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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 phrase
both questions and answers along mainstream IB lines, most of you will probably do a better job than I
in 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 the
book itself or the questions/answers in this document. Everything — good, bad and ugly — herein is my
own merit or fault.
In a similar issue, you will notice that I have not attempted to set grade boundaries or individual
marks in the answers. This is best left to you and your professionalism — not to mention that it would
also 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. answers
as they are in fact more suggestions than anything else) in your day to day teaching. I would gladly see
any errors/omissions and such pointed out; please write to me at matt.mcgee@helsingborg.se and I
will get back to you.
Finally, I beg you to respect the intellectual property rights attached to this document. I ask that you
do not upload and/or send digital or hard copies of any part of this document without permission from
IBID 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 and
distribution of goods is decided. In the process, of solving the basic economic problem there will
always be a trade-off (i.e. an opportunity cost) since resources are limited and our (societal) wants are
infinite. 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 to
increasing 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 and
also 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 and
referred to in the text.

2. A country s choice between the production of education and nuclear submarines is an issue of
opportunity cost. Explain the issue using a PPF.
Basic answer: Resources are limited while wants are infinite and the choices made lead to opportunity
costs — defined as the next-best alternative given up. The PPF illustrates the opportunity cost in the
movement along the PPF; an increase in submarines has an opportunity cost of an amount of
education 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 PPF
diagram 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 of
having wants that cannot be met. Assuming that wants are endless but that economic resources are
scarce means that all economies will have to deal with the issue of scarcity, i.e. that all wants simply
cannot 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 scarce
resources 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 are
being 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 and
consumption goods on the other.
Basic answer: Again, a good definition of opportunity costs linked to the notion of limited societal
resources is the answer. Assuming two bundles of goods — capital and consumption goods — and
maximum efficiency in the economy being attained (the economy is producing on the PPF), then any
increase in the production of investment goods will of course mean an opportunity cost in terms of
quantity 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 — the
opportunity 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 PPF
diagram showing that increased output of one good results in foregone output of the other good, i.e. an
opportunity 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 qualitative
variable — and thus includes a number of measurement such as access to basic sanitation/water/health
care; living standards such as in basic education; social choice and freedom such as democracy and the
rule of law. The basic answer is that while GDP in fact indicates the level of development, they are not
one 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 different
composition, i.e. guns and butter. The Lorenz curve (HL) could be used to illustrate inequality in
income distribution.

Note: Students all too often get off on a track where national incomes of different countries are
compared, 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 — but
de facto output is shown by a point on or within the PPF. Actual growth means that the point
moves 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 serve
to 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 between
increased 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 increase
in GDP (over a time period) while development deals with wider issues such as living standards and
quality of life.

Possible points:
• definition of growth (increase in GDP during a time period)
o discussion on real and nominal
o per capita income
o purchasing power parity adjusted income
• definition of development, indicators
o qualitative issue wider than simple GDP or GDP per capita
o standard of living, income/wealth distribution
o empowerment, choice and freedom
• outlining ways of measuring development indicators such as
o life expectancy
o infant mortality
o 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 clarifies
ways 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 signal
to 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 outline
economic 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 (at
HL) 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 between
profits and incentives, reallocation and the signalling issue to firms. High marks should not be
awarded if mainstream economic terminology is not used.

Extended response questions

1. a) Planning is something that planned economies need - not market economies . Comment
on this from the viewpoint of an economist. (10 marks)
Basic answer: The statement is in fact not entirely correct; all economies use various degrees of
planning — it is more a question of degree. Outline of planned economy as a system where the basic
economic 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, with
a degree of (central) state planning.

Possible points:
• outline of a planned economy
o output and pricing decisions are made centrally
o resource allocation in planned economy
o output targets
• outline of competitive (market) economy
o supply and demand function
o role of price mechanism
o individual decisions the basis for resource allocation
• examples of planning in market economies
o census taking by government in order to plan ahead for school enrolment, road
building, infrastructure etc
o 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 to
planned/command economic systems. Reward students who are able to link theory to real life
examples.

b) What problems might a planned (command) economy encounter in moving towards a market
system? (15 marks)
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Basic answer: The central answer pivots around the seeming inefficiency (or built-in inefficiency) of
planned economies, and how this has resulted in a painful transition to market systems. The structural
readjustment of many of the Central and Eastern Europe and Former Soviet Union (CEEFSU)
economies was marked by depreciating currencies, high unemployment, rampant inflation and falling
growth 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 jobs
o higher efficiency and productivity means that demand for labour falls
o increased imports can cost domestic jobs
o 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 the
effects 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 in
descriptive terms but in specific examples and measurements.

Possible points:
• definition of growth (increase in GDP during a time period)
o discussion on real and nominal
o per capita income
o purchasing power parity adjusted income
• definition of development, indicators
o qualitative issue wider than simple GDP or GDP per capita
o standard of living, income/wealth distribution
o empowerment, choice and freedom
• outlining ways of measuring development indicators such as
o life expectancy
o infant mortality
o 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) to
show income equality (HL).

Note: A relatively straightforward question which nonetheless should be addressed using quite specific
economic terminology and concepts.
b) Why and how are economists attempting to create more accurate measurements of
development? (15 marks)
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Basic answer: The why part is simply because of the difficulties built-in to the concept of
development — it is a very wide (rather subjective) and non-quantitative concept. In order to increase
the 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 development
o correlation between income and development, but there are other aspects
o many development issues are not shown in a single indicator such as GDP
o other weaknesses of GDP as a measure of development; does not show purchasing
power or what is produced etc
o 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 developing
countries, such as crime rates, ability to vote, pollution levels and other forms of
environmental degradation etc
o defining living standards and quality of life in as quantifiable terms as possible, for
example
ƒ roads per 1,000 citizens
ƒ availability of culture
ƒ access to water
ƒ amount of time it takes to earn minimum subsistence income
ƒ growth rates referenced to LR sustainability
o constructing composite indices, such as
ƒ HDI
ƒ Human Suffering Index
ƒ Gender Related Development Index
ƒ Environmental Impact Index
• problems of measuring development, such as definitional problems (poverty) and
accounting/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 to
development should be made clear, i.e. why is number of girls in secondary education an indicator of
development?

3. a) How would you go about comparing the welfare of citizens in different countries? (10
marks)
Basic answer: This is a very open-ended question and there should be any number of constructive
answers available — yet all should be centred on the definition/outline of welfare. Any of the
mainstream 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 freedoms
o consumption capability and variety — across a broad section of society
o access to education
o availability of culture
o availability of employment
o entrepreneurial freedom
o individual rights —legal and political
o 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 registration
o income per capita (at PPP)
o proportion of girls in secondary education proportion of children in primary
education
o amount of theatres, libraries, culture centres per capita
o percentage of teenagers unemployed
o number of private newspapers/radio channels
o number of women in local municipal council
o whether basic democratic freedoms are guaranteed in law — and enforced/upheld
o 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 of
examples — as long as the examples are concrete and the variables are measurable.

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

Possible points:
• possible successes in planned economies
o income distribution
o general equity
o focusing resources in narrow areas, for example medicinal research in the former
USSR
o providing basic necessities
o providing basic education and housing for a large proportion of the population
o providing jobs
• possible failures in planned economies
o environmental aspects
o providing democratic institutions
o providing consumer goods and generally meeting the demands of citizens for
consumption items
o 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 exception
o use of resources — there were often high levels of waste in production
o creating growth
• possible successes in market economies
o attaining high (real) growth rates
o enabling democratic institutions, and personal freedoms
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o producing high quality goods to meet the demands of citizens

o high productivity and incomes have meant increased living standards
o innovation and R&D
o allocating resources efficiently
• possible failures in market economies
o the provision of merit and public goods for all has in some notable cases been lacking
o income distribution
o consumerism and unnecessary products become a lifestyle
• discussion on whether free markets, capitalist systems and individualistic societies benefit the
strong and able while disadvantaging the weak
• discussion to the effect that economic growth, productivity increases and liberal democratic
government 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 sweeping
generalising. This can be partially countermanded by reference to real world examples — at the risk of
using anecdotal evidence as a way of underscoring an argument. Students who actually summarise and
assess 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) any
form of price support scheme involving government purchasing of the good; and 4) government
controls 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 price
o government purchasing — perhaps in reference to government stockpiling in the
context of a government run buffer stock scheme
o government controls — shifting supply curve left
• other possibilities include curtailing market entry, nationalisation of an industry to lower
externalities, trade barriers

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

diagram 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 for
rental housing. The possible outcome in this case will be to limit quantity supplied and increase
quantity 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 storage
o effects on PES
o 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 reference
to 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 set
ceiling 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 supply
from warehouse
• commenting and/or illustrating what might cause the market price to move outside the desired
corridor (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 imports
o cheaters i.e. non-aligned producers can affect market price
o expensive for government
o 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 buffer
stock schemes in later years as surpluses become increasingly criticised

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

Note: Very important that the answer uses the diagram and refers clearly to shifts in supply/demand
and 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 decrease
traffic 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 a
given area during a given period of time. There is scope here for ingenuity in the answer, but basically
a good answer would point to lowering demand during weekends by increasing the availability of
substitutes 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 limits
o creating viable and attractive substitutes, for example by increasing bus runs and/or
lowering the price of public transportation
o 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 number
license 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-city
driving 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; excess
supply of labour, which in this case results in an increase in unemployment. As the issue deals
specifically with labour market newcomers, there is the distinct possibility that demand for more
experienced 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 labour
market. 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 for
answers which completely neglect the fact that we are dealing with only a portion of the labour market
and not the entire market.

6. Why would the weekly price of rental scooters in a holiday resort vary over the course of a
year?
Basic answer: The expected response here is that seasonality is the main cause of variations in demand
over a year; more tourists during high season will lead to an increase in the demand for goods and
services associated with tourism, e.g. scooters. It is also possible (probable?) that suppliers will adjust
in 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. other
resorts, 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 in
their 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 to
even-out price fluctuations over the course of a year (to avoid insecurity and badwill amongst
customers) 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 to
explain and illustrate how shifts in demand and/or supply will affect the market price. It is important
that rote-memorised factors are not simply tossed in, but founded on examples. For example, the price
of other goods will affect the price of a good — a fall in the price of DVD rentals might decrease
demand for purchasing DVDs, which could ultimately lower the price of purchasing DVDs.

Possible points:
• change in demand
o price of complements/substitutes
o change in income
o preferences
o any non-price variable
• change in supply
o change in price/availability/efficiency of factors
o 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/or
supply.

Note: Earning higher marks should be based on clarity of example and how well the diagram is
referred 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 have
influence on firms output and pricing decisions, and thus affect resource allocation. In reality, there
will be a number of reasons why consumers influence will be lower — due to imperfect markets
primarily.

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 competition
o non-price competition — possible collusion, advertising/marketing
o 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 market
intervention such as taxes/price controls); (HL) any model from theory of the firm showing how
powerful firms might be able to disregard effective market demand and set lower output (and higher
price) than on a competitive market.

Note: Students are often hazy in defining consumer sovereignty, often confusing the concept with
consumer choice. Reserve top marks for answers which clearly explain the link between consumers
preferences 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 not
able to get hold of tickets. What might the outcome of this be? Use a diagram to support your
answer.
Basic answer: The issue revolves around an excess in demand (price is too low ) and possible black
market 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 the
explanatory body of text well.

