — from many countries via a central aid agency to many countries• soft loans — loans with longer amortisation period and lower than market interest• debt write-offs — a creditor nation simply erases certain debts

Diagram(-s):

Note: Weaker students might simply iterate various forms, while stronger candidates will be able toexemplify. Full marks may be earned by in-depth examples and outline of two or three types of aid.

b) Compare aid and trade as the most effective means of development. (15 marks)Basic answer: Unfortunately, this is one of those it depends questions. Few development economistswould deny that aid has its place, for example in cases of famine, natural disaster etc — and also inprojects which are well designed for countries which have adequate framework (institutions, forexample) to implement development projects. Criticism of aid — and the advocacy of trade, often in thesame breath — often points out that many of the most aid-inundated countries in the world have notseen anywhere near the development of fiercely outward-oriented nations which have receivedproportionately little aid.

Possible points:• benefits of aid

o enables SR stimulation of an economyo can be vital in providing basic necessities and SR reliefo can help in education and transferral of knowledgeo has been shown to be beneficial in countries with strong institutions and functioning

government/administration• criticism/limits of aid

o inefficient monies are squandered by inept/corrupt govt capital flight aid does not reach the neediest most of the time poorly planned projects high costs of experts from developed (aiding) country

o aid can knock out local investment and businesseso creates dependency and entrepreneurial lethargy (= laziness)o political aspects

aid may serve to help dictators stay in power aid was often politically motivated during cold war period

• benefits of tradeo has been strongly pro-growth in many cases, which in turn enables

tax bases funnelling resources towards human capital resources towards infrastructure

o has a self-reinforcing effect — both exports and inward foreign investment fuel growtho strong empirical evidence in favour of trade (e.g. Asian Tigers) as strongly pro-

developmental• criticism/limits of trade

o many barriers still existo the severest barriers are still aimed at the goods which are the staple industry in many

developing countries; textiles and agricultural goodso race to the bottom argument, i.e. that uninhibited globalisation would create a

competition amongst developing countries to have the weakest labour/environment/working environment legislation

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o externalities such as pollution and increased income inequality• other issues; discussion on whether the falling proportion of monies going to aid during the

past 10 — 15 years might be the result of the end of the cold war, or possibly that countries aresimply suffering from aid fatigue

Diagram(-s):

Note: A few central points — for each side — well-developed and clearly linked to development shouldbe able to earn full marks.

4. a) Explain how developing countries can acquire investment funds for development. (10marks)Basic answer: Two basic methods present themselves; domestic funds and foreign funds. Domesticfunds arise from savings while foreign funds are the result of inflows of foreign investment. Variousforms of saving present themselves; simple bank deposits, shares (equity market), bills and bondsissues by both firms and government. Incoming foreign investment entails FDI and portfolioinvestment. There are a number of barriers in developing countries to acquiring investment fundswhich might be commented on.

Possible points:• domestically acquired funds

o increased saving increase in income, for example demand-side policies increase in income, for example supply-side policies

o possibility of issuing bills and bonds (securities)o micro credit schemeso incentives to domestic firms to re-invest

lower corporate taxes tax breaks for re-investment

• funding from abroado attracting FDIo attracting portfolio investmento outward/export orientationo foreign loans — development banks, World Banko aido NGOs

• barriers to acquiring investment fundso reference to poverty cycleo reference to savings gapo increased saving in the economy may have a dampening effect on ADo high debt servicing may lead to lack of fundingo unattractive investment opportunities for foreign firms, i.e. poor infrastructure, non-

convertible currency etco lack of well-functioning banking institutionso large parallel economyo capital flighto lacking property rights and thus collateral for loans

• other issues; reference to Harrod-Domar model

Diagram(-s): Use of AS-AD to illustrate growth.

Note: Award any feasible/relevant example which is clearly linked to investment.

b) Evaluate the role of multinational companies (multinational enterprises) in investment anddevelopment. (15 marks)

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Basic answer: Define multinational companies (MNCs) as companies having production in more thanone country. Define investment (increase in capital stock) and effects on growth and development(increase in standard of living). Some common issues for and against MNCs should be developed andtheir costs/benefits evaluated.

