SERANGOON JUNIOR COLLEGE

1

SERANGOON JUNIOR COLLEGE

JC2 H2 ECONOMICS PRELIMINARY EXAMINATION 10

PAPER 21Assess the usefulness of price elasticity of demand, income elasticity of demand and price elasticity of supply to a government in formulating microeconomic policies. [25]

ANSWER OUTLINE

Intro Aim of microeconomic policies: To achieve efficiency in resource allocation and equity in income distribution.

Overview of uses of different elasticities concepts in formulating microeconomic policies:

(i) Ensure economic efficiency: e.g. PED can be used to measure how much taxes and subsidies should be imposed in order to reallocate resources to achieve social efficiency OR encourage/discourage consumption/production

(ii) Income effects on different groups within the society (producers or consumers of different goods/services) as well as impact on price stability.

(a) Explain concepts of PED, YED and PES concepts(i) PED concept

Price elasticity of demand is the degree of responsiveness of quantity demanded of a good to a change in the price of the good itself, ceteris paribus.

The sign of price elasticity of demand is negative.

For goods whereby PED value is less than one: Demand for a good is said to be price inelastic when a change in the price of a good leads to a less than proportionate change in quantity demanded for the good, ceteris paribus. For goods whereby PED value is more than one: Demand for a good is said to be price elastic when a change in the price of a good leads to a more than proportionate change in quantity demanded for the good, ceteris paribus.(ii) YED concept

Income elasticity of demand (Ey) measures the degree of responsiveness of demand to changes in the income of consumers, ceteris paribus.

A good that has positive income elasticity of demand is one in which the demand for the good rises when the income rises and falls when income falls, ceteris paribus. Such goods are known as normal goods.

For goods whereby demand is income inelastic (0 < Ey < 1): This is where a change in consumers income leads to a less than proportionate change in the demand for the good, ceteris paribus. An example of good with income inelastic demand is necessities. For goods whereby demand is income elastic (Ey > 1): This is where a change in consumers income leads to a more than proportionate change in the demand for the good, ceteris paribus. An example of this would be luxury goods. Luxuries are items we can manage to do without during periods of below average income and falling consumer confidence. When incomes are rising strongly and consumers have the confidence to go ahead with big-ticket items, the demand for luxury goods will rise.more than proportionately. A good that has negative income elasticity of demand is one in which the demand for the good falls when the income rises and rises when income falls, ceteris paribus. Such goods are known as inferior goods.

(iii) PES concept

Price elasticity of supply is the degree of responsiveness of quantity supplied of a good to a change in the price of the good itself, ceteris paribus.

Supply curves are upward sloping. Thus the sign of price elasticity of supply is positive.

For goods whereby supply is price inelastic (0 < Es < 1): When the supply of a good is price inelastic, a change in the price of the good will cause a less than proportionate change in the quantity supplied of the good, ceteris paribus. For goods whereby supply is price elastic (1 < Es < (): When the supply of a good is price elastic, a change in the price of the good will cause a more than proportionate change in the quantity supplied of the good, ceteris paribus. (b) Assess the usefulness of PED, YED, XED and PES concepts

(1) Knowledge of PED and PES concepts in implementing price controls (explain either case of price ceiling or price floor)

The market forces of demand and supply determine the equilibrium price and output produced. In some cases, the equilibrium price may be too high or too low or it may fluctuate widely such that it leads to undesirable effects on the economy. E.g. loss of consumer welfare when prices are too high

As such, the government may intervene in the market by imposing price controls (i.e. ignore market prices totally) or manipulate prices (increase or reduce the price of the good).

Price ceiling

Objectives of price ceiling: To keep the prices of some goods, like essential foodstuff, at affordable levels, prevent suppliers from exploiting consumers by charging exorbitant prices in times of shortage or restrict or discourage production of the good, thereby freeing some resources for other uses. A price ceiling is a legally established maximum price. When a price ceiling is imposed, firms are only permitted to sell at or below this upper limit. A price ceiling is effective only if it is set below the equilibrium price. If a price ceiling is set above the equilibrium price, then there will be no effect on price or quantity traded.

There is a shortage of Q2Q1 at the price ceiling imposed as the quantity demanded is 0Q2 but the quantity supplied is only 0Q1. This shortage will persist because the market is prevented from readjusting itself. The relative size of the shortage depends on the price elasticities of demand and supply. The more price elastic the demand and supply, the greater is the resultant shortage.Fig 2: Price Ceiling The shortage of the good may lead to black markets. In the black market, goods are sold illegally at prices that are above the ceiling price. It exists because unsatisfied buyers are willing to pay higher prices to get the good. Also, profits can be made by those who buy at the controlled price and later resell them at a higher price in the black market.

Implications on government policy:

With knowledge of the price elasticity of demand and supply of the goods that the government may plan to impose a price ceiling on, it can have an estimate of the extent of the resultant shortage so as to better deal with the problems that may arise.(i) Alternative measures to alleviate the shortage:

With a larger extent of shortage in the market, the government needs to be prepared with clear measures to allocate the amount of goods in the market more equitably, for example through rationing methods. The government can distribute sufficient coupons to match the available supply. These coupons may be distributed equitably among the population according to age, family income, family size or any other criterion.(2) Knowledge of PED concepts in implementation of taxes or subsidies (explain one case will do)

Tax To discourage consumption of socially undesirable goods

Analysis of how taxes discourage consumption of socially undesirable goods like cigarettes:

Imposition of taxes ( ( COP of cigarettes ( (expected profits ( (SS ( (price of cigarettes ( (QDD of cigarettes

Assess usefulness of PED in implementing microeconomic policies like taxes to improve efficiency in resource allocation:

The use of a tax to discourage consumption of socially undesirable goods will be more successful the greater the price elasticity of demand. If demand for the good is price elastic, a small amount of tax per unit would be sufficient to reduce consumption significantly.