10. Government raises the taxes on car ownership. Explain the possible market outcomes of such
a decision.
Basic answer: As this is a tax paid by owners, and thus not levied indirectly via suppliers in selling
cars, one can expect a decrease in the demand for cars and an increase in demand for possible
substitutes. (Basically, the ownership tax might be regarded as a complement to car ownership.) One
could 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

SL
1. a) What do economists mean by markets ? (10 marks)
Basic answer: A sound definition of markets should encompass the concept of willing buyers and
willing 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 marks
should not be given for answers which do not use core concepts such as the price mechanism and the
basic economic problem.

b) Are markets the best way of solving the basic economic problem? Justify your answer. (15
marks)
Basic answer: The core of the economic problem ( who, what, for whom ) is something all societies
must address. Planned economies solve it by central price and output setting, while market economies
solve it by the price mechanism. Both systems have their basic flaws. Another issue is that of market
failure, 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 illustrate
externalities and/or public/merit/demerit goods, HL might use monopoly diagram to illustrate
shortcomings of a market system.

Note: Answers have a tendency to become opinionated and/or dogmatic — which is perfectly alright as
long 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 and
incentives function for the actors on a competitive market, creating equilibrium on the market and
allocating 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 consumer
and supplier surplus
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Note: Answers often use planned economies to contrast the allocative efficiency of the perfectly
competitive 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 potential
supply has a finite limit and that ever-lower reserves of oil mean scarcity Æ higher price Æ incentive
for suppliers to find additional reserves. It also means that the rationing function will kick in; higher
price Æ 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 demand
o depletion of known reserves will ultimately lower supply
o the price of oil can be expected to rise
o 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 supply
potentially
o increased R&D spending by producers on technology to enable finding new fields
o incentive for oil users to become more efficient in their use — for example car
manufacturers
o 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. externalities
o externalities in the use of more oil
o increased pollution as dirtier oil is refined
o 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 line
of reasoning in use of S/D model to show possible outcomes.

HL
3. a) Explain how a government might use buffer stocks to even-out price fluctuations. (10
marks)
Basic answer: Define the basic function of a buffer stock scheme and illustrate this with a S/D diagram
and 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 stable
o keep prices at a desired level
• characteristics of buffer stock scheme
o storable good
o often commodities/agricultural goods
• the market mechanism used by the scheme, i.e. adjusting supply in order to change market
price
• 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 as
exemplified 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 societal
costs include misallocation, oversupply and waste. Buffer stocks have been increasingly abandoned
for a number of reasons, mainly dealing with costs, political pressure, large unwanted stocks and
increasing criticism of the bad incentive effect perpetuating oversupply of goods.

Possible points:
• direct costs to buffer stock scheme
o administrative costs
o storage costs
o opportunity costs of storing goods and oversupplying
• indirect — societal — costs
o opportunity costs of using taxpayer monies to run the scheme
o allocative losses arising from overproduction
o possible dumping of excess stocks on other markets
• difficulties in operating buffer stock schemes
o difficult to foresee price fluctuations and act in time
o goods need to be storable
o 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 on
societal 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 between
different types of goods?
Basic answer: Define income elasticity — use formula — and identify different types of goods with
different 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 quantity
demanded 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 Nobel
Committee.

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 — and
explain — possible factors, such as number of producers, barriers to entry, time period, availability of
producer 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 producers
o type of market, i.e. monopoly, PCM etc
o barriers to entry
o availability of vital raw materials
o time frame involved
o access to intellectual property, e.g. production processes and patent rights
o availability of producer substitutes
o switching costs of producers
o ability to hold stocks (i.e. storage capabilities)
o legal restrictions on market entry, for example nuclear fuels
o 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.
 19/110

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

4. A government imposes an indirect tax on the supply of a good with zero price elasticity of
demand. 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. As
demand is zero elastic (vertical), the shift left of the supply curve will raise the price by the same
amount 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 largest
incidence 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 other
goods, which in turn deals with the availability of substitutes, the amount spent on the good and how
income sensitive the good is. Taken together, in the SR, consumers are rather unwilling to switch to
 20/110

other goods when it comes to primary commodities, as are firms, which use such goods as factor
inputs. PES deals with the availability and ease of switching to supplier substitutes, which in the SR is
rather difficult for commodity goods — due to seasonality of agricultural goods and the heavy
investment 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 increasing
capital 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 the
variables 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 producer
substitutes. 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 seasonal
o and non-storable
o 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 to
o 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 and
availability 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? (15
marks)
 21/110

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 consumer
substitutes (falling demand for commodities), the movements of increased supply and decreased
demand 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 substitutes
o 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 demand
o 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 exports
o worsening terms of trade
o less export revenue
o depreciation of currency
o harder to import vital goods, e.g. capital
• attempts of certain commodity producers to develop buffer stocks and/or cartels (e.g. coffee
and oil)

Diagram(-s): S/D diagram illustrating inelastic supply and demand curves — and shifts which show
price 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 falling
commodity 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 is
dependent on availability/closeness of substitutes, time frame involved, proportion of income spent on
good. 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 substitutes
o time frame involved
o proportion of income spent on good
• determinants of yED
o 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 income
and quantity demanded.

Note: A very straightforward question which should be addressed most rigorously in terms of clearly
defined economic concepts.
 22/110

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 to
maximise revenue and profit. A good with few substitutes (inelastic) can fetch a higher price without
losing customers. Income elasticity will have influence on how the firm markets the good and to
which 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 correlation
between income and quantity demanded.

Note: Students often come up with some surprisingly insightful suggestions here. Reward any good
example which utilises the concepts correctly.
 23/110

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 maximises
revenue? 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 from
profitmax 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) and
LR (where all factors are variable). Diminishing returns (marginal returns) arise in the SR and
diminishing 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 between
returns to scale and economies of scale ! (See warning on page 206)
• keeping in mind the point above, referring to LRAC and increasing/constant/decreasing
returns 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 numerical
examples, marks should be given for a sound distinction between the two concepts.
 24/110

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 to
marketing 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 by
o collusion
o merging
• since oligopoly firms wish to avoid harmful price competition, great effort often goes into
R&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 this
question.

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 revenue
minus costs — which include opportunity costs . The term profit is more correctly
economic/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 interest
o foregone wages
o 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 accounting
profit 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 of
opportunity 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 = 0
o 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 interest
o foregone wages
 25/110

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 normal
profits. Two separate AC curves should be used. Profit per unit or total profit should be clearly
outlined, either numerically or graphically.

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

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

Note: Students usually have a good grasp of this issue, but messiness and sloppiness in the use of
important 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 a
strong 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 an
oligopolistic firm would be reluctant to both raise and lower the price. A collusive oligopoly often
breaks 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 a
competitive market.
 26/110

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

Possible points:
• outline of a monopoly enjoying benefits of scale
o diagram illustrating benefits of scale
o comparing the monopoly to PCM (page 238)
• predatory pricing in monopoly
o how monopoly can use the price weapon to kill off rivals
o diagrammatic illustration of this (page 237)
• natural monopoly
o definition of natural monopoly — it should be clear that a natural monopoly will have
both 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
• 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 to
dissuade 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 PCM
firm is a price-taker — and cannot influence the market, either in terms of output or price. Using the
unit cost picture, it should be made clear that ATC = AR is the breakeven level of output, and that the
firm will incur losses if the price is below ATC (see page 223). However, as long as the firm is
covering some of the fixed costs (any price above AVC in diagram), it might be willing to stay in the
market 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 normal
profits
• 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. Award
good iteration which might not always refer to a correct point in the diagram.

10. Explain the difference between productive and allocative ( economic ) efficiency.
 27/110

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 the
right 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 that
competitive markets might often hold true, there are three main notable exceptions: 1) Natural
monopolies; 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 have
both 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 scale
o diagram illustrating benefits of scale
o 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. the
MSC (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 in
fact might be more beneficial is some respects than competitive markets, and a good many students
simply refer to abnormal profits and possibilities of R&D .

12. Explain how/why profits from a monopoly are likely to be different from those in
monopolistic competition.
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Basic answer: It is important to have the most basic assumptions down for both market types; the
monopoly does not fear market entry as there are barriers to entry, but the monopolistically
competitive firm faces many competitors with differentiated products. The monopoly can thus earn
abnormal profits even in the LR but the monopolistically competitive firm (assuming perfect
knowledge 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 (page
244).

Note: The diagram showing normal profit in monopolistic competition is a bit tricky for students
under 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 paid
different prices for the same journey. Explain how this could be.
Basic answer: These passengers have been subjected to price discrimination. The explanation here
should 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 groups
o having different PED
o 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 market
segments (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 original
abnormal profit square for a single-price monopoly is wrong — often the shaded area goes down to
where 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 and
preferences 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/profits
o spread of technology — firms will gain technological edge by merging or acquiring
other firms
o international firms will have access to foreign capital and lower cost factors of
production
o 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 of
scale 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 oligopolistic
international market structures, and many of them find nourishment in the on-going globalisation
debate.

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 local
tastes and preferences
• there are possibly a number of positive effects
o lower costs for firms
o lower prices for consumers
o spread of technology/innovations
o increased trade
o better resource allocation
• possible negative effects
o danger of global monopoly-like market structures, as benefits of scale for increasingly
large firms eject smaller — local — firms from the market
o international firms will have an increasing degree of economic and political power
o 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 be
awarded on basis of reasonable links to oligopolies operating internationally.

2. a) Explain what economies of scale are and why they have become increasingly common in
later years. (10 marks)
Basic answer: The answer should broadly outline internal and external economies of scale and then
focus on how deregulation and open — market based — economies have arisen during the past 30 or so
years, 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 capital
o managerial economies of scale — higher efficiency in firms production units via
specialisation
o purchasing economies — bulk buying, good customer prices
o marketing economies of scale — benefits of having broad brand-name recognition
o 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 openness
o trade deregulation
o deregulation of international capital markets
o lower transport costs have made large scale operations cost-efficient
o 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 into
macroeconomics here and start writing about countries.

b) In spite of this, many small firms still exist. What possible reasons do you see for their
success? (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 firms
are 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 heavily
interdependent.

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 entrants
o collusion is most often illegal
o collusion often short-lived, as cheating is a strong incentive
o overt and tacit collusion
o price leader
• non-collusive oligopolies
o non-collusive outcome results often in price rigidity
o firms are heavily interdependent and reluctant to engage in head-on competition
o 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 the
question.

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-setting
and any form of collusion will lower consumer welfare. Yet it is also the fact that many oligopolies in
fact have to act in accordance with market demand basics and are thus to a certain extent competitive.

Possible points:
• against
o firms might collude
o higher prices would result from collusion
o increasing market ratio on market in fact moves towards monopoly structure
o even in non-collusive oligopolies one might expect competition to be limited
o entrants are dissuaded which lowers competition
• other issues might include the wastefulness of advertising; power of large firms in
international markets; dangers of streamlined consumerism and decline of local firms

• for
o non-price competition is an incentive for firms to come up with better/new goods
o product innovation and R&D due to abnormal profits
o lower costs due to scale benefits can be passed on to consumers
o 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 of
multinational 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 matter
where the good was purchased

Diagram(-s):

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

4. a) What are the main assumptions made in the model of perfect competition and contestable
markets? (10 marks)
Basic answer: The main issue is the difference between the two sets of assumption; in contestable
market 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 entry
o perfect knowledge and information
o homogeneous good
o large number of firms — no firm is large enough to affect market supply/price
o the firm is a profit maximiser
• assumptions of contestable markets
o no barriers to entry
o perfect knowledge and information
o the firm is a profit maximiser
o one or many firms
o homogeneous or differentiated good
o zero exit barriers

Diagram(-s): See below.