Possible points:• definition of growth; increase in GDP per time period• definition of development; growth and wider spread of income, general increase in standard of

living• positive role of MNCs in development

o a way to fill the savings gap (possible reference to Harrod-Domar model)o both FDI and portfolio investment in fact creates job opportunitieso and increases the capital stock of the countryo increase in AD and thus GDP (HL: possible multiplicative effects)o subsidiary companies generate possible inward flows of profits from abroado it is possible that MNCs transfer not only capital, but also technology, knowledge and

experience to developing countries• negative effects

o inflow of FDI may cause current account deficito not all capital put to use in LDCs is appropriate

highly capital intensive production does not create many jobs capital intensive production does not utilise comparative advantage, i.e.

labour imported capital is often demanding in terms of technological expertise in set

up, maintenance and repairs — such services are often imported from abroado a number of MNCs have been accused of heavily marketing inappropriate productso a goodly proportion of profits might be repatriated abroad and thus not be re-invested

in the local communityo it is possible for MNCs to avoid a proportion of taxes by, for example, internal pricing

of goods within the companyo very large and powerful MNCs might simply use there power as leverage and

bargaining power in land/rent/tax/labour negotiations with firms/unions/governmentsin developing nations

• other possibilities, for example that MNC presence might create the need for functioninginfrastructure/institutions

Diagram(-s): Possibly AS-AD model to show growth due to investment.

Note: Real world examples should merit marks. Answers which do not attempt to assess points shouldnot be able to earn full marks.

5. a) Explain three major barriers to development experienced by developing countries. (10marks)Basic answer: Well, the scope of possible answers here is, em, wide, to say the least. The issue is notto simply list three barriers, but to show and explain how they impact on the development process. Forexample, the poverty cycle of low income low savings low investment low income etc is agood example — as long as the answer shows clearly how these are linked.

Possible points:• poverty cycle• large informal sector, parallel markets• low tax base & ineffective taxation structure and thus low government spending on

infrastructure/public goods/merit goods• dual economy with concomitant issues of large traditional sector, low productivity and

migration to urban areas

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• non-convertible currencies (or over-valued exchange rate) and loss of trade possibilities• international barriers to trade and the effects on AD• large foreign debt (as a ratio to trade for example) and squandered resources on debt servicing• overdependence on primary goods, worsening terms of trade, falling commodity prices,

dependency on international commodity markets• low FDI (due to political instability, corruption, lack of infrastructure etc) which disenables

the LDC to fill the investment gap (S < I)• unequal distribution of income and resulting capital flight• institutional factors such as lack of democracy, poor financial institutions, property rights, rule

of law and how this affects investment and entrepreneurial spirit

Diagram(-s): Trade diagram showing tariffs/quotas; AD-AS model showing how equilibrium incomemight remain below potential; Lorenz curve and Gini-coefficient (HL); investment schedule showingthat keeping interest rates high in order to set exchange rate higher will have a negative effect ondomestic investment.

Note: There are many possibilities here — and most of the variables put forward above are stronglyinterlinked! Higher grades should be reserved for students who clearly show how both economicgrowth and development suffer as a result of barriers put forward.

b) What strategies might developing countries adopt in order to overcome these barriers? (15marks)Basic answer: Again, there are a number of possible approaches to this question. A student might referto each barrier put forward in a) and address each one in turn, or simply address the issue by goingthrough standard development strategies, i.e. Harrod-Domar, export-led growth and so on.