For example, as seen from Figure 1, for a given amount of tax (P1-P2), for goods whereby demand is relatively price elastic, there will be a significant fall in quantity demanded from Q0 to Q1.

Implications on government policy:

(i) If the demand for the good is price inelastic for example due to habit-forming nature as shown in Figure 1, as in the case of cigarettes and alcohol, a given amount of taxes will only reduce quantity demanded less than proportionately from Q0 to Q1. Hence for goods whereby demand is price inelastic, even a large amount of tax may not reduce the quantity demanded very much. Thus if demand for a good is price inelastic, it might be necessary to impose a very high tax in order to reduce consumption to the desired level. Alternatively, to discourage consumption of such goods, the government may not be able to rely on the imposition of taxes to reduce the consumption of such national campaigns can be adopted. It may even be necessary to impose legislation or ban the sale of the good.

(ii) On top of that, if the demand for the good is price inelastic, the amount of tax revenue collected will be larger for the government and government can use it to finance other projects to reduce the consumption of such demerit goods for e.g. to finance national campaigns to discourage smoking.

(3) Knowledge of YED concepts in implementation of policies:

Knowledge of YED concept will also guide the government in planning their expenditure on social goods and services. The government would be able to provide more and better social and community services to meet the increasing demand of the public.

For example, as the national income of the country increases, people would demand better recreational amenities, medical care and educational facilities as these are goods with high positive income elasticity. Therefore, knowledge of income elasticity enables the government to identify the areas in which it should increase its spending.

(i) Evaluate the limitations of these concepts

Accuracy and Reliability of the Data

In addition, the data collected for elasticity of demand may not be accurate due to changes in consumers tastes and preferences over time or changes in the types of goods available in the market (e.g. new products). There could also be difficulty in collecting data or the sample size taken may be too small to reflect the actual elasticity values. There may be a time-lag between the collation of the data and the actual implementation of the appropriate measures. By the time, the measures are implemented, the values may have changed. This may render these measures ineffective.

Conclusion

The price elasticities of demand and supply will affect the extent in which price and output will change in a market. And elasticity is also significant in determining some of the effects of changes in government policy when the state chooses to intervene in the price mechanism.

Levels Marking Scheme

L520-25 The answer is relevant to question and theory is fully explained

Competent analysis of 3 microeconomic policies with use of all elasticity concepts but analysis may not be consistently thorough throughout essay Detailed discussion of measures that is well-supported by diagrams

Good evidence of highlighting unstated assumptions that is supported by analysis

Good ability to discriminate & form elementary judgements

L415-19 The answer is relevant to question but theory is adequately explained

Relatively competent analysis of 2 microeconomic policies with use of elasticity concepts but analysis may not be consistently thorough throughout essay Detailed discussion of measures that is well-supported by diagrams

Good evidence of highlighting unstated assumptions, but not supported by analysis

Some ability to discriminate & form elementary judgements

L312-14 The answer has more relevance to question but theory is not fully explained.

Relatively competent analysis of 1 microeconomic policy with use of elasticity concepts Some use of diagrams in explanation

Some evidence of highlighting unstated assumptions, but not supported by analysis

Limited ability to discriminate & form elementary judgements

L210-11 Accurate but undeveloped explanation of facts related to question and theory.

Logical explanation not clear

No use of diagrams to illustrate explanations

Not much evidence of highlighting unstated assumptions

L11-9 Poor understanding of question requirements

Mere regurgitation of lesson notes on 3 concepts of elasticity

Glaring conceptual flaws is evident

2Barriers to entry is the only factor influencing a firms pricing strategy and it would always lead to inefficiency. Discuss.

[25]Introduction:

Barriers to entry are obstacles that prevent new rival firms from entering the industry and eroding the incumbents profits. They may be either natural or created. They form the basis of monopoly power. The barriers can be classified as economic and institutional barriers. Besides influencing a firms pricing strategy, barriers of entry also have an impact on efficiency.

Body:

In an industry with high barriers to entry, the firm would have some market power. As a result, there would be an imperfect market structure, for example a monopoly. In this case, the firms profit-maximising pricing strategy can be illustrated below.

The firms profit-maximising output is 0Q1 where MC=MR and MC is rising. At output 0Q1, the equilibrium price is 0P1. At output 0Q1, the total revenue is 0P1GQ1 and the total cost is 0HFQ1. Hence, the firm makes a supernormal profit of HP1GF. In this case, the firms pricing strategy is to charge a price of 0P1, so as to make supernormal profits. In the long run, the firm could continue to charge the same price as it would be able to make supernormal profits due to the presence of high barriers to entry that deter new firms from entering the industry.

For example, in a perfectly competitive industry where there is no barrier to entry, a firm does not set its own price and follows the market price instead. Suppose the market price is 0P. The firms profit is maximised when output is 0Q units where MC=MR and MC is rising. At this equilibrium output, total revenue is given by the area 0PEQ. Total cost is the area 0CDQ. Here, total revenue exceeds total cost by EPCD. The area EPCD thus represents supernormal profit.

When the firms are making supernormal profit, new firms would also be attracted to enter the industry. As there are no barriers to entry, new firms can enter the industry with ease. As a result, the market supply increases, leading to a fall in the market price of the good. Hence, as the AR falls, the supernormal profit earned by the firms will fall until all the firms are producing at the minimum long run average cost curve and earning normal profit. This is the equilibrium point E1.When all firms make normal profit, there is no more incentive for new firms to enter the industry. The number of firms stabilises. Price charged by the firms also stabilises as firms are producing at the profit-maximising level of output where MC=MR and AR=AC.