Note: Many students will include diagrams and explanations of why/how the firm will make a normal
profit 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 of
quantity, price and efficiency. (15 marks)
Basic answer: Each set of assumptions must be clearly shown to have bearing on the market outcome
in 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 it
produces
o output is set at MC = MR, i.e. profitmax point of output
o the firm is too small to influence the market, thus is a price-taker
o since there is perfect knowledge/info, any abnormal profit will attract entrants
o and since no entry barriers exist, this will increase supply and dissolve the abnormal
profit
o thus, in LR, the PCM firm will operate where P = MR = MC = AC = AR = D
o 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 is
pricing and output power
o as no entry barriers exist (to speak of ) firms might expect market entry if the make an
abnormal profit (keeping in mind here that there is perfect knowledge and
information)
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 limited
time and then exiting
o there is thus an incentive for incumbent firms to dissuade potential entrants
o this can be done by operating at a level where all incumbent firms set price and output
so as to make only a normal profit
o 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 equilibrium
diagram (page 259).

Note: It is impossible to fit all the above points in, but full marks may be given for answers which
clearly 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 in

providing goods? (10 marks)
Basic answer: Define natural monopoly as a situation where the benefits of scale an fixed costs are so
high that it is impossible to fully exploit them. A diagram illustrating falling (or constant) MC and AC
should 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 scale
o 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 price
o that indeed a PCM outcome would mean a far higher price
o 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 would
indeed 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 ifanyone has an answer. It would seem that
most natural monopolies come with high MSB and also that society has deemed these goods far to
societally important to be owned/operated by private interests. Thus, water, gas, sewage, public
transportation, 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 AC
o 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.
 35/110

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 to
few loans, higher saving and hence lower investment and consumption. This will have a dampening
effect 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 investment
o household will hold off on big-ticket consumption
o 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 Æ AD Æ 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 AD
components (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 an
economy.
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, increasing
GDPreal 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 lines
referring to increase in output and price level.

3. Why might stimulatory fiscal policy have no (long run) effect on national income?
 36/110

Basic answer: This is squarely in the camp of monetarist/classical theory. Define stimulatory policies
as 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 up
of wages and factor prices, which then shifts AS to the left — back to LRAS and the full employment
level 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 illusion
o households will know that real incomes have in fact fallen
o workers bid up wages, firms raise price of factors
o the effect is to decrease AS — shifts left
• comments to the effect that according to monetarists, demand-side policies are purely
inflationary 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 with
Keynesian) to show possible crowding out.

Note: The entire kit of monetarist assumptions above is not necessary — but the answer must clarify
that 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-offs
which arise so when a given issue is addressed, such as growth, another set of problems arise, such as
inflation.

Possible points:
• definition/outline of main macro objectives
• specifically showing possible trade-offs, i.e.
o stimulatory policies which increase AD might cause inflation
o growth might conflict with full employment as structural and technological change
affects demand for certain labour groups (see sectoral/technological/regional
unemployment), supply-side policies might increase efficiency and create
redundancies amongst labour groups
o full employment might also create inflation
o growth might increase imports (HL: MPM, and lower multiplicative effects) and
decrease exports due to inflation
o growth Æ inflation Æ depreciation of currency
o 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 Ù environmental issues, or growth Ù 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 inflation
Diagram(-s): AS-AD, LRAS to show supply-side issues, Phillips curve, labour market diagram to
show 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 transfer
payments (unemployment/welfare benefits) and a progressive taxation system. Illustrate the effects on
AD during phases of the business cycle.

Possible points:
• definition of automatic stabilisers
o transfer payments help to bolster falling incomes during recessionary periods, boosts
AD
o marginal tax rates mean higher average taxes during boom periods, has a dampening
effect 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 not
necessary 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 and
possibly credit controls — not part of syllabus) to dampen or stimulate AD and thus output — and often
inflation/disinflation/deflation.

Possible points:
• definition of monetary policy
o changing central bank interest rates
o changing the supply of money
o 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 also
how saving is affected
• illustrating clearly the effects on AD
o lower r Æ decreased S, higher C, I Æ dampening of decrease in ADÆ stimulation
and possible increase in Y
o higher r Æ increased S, lower C, I Æ dampening of increase in ADÆ 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 quite
clearly illustrated.
7. How might a country s Central Bank use monetary policy to stimulate domestic aggregate
demand via exchange rates?
Question scrapped — too far outside the syllabus.
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HL only
8. 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 in
government spending. Knowing that, for example, the value of k is 2, and that 10,000 jobs are
expected to be created for each additional billion in national income, then additional government
spending of 0.5billion will create the necessary jobs.

Possible points:
• definition of multiplier, i.e. k = 1 / MPL
o leakages, S, M, T
o 1 — MPL = MPC
o 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 given
increase in national income would entail
o demand-management policies would be far more accurate
o inflation rates might be held in check
o future tax revenues might be better calculated

Diagram(-s): Well, the ol 45¡ degree diagram is clearly superior at showing the multiplicative effects
of 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, the
basic 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!) might
serve 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 a
monetarist/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 whether
crowding out takes place has implications for the effectiveness of demand-side policies, and thus
serves to underpin the on-going debate between monetarism ( complete or near-complete crowding
out 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-side
policies 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 place
o 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 the
monetarist/classical side and the Keynesian side) into policy discussions by linking demand-side
policies to the (possible) increase in AD.

Extended response questions

1. a) Carefully distinguish between demand-side policies and supply-side policies. (10
marks)
Basic answer: The answer should broadly illustrate the general macroeconomic objectives of
governments 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 and
transfer 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, profits
o adjusting government spending
o 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; abolishing
minimum wages; easier hire-and-fire policies etc
o capital — tax breaks for investment and education in firms; lower taxes on
profits/dividends etc
o competition — privatisation and deregulation; subsidies for R&D; trade and general
market 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 weaker
students tend to neglect showing more specifically how a given policy affects AS and/or AS and thus
the 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 view
the 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 increased
debt
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 Æ implementation lags Æ impact lags — might lead to exacerbation
of business cycle
• monetarist/classical criticism
o 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 diagram
3.4.12 I on page 393)
• mentioning that markets have become increasingly open/integrated, which has lessened the
degree to which demand-side policies have a multiplicative effect, as leakages (imports) have
increased (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 market
does 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 able
to give basic critique of demand-side policies. Most answers should utilise the LRAS curve and the
Phillips-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 used
to 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 AD
o increase in output potential — AS
o possible supply-side issues, i.e. increasing the LR potential while keeping inflation in
check
o productivity and link to real wages and income
• developmental issues
o saving often lower than investment, need for foreign investment
o transfer of knowledge/technology
o reference to Harrod-Domar and capital output ratio

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

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

b) Explain the role governments can play in supporting investment levels in the economy. (15
marks)
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Basic answer: Government — and the central bank — can influence investment levels through various
forms of tax legislation, open market mechanisms and monetary policy. Linking any viable example to
increased propensity of firms to invest should get marks.

Possible points:
• monetary policies
o lowering interest rates would stimulate investment
o relaxing credit restrictions to firms which invest
• fiscal policies
o tax breaks for firms which re-invest profits
o decrease in profit taxes
o decrease in capital gains taxes
• legislation
o tax holidays for FDI
o allowing larger write-offs for firms — which would in fact lower corporate taxes
• market orientated policies
o allowing easier entry to financial markets by domestic and foreign players
o 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 ratios
o subsidising loans for investment — i.e. government backing of loans

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

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

3. a) Outline and briefly explain the main macroeconomic objectives of governments. (10
marks)
Basic answer: The answer should include growth, high employment, price stability and external
balance (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 concept
o enables the economy to improve living standards
• high employment
o percentage of labour force employed
o shows utilisation of social factor of production
• price stability
o steady rate of price increase; change in CPI/RPI/GDP deflator
o allows predictability and reliability in the economic environment
• external balance
o balance of payments
ƒ equilibrium in foreign sector trade, i.e. exports and imports
o exchange rate
ƒ 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 , which
should elicit a brief definitional measurement ( change in GDP during a time period ) and a brief line
of 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 most
important of them all. (15 marks)
Basic answer: This is a very wide and open-ended question which requires the student to justify
his/her choice. This calls for the weighing of options in terms of the possible trade-offs of any one
objective, and a comparison with other objectives in argumentation. The monetarist/classical vs
Keynesian 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 larger
cake means that more is available for consumption; the possible trades-off of inflation is
worth it and environment can be dealt with ultimately as increased prosperity will provide
resources for this
• high employment; people are the most vital resource and should not be squandered due to high
societal costs of such waste; people with jobs will have opportunities and meaningful lives;
high employment enables growth, entrepreneurship, innovation; high employment lowers not
only social costs but has financial benefits in the form of lower transfer payments/benefits and
higher tax revenues for government; possible trade-off of inflation does not negate the greater
societal benefits of low unemployment
• price stability; reliability and predictability in the economy can be created by keeping inflation
under control; high costs of inflation, i.e. redistributive effects, behavioural distortions, shoe
leather and menu costs etc; monetarist theory indicates that strong non-interventionism by
government and free markets increase real incomes; macroeconomic policies should focus on
price 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 have
created more output and labour markets will clear
• external balance; assuming a small, highly export-oriented and open economy — Hong Kong
for example — it is imperative that the export sector is flourishing, since this creates the brunt
of the economic base; export orientation creates jobs, tax bases and income; a stable and
reliable exchange rate is absolutely vital in this case; trade-off is possibly that monetary policy
freedom is given up to retain a fixed exchange rate
• environment; students might adopt the stance that in the LR it will not matter what the
economic 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 if
the brunt of income/wealth goes to a small powerful minority; equitable distribution of income
has shown to have both social benefits and economic benefits (in terms of growth rate); the
wider concept of development — of which income distribution is part — outweighs simple
growth or inflation concerns
• productivity; it is possible to philosophise that ever-higher incomes and increasing
prosperity in developed countries, together with declining birth rates makes it absolutely
imperative to increase productivity to retain living standards, provide tax bases and thus
public/merit goods and pensions in the future; productivity can be said to be at the heart of
national 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 issues
and 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 better
answers than above from gifted students! Award points not only on the basis of clarity of economic
thought 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 straightforward
method would then be to add a LRAS curve to the left of this equilibrium, showing that the economy
is at less than full employment. Another version shows general equilibrium (AS=AD=LRAS) but
comments 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, and
o 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 natural
unemployment (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 , while
deflation is a consistent fall in the general price level , i.e. negative inflation. A good answer will
outline the basic damage to an economy of both, ultimately showing — perhaps — that deflation, while
rarer, 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 costs
o redistribution effects — fixed income earners lose, borrowers gain
o behavioural distortions in the economy
o effects on output
o 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 deflation
o use of AS-AD model to illustrate the above
o possibility of negative expectations and
o 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 out
of a negative feedback loop of falling prices Æ falling demand Æ falling prices — see Japan in
1990 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 natural
rate 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. It
seems 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 not
registering 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 and
the 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 the
labour market diagram.