Possible points:• inward oriented strategies; infant industry protection, government planning, national

champions• outward oriented strategies; focus on exports and markets, utilise domestic comparative

advantage (often in labour intensive sectors), in some cases attract FDI, targeting certainsectors and utilising infant industry protection

• market-led strategies; privatisation, increased use of market mechanism in setting prices andoutput etc

• reference to commodity agreements in order for small suppliers in developing countriesdependent on commodity exports to stabilise/increase prices

• Harrod-Domar; increase growth by either increasing savings (and thus investment) and/orincreasing productivity (and thus decreasing the capital-output ratio)

• dual sector model; unlimited labour in traditional sector is a resource in accelerating growthvia the modern (industrial) sector

• various types of aid; can alleviate some of the most immediate problems in infrastructure andpoverty, can direct funds towards socially beneficial projects

• borrowing from international creditors (IMF, World Bank)• micro credit schemes; enable small scale start-up businesses by supplying much-needed

capital to budding entrepreneurs• FDI and multinational companies; can help transfer knowledge/technology, fill domestic

savings gap

Diagram(-s): Trade diagrams showing infant industry barriers to trade; AS-AD model to showincreases in AD/AS due to increased exports/investment etc; (HL) LRAC curve and world supplyshowing how a country might enjoy initial (infant industry) protection enabling the country to gainbenefits of scale

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Note: The answer should address the development barriers rather than simply listing all the possibledevelopment paths. Really good answers will contain an element of discussion on the difficulties inimplementing development strategies — since there are a number of barriers to implementation!

6. a) Explain how a developing country can have growth without development. (10 marks)Basic answer: A good answer will address the issue of growth › development, and that whilecorrelated the one does not necessarily lead to the other.

Possible points:• definition of growth as an increase in GDP (quantitative measurement)• definition of development as a wider measure of standard of living, empowerment and choice

(qualitative measurement)• reference to HDI• growth is an average — distribution of income might actually worsen during high growth• nothing guarantees that increased national income will trickle down to wider segments of

the population (in fact, trickle-down theory has been largely discounted)• population can increase faster than GDP• high inflation might negate any increase in nominal GDP• possibility that the growth is a rebound from a lengthy period of recession• capital flight, corruption and inflated crony government sector would hamper the spread of

increased income to wider circles• poor institutions and government redistribution schemes would negate attempts to increase

wider income distribution• the negative externalities often associated with growth; criminality, environmental

degradation, painful readjustment of employment when structural change takes place• possible restructuring of industries focusing on high productivity in export sector and ensuing

lack of employment opportunities for majority

Diagram(-s): AS-AD diagram to illustrate growth, business cycle to illustrate rebound fromrecessionary period.

Note: Higher marks should be reserved for answers clearly outlining the distinction between growthand development.

b) Evaluate import-substitution as a method of achieving growth and development. (15 marks)Basic answer: The answer should outline the basics of an import-substitution (inward oriented)strategy, while referring to real life examples of such — for example India and China. While the theoryof import-substitution might still have adherents, the reality is that this strategy has been largelyabandoned in favour of export-led growth.

Possible points:• definition of import-substitution as a focus on replacing imports with domestically made

goods• that this often was attempted in countries with large domestic markets• import-substitution often meant extreme trade barriers and a large element of planned

economy, e.g. China and India• that international capital markets were shut off for the domestic economy — i.e. FDI/portfolio

investment and international borrowing was severely limited• such economies frequently allocated huge resources towards state-owned enterprises and/or

heavy subsidies towards national champions• the results of import substitution were for the most part a dismal failure;

o governments have been notably inept in picking winning industries or industrieswhich there is a comparative advantage

o domestic firms lacked competition and produced poor quality goods

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o there were forward linkage effects — high tariffs on imported capital increased costsfor domestic producers

o cronyism and corruption often became commonplace in these protected inner marketso growth was dismal — and often negative in real per capita termso wider development was often held back — there was never a massive decrease in

poverty such as in outward oriented nations

Diagram(-s): Use the trade/tariff diagram showing the effect of a barriers to trade (tariffs andsubsidies) plus the LRAC curve together with the world price (see page 678).

Note: This is a rather tricky question as it requires some degree of historical economic knowledge onthe part of the student in order to evaluate an import substitution strategy. Be prepared to give marksto students who evaluate by comparing the results of import-substitution with the relative success ofexport-oriented policies in Hong Kong, Singapore, Taiwan etc.