In an oligopoly, the mutual interdependence among firms influences a firms pricing strategy. By this, we mean that each firm is aware that demand for its good depends not only on its own actions, but also those of its rivals. Here we assume that there is no collusion among the firms, i.e. firms compete with one another. In addition, the rivals will follow price cuts but not price increases initiated by a firm.

If one firm reduces its price, the others will react by cutting their prices too. Thus, if the firm reduces its price, there will be a less than proportionate increase in quantity demanded for its goods. Hence, its total revenue will fall. Conversely, if the same oligopoly firm raises its price, its rivals will not follow suit. Thus there will be a more than proportionate decrease in quantity demanded of its good. Hence, its total revenue will fall. So, each firm must consider the reactions of its rivals when formulating its pricing strategy.

When there is the threat of another firm replacing the incumbent through the invention of new products or new production techniques, i.e. creative destruction which is a term coined by Joseph Schumpeter, the existing firm could adopt limit pricing. In this pricing strategy, the incumbent might choose to set a price that does not maximise short-run profits. This price may well be below the firms short-run profit-maximising price, but the incumbent does so to deter new firms, which may be discouraged by the prospects of making losses, from entering the industry.Besides having an important role in shaping a firms pricing strategy, barriers to entry also have an impact on efficiency. Economic efficiency in the allocation of scarce resources is achieved if it is not possible to change the existing resource allocation to make someone better off without making someone else worse off. Essentially, it means that resources must be allocated such that the right type and right amount of goods and services are produced at the lowest possible cost. That is, the production of goods and services are both allocatively and productively efficient.The monopolist, by virtue of having a high degree of market control, can restrict his output and charge a higher price for his product than the perfectly competitive industry.

Given his profit-maximising motive, the monopolist will produce where MC=MR. At this output, 0Qm, the price charged by the firm is higher than his marginal cost of production (P>MC). It means that society values the last unit of good more than the alternative goods forgone (i.e. opportunity cost). This means that not enough of the good is being produced. This represents a misallocation of resources or allocative inefficiency and societys welfare is not maximised. Societys welfare can thus be improved by allocating more resources to produce this good up to quantity 0Qc where P=MC. Hence, allocative efficiency is attained in a perfectly competitive industry in which there are no barriers to entry.The dominant firm may incur higher costs of production due to X-inefficiency, a term coined by Professor Harvey Libenstein. With high barriers to entry, there is no competitive pressure on profits. Thus, cost control can become lax. There may be overstaffing and less effort to keep technology up-to-date, hence resulting in higher average cost of production than it would otherwise be. In this case, the firm would be producing at a point above its LRAC curve. Hence, productive inefficiency arises.There is a lack of incentive for the dominant firm, e.g. monopolist, to innovate and undertake research and development. This is because of the complacency brought about by the absence of competition as the monopolist is protected by high barriers to entry. In such a case, consumers may be faced with a limited variety of goods and hence less choice for the consumers.

A firm is said to be productively efficient if it produces at the lowest average cost possible for a given level of output. As long as the firm aims to maximise profits, it would have the incentive to adopt the least-cost method of production so as to keep unit cost the lowest at that equilibrium output level. Hence, it would produce at a point on its LRAC curve. In this light, even if there barriers to entry, the firm could still be productively efficient. A monopolist has the incentive to invest in large-scale research and development (R&D) programmes for his product. This is because firstly, he is likely to have the funds due to his ability to earn supernormal profits in the long run, which is a result of the high barriers of entry that prevent the erosion of profits. Secondly, there is always the threat of another firm replacing the monopoly through the invention of new products or new production techniques, i.e. creative destruction.

Conclusion:

There are different factors that influence a firms pricing strategy, of which barriers to entry is only one of them. The firm should also consider its rivals reaction before implementing any pricing strategy. Additionally, barriers to entry may not always lead to inefficiency. While allocative inefficiency may be inevitable in an industry with barriers to entry, a more holistic assessment of efficiency is needed before it can be concluded that barriers to entry lead to inefficiency.

Marking scheme:

L520-25 Good understanding of question requirements with a very clear attempt to discuss both aspects of the question

Discussion of the role of barriers to entry in influencing pricing strategy and causing inefficiency is well-supported by rigorous economic analysis (including diagrams)

Informed conclusion is provided

L415-19 Provide sufficient analysis in discussing how barriers to entry can influence pricing strategy and cause inefficiency e.g. diagram(s) is drawn and explained

For higher band in this level (i.e. 18m and above), students should be able to link arguments to barriers to entry influencing/not influencing a firms pricing strategy and to barriers to entry leading/not leading to inefficiency

L312-14 Show some understanding of how barriers to entry can influence a firms pricing strategy and how barriers to entry can lead to inefficiency

L210-11 Show some understanding of how barriers to entry can influence a firms pricing strategy or how barriers to entry can lead to inefficiency

L11-9 Mere regurgitation of lesson notes on barriers to entry with weak application to pricing strategy and inefficiency

Glaring conceptual flaws are evident

3(a)Explain how public goods and merit goods cause markets to fail.

[10]

(b)Consider whether market-based solutions are the best way for the Singapore

government to correct market failure that results from the existence of a

negative externality.