4. Explain how an unexpectedly large increase in the price of oil might affect a non oil exporting
country.
Basic answer: This is something of a classic , dealing with supply-side shocks and the effects on AS
and AD. Start off by determining oil as a major factor of production and then use a AS-AD diagram to
illustrate 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 output
o increase in price level
o 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 have
negative 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 investment
o insecurity and lack of predictability; firms will be wary of increasing investment and
consumers might hold of on spending
o shoe leather and menu costs
o inflation might cause exports to fall
o and depreciate the currency
• social costs
o people on fixed incomes will suffer more than those strong enough to bid up wages in
line with inflation
o the poor will suffer more than the financially strong
• redistribution effects — for example, borrowers will gain at the expense of lenders (as the real
value 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 to
show how investment falls when interest rises.

Note: Students often produce a list of ills without bothering to explain or elucidate. Clearly higher
marks should be reserved for answers which give some depth as to why a certain effect constitutes an
economic 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 stimulating
labour mobility, capital formation and increased competition. Note that supply side policies are LR
policies.

Possible points:
• outline of supply-side policies
o labour policies — reducing union power; cutting back on welfare benefits; abolishing
minimum wages; easier hire-and-fire policies etc
o capital — tax breaks for investment and education in firms; lower taxes on
profits/dividends etc
o competition — privatisation and deregulation; subsidies for R&D; trade and general
market 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 US
o 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 budget
deficits as taxes are cut, social costs of decreasing social benefits, rise in income
inequality,
• limitations also include Keynesian criticism; market are imperfect and could take considerable
time to clear, highly politicised issues of whether tax incentives actually work, the long run
might 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 merits
in 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 of
the labour force and then outline the proportion of the labour force which would be unemployed even
when the labour market is in equilibrium — this consists of frictional, seasonal and structural
unemployment. Classical/monetarist theory looks at any unemployment in excess of the natural rate of
unemployment 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 voluntary
o the labour market has not cleared
o the real wage level is too high
o 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 unemployment
o this could be demand-deficient in nature — AD L has fallen and wages are sticky
and/or labour markets are generally immobile
o 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 level
of output.

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

8. The government of a less developed country decides to reduce the extent of income and wealth
inequality. What methods could the government use to achieve its goal?
Basic answer: The answer is centred around redistribution issues — governments can influence net
disposable income and wealth in a number of ways. Taxes on income, wealth, expenditure and imports
can be adjusted to decrease the burden on the poor. Transfer payments and benefits in kind are ways of
redistributing 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, capital
flight, increased use of parallel markets, lack of government funds to implement increased
transfers 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 be
reduced rather than how.

HL only
9. 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 the
trade-off is at best temporary. This has some profound implications for economic policy in terms of
focus 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-off
o presents a menu of possibilities for government
o clear correlation between demand stimulation and unemployment
• monetarist/supply-side
o people/firms do not suffer from money-illusion
o thus the fall in real income will be noticed
o and firms will increase factor prices and households will bid up wages
o 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-side
and supply-side views of the Phillips curve — a clear reference must be made to the effects on policy
making.

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 wage
unemployment. After defining unemployment (percentage of the workforce not holding a job), relative
depth should be given to these two main rubrics.

Possible points:
• demand-deficient unemployment
o reference to business cycle (cyclical unemployment)
o derived demand for labour
o illustrating increase in unemployment in labour market diagram, shift left of ADL
o possibility of downward stickiness of labour
o primary cause is low AD in the economy
• real wage unemployment
o market for labour does not clear due to market imperfections
o unwillingness/inability of labourers to accept going real wage rate results in voluntary
unemployment
o 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 economies
o 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-deficient

unemployment 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 theoretical
standpoints 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 broad
groups; interventionist and market (supply-side) solutions. Interventionism should not be limited to
simple demand-management but include interventionist supply-side suggestions. Market solutions are
firmly 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 retraining
and education; grants and subsidies to firms to hire; tax incentives to firms investing
in retraining/education of labour etc
• market based solutions
o lowering social/unemployment benefits
o decreasing income taxes
o relaxing hire and fire legislation to increase labour mobility
• illustration of natural rate of unemployment in diagram
o showing shift in ASL to the right
o possible shift of ADL to the right
• any reasonable suggestion which clearly addresses the issue of getting more members of the
labour 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 to
help the labour market to clear. The question, however, deals with decreasing the natural rate of
unemployment.

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 a
Keynesian side and a monetarist/classical side. Keynesians would claim that sufficient demand in the
economy would create full employment, while monetarist/classical theory claims this would lead to
inflation — 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 labour
o as ADL shifts right, unemployment falls
• monetarist/classical arguments
o unemployment level is above the natural rate of unemployment due to market
imperfections
o 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 be
used.

b) What possible social and economic costs might arise in trying to attain full employment? (15
marks)
Basic answer: In terms of Keynesian demand-side policies, there might be inflation, government
deficit spending, loss of international competitiveness and depreciation of the exchange rate. On the
monetarist/classical side, one might see increased unemployment (in the medium term), social costs
due to lower social benefits, de-skilling of the workforce, and increased inequality in society as the
poorest 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 competitiveness
o depreciation of currency
o deficit spending, government debt
• ditto for monetarist/classical supply-side policies
o increased unemployment
o social cost of unemployment
o social costs of lower social benefits
o income inequality
• other possibilities; trade barriers might be used to save jobs, which would render welfare
losses 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 during
the 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, two
and a half basic reasons: 1) demand-pull inflation; 2) cost-push inflation and; 2.5) demand-pull
inflation caused by excess money supply.

Possible points:
• definition of inflation
• cost-push inflation
o factor costs increase and
o fuel bidding up of wages
o illustration of cost-push inflation in AS-AD model
• demand-pull inflation
o a demand-side shock increases AD
o and households/firms act in anticipation of higher prices, which causes further
increase in AD
o illustration of demand-pull inflation in AS-AD model
• excess money supply
o an increase in the supply of money above and beyond the LR potential of output will
be inflationary
o illustration of excess monetary growth using transmission mechanism (page 436)
• other reasons; imported inflation when a main trading partner has inflation it is possible for
the imports from them to raise the price level (depending on rigidity of exchange rate system
and 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 of
inflation. (15 marks)
Basic answer: Define monetary and fiscal policies and show how these policies might decrease
inflation rates caused by demand-pull, cost-push and excess money supply. Problems such as
decreased AD during cost-push inflation should be brought up, and the SR and LR issues of these
policies 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
ƒ affect on AD; increased S, lower C and I
ƒ possibly a higher exchange rate which in turn would lower X and increase M
o increased taxes and/or lower G
ƒ takes some time to implement and take effect
• applied to cost-push inflation
o both increased interest rates and lower G/higher T would affect cost-push inflation,
yet
o 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 by
lowering tariffs — which is in reality a bit far-fetched)
o supply-side policies might be enacted to deal with cost push inflation — yet these are
of 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 with
cost-push inflation.

4. a) How could government change its tax system in order to shift more of the overall tax
burden from the poor to the rich?
Basic answer: The core issue here is to tweak the tax bases — primarily income, expenditure, profits
and 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 can
be increased; and tariffs can be shifted away from imports purchased by low-income households to
more 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 progressive
o the minimum required level of taxable income can be increased
• expenditure tax
o goods with high yED can be taxed more
o lower tax on basic necessities
o low yED goods — inferior goods — taxed less
o various forms of luxury taxes can be implemented
• corporate tax
o lower corporate tax on smaller businesses
o and shift tax base to larger businesses
• capital gains tax
o 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 the
well off far more than the poor
• tariffs
o 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 logical
suggestions.
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 have
both growth and developmental effects. More equitable distribution of income lowers a number of
social ills, such as crime, alcoholism, corruption etc. Simultaneously, better income distribution
enables better and more borrowers (and thus more businesses) and a wider spread of social goods such
as 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 income
o spread of social goods
o increasing participation and contribution to society
• effects of better income distribution and spread of social goods
o wider spread of wealth enables more borrowers and thus entrepreneurs
o lower crime rates
o lower social costs such as drug addiction, prostitution, alcoholism
o 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 a
tricky issue for students.

HL only
5. 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 basic
Keynesian-monetarist debate. The Keynesian side posits that policies can indeed be used to stimulate
demand — demand-side policies — and that markets are imperfect and thus need priming . The
opposing view, from the monetarist/classical side, argues that any intervention by government aimed
at stimulating demand beyond the full employment level of output (i.e. LRAS) will be purely
inflationary — 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 AD
o would decrease unemployment
o but increase the price level (see figure 3.5.22, page 443)
• yes, there is a trade-off
o reference to the Keynesian premise that disequilibrium unemployment is primarily
demand-deficient
o solution is to stimulate demand (fiscally for the most part), i.e. AD
o 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-illusion
o thus the increase in AD will result in a fall in real income
o and firms will increase factor prices and households will bid up wages
o in time, AS will shift left, back to equilibrium and the economy will adapt to higher
inflation expectations
o thus, there is no trade-off in the LR
o this is shown in the LR Phillips curve (page 444)
• empirical evidence
o evidence suggests that a trade-off existed during the 1960 s
o 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. Most
students should be able to get reasonable marks here.

b) What are the implications of your answer in terms of economic policies aimed at growth? (15
marks)
Basic answer: The implications are as simple as they are hotly debated; Keynesian policies have been
adopted by the political left while monetarist/classical policy prescriptions have been supported by the
political right. The existence of an inflation-unemployment trade-off suggests that demand-side
policies should have a degree of success in lowering unemployment — at the cost of higher inflation
levels. 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 economy
o fiscal stimulation has an effect on unemployment
o 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 unemployment
o inflation becomes a problem when economy is stimulated via demand-side policies
o there is a natural rate of unemployment which cannot be dealt with using demand-side
policies
o 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 LR
potential (LRAS) of the economy will ultimate result in the natural rate of unemployment but
at a higher price level
• possible convergence; increasingly, the debate has had a degree of convergence, in that
economists of demand-side persuasion agree that it is indeed sound policy to also increase
output potential in the economy — AS — yet disagree that this necessarily means a market
based 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 is
a trade-off or not. The task, however, is to clarify how the two sides use their theoretical bases to
prescribe 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 and
improve 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 good
o assumptions of comparative advantage and PPFs
o use of PPFs to illustrate
o divergent PPFs and cost ratios show possible terms of trade
• investment
o increased investment via
ƒ government grants, tax breaks and incentives
ƒ foreign investment
ƒ possible reference to capital output ratio
• specialisation
o increased specialisation move the economy along a learning curve
o scale benefits possible
• labour capital
o education, training, experience will all increase productivity
o 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 in
the 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 will
improve the current account.