7. a) Outline the benefits of increased openness in trade. (10 marks)Basic answer: Narrowly defined, trade openness is lowering trade barriers — facilitating increasedimports — while focusing on international export markets. Benefits include choice/consumption etc forconsumers, while firms have access to a broader (international) market. Society gains from economicgrowth, improved resource allocation and the spread of knowledge/technology.

Possible points:• firms

o specialisation and increased use of comparative advantageo possibility of benefits of scaleo spread and knowledge of technology — production gainso spread of skills and labour capitalo access to new/wider marketso foreign investment via multi-national companies provides capital

• consumerso increased choice, i.e. varietyo lower priceso overall consumer welfare (consumer surplus — outside of syllabus) in lower prices and

increased consumptiono increase in standard of living

• society in generalo political issues; cooperation, peace-dividendo improved global resource allocationo growth via exports

• other points; possible improvement in environment due to better resource allocation,possibilities of growth in developing countries

Diagram(-s): PPFs showing comparative/absolute advantage and increased consumption possibilities(CPF). AS-AD showing growth due to exports.

Note: Good answers can cover a few points in illustrative depth, or more issues in less depth.

b) Critically assess the claim that developing countries will benefit from increased tradeliberalisation. (15 marks)Basic answer: Definition/outline of trade liberalisation — decreased barriers to trade, relaxingrestrictions on foreign exchange (convertibility of currency), allowing market forces to set exchangerate (non-intervention in currency market), openness to international capital, use of market forces.

Possible points:• benefits of increased trade in developing countries

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o has been strongly pro-growth in many cases creates jobs and thus tax bases funnelling resources towards human capital resources towards infrastructure enabled investment in human capital, merit/public goods

o can help a developing country diversify outputo industrialisation might enable

initial focus on relatively simple industrial goods enabled technologicaladvances leading to higher level goods

increased value-added improved productivity

o focus on key growth industries in which comparative advantages existed has beenbroadly successful

Japan in 1950 s and 1960 s, Korea in 1970 s and 1980 so specialisation enables

benefits of scale firms to move along learning curve

o has a self-reinforcing effect — both exports and inward foreign investment fuel growtho broadened production base enabled these economies to move away from commodities

and into higher income elastic goodso strong empirical evidence in favour of trade (e.g. Asian Tigers) as strongly pro-

developmentalo the increase in free trade has improved relations between countries ( peace

dividend ); possibility of reciprocal trade barriers and trade war; declining relations ofnations in trade dispute; there is ample evidence that trade is not a zero sum gameand that jobs are in fact not saved in the LR

• criticism/limits of increased tradeo possibility that initial effects of increased openness to trade are negative

competition with more efficient foreign firms might increase unemployment domestic industries and markets could be overtaken in part by foreign

suppliers infant industry argument — protect fledgling industries, allow them to get up to

scale worsening of current account in balance of payments (HL: reference to

Marshall-Lerner condition and/or J-curve) possible loss of government revenue from tariffs

o many covert barriers still exist in many developing countries (textiles and agriculturalgoods), yet strong pressure from developed countries may force developing countriesnot to do the same

o race to the bottom argument, i.e. that uninhibited globalisation would create acompetition amongst developing countries to have the weakest labour/environment/working environment legislation

o externalities such as pollution and increased income inequalityo dependency on foreign markets and international business cycleo imports of inappropriate/harmful goods

• general results of export orientation

Diagram(-s): Use of trade diagram to illustrate removal of tariffs/quotas. AS-AD model to showeffects on national income of a change in exports and imports.

Note: A couple of weighty arguments and counter-arguments with clear assessment should be able toget full marks.

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8. a) Explain how foreign aid might help in the development process of a developing country. (10marks)Basic answer: Definition/outline of various forms of aid, i.e. donor aid, tied aid, bilateral aid etc.Examples should clearly link aid with development, for example that multilateral aid to developingcountry governments can be used for any number of development issues, such as education and healthcare, infrastructure etc.