[15]

Part (a)

Introduction:

Market failure refers to a situation where resource allocation concerning what, how, how much and for whom to produce using the market mechanism fails to achieve efficiency in the allocation of scarce resources and equity among the various income groups.Body:

One area in which the market fails to perform adequately is in the provision of public goods. In fact, the market completely fails to provide any amount of these goods at all. This complete market failure is explained by the two key characteristics of non-rivalry and non-excludability in the consumption of public goods. A good is non-rival in consumption if one persons consumption of the good does not reduce the quantity available to another person. Because of this, once a public good is provided, the marginal cost of providing the good to an additional user is zero.

With zero marginal cost, the basic principle of optimal resource allocation calls for provision of public goods and services at zero price or no charge. However, if the price is zero, no firm would want to supply the good. Hence, there is market failure.

A good is non-excludable in consumption if it is difficult to exclude non-payers from enjoying the good. This gives rise to a free rider problem. Since non-payers can also enjoy the good, no one would be willing to pay for it. As a result, demand is concealed and difficult to estimate.

Because of non-rivalry and non-excludability in consumption, it is not only often impossible to charge a market price for a public good, it is often undesirable to do so as well.

A public good is also indivisible, that is, it cannot be produced or sold easily in small units. It satisfies collective wants.

Given all these characteristics, the private producer who is motivated by profits will not be keen to produce the good at all. Public goods are goods which are valuable socially but whose provision would not be undertaken by private enterprise.

Another area in which the market fails to perform adequately is in the provision of merit goods, e.g. education and healthcare such as the H1N1 flu vaccine. Marginal private benefit (MPB) is the benefit derived from the consumption of an additional unit of H1N1 flu vaccine. Marginal private cost (MPC) is the cost of consuming an additional unit of vaccine. Marginal external benefit (MEB) is the benefit conferred to third party who is not directly involved in the consumption or production of the vaccine.

Because of MEB, there is a divergence between MSB and MPB by the full extent of the MEB.

Because individuals only consider their own private benefits and costs, the private equilibrium level of healthcare services consumed occurs at MPB=MPC, i.e. Qm. When the true benefits and costs of consuming healthcare are taken into account, the social equilibrium occurs at MSB=MSC, i.e. Qs.

Since Qm is less than Qs, there is underconsumption of healthcare services.

Between Qm and Qs, for every additional unit of healthcare service consumed, it adds more to social benefit than to social cost. Hence, there is a net benefit that is not enjoyed by society since only Qm level of healthcare service is consumed. This loss of net benefit is known as deadweight loss and is denoted by area ABC. Conclusion:

Market failure arises when provision of public goods and merit goods are left solely to the private sector. While the latter would underproduce merit goods, there will be no provision of public goods if resource allocation is left solely to the market forces of demand and supply.

Marking scheme:

L37-10 Detailed explanation of both types of market failure with good use of examples.

L25-6 Some explanation of how public goods and merit goods cause markets to fail

L11-4 Poor understanding of market failures is evident

Glaring conceptual flaws are evident

Part (b)Introduction:

Negative externality is the cost incurred by a third party, who is someone who is not directly involved in the consumption or production of the good, for which there is no compensation. Market-based solutions are measures that reduce the consumption or production of the good by influencing the market forces of demand and supply. These solutions include Pigovian taxes and tradable pollution permits.

Body:

Assume the case of traffic congestion. The private benefit is the ease and comfort and convenience of travelling in private transport. The private cost is the cost incurred by the private motorist, e.g. cost of car and petrol, maintenance costs etc. The external cost is cost to the third party who is not directly involved in the production or consumption of the good. This may be medical costs incurred by the other road users such as pedestrians who breathe in the polluted air and the loss of output suffered by firms due to traffic congestion. Assume that the marginal private benefit is also the true benefit or marginal social benefit.

The MPC curve shows the additional cost incurred by the private motorists in the consumption of cars. Marginal social cost is the sum of marginal private cost and marginal external cost. In the case of goods with negative externalities, the total opportunity cost to society is greater than the private cost. Thus MSC is greater than MPC and the MSC curve is above the MPC curve.

The market equilibrium is determined by private benefit and cost considerations only or demand and supply. Hence, the private equilibrium number of car journeys occurs at 0Qm where MPB is equal to MPC. The social optimum level of output is attained by taking into account all costs and benefits of the good to the society. Hence, it is the level of output where the cost of consuming the last unit of output (MSC) is equal to the benefit derived from that unit consumed (MSB). This gives us an output of 0Qs.

Thus, the equilibrium output as determined by the price mechanism is greater than the social optimum level of output bringing about an over-consumption of cars by QmQs.

The above illustrates a situation in which there is a negative externality in consumption. A similar analysis could be applied to a situation in which a negative externality in production exists.

The government could impose a tax, which is known as a Pigovian tax, on consumption of cars equal to the marginal external cost. A tax on consumption of cars, such as road taxes, has the same effect as an increase in the price of a car journey. The tax shifts the marginal private cost curve vertically upwards by the full amount of the tax.

If the tax is calculated to reflect accurately the marginal external cost the firm inflicts on a third party, the car user is then said to internalise the external cost. The resulting higher cost now induces him to reduce consumption to an amount equal to OQs, which is the socially optimum output level where MSB=MSC. The welfare loss arising from overconsumption is thus eliminated.

Tradable pollution permits are rights to firms to buy or sell pollution in artificially created markets. Firms can thus bid for a permit that allows them to create a fixed amount of pollution. The government can gradually reduce the number of pollution permits available so that total pollution emissions can be controlled. Tradable permits have been tried in several countries, including Singapore where an auction mechanism has been introduced for the trading of ozone-depleting substances.

In due course, when the government reduces the number of pollution limits, the total amount of pollution allowed can be reduced. This will make the permits more valuable, and thus more advantageous to firms that can reduce pollution levels at the lowest marginal costs.