Possible points:
• definition —and illustration — of current account
o visible trade balance
o invisible trade balance
o net transfers
• definition and examples of trade barriers
o tariffs
o non-tariff barriers, e.g. quotas, subsidies, anti-dumping etc
o 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 Æ decrease in quantity of imports Æ
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 exceptions

o Marshall-Lerner condition
o J-curve effect
o a bit peripheral but a bit relevant — dangers of trade barriers
ƒ risk of reciprocal barriers by trade partners, which to a certain extent negate
export gains of original protectionist country
ƒ 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 between
export 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. Discuss
this 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 of
barriers to trade which have replaced the more traditional ones. Trade is in fact still in many respects
subject 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 regulations
o anti-dumping tariffs
o government favouritism
o environmental standards
o labour standards
o administrative barriers
o 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 price
of 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 right
o adding in Pworld, i.e. trade diagram, showing how quantity of imports decreases
o possibility of export subsidies
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• how developing countries are severely disadvantaged here — since a) they often cannot meet
these subsidies, and b) their own markets can be dumped upon by foreign subsidised
producers

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

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

5. How can trade barriers for agricultural goods in developed countries affect developing
countries?
Basic answer: Define trade barriers as decreasing the ratio of price of exports to price of imports and
illustrate 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 tariffs
o non-tariff barriers; quotas, regulations, health/safety barriers etc
o subsidies
• examples of developed country trade barriers specifically affecting developing countries
o domestic subsidies in developed countries disadvantage producers in developing
countries
o tariffs and quotas for a number of goods still exist
o illustration of tariffs/quotas in trade diagram
o comments to the effect that effective tariff levels are in fact much higher than visible
tariffs
o 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 coffee
o 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 advantage
o textiles
o agricultural goods
o 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 international
competitiveness is a matter of relative price and quality of domestic goods compared to other
countries 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 as
steel
• 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 on
products 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 an
exportable surplus; the LRAC curve (HL) together with the world supply can illustrate how increased
capital can lower AC and enable benefits of scale; investment schedule together with AS-AD diagram
can illustrate the competitive effects of supply-side policies.

Note: There is, as mentioned above, wide scope for good answers. Marks should be awarded on the
basis of how well the student shows a concrete link between, for example, increased investment in
human 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 shift
Sworld upwards to show a tariff. The trapezium (see page 487) shows the loss of domestic
consumer surplus, and the two triangles (B and D, figure 4.2.2, page 487) show green loss and net
loss 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 society
o C) tax revenue to govt
o 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 to
outline 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 price
lower 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 supply
on 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 price
o goods are sold at below cost of production
o HL: goods are sold at below MC
• examples of dumping
o developed countries dumping agricultural goods on developing countries
o use of examples of goods, often in agriculture
o examples, say EU and North Africa
o 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 at
what 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 sell
at 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 cost
countries 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 imports
up and reflect the true cost of production. Anti-dumping tariffs have become common for three main
reasons: 1) they are allowed according to WTO rules; 2) it is almost impossible in many cases for an
offending nation to prove that the real costs are lower than the foreign sales price; and 3) the main
anti-dumper is the US — where any fines levied on offending foreign firms go to the US firms which
have lodged a complaint. The issue of how low cost countries might defend themselves against
dumping accusations is, well, difficult, to say the least. The most efficient way would probably be to
have 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 production
o almost impossible to establish — and thus in many cases in all likelihood unfair
• reasons for them becoming common
o the WTO has granted such tariffs an exception
o very difficult to prove one way or another
o 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 producers
o 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 firms
in developed world countries
• possible solutions for low cost countries
o 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 for
competitive reasons)
o low cost countries could band together and establish an office/organisation where
firms subjected to anti-dumping tariffs could ask for legal assistance
o have the WTO or other international body act as arbiter (judge) in controversies
o 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 is
relevant.

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, clarifying
how/why such an advantage might rise.

Possible points:
• firms
o specialisation and increased use of comparative advantage
o possibility of benefits of scale
o spread and knowledge of technology — production gains
o spread of skills and labour capital
o access to new/wider markets
• consumers
o increased choice, i.e. variety
o lower prices
o overall consumer welfare (consumer surplus — outside of syllabus) in lower prices and
increased consumption
o increase in standard of living
• society in general
o political issues; cooperation, peace-dividend
o improved global resource allocation
o 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, domestic
strategic arguments, and developing infant industries.

Possible points:
• employment
o save jobs in domestic industries
o protect domestic industries from unfair competition, e.g. low-cost labour goods
• safety/health reasons
o safeguard domestic society against harmful products
o examples; FDA in the US or any national agency charged with consumer protection
• environment
o regulations against goods using valuable and limited resources, e.g. hardwoods from
diminishing rainforests, ivory from elephants etc
o ban on goods which do not meet certain production standards, e.g. goods using CFCs
in production
o regulations on minimum standards of emissions in production
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• labour/work standards
o argument of fairness/solidarity in buying goods from sweatshop firms (often
MNCs) in developing countries
• tax revenue
o tariffs will generate government revenues
o particularly in countries with scanty domestic tax bases, e.g. developing countries
• anti-dumping
o 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 regions
and 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 case
of war/blockade/conflict
• infant industry argument
o developing nations need to have protection — for a period of time — in order to develop
domestic industries which initially cannot compete with far more efficient
international firms (which might enjoy benefits of scale)

Diagram(-s): Trade diagrams to show how imports are limited (tariffs and/or subsidies) and how tax
revenue is created. The LRAC curve (HL) may be used to illustrate the infant industry argument and
moving 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 how
imports are limited.

Possible points:
• examples of barriers to trade
o tariffs
o non-tariff barriers; quotas, regulations, health/safety barriers, buy domestic policies
in local and national government, strategic argument etc
o subsidies
• other ways in which to limit imports
o ban (extreme, but US-Cuba is an example)
o devaluation of domestic currency
o non-convertibility of domestic currency
• showing how these barriers and policies can limit imports
o 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 imports
o 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 examples
should 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 get
maximum marks. The main issues lie in whether the barriers to trade are in fact more costly to society
than not implementing them. Each given example of import limitation could be granted a brief pro et
con — in spite of any argumentative stance taken by the student. Alternatively, a good answer might
pick to argue for/against different policies in total. The key is to render solid economic arguments in
support of the line of argument taken.

Possible points:
• limiting imports is generally negative
o less choice for consumers
o higher prices
o decrease in consumption and lower living standards
o less consumer welfare (consumer surplus lost — use trade diagram)
o domestic firms grow lazy/uncompetitive behind protectionist walls
o forward-linkage effects can increase domestic price of goods and decrease the
international competitiveness of domestic firms
o limits possibilities of trade — and thus utilising comparative advantage, benefits of
scale etc
o 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 imports
o infant industry argument — protect fledgling industries, allow them to get up to scale
o limit harmful goods
o strategic argument
o possible government revenue from tariffs
o protection of domestic labour market against unfair competition
o anti-dumping argument
o 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 saving
10,000 jobs in the steel industry when this is offset against higher domestic steel prices for
steel-using industries — i.e. what is the real cost of each job?
• other issues
o the increase in free trade has improved relations between countries ( peace
dividend ); possibility of reciprocal trade barriers and trade war; declining relations of
nations in trade dispute; there is ample evidence that trade is not a zero sum game
and that jobs are in fact not saved in the LR
o developing countries must be allowed to protect themselves from highly efficient
international firms — just like the present developed nations did once; increasing trade
liberalisation can lead to global entities which empower themselves at the expense of
small domestic firms — and even governments

Diagram(-s): PPFs/ CPFs showing increased consumption possibilities (CPF). Trade diagram showing
effects 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 average
price of a country s basket of export goods in relation to the average price of a country s basket of
import goods. (HL: use index of terms of trade, i.e. IndexflP X/IndexflPM x 100). The balance of trade
is the total amount of export revenue minus import spending.

Possible points:
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• definition of terms of trade

o the amount of a given amount of export goods necessary to buy a given amount of
import goods
o barter or commodity terms of trade, i.e. quantity of Volvos per quantity of Toyotas
o 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 revenue
o price of imports times quantity of imports equals imports spending
o export revenue minus import spending equals the (visible) trade balance
o 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 defining
basic concepts.

b) How might a country use trade barriers and the exchange rate to affect both the terms of
trade 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 ratio
between export and import prices — as this is the central theme. The answer should clearly identify
how 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 imports
o thus decreasing imports
o illustration using trade diagram to show increase in price, decrease in imports
o 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 rises
o 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 balance
o thus the trade balance should improve when imports fall
• definition of the exchange rate — price of domestic currency in terms of a trade partner s
currency
• use of the exchange rate to affect the terms of trade and trade balance
o a devaluation/depreciation of the currency (ceteris paribus) will decrease the terms of
trade
o a lower exchange rate will raise the price of imports
o and lower the price of exports
o leading (possibly — HL should include Marshall-Lerner condition and/or J-curve) to an
increase in exports and export revenue
o and a decrease in imports and import spending
o 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 can
actually 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 affect
the exchange rate.
Basic answer: The main task here is to make clear that the causal flows move from the change in
exports/imports to a change in the exchange rate. Using a S/D diagram, a good answer will state the
derived-demand issue involved in currencies, and then illustrate how an increase in demand for
Home s export goods will increase the demand for Home s currency. Concomitantly, if Home s
demand for imports increases, there will be an increase in the supply of the Home currency — as this is
used 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 goods
o can cause an increase in the demand for Home s currency
o 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 imports
o causes Home to buy more foreign currency
o supply of Home currency on currency market increases
o 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 current
account surplus?
Basic answer: Define full employment and illustrate using an AS-AD diagram. Define current account
surplus, i.e. sum of visible and invisible trade balance is positive. Assume that attaining full
employment necessitates the use of demand-side policies. There are thus two main effects possible on
the current account: 1) the stimulatory effects on AD increase national income — and thus there is an
increase in general spending, some of which will go to imports (HL: MPM); and 2) increased AD
might well lead to inflation, and since the relative prices have now changed in favour of foreign
countries, imports might increase and exports decrease. Both of these effects work in the same
direction, 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 employment

o outline of demand-side policies
o illustration of less that full employment — AD curve to the left of general equilibrium
o fiscal and monetary policies which would increase AD
o showing how such policies would increase C, I and shift AD to the right
o comment on the increase in income
o and higher price level
• the effect on current account of the above
o increase in spending due to income effect might lead to increased demand for imports
o higher price level might decrease exports (as prices relative to foreign sector have
changed) and increase imports
o 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 economy
more 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 by
using 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 uses
the currency market mechanism — buying and selling its own currency — to set the exchange rate in the
LR. Using a S/D diagram, show how the corridor of the exchange rate can be set and then how the
central 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 bank
sells home currency — shown by an increase in supply and a return to within the
boundaries of the ceiling
o when there is a tendency for the exchange rate to go below the floor, the central bank
buys home currency (using foreign reserves) — shown by an increase in demand and a
return 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 policy
o limits to fiscal policy, as the pegging country cannot risk large deficits and debt which
would exert a negative influence on the exchange rate
o 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, the
demand 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 factors
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 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 currency
by the central bank, speculative buying by foreign speculators
• issues influencing the supply of the home currency, i.e. change in import demand, change in
FDI 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; government
deficits/debt, current account deficits, supply-side issues (which in turn influence productivity
and relative inflation), 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 appreciation
or 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 in
supply of the home currency. Both should then be commented on to make clear how the exchange rate
is influenced.

Note: This is a wide question with many possible angles of attack. Students should be amply rewarded
either for dealing with a few issues in depth (say, one good example of a change in demand and one
for 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/speculators
might cause an increase/decrease in the supply/demand for a currency, causing a depreciation or
appreciation 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 for
speculation
• example of speculation — such as a currency trader buying a currency in a country where the
interest rates is expected to rise
• using S/D diagrams to show the effects of speculation
o if speculators fear a fall in the exchange rate for the $US, they will sell off the dollar
and supply of the $US will increase
o 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 currency
and then immediately trading it in for another currency Æ ˘_S for the currency), it is possible
that 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 or
something like this.