Possible points:• definition/outline of aid

o bilateral/multilateralo tied aido donor aid

• benefits of aido enables SR stimulation of an economyo can be vital in providing basic necessities and SR reliefo can help close the savings-investment gapo can help in education and transferral of knowledgeo has been shown to be beneficial in countries with strong institutions and functioning

government/administration• other issues; aid should not only be seen in the line of SR issues but in wider LR issues as well

— development simply does not occur overnight, as seen by the fact that many of the presentOECD countries took centuries of very small steps to where they are now

Diagram(-s): AS-AD model to show effects of increased government spending (infrastructure,merit/public goods) on AD. Possibly a PPF to show increase in potential growth.

Note: Good answers will have clear examples of any given suggestion of how aid can be linked todevelopment.

b) Critically examine the claim that Trade is better than aid in the development process. (15marks)Basic answer: The trade or aid debate implicitly touches upon an outward-oriented growth strategy,which could be defined and outlined. Benefits/weaknesses of both trade and aid might be highlightedbefore examining the merits of each in the light of real world examples.

Possible points:• benefits of aid

o enables SR stimulation of an economyo can be vital in providing basic necessities and SR reliefo can help in education and transferral of knowledgeo has been shown to be beneficial in countries with strong institutions and functioning

government/administration• criticism/limits of aid

o inefficient monies are squandered by inept/corrupt govt capital flight aid does not reach the neediest most of the time poorly planned projects high costs of experts from developed (aiding) country

o aid can knock out local investment and businesseso creates dependency and entrepreneurial lethargy (= laziness)o political aspects

aid may serve to help dictators stay in power aid was often politically motivated during cold war period

• benefits of increased trade in developing countries

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o has been strongly pro-growth in many cases creates jobs and thus tax bases funnelling resources towards human capital resources towards infrastructure enabled investment in human capital, merit/public goods

o can help a developing country diversify outputo industrialisation might enable

initial focus on relatively simple industrial goods enabled technologicaladvances leading to higher level goods

increased value-added improved productivity

o focus on key growth industries in which comparative advantages existed has beenbroadly successful

Japan in 1950 s and 1960 s, Korea in 1970 s and 1980 so specialisation enables

benefits of scale firms to move along learning curve

o has a self-reinforcing effect — both exports and inward foreign investment fuel growtho broadened production base enabled these economies to move away from commodities

and into higher income elastic goodso strong empirical evidence in favour of trade (e.g. Asian Tigers) as strongly pro-

developmentalo the increase in free trade has improved relations between countries ( peace

dividend ); possibility of reciprocal trade barriers and trade war; declining relations ofnations in trade dispute; there is ample evidence that trade is not a zero sum gameand that jobs are in fact not saved in the LR

• criticism/limits of increased tradeo possibility that initial effects of increased openness to trade are negative

competition with more efficient foreign firms might increase unemployment domestic industries and markets could be overtaken in part by foreign

suppliers infant industry argument — protect fledgling industries, allow them to get up to

scale worsening of current account in balance of payments (HL: reference to

Marshall-Lerner condition and/or J-curve) possible loss of government revenue from tariffs

o many covert barriers still exist in many developing countries (textiles and agriculturalgoods), yet strong pressure from developed countries may force developing countriesnot to do the same

o race to the bottom argument, i.e. that uninhibited globalisation would create acompetition amongst developing countries to have the weakest labour/environment/working environment legislation

o externalities such as pollution and increased income inequalityo dependency on foreign markets and international business cycleo imports of inappropriate/harmful goods

• general discussion of aid vs trade; reference to real world examples of successes and failuresof both

Diagram(-s): AS-AD model illustrating the effects of increased exports/imports on national income.The PPF might be used to illustrate development and/or potential growth.

Note: As the list above suggests, this is a very open-ended question, where marks should be awardedto any clear line of argumentation based on core economic reasoning. Real world examples should beamply rewarded.