Many economists favour the market-based solution to correct externalities because they still allow the market to operate. Hence, consumer sovereignty is protected. They are also fair because they force the responsible parties to take on board the full social costs of their actions. In particular for taxes, by taxing firms for polluting, producers may be encouraged to find cleaner ways of producing a good. The tax thus acts as an incentive over the long run to reduce pollution: the more a firm can reduce pollution, the more taxes it can save. In the case of pollution permits, it is difficult to ascertain the permitted level of production. If they are based on current production levels, there may be no advantage for firms that have already taken steps to control their pollution emissions. For taxes, the damage from pollution is extremely difficult to assess. It is also difficult to apportion blame. An overestimation or underestimation of the size of the external cost would lead to over-taxing or under-taxing. This means that a less than or more than social optimum level of output is consumed. As a result, government failure would arise.There are stipulated bus lanes at certain times of the day. This is done to ensure that the passengers of buses can get to their destinations on time. This would increase the attractiveness of using public transport and hence reduce the demand for private cars during peak hours since both modes of transportation are seen as substitutes. Furthermore, industries sited near urban areas are required to use fuel with lower sulphur content.

Rules and regulation are simple and clear to understand and are often relatively easy to administer. Inspectors or the police can conduct spot checks to see that the law is being obeyed. However, if a firm is required by law to maintain pollution at a certain level, there would be no incentive for the firm to reduce the pollution below the stated level. With a tax on the pollutant, however, the more the firm reduces the effluent, the less tax it would pay. Thus, with a system of taxes there is a continuing incentive to reduce pollution.

Conclusion:

Market-based solutions and other measures are adopted by the Singapore government to correct market failure that results from the existence of a negative externality. There appears to be no one best way to correct this market failure. As a matter of fact, both market-based solutions and rules and regulation for example complement each other in correcting the market failure that results from the existence of a negative externality.Marking Scheme:

L412-15 Detailed explanation of how negative externality causes market failure and competent discussion of at least one market-based solution and one non-market-based solution to correct said market failure are evident

Analysis shows good application to the Singapore context

L39-11 Some detailed explanation of how negative externality causes market failure and good discussion of at least one market-based solution and one non-market-based solution to correct said market failure are evident

Examples relevant to Singapore are evident

Analysis is not consistently rigorous

L27-8 Some explanation of how negative externality causes market failure and some discussion of solutions to correct said market failure are evident

Examples pertaining to Singapore are largely not evident

L11-6 Explanation of negative externality and solutions to correct market failure is smattering

Glaring conceptual errors are evident.

4Labour productivity in Singapore has fallen by 3.9% in 2009.

(a)Analyse the possible macroeconomic outcomes of falling labour productivity. [10]

(b)Discuss the view that supply-side policies are more effective than demand- management policies to achieve full employment in an economy. [15]

PART A

Answer Outline

INTRO

Explanation of labour productivity:

Labour productivity is the ability to create goods and services from a given amount of output and is typically measured as output per unit of labour input. The main drivers of labour productivity are skills, innovation and investment.

Provide an overview of macroeconomic objectives / Provide a link between falling labour productivity with that of macroeconomic objectives:

The main macroeconomic objectives that a government have are sustained economic growth, price stability, low unemployment & healthy BOP. With falling labour productivity, there is an adverse impact on the macroeconomic outcomes for an economy.

BODY

Assuming firms employ the same number of workers, if labour productivity falls ( each worker producing less ( (AC of production ( (AS

With the above (AS, this will lead to a shortage of goods and services at original price P0 whereby output demanded exceeds output supplied. There will be an upward pressure on prices within the economy. Consumers will respond to the higher prices by decreasing the output demanded. Firms will respond to higher prices by increasing output supplied. This process of adjustment will continue until a new equilibrium is reached at a higher general price level. Hence, leading to a rise in inflation from P0 to P1 and a fall in NY from Y0 to Y1 leading to a fall in actual growth. Full employment level of the economy will also fall from Yf0 to Yf1 due to the fall in labour productivity.

in labour productivity ( in efficiency in producing goods and services ( ceteris paribus, this leads to a in unit labour costs ( SS ( prices of goods quantity demanded of goods revenue and expected profits production by firms demand for factors of production like labour ( firms retrench workers unemployment

With a fall in labour productivity ( rise in unit labour costs prices of goods including price of exports ( Assume PEDx>1 ( more than proportionate fall in QDDx ( (TRx. On the other hand, imports are relatively cheaper due to in domestic inflation in Singapore ( in DDm ( TEm. Hence, worsening of current account

With worsening current account, a fall in labour productivity would lead to a deterioration of a countrys balance of payments.

CONCLUSION

For economies like Singapore which only has a small pool of labour as the main resource, labour productivity is an area that needs to be monitored closely at all times. This is because a fall in labour productivity can have significant adverse impact on the macroeconomic objectives of Singapore. LevelMarksDescriptors

L37 -10Clear and thorough explanation of how falling productivity can lead to impact on 3 macroeconomic outcomes. Reference to AD/AS diagram is clearly made and explained.

A considered introduction or conclusion is also observed.

L25-6Clear explanation of how falling labour productivity can lead to impact on 2 macroeconomic outcomes (e.g. rise in inflation and fall in economic growth)

Diagram may not be clearly explained or impact on 3rd macroeconomic outcome is not clearly explained. Some gaps in analysis.

L11-4Smattering of points with vague understanding of how a fall in labour productivity affects macroeconomic outcomes. Conceptual error/s evident.