Note: Often weak answers will confuse the causal flows here, i.e. write about how exchange rate
changes 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 s
currency and balance of payments?
Basic answer: A rise in the interest rate might have a SR effects on the Home economy; as global
investors/speculators shift their portfolios to increase the weight of Home currency (higher SR rate of
return for investors/speculators), the demand for Home currency will increase — thus appreciating the
Home currency. In the LR, the monies flowing into the capital account (+), might create outflows in
current account (-). A higher exchange rate may also exacerbate the balance of payments
disequilibrium 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 on
deposits
• 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 of
payments; 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 exports
and 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 the
factors 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 foreigners
o investment (portfolio and direct) demand by foreigners
o relative rate of return on saving (interest rates)
o intervention purchasing of the home currency by the central bank
o speculative buying by foreign speculators
• issues influencing the supply of the home currency
o 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 the
supply of the home currency
o change in foreign interest rates
o speculative selling of the home currency
o intervention buying/selling of home currency by central bank
o change in relative inflation rates
• mentioning that there are a number of LR issues influencing the exchange rate
o government deficits/debt
o current account deficits
o 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 appreciation
or 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 in
supply of the home currency. Both should then be commented on to make clear how the exchange rate
is influenced.

Note: Full marks should be possible for clear answer dealing with two variables which affect demand
and two affecting supply for a currency.

b) How might a change in the exchange rate affect the domestic economy of the country? (15
marks)
Basic answer: A change in the exchange rate — ceteris paribus — will alter relative prices between
trading countries. The answer should (one again) be clear on the price of the currency, the price of
exports, 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 rate
could increase exports and export revenue, thus increasing AD — while possibly reducing import
spending. 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 foreigners
o possible increase in exports and increase in export revenue
o possible decrease in imports and decrease in import spending
o HL: possible reference to Marshall-Lerner condition and/or J-curve
o the effects clearly illustrated in AS-AD model; shift of AD to the right
o increase in national income and price level
• effects of appreciation
o price of home goods increase for trade partners
o possible decrease in exports and decrease in export revenue
o possible increase in imports and import spending
o HL: possible reference to Marshall-Lerner condition and/or J-curve
o the effects clearly illustrated in AS-AD model; shift of AD to the left
o decrease in national income and deflationary effect on economy
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• assuming a fixed/pegged currency

o the economy might realign (devalue/revalue) the exchange rate
o possible reciprocal/retaliatory effects due to devaluation
o 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 appreciate
the 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 a
depreciation/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 simply
pegged exchange rate regime — will see how the rate is set by central bank policy and upheld by
intervention 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 the
boundaries of the ceiling
o when there is a tendency for the exchange rate to go below the floor, the central bank
buys home currency (using foreign reserves) — shown by an increase in demand and a
return to within the boundaries of the floor
• other issues; the central bank can also use interest rates to change demand for the domestic
currency — 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 terms
of another/basket of currencies . The fixed exchange rate corridor (page 569) may be used for
further illustration.

Note: This question is usually well addressed — main weakness probably being sloppiness in
adequately labelling diagrams.
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b) Discuss the advantages and disadvantages in having a managed exchange rate regime. (15
marks)
Basic answer: Well, this is actually only a HL question, but the list below should in part be included in
SL sections.

Possible points:
Advantages of a managed/fixed exchange rate
• predictability and certainty
o fixed exchange rates make it easier for importers and exporters to calculate earnings
o costs, revenues and profit margins are clear and predictable
o 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 future
profits it is easier to plan business
o international stability in exchange rates lowers barriers to partaking in international
trade and thus increases trade.
• fiscal/monetary discipline domestically
o 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 a
minimum in order to avoid depleting the reserves. This limits inflationary fiscal and
monetary policies.
o countries within a fixed exchange rate system will not be able to run up large current
account deficits in the long term. Stimulating aggregate demand leads to increased
imports and inflation — both of which will create net outflows in current account. A
current account deficit means that more domestic currency is hitting the international
market which will exert downward force on the exchange rate.
• less risk of speculation
o 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 have
limited 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 another
currency, since higher interest rates attract foreign funds and thus increased demand
for the domestic currency. Since the priority of the central bank must be to keep the
exchange rate steady there is little room to set interest rates in order to stimulate or
deflate the domestic economy. There is a trade-off between having a fixed exchange
rate 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 reserves
enough to dissuade speculators from attacking the currency.
• possibility of increased unemployment
o 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 increase
demand for the domestic currency. Government spending might also be cut to
decrease imports. Both policies will have a negative effect on aggregate demand and
thus employment.
• possibility of imported inflation
o 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 materials
and goods.
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Diagram(-s):

Note: The list above is quite extensive — exhausting you might say — and top marks should be allowed
for 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. (10
marks) Note: HL question.
Basic answer: This can be answered by linking to the problems faced by EMU members. The basic
problem is one of convergence; when countries take the step to permanently align (and a single
currency 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 respectively
o a common currency means a common interest rate — thus members will give up the
ability to use monetary policy to affect AD
o 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 converge
o inflation must be roughly the same in member countries
o government deficit and debt cannot be widely disparate in member countries
• other issues; political and perhaps nationalistic issues, where citizens feel loss of political
power and loss of identity;

Diagram(-s): Possibly two separated AS-AD diagrams showing different AD curves in relation to
LRAS to illustrate the difficulty in having a one size fits all monetary policy for common currency
members 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 will
also be a convergence problem in maintaining it — commonly called the asymmetry problem. There are
also the economic and political costs of giving up domestic policy freedoms. In spite of this, there are
numerous benefits in having a single currency for an area which is economically integrated.

Possible points:
• possible costs
o restriction of monetary policy
o loss of political power
o increased integration might render a fiscal straightjacket , i.e. diminished freedom
for member governments in setting taxes and government spending
o 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 rate
of 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 — and
rounding all prices upwards
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• possible benefits
o possibility of trade creation within the currency union
o price transparency as all prices will be in a common unit
o greater competition, lower prices, consumer welfare increase
o lower transaction costs for firms in dealing with foreign firms
o 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 the
scene for inevitable economic/social integration — that a single currency forces a single
monetary policy, increases coordination of fiscal policies, and leads to further integration
along the lines of converging taxes, welfare benefits, common borders etc

Diagram(-s): Possibly trade diagrams showing trade creation and diversion — noting that these
diagrams are not core syllabus illustrations (page 534).

Note: These are the main issues, yet any other reasonable issues should render marks. Any four issues
well 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. Define
current account and current account deficit — i.e. that the sum of visible and invisible trade balances is
negative. In support, possible arguments are that a current account deficit entails a capital account
surplus — 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 the
statement, possible arguments might be that capital account inflows create jobs and increase the capital
base; foreign firms are simply allocating funds to a vibrant economy yielding higher rate of return; and
that 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 speculative
o if capital inflows — such as FDI — are used productively in the economy
o linking FDI/portfolio investment to increased demand for labour, increased output
o 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 in
o no real problem as long as foreign investors are willing to invest and thus finance the
current account deficit
o if the current account deficit simply reflects increasing incomes for the home
economy
o if the current account deficit in relation to GDP or total trade is relatively small
o 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
ƒ debt burden
ƒ country becomes vulnerable to international interest rate hikes
ƒ increased debt burden due to exchange rate depreciation
o the capital account inflows are speculative
ƒ possible effects on speculative bubbles in the economy
ƒ possible depreciation of exchange rate
ƒ financing the deficit may run down foreign reserves
o the capital account inflows are squandered or become capital flight
o foreign investors see the growing current account deficit and decrease investment
o 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 due
to foreign capital ) and Thailand/Indonesia/Malaysia in 1997/98 ( South East Asian
meltdown )

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 be
possible.
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2. Explain how a country which is experiencing a boom in the domestic economy might see the
current account go into a deficit.
Basic answer: Definition of boom period as heightened growth commonly associated with an
increase in AD. Definition of current account as inflows/outflows in the economy created by trade and
transfers. The question asks for the student to link AD — and possible inflationary gap — to an increase
in 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 increased
o possible inflationary gap
• definition of current account deficit, i.e. outflows are greater than inflows on current
account
o and that this may be caused by a trade deficit
o reference to invisibles (services, net tourism, repatriated profits, interest )
• high domestic growth causing increased imports
o reference to income effect
o possible bottlenecks in domestic supply
o 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-Lerner
condition (HL)
• clear explanation of how increased import spending and decreased export revenue affects the
current 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 be
made 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 and
transfers) and capital account (net flows of investment, deposits etc). The link between a country s
exchange rate and balance of payments is primarily to be found in current account; the currency also
affects the price of goods and services for foreigners, thus a lower/higher price of the currency will
affect demand for goods and services itemised under export revenue and import spending in the
current 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 net
flows due to foreign investment, deposits, speculation, loans and foreign reserves
• assuming a floating exchange rate
o a depreciation will lower the domestic price of goods and services
o exports increase, imports decrease
o and this possibly increases import revenue and decreases import spending
o 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 foreign
currency reserves to purchase the home currency — this would be an inflow to capital
account 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 Æ price of exports (in foreign
eyes), price of imports (domestic eyes) Æ quantity of exports/imports Æ export revenue/import
spending Æ current account and balance of payments.

4. How might deteriorating terms of trade improve the current account in the balance of
payments?
Basic answer: Define and exemplify terms of trade (ratio: price of exports over price of imports) and
clarify that a deterioration of the terms of trade means that export prices have fallen relative to import
prices — leading possibly to increased exports (and export revenue) and decreased imports (import
spending). As the current account is basically made up of the balance of exports minus imports, the
above 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 Æ higher quantity exported Æ higher export revenue
o higher price of imports Æ lower quantity imported Æ lower import spending
• clear account/illustration of current account, including visible and invisible trade balances
with examples of the latter (repatriated profits/interest, transfers)
• simple numerical example showing clearly a change in terms of trade, export revenue/import
spending, 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 in
fact not entirely certain that a deterioration in the terms of trade will lead to an improvement in
current account

Diagram(-s): J-curve.

Note: I usually generously reward students who manage to show a clear link in some way between
terms of tradeÆprice of X/MÆquantity of X/MÆX/M revenue or spendingÆcurrent account.
However, I demand that there is a clear distinction between price/quantity/revenue(spending) when it
comes to exports and imports. Also, I highly reward HL students who take the path of criticising the
question 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 exports
dearer to foreigners and imports dearer to domestic citizens, there are a number of possible benefits
but also disadvantages. Benefits include increased purchasing power for households, lower imported
factor prices for firms and forward linkage effects, increased standard of living perhaps, a wider range
of goods and travel possibilities, decrease in real foreign debt etc. Possible negative effects are
 77/110

decreased exports and increased imports with implications for the balance of payments and possible
currency 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 citizens
o enhanced choice and array of goods, standard of living increase
o lower factor prices for domestic firms
o forward linkage effects on domestic production and possibly increased international
competitiveness
o decrease in (real) foreign debt
• negative aspects of appreciation
o price of exports (in foreign eyes) has increased leading possibly to a decrease in
exports and export revenue
o implications for current account and balance of payments
o increased imports may decrease AD
o loss of jobs in export sector
• additional issues; a stronger currency might cause expectations-based speculative buying of
the 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 negative
effects 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 account
in the short run?
Basic answer: Devaluation (intentional downward adjustment of a fixed exchange rate) is commonly
expected to increase quantity of exports as the price of exports has decreased. This might not
necessarily lead to an increase in export revenue for two primary (overlapping) reasons; 1) the
Marshal-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 is
more than one, will a devaluation improve current account
o J-curve effect; consumers might take time to adjust purchasing behaviour to a higher
price levels of imports, and firms can be locked into fixed currency contracts — both
could in fact mean that the current account would worsen in the SR (also hinges upon
the fact that some import goods might be highly demand inelastic)
• possibility that the economy is highly dependent on imported factors for domestic production
which is primarily exported — a devaluation would have serious forward linkage effects and
could in fact diminish the economies international competitiveness and thus decrease export
revenue (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 high
marks.