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9. a) Distinguish between interventionist and market-led strategies of development. (10 marks)Basic answer: Definition of interventionist strategy; heavy government involvement in the planning ofoutput, prices and also limits to free trade (and possible references to notable exceptions — for exampleSingapore). Market-led strategies commonly focus on decreasing/removing barriers and limits on tradeand capital, with non-intervention by government as a guiding general principle.

Possible points:• interventionist strategies may include

o government ownership of industrieso centralised planning of major (key) industrieso frequent use of subsidies targeted at infant-industrieso demand-side policieso other — international —issues could include

infant industry protectionism inward-oriented strategy (import-substitution) tightly controlled exchange rate capital controls limits on FDI

• market-led strategies may includeo privatisation of nationalised industrieso use of market mechanism in setting output and priceso implementation of policies allowing and guaranteeing private property rightso reference to structural adjustment policies at the behest of the IMF/World Bank

reference to the Washington Consensuso international issues

decrease/removal of barriers to trade outward-oriented strategies (export orientation) non-intervention in exchange rates convertibility of currency loosening of capital controls encouragement of foreign direct investment inflows (MNCs)

Diagram(-s):

Note: Real world examples, well used, should render good marks.

b) Evaluate the effectiveness of each approach. (15 marks)Basic answer: Points outlining the successes and failures of each approach should be outlined andevaluated.

Possible points:• in favour of interventionist strategies

o planning often a necessary element in development, due to weak institutions and lackof goods considered missing markets such as education and roads

o possibility of focusing national resources on target areaso issue of sustainability perhaps better addressed by government than private enterprise

externalities such as pollution, deforestation and soil erosion use of limited resources reference to how often oil and mineral deposits are nationalised

o allows for a more equitable distribution of income/wealth• results of interventionist strategies

o generally negative weaknesses of institutions and governments in many cases did not enable

good use of resources government deficits and debt quite often resulted

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poor growth rates were the norm in many countries using mainlyinterventionist strategies

o mentioning the shift from interventionism to market strategies in the 1980 so view of IMF/World Bank (e.g. Washington Consensus)o general results of import-substitution

tariff protection and subsidies created comfort zones for domestic firms tooperate behind

forward linkage effects government decisions as to which industries to sponsor have been notoriously

poor — based, as they frequently were, more on political manifests rather thaneconomic reasoning

few of these chosen industries became winners — and fewer still survivedwhen the step towards open markets was taken

lower consumer welfare — less choice, fewer goods, higher prices general failure of import-substitution real world examples, e.g. China (until 1980 s) and India (until 1990 s) other issues; countries which have implemented export orientation policies

have in some cases had any number of accompanying problems; externalitiesin the form of pollution and environmental degradation, speculative inflows offunds which have fuelled bubble economies, harsh labour policies designed infavour of employees, bans on unions, poor labour rights

• in favour of market-led strategieso clear correlation between market-openness and economic growth in, for example,

China and India in the 1980 s and 1990 so privatisation and individual ownership provides incentives for both entrepreneurship

and efficiency in the economyo general market arguments, i.e. efficiency in production and resource allocationo focus on dealing with fundamental issues of disequilibrium in the economy, such as

inflation and non-convertible currency• results of market-led strategies

o mixed bag here; negative results

• inflation, falling output and unemployment in the CEEFSUeconomies

• debt burden of developing countries which were forced into adoptingstabilisation/structural adjustment policies by, respectively, the IMFand the World Bank

• widening income and wealth gaps in, for example, Argentina andBrazil

• speculative bubbles with near-collapsing economies as a result, SEAand Argentina as examples

positive results• in many cases there has clearly been accelerating economic growth• rising incomes have enabled tax bases and provided governments

with funds for merit and public goods• openness to international capital markets has enabled economies to

fill domestic savings-investment gap• generally, the competitive market orientation of export orientation has

improved resource allocation• real world examples such as China and India

o general results of export orientation focus on key growth industries in which comparative advantages existed has

been broadly successful Japan in 1950 s and 1960 s, Korea in 1970 s and 1980 s specialisation enables benefits of scale

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industrialisation and FDI• initial focus on relatively simple industrial goods enabled

technological advances leading to higher level goods• increased value-added• improved productivity

broadened production base enabled these economies to move away fromcommodities and into higher income elastic goods

high export levels have generated much-needed growth• created jobs• increased tax bases• enabled investment in human capital, merit/public goods

Diagram(-s):

Note: Export-orientation and import-substitution are included in the points above, since such policiesoften went hand-in-glove with, respectively, market led and interventionist policies.