PART B

INTRO

Unemployment is a main concern from the societys point of view. This is in view of the many costs it brings like output loss to the economy and revenue loss to the government. There are many policies that governments can use to achieve full-employment, namely demand-management policies like fiscal and exchange rate policies, as well as supply-side policies. Usually a mixture of policies is needed because different policies are targeted at specific types of unemployment. BODY

Supply-side policies ensure that our workers are constantly equipped with the necessary skills for the knowledge-based economy so as to raise labour productivity. This will in turn increase efficiency and reduce cost of production( (AS ( (GPL

6 years compulsory education to ensure that we have a ready pool of workforce with basic literacy skills so as to raise labour productivity. This will in turn increase efficiency and reduce cost of production ( (AS ( (GPL

Through education, training and retraining, this can ensure an increase in labour productivity & employability of workers such that they acquire new skills that are relevant to a rapidly changing economy, thus reducing structural unemployment.

Evaluation:

1. Takes long time to produce results because time is needed to train workers. Firms may not want to spend workers for training as there will be loss of output during training. Workers face difficulties in learning new skills especially the elderly.

Analysis of expansionary fiscal policy:

(G on final gds/svcs such as building infrastructure, spending on education and healthcare ( In Spore, (G is done through speeding up spending in projects such as public housing and lift upgrading. In addition, they also give payments (eg: Workfare Income Supplement Scheme) to increase disposable income so as to (C ( (AD

Government can also ( taxes to (AD. By ( personal income tax like in Singapore ( (Yd ( (C ( (AD. Also, (corporate income tax ( ( post-tax profits ( more funds for investment ( (I ( (AD

The (AD ( shortage of goods and services ( incentive for firms to increase production ( ( demand for factors of production like labour ( multiple (national output, NY and employment, thus reducing cyclical unemployment.

Evaluation:

1. Effectiveness depends on size of K. Spores K is small due to high MPW arising from high MPS and MPM.

The high MPS arises from compulsory savings through CPF contribution. In addition, households save another proportion for precautionary and other purposes.

The high MPM is due to Spores limited resources. Hence, we import virtually all final gds/svcs and raw materials.

Hence, expansionary FP is ineffective to stimulate growth and employment because with small K, the final (NY is limited. Therefore, govt may have to spend even more or reduce tax further in order to achieve the desired outcome.

Analysis of exchange rate policy:

Government may allow the currency to depreciate. When domestic currency depreciates,

(P exports in foreign currency. If DDx is price elastic ( more than proportionate ( quantity demanded of exports ( (TRx

At the same time, there is an (P imports in domestic currency. If DDm is price elastic ( more than proportionate ( quantity demanded of imports ( (TEm

Consequently, there is (TRx and (TEm ( ( net exports ( (AD

As long as Marshall-Lerner condition is met (sum of PEDx and PEDm > 1), depreciation would lead to ( net exports ( (AD

The (AD ( shortage of goods and services ( (P ( incentive for firms to increase production ( ( demand for factors of production like labour ( multiple (national output, NY and employment

Evaluation:

1. This policy of (AD to promote employment is certainly effective for trade-reliant economies like Singapore.Conclusion

During stable periods of economic growth, most countries like Singapore which is reliant on its labour pool to sustain economic growth and achieve full employment would definitely engage in supply-side policies. This is especially so in view of the increasing interconnectedness of the global economy with globalisation. LevelMarksDescriptors

L412-15 Detailed explanation and evaluation in terms of effectiveness and desirability of at least 3 policies (SR and LR) with the use of AD/AS framework, adopted by a government to achieve full employment.

Evaluation is thorough and based on sound economic analysis.

Clear response to question requirements to compare the effectiveness of supply-side and demand-management policies to achieve full employment

L39-11 Adequate explanation and evaluation in terms of effectiveness and desirability of at least 3 policies (SR and LR) with the use of AD/AS framework, adopted by a government to achieve full employment.

Evaluation is largely thorough and based on sound economic analysis.

Some response to question requirements to compare the effectiveness of supply-side and demand-management policies to achieve full employment.

L27-8 Some explanation and evaluation in terms of effectiveness and desirability of at least 2 policies with the use of AD/AS framework, adopted by a government to achieve full employment. Some conceptual errors or gaps in analysis.

Evaluation may not be consistent for all policies discussed.

L11-6 For an answer that shows some superficial knowledge of the economic policies adopted by a government to achieve full employment. Conceptual error/s evident.

Little or no evaluation of the policies mentioned.

5(a)Explain why governments should be concerned about a fall in real GDP. [10](b)To achieve high and sustained growth, low inflation is an essential condition. Hence, its attainment should be the main aim of government economic policy. Discuss.

[15]Part (a)Introduction Define real GDP: GDP refers to the value of final goods and services produced in the country over a period of time. It is in real terms because the value has been adjusted for inflation.

Explain the meaning of fall in real GDP:

fall in real GDP means the country produces less goods and services. It implies a fall in the level of economic activity.

BodyGovernments should be concerned with a fall in real GDP, esp. if it occurs for a prolonged period of time for a few reasons:

a. Fall in real GDP will lower the standard of living of the people.

Standard of living refers to the material and non-material welfare of the people. Real GDP per capita is a very reliable single indicator that reflects the standard of living.

Fall in real GDP means that national income increases. Ceteris paribus, this means that peoples purchasing power has decreased. Hence, they are not able to buy as much as before, leading to a fall in their standard of living.

b. Lower level of economic development

Fall in real GDP fall in real incomes (personal incomes and profits) govt tax revenues less funds for expenditure on infrastructure e.g. roads, hospitals, schools hinder economic development.

c. Lowers the level of confidence in the economy

If a country experienced a fall in real GDP for a prolonged period of time, this can erode consumer and investor confidence. The fall in confidence level due to fall in expectations of future profits investment and capital flight.

d. Fall in real GDP can lead to social instability. This is due to the fact the fall in real GDP usually occurs with rise in unemployment. In such a situation, firms usually retrench workers due to fall in production. The rise in unemployment can contribute to more petty crimes and also rise in social discontent which can disturb the social stability of the country.