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 to
explain 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 reserves
o 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 rate
o increased loans from abroad to enable import expenditure
• then there are some LR effects;
o depreciation of exchange rate
o increased foreign debt
o higher interest rates on future loans as a risk premium for lenders
o possibility of increased interest rates in order to continue to attract foreign investment
o high level of FDI might cause increased outflow of repatriated profits
o 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 indeed
caused by decreased competitiveness, higher inflation

Diagram(-s): S/D diagram for currencies illustrating speculative outflows of currency and depreciation
for 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 range
of 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 to
MPM)

Diagram(-s): Trade diagram showing effect of tariffs/subsidies; S/D diagram showing increased
demand 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 positive
effect 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 the
average price of imports — and exemplifying using some form of export and import basket. The
balance of trade is defined as the total export revenue minus total import spending (in the visible trade
account).

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 outlined
via 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 of
currencies). 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 trade
balance. The terms of trade change when the price of exports and imports change — thus, a
depreciation of the currency will cause a deterioration in the terms of trade but possible an increase in
export 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 trade
o this might serve to increase exports and/or decrease imports
o 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 Æ increased exports Æ increased export revenue Æ
improvement in balance of trade
• effect on terms of trade of depreciation
o exchange rate decreases Æ fall in the ratio between export and import prices (ceteris
paribus) Æ deterioration in terms of trade
• other examples, for example
o lower domestic inflation relative to trade partners Æ increase in exports and decrease
in imports Æ improvement in trade balance
Diagram(-s):

Note: Higher scores are often for answers which exemplify and illustrate changes in the terms of trade
and 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 good
answer will be able to make clear that the only way a country can persistently run a current account
deficit is by having a capital account surplus. The answer lies squarely in how/why money is flowing
into 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 loans
o speculative inflows
o FDI and portfolio investment
• reference to real life examples such as the US current account deficit during most of the 1980s
and 1990s

Diagram(-s):

Note: Highest marks should be given to students who clearly outline the balance of payments and are
able 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 a
counterargument.

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 speculative
o if capital inflows — such as FDI — are used productively in the economy
o linking FDI/portfolio investment to increased demand for labour, increased output
o 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 in
o no real problem as long as foreign investors are willing to invest and thus finance the
current account deficit
o if the current account deficit simply reflects increasing incomes for the home
economy
o if the current account deficit in relation to GDP or total trade is relatively small
o 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
ƒ debt burden
ƒ country becomes vulnerable to international interest rate hikes
o the capital account inflows are speculative
ƒ possible effects on speculative bubbles in the economy
ƒ possible depreciation of exchange rate
ƒ financing the deficit may run down foreign reserves
o the capital account inflows are squandered or become capital flight
o foreign investors see the growing current account deficit and decrease investment
o 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 in
1997/98 ( South East Asian meltdown )

Diagram(-s): AS-AD model to show effects of FDI, increasing demand and inflation, and the effects
of a speculative (inflationary) economy.

Note: For full marks there has to be an element of evaluation; the student should include a discussion
on why/how the deficit does or does not represent a serious problem. Real world references which are
relevant and clearly linked to argumentative stance should be amply rewarded.

HL
4. a) Explain how a floating exchange rate works and the variables which affect the rate. (10
marks)
Basic answer: Define a floating exchange rate as the price of a currency (in terms of another or basket
of currencies) being determined by market forces, i.e. supply and demand of the currency. Using two
S/D diagrams, illustrate and exemplify such market forces — all the while clearly referring to the
diagram.

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 how
much 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 is
depreciation while a rise in the external value is an appreciation
• issues which influence demand for the home currency
o the derived demand for domestic goods and services by foreigners
o investment (portfolio and direct) demand by foreigners
o 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 currency
o change in import demand
o change in FDI abroad
o change in foreign interest rates
o speculative selling of the home currency
o intervention selling of home currency by central bank
o change in relative inflation rates
• viable and clear examples of how the exchange rate changes in line with changes in
supply/demand, for example
o a fall in home s inflation rate relative to trade partners (= fall in relative inflation
rates) Æ increased demand for home s exports Æ increased demand for home s
currency Æ appreciation of home exchange rate
o higher corporate taxes in home
ƒ lower demand for FDI from foreigners Æ demand for home currency falls Æ
depreciation of home currency
ƒ it is plausible that even home firms will seek out higher net rate of return by
diverting investment abroad Æ increased outflows of FDI abroad Æ increase
in the supply of home currency Æ depreciation of home currency
• mentioning that there are a number of LR issues influencing the exchange rate; government
deficits/debt, current account deficits, supply-side issues (which in turn influence productivity
and relative inflation), increasing focus on R&D/comparative advantage etc to increase
competitiveness 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 shift
in supply of the home currency. Both should then be commented on to make clear how the exchange
rate is influenced.

Note: This is a wide question with many possible angles of attack. Students should be amply rewarded
either for dealing with a few issues in depth (say, one good example of a change in demand and one
for 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 trading
countries? (15 marks)
Basic answer: This centres around PPP theory of exchange rates, which deals with the LR effects on
exchange 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 country
relative the exchange rate based cost in a trading country
• example of relative price prices
o home s shirt costs $30 and foreign s shirt costs 60
o the exchange rate is $1 = 1.5
o the relative price means that
ƒ home citizens pay $30 for domestic shirts and $40 for foreign s shirts
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ƒ 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
• assumptions
o homogeneous goods
o no transport costs
o no trade barriers
o 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 in
foreign, thus
o foreign citizens will increase imports of shirts from home Æ increase in the supply of
Æ depreciation of the
o foreign citizens demand for the $ will increase Æ 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 rates
o 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 from
foreign — this will ultimately readjust the exchange rate to reflect relative prices (the
home $ will depreciate and the foreign will appreciate)
• criticism of PPP theory
o assumptions do not hold up in reality
o 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 how
this would cause changes in exports/imports and affect exchange rates should be rewarded. Any well
exemplified answer which takes a counter-stance and states that exchange rates will not in fact reflect
relative 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 growthÆ incomeÆ tax bases Æ enhanced
ability for infrastructure/merit- and public goods
• increased income Æ 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 and
potential output.

Note: As so often is the case in development questions, students have a tendency to be vague and
anecdotal here. Highest marks should go to students who are able to clearly link enhanced human
capital 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 model
and then outline various impediments to its implementation in real life in developing countries. Note
that the question necessarily leads to a degree of spin-off in that the basis of the Harrod-Domar
equation 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 output
o 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 Æ low savings Æ low investment Æ 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. insufficient
funds for investment level
o can be filled by foreign loans and/or foreign investment
o 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-Domar
model, 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. Define
sustainable development; development that meets the needs of the present without compromising
the ability of future generations to meet their own needs. The issue of sustainability needs
elucidation, as there is no generally accepted or universal translation of this excerpt from the 1987
Brundtland Report. The possible trade-off between growth and sustainable development deals with
resource use, environmental degradation, carrying capacities of our world and the ability of human
ingenuity 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 population
o environmental degradation, i.e. air pollution, soil erosion, global warming etc
o carrying capacity of the globe in terms of maximum sustainable LR population
o 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 intact
during growth, but that productivity increases (and technological advances) are such
that there are sufficient resources to sustain living standards (i.e. that the economic
system 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 is
unlikely that any of the IB examiners would define and outline sustainable development in exactly
the 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 then
illustrate how this might adversely affect a developing country. Main points deal with possible
inflation, income distribution and externalities such as environmental issues.

Possible points:
• trade-off issues
o inflation due to increase in AD
o balance of payments issues due to growth
o 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, industrial
areas, 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 unevenly
o 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 higher
marks 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 student
should 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 to
exemplify. 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 achieve

economic growth/development.
Basic answer: Define multinational companies (MNCs) as companies having production in more than
one country. Define growth (increase in GDP) and development (increase in standard of living). Some
common 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 opportunities
o and increases the capital stock of the country
o increase in AD and thus GDP (HL: possible multiplicative effects)
o subsidiary companies generate possible inward flows of profits from abroad
o 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 deficit
o not all capital put to use in LDCs is appropriate
ƒ highly capital intensive production does not create many jobs
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ƒ capital intensive production does not utilise comparative advantage, i.e.

labour
ƒ imported capital is often demanding in terms of technological expertise in set
up, maintenance and repairs — such services are often imported from abroad
o a number of MNCs have been accused of heavily marketing inappropriate products
o a goodly proportion of profits might be repatriated abroad and thus not be re-invested
in the local community
o it is possible for MNCs to avoid a proportion of taxes by, for example, internal pricing
of goods within the company
o very large and powerful MNCs might simply use there power as leverage and
bargaining power in land/rent/tax/labour negotiations with firms/unions/governments
in developing nations
• other possibilities, for example that MNC presence might create the need for functioning
infrastructure/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 should
not be able to earn full marks.

7. Explain how many developing countries became burdened with severe debt problems in the
1980 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 developing
nations; 2) the oil crises of 1973/ 74 and 1979/80; 3) massive amounts of petro-dollars flooding
liquidity markets in western commercial banks; 4) stagflation of the 1970 s and low demand for
investment 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 $US
o these so-called petro-dollars were often deposited in western commercial banks
o abundance of available loanable funds
• stagflation and effects on western economies
o low demand for loanable funds
o banks sought out new customers — countries, which do not go bankrupt
• many newly liberated countries — ex-colonies — sought access to development capital and were
happy 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 countries
o borrowed monies were often directed towards increasing cash crops
• interest rates in early 1980 s increased drastically — one possible reason being that US
President Reagan raised US rates to stifle inflation
• falling commodity prices continued during 1980 s and 1990 s
o decreased terms of trade for developing countries
o lower export revenue for commodities and cash crops
• in conclusion
o already substantial debt taken on in the 1970 s increased as
ƒ interest rates increased
ƒ many of the loans were dollar denominated and the dollar appreciated as the
US raised interest rates
ƒ 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 the
World 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 of
why 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; and
agricultural goods such as rice and wheat. These prices have been falling more or less continuously
since the 1970«s, and severely hampering growth/development in developing countries which are
dependent 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 Æ deteriorating terms of trade Æ low
PED for commodities Æ fall in export revenue Æ worsening of current account Æ fall in
exchange rate Æ falling prices of exports .
• the above has exacerbated the debt situation for developing countries, since a depreciation
leads to higher real foreign debt, and also that falling commodity prices mean that more goods
have to be sold in order for the developing country to receive vital foreign currency necessary
to service debt
• any reasonable/viable example of the severe anti-developmental effects on developing
countries 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 is
not 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 take
place, low (and perhaps negative) marginal productivity of labour in the traditional sector will
allow/entice the relative abundance of available labour to move to the modern sector (terminology is
found in the Lewis model).