10. a) Examine the role of foreign direct investment (FDI) for developing countries. (10 marks)Basic answer: Definition of foreign direct investment as the direct ownership of capital in anothercountry by a firm — for example establishing a subsidiary production plant abroad. Foreign directinvestment inflows helps developing countries by making accessible capital which might not beavailable domestically, while transferring technology, skills and knowledge.

Possible points:• definition of FDI as direct ownership of capital in another country• possible influences on AD of inward FDI

o increased capital base increased output potentialo reference to savings-investment gapo income from sales and increased exportso multiplicative effects (HL)

• other possibilitieso decrease in unemploymento wider tax base in the economyo re-investment by foreign firmso transferral of skills, knowledge and technology to recipient developing country

• reference to Harrod-Domar model• note that it is possible that there are FDI outflows too — creating a future stream of repatriated

profits (reference to GNP)

Diagram(-s):

Note: A wider range of answers is possible — but note that the question does not deal with positiveand negative effects of FDI .

b) Evaluate whether foreign direct investment is more important than aid in attaininggrowth/development. (15 marks)Basic answer: Define/outline aid; donor aid, tied aid, multilateral aid etc. The evaluation might buildon any number of points outlining the relative successes/failures of FDI and aid.

Possible points:• definition of aid, i.e. donor aid, tied aid etc• assessment of aid

o positive aspects enables SR stimulation of an economy can be vital in providing basic necessities and SR relief

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can help in education and transferral of knowledge has been shown to be beneficial in countries with strong institutions and

functioning government/administrationo negative aspects

inefficient• monies are squandered by inept/corrupt govt• capital flight• aid does not reach the neediest most of the time• poorly planned projects• high costs of experts from developed (aiding) country

aid can knock out local investment and businesses creates dependency and entrepreneurial lethargy (= laziness) political aspects

• aid may serve to help dictators stay in power• aid was often politically motivated during cold war period

• assessment of FDIo positive aspects

a way to fill the savings gap (possible reference to Harrod-Domar model) both FDI and portfolio investment in fact create job opportunities and increases the capital stock of the country increase in AD and thus GDP (HL: possible multiplicative effects) subsidiary companies generate possible inward flows of profits from abroad it is possible that MNCs transfer not only capital, but also technology,

knowledge and experience to developing countrieso negative aspects

inflow of FDI may cause current account deficit not all capital put to use in LDCs is appropriate

• highly capital intensive production does not create many jobs• capital intensive production does not utilise comparative advantage,

i.e. labour• imported capital is often demanding in terms of technological

expertise in set up, maintenance and repairs — such services are oftenimported from abroad

o a number of MNCs have been accused of heavily marketing inappropriate productso a goodly proportion of profits might be repatriated abroad and thus not be re-invested

in the local communityo it is possible for MNCs to avoid a proportion of taxes by, for example, internal pricing

of goods within the companyo very large and powerful MNCs might simply use there power as leverage and

bargaining power in land/rent/tax/labour negotiations with firms/unions/governmentsin developing nations

• other possibilities, for example that MNC presence might create the need for functioninginfrastructure/institutions, real world examples of countries which have shown strong/growthdevelopment due — or in spite of — aid

Diagram(-s):

Note: Good answers can land anywhere between a definite statement ( thus, aid is in factinferior ) to answers which allow for the vagaries often found in the real world ( so, it dependson the situation and the type of FDI/aid ).

2005 Copyright 'IBID Press, Victoria & McGee, M.