L37 10Thorough analysis of the consequences of fall in real GDP through different aspects. Covers at least 3 aspects.

L25 6Adequate analysis of consequences of fall in real GDP. At least one idea must be carefully explained and elaborated.

L11 4Some understanding of the concept of fall in real GDP and its implications. Very limited explanation throughout the essay.

Part (b)

IntroductionDefine and explain meaning of low inflation:

Low inflation is defined as a period of relative price stability. Inflation is mild.

Low inflation does not distort the pattern of resource allocation. It is a generally good sign of the health of an economy.

There are many factors that are essential for sustained economic growth. These include the quantity and quality of the factors of production, the level of technology, infrastructure, business environment, social and political stability. Low inflation is one of those conditions that are needed to ensure a conducive environment for investments and hence economic growth.

Body1. Define and explain high and sustained growth

2 concepts of economic growth actual and potential.

Actual growth is the increase in national output actually produced. It is represented by a movement from a point inside the production possibility curve (PPC) to a point on the PPC. To have sustained economic growth, the country must achieve potential growth. Potential growth refers to the increase in the full-employment level of national output. Potential growth increases when there is an increase in the productive capacity of the economy. It can be illustrated by an outward shift of the PPC.

2. Explain how low inflation can contribute to economic growth.

a.Low inflation provides an environment that is conducive for savings and investment.

Low inflation real value of savings is protected because of greater certainty over real interest rate. Savings more funds for capital formation more investments can be undertaken.

I AE NY induced consumption further NY.

b. Low inflation contributes to export price competitiveness

If the countrys inflation rate is lower than in other countries its exports will be relatively cheaper dd for countrys exports export earnings AE NY. Thus, we can see how low inflation can instill confidence in the economy as well as boost export price competitiveness, thereby contributing to economic growth.

Whether the attainment of low inflation should be the main aim of govt economic policy depends on the following, among other things:

1. Severity of the problem

When a country is plagued by hyperinflation, the situation is so chaotic that it can lead to a collapse of the monetary system as people lose confidence in money as a medium of exchange and store of value. There is great uncertainty and instability which result in capital flight and thus reducing the volume of savings, investment and economic growth. In such a situation of hyperinflation, it is important that the government arrest the problem of inflation first, restore confidence in the economy and then proceed with other measures to achieve economic growth.

2. Possible trade-offs

Furthermore, low inflation may not always be the main aim of govt economic policy. Most governments today have an inflation target. However, its attainment can come at a cost of slower economic growth. E.g. contractionary monetary policy such as higher interest rates used to control inflation C and I AE surplus of goods and services downward pressure on prices and real national output.

Because of this conflict between low inflation and high growth, at times e.g. when the problem of slow growth is deemed to be more severe than inflation, it may be necessary to let go of the low inflation target in order to accelerate the economic growth rate.

Conclusion

It is indisputable that low inflation is an essential condition for economic growth. Govts should consistently use supply-side policies to increase its productive capacity in order to ensure that its AS can meet with the rise in AD and hence achieve price stability. L412 15Rigorous analysis of the benefits of low inflation, making clear the links between low inflation and sustained economic growth.

Good discussion of the statement, e.g. provides rationale or basis for thesis and anti-thesis. Clarity and maturity of thought are displayed. Reasoned judgement based on sound economic theory.

L39 11Rigorous analysis of the benefits of low inflation, making clear the links between low inflation and sustained economic growth.

Adequate attempt to discuss the statement, although the substantiation may not be consistently thorough. Generally good analysis but quality of evaluation may be just adequate.

L27 8The links between low inflation and sustained economic growth are adequately explained with at least 2 well-explained ideas. However, there was lack of clarity in discussing the statement. Assertions were made as to whether low inflation or other goals should be the main aim but with very limited substantiation.

L11 6Some explanation of the benefits of low inflation. Very limited attempt to discuss the view.

6While integration into the world economy continues to underpin Singapores economic success, its exposure to the global business cycle is posing considerable challenges at present.

(a)Explain how Singapores balance of payments might have been affected by the global business cycle in recent years.

[10](b)Discuss what policy options would best reduce a countrys balance of payments deficit.

[15]Part 6(a)IntroductionExplain briefly, how being small and open, Singapores balance of payments have been very much affected by the global cycle.

The downswing of the cycle usually had an adverse impact on Singapores balance of payments. Conversely, an upswing of the business cycle resulted in an improvement in Singapores balance of payments.

BodyExplain briefly the meaning of balance of payments, and the 2 components of the balance of payments i.e. the current and capital accounts. With relevant examples, explain the items in the 2 accounts.

The global recession in recent years have affected Spores BOP in the following ways:

Global recession e.g. in the US that was brought about by the sub-prime crisis contraction of world trade, Singapore being no exception.

1.( foreign incomes + ( unemployment (( purchasing power ( ( dd for Singapores exports. Since the US is Singapores major trading partner, there is a significant drop in demand for its exports of manufactured goods and services for both final and intermediate goods ( ( export earnings, worsening current balance.

2. Global cut-backs in consumer spending due to poor consumer confidence + fallin stock prices that reduce MNCs ability to fund investments + ( profits, poor business confidence ( ( FDI into Singapore as MNCs cut back their overseas investment plans in preparation for worst case scenarios ( ( long-term capital inflow ( worsening capital balance.

3. Subprime crisis + disruptions in financial systems ( tighter credit conditions e.g. higher interest rates and more stringent regulations on lending and borrowing ( ( in both exports and investments into Singapore.

4.Singapore BOP has also been affected by the business cycle which was caused by the higher crude oil and food prices. ( prices of crude oil and food ( less than proportionate fall in Qty dd of imports due to its price inelastic demand (oil and food being essential ingredients and raw materials) ( ( total import expenditure on these items ( worsening current balance.

Mark Scheme

L37 - 10Rigorous analysis with clear examples used to explain the changes in BOP. Explained how each of the 2 accounts (current and capital) is affected.

L25 6Explanation of changes in BOP is adequate but not rigorous. Did not bring out clearly the characteristics of Singapore that explains why its BOP is sensitive to global business cycle.

L11 4Some understanding of the structure of balance of payments with an attempt to explain how BOP is affected by business cycle.

Part (6b)Introduction State meaning of BOP deficit and that it can arise from current and/or capital balance.

Explain briefly why huge and persistent BOP deficits can be a cause of concern for the govt: -falling foreign reserves which means less funds for future economic development

Increase in external debt which will can lead to lower standard of living for future generations

Currency devaluation which can cause inflation, loss of confidence in the country, capital flight and hence slower economic growth.

Body1. Devaluation

Devaluation refers to the deliberate attempt by a government to reduce the external value of its currency. For example, assume that the US has a balance of payments deficit and its government decides to devalue its currency to solve the deficit problem.

Devaluation of US$ makes US exports cheaper in foreign currency (SGD) and its imports more expensive in domestic currency (US$).

If the demand for US exports is price elastic, the fall in export prices in foreign currency will result in a more than proportionate increase in quantity demanded for exports, ceteris paribus. Hence, there would be an increase in its export earnings.

At the same time, if the demand for imports is price elastic, the higher import prices will lead to a more than proportionate fall in quantity demanded for imports, ceteris paribus. Hence, there would be a fall in import expenditure.

Therefore, net exports would rise, leading to an improvement in the current account balance, ceteris paribus. Ceteris paribus, there would be a reduction in the US balance of payments deficit.

The Marshall-Lerner condition should be used to determine whether devaluation is effective in reducing the balance of payments deficit. Evaluation

Devaluation is an appropriate tool to solve the BOP deficit if:

In managing a countrys exchange rate, its currency may be over-valued i.e. the fixed price of the currency is higher than what it would have been under a floating exchange rate system. Over-valuation reduces the countrys export price competitiveness and hence lowers the demand for the countrys exports. On the other hand, it also encourages imports due their artificially lower prices.

Hence, the govt should sell the domestic currency in order to lower the value of the currency to solve the BOP deficit problem.

2. Expenditure-reducing or deflationary policy

The govt can also consider using expenditure-reducing or contractionary demand management policies such as monetary and/or fiscal policies.

A contractionary fiscal policy involves an increase in taxes and reduction in government expenditure. An increase in personal income taxes will lead to a fall in disposable income. This will lead to a fall in consumption expenditure. An increase in corporate taxes will lead to a fall in post-tax profits which results in a fall in investment expenditure. The fall in government expenditure, consumption expenditure and investment expenditure will reduce the level of aggregate demand, resulting in a fall in national income.

This will induce a fall in demand for imports, hence leading to a fall in total import expenditure. Ceteris paribus, net exports would fall, leading to an improvement in the current account balance. Ceteris paribus, this will reduce the balance of payments deficit.

Evaluation:

These contractionary demand management policies would be most appropriate if:

i. inflation is the cause of the deficit. The higher inflation can be due to rise in AD such as C and I. Higher relative inflation rates of a country can cause its exports to be relatively more expensive and imports relatively cheaper than domestically produced goods. Thus, the countrys current balance worsens. Furthermore, the higher inflation rates can also lead to capital flight as people lose confidence in the economy. As such, it is import for the govt to lower inflation rate to solve the problem.

3. Supply-side policies

To reduce the balance of payments deficit, the government can introduce measures to lower the costs of production and boost the productivity of the factors of production. This can be done with a higher expenditure on training of labour and research and development.

When the countrys exports become more competitive, its volume of exports will increase. In addition, its demand for imports will fall, as domestically produced goods are now cheaper relative to foreign goods. The balance of payments deficit can thus be reduced.

Evaluation

1. Supply-side policies are especially needed if the cause of the BOP deficit is that of loss of comparative advantage. In this age of globalisation, the emergence of new low-cost producers has caused a shift in comparative advantage across the world. As such, a country that experiences a loss of their comparative advantage will suffer a permanent fall in its export demand. Thus, there is a need for the country to restructure its economy to find new products to sell and so improve its BOP.

ConclusionThe best policy options would be those that solve the root cause of the problem. That would be ideal. In reality, there are many factors that could have contributed to the BOP problem. As such, different policies are needed to counter these sources of the problem. L412 15 Rigorous analysis and evaluation of at least 3 policies and must address both current and capital balance problems. Thorough evaluation of all 3 policies with clear understanding of what determines a best policy. Insightful conclusion, preferably with some reference to Singapore.

L39 11 Rigorous analysis and evaluation of at least 3 policies and must address both current and capital balance problems. Evaluation is limited to making statements without clear development of ideas.

But for 10 marks and above, expect thorough evaluation of 1 policy.

L27 8 Adequate explanation of 2 policies with some evaluation. Both policies may address only current balance problems. Limited evaluation.

L11 6Some explanation of the policies used. May not be clear in terms of stating which is the best policy.

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