Possible points:
• definition of dual economy
o traditional sector based primarily on agriculture and/or subsistence households — large
supply of labour
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o modern sector resulting from industrialisation and manufacturing — increased income

and 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
ƒ low — even negative marginal productivity of labour in traditional sector
ƒ higher and increasing marginal productivity of labour in modern sector
o supply and demand for labour
ƒ excess supply of labour in traditional sector
ƒ 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
ƒ urban unemployment
ƒ large wage differentials between traditional and modern sector
ƒ large poor urban population, overcrowding

Diagram(-s):

Note: A good answer would be one which clearly outlines — descriptively — the existence of a modern
and traditional sector side-by-side. A thorough description of the marginal productivity of labour is not
necessary.

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; low
incomes Æ low savings Æ low investment Æ low incomes. As for the issue of breaking the cycle
there are a range of possible suggestions, all of which unfortunately encounter any number of other
obstacles.

Possible points:
• definition of poverty cycle; low incomes Æ low savings Æ low investment Æ 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 starves
the financial institutions (e.g. banks) from loanable funds for investment; investment is central
to the concept of economic growth — which leads back to low income
• breaking the cycle
o increased use of government funds towards infrastructure and merit/public goods in
order to increase human capital
o micro-credit schemes might make more entrepreneurial capital available
o enforced property rights would give more households the opportunity to use property
as collateral (= security) for loans
o freer international movement of capital, allowing foreign investment to fill savings
gap
o attracting MNCs to increase both income and investment
o changing the tax system to redistribute incomes, which would enable more saving
amongst a wider group
o enforcing legislation against various forms of capital flight
o 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 prerequisite
o foreign investors need incentives such as able labour force, distinct and well-enforced
property rights etc
o 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 flight
o 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 and
buildings but have a much wider scope. Property rights encompass also the use of land/buildings in
accordance 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 to
keep 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
ƒ lack of collateral for loans
ƒ future gains cannot be used as security for loans
ƒ farmers on customary land and squatter have little incentive to improve the
quality of this property — lowering any potential value as security
o inability to sell property to others who might use it more productively
o lack of investment results in
ƒ less income
ƒ lower tax base
ƒ less government revenue and thus public/merit goods
ƒ large parallel economy
o often the poorest segments who lose the most from lack of property rights
ƒ poor entrepreneurs might be forced to borrow from loan sharks at
preposterously high interest rates
ƒ 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 low
levels of entrepreneurship, investment and the vulnerability of poorer sections in society should merit
marks.
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13. Distinguish between growth and development .

Basic answer: Growth is quantitative measure (change in nominal or real GDP/GNP) while
development 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 of
choice/religion/politics etc
• measures of development include
o percentage of population in absolute/relative poverty (define!)
o percentage of women with secondary/tertiary education, proportion of women in
parliament
o mean distance to hospital, infant mortality rates, longevity
o proportion of population literate
o telephones per capita, kms of roads per 1,000 citizens
o number of violent crimes per 1,000 citizens,
o unemployment rate, voting rights
o HDI or any composite development index
o 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 forth
should receive marks

Diagram(-s):

Note: A good answer will not consist simply of a description of development but include more specific
measures 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 a
debtor nation which has seen necessary to reschedule old debt or borrow anew. These demands are
aimed 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 inflation
o implement various forms of supply-side measures to increase growth, decrease
inflation
• government debt
o decrease government spending
o increase taxes to balance budget
o restructure debt
• exchange rate
o cessation of intervention in currency markets
o allow convertibility of currency
o floating exchange rate
• market-based economy
o removal of minimum prices
o decrease in government subsidies
o decrease labour market rigidities
• openness to trade
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o removal/lowering of barriers to trade

o increased openness to FDI and capital movements
• free-market orientation, currency convertibility and openness to trade is aimed at improving
balance 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 not
asked for here.

15. Outline the possible negative effects of import-substitution policies.

Basic answer: Define and outline import-substitution; focus on decreasing domestic reliance on
imports by implementing high barriers to trade and channelling government resources towards
specified domestic industries. The rather dismal results of import-substitution include a strong political
rather than economic philosophy , focus on domestic champions which decreased competitiveness,
failure to identify winning industries, squandered government resources on goods for which there
was no competitive advantage, forward linkage effects and a lack of capital/ skills/ knowledge
transferred from abroad.

Possible points:
• definition/outline of import-substitution
o high (infant industry) tariffs on imports
o funnelling resources towards state-run or heavily state-subsidised industries
o large element of central planning in fact
o reference to national champions or license Raj of India
o often attempted in countries with large inner markets
• negative effects herein
o tariff protection and subsidies created comfort zones for domestic firms to operate
behind
ƒ lack of competition and high prices
ƒ inefficiency in production
ƒ poor quality goods
ƒ low productivity
o forward linkage effects
ƒ higher costs of factors produced domestically raised costs further forward in
production
ƒ 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 economic
reasoning
o few of these chosen industries became winners — and fewer still survived when the
step 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 North
Korea
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 the
LRAC 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 Tiger
economies — is solely the result of outward oriented policies.
Basic answer: Define outward oriented policies; (also referred to as export-orientation or export-led
growth) a policy of focusing on goods aimed at the international goods market which has frequently
been 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 strategy
were 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 imports
o and often a degree of infant-industry protectionism
o often liberalised international capital flows to allow inflows of foreign investment
o strong focus on competitive advantage — often labour intensive goods (at least
initially)
o strong government involvement
ƒ subsidies to key sectors and industries
ƒ tax breaks for investment
• not all successes can be attributed to outward oriented policies
o often very strong focus on education and infrastructure — both as a cultural dimension
and government funding
o 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 were
initially 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 the
LRAC curve (see page 678).

Note: Full marks should not be possible without using at least one clear example of the limits of
outward 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 and
developed 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 1,000
citizens is. The way to address this question is thus to not only exemplify with variables which are
part of living standards, but also render them measurable in some way.

Possible points:
• defining standard of living
o poverty levels
o inequality
o health care
o education
o infrastructure
o 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 parliament
o mean distance to hospital, infant mortality rates, longevity
o proportion of population literate
o telephones per capita, kms of roads per 1,000 citizens
o 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 receive
marks
• 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 arespecific 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 living
standards? (15 marks)
Basic answer: Again, a very broad topic with many possibilities. Possible answers include the entire
trade vs aid debate — and virtually any of the development strategies put forward. The key here is to
clearly link development strategies to increased living standards in LDCs.

• trade
o developed countries can lower trade barriers for goods such as textiles and agricultural
products for which LDCs have comparative advantages
o exceptions (via WTO) to developing countries allowing certain types of infant
industry protection for LDC industries
o fair trade organisations
• increased FDI in developing countries - multinational companies; can help transfer
knowledge/technology, fill domestic savings gap
• increased aid
o might help close the savings-investment gap
o in line with the above, reference to Harrod-Domar model; increase growth by either
increasing savings (and thus investment) and/or increasing productivity (and thus
decreasing the capital-output ratio)
o aid in the form of expertise, training and education
o assistance in infrastructure and poverty relief
o 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 from
LDCs; 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) protection
enabling 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 trade
and channelling government resources towards specified domestic industries.

Define and outline import-substitution; The rather dismal results of import-substitution include a
strong political rather than economic philosophy , focus on domestic champions which decreased
competitiveness, failure to identify winning industries, squandered government resources on goods
for 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 etc
o increased use of international capital
o openness to FDI and portfolio investment
o removing restrictions on foreign exchange, i.e. allowing the currency to be convertible
and subject to market forces
o 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 imports
o funnelling resources towards state-run or heavily state-subsidised industries
o large element of central planning in fact
o reference to national champions or license Raj of India
o often attempted in countries with large inner markets

Diagram(-s): Trade diagram to show effects of tariffs and subsidies — together, possibly, with the
LRAC 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 successful
than import-substitution. The main point in putting forth this claim are that export-orientation has led
to rapid growth while import-substitution has in fact been a dismal failure — resulting in the general
abandonment of import-substitution as a main development policy. The however , as there always is
in the dismal science, is that numerous specific policies in export-orientation in fact closely mirror
policies implemented in import-substitution policies.

Possible points:
• general results of export orientation
o focus on key growth industries in which comparative advantages existed has been
broadly successful
ƒ Japan in 1950 s and 1960 s, Korea in 1970 s and 1980 s
o specialisation enables
ƒ benefits of scale
ƒ firms to move along learning curve
o industrialisation and FDI
ƒ initial focus on relatively simple industrial goods enabled technological
advances leading to higher level goods
ƒ increased value-added
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ƒ improved productivity
o openness to capital markets has enabled open economies to fill domestic savings-
investment gap
o broadened production base enabled these economies to move away from commodities
and into higher income elastic goods
o generally, the competitive market orientation of export orientation has improved
resource allocation
o high export levels have generated much-needed growth
ƒ created jobs
ƒ increased tax bases
ƒ enabled investment in human capital, merit/public goods
• general results of import-substitution
o tariff protection and subsidies created comfort zones for domestic firms to operate
behind
ƒ lack of competition and high prices
ƒ inefficiency in production
ƒ poor quality goods
ƒ low productivity
o forward linkage effects
ƒ higher costs of factors produced domestically raised costs further forward in
production
ƒ 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 economic
reasoning
o few of these chosen industries became winners — and fewer still survived when the
step towards open markets was taken
o lower consumer welfare — less choice, fewer goods, higher prices
o general failure of import-substitution
ƒ now pretty much abandoned — possible exceptions are Burma/Myanmar and
North Korea
ƒ the infancy of infant industry tariffs could get rather middle-aged in fact
o 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; externalities in the form of pollution and
environmental degradation, speculative inflows of funds which have fuelled bubble
economies, harsh labour policies designed in favour of employees, bans on unions, poor
labour rights

Diagram(-s):

Note: A good answer will outline both sides critically and clearly link issues brought up to
development.

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 student
should 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
ƒ medicines
ƒ catastrophe relief
ƒ 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 to
exemplify. 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 economists
would deny that aid has its place, for example in cases of famine, natural disaster etc — and also in
projects which are well designed for countries which have adequate framework (institutions, for
example) to implement development projects. Criticism of aid — and the advocacy of trade, often in the
same breath — often points out that many of the most aid-inundated countries in the world have not
seen anywhere near the development of fiercely outward-oriented nations which have received
proportionately little aid.

Possible points:
• benefits of aid
o enables SR stimulation of an economy
o can be vital in providing basic necessities and SR relief
o can help in education and transferral of knowledge
o has been shown to be beneficial in countries with strong institutions and functioning
government/administration
• criticism/limits of aid
o inefficient
ƒ monies are squandered by inept/corrupt govt
ƒ capital flight
ƒ aid does not reach the neediest most of the time
ƒ poorly planned projects
ƒ high costs of experts from developed (aiding) country
o aid can knock out local investment and businesses
o creates dependency and entrepreneurial lethargy (= laziness)
o political aspects
ƒ aid may serve to help dictators stay in power
ƒ aid was often politically motivated during cold war period
• benefits of trade
o has been strongly pro-growth in many cases, which in turn enables
ƒ tax bases
ƒ funnelling resources towards human capital
ƒ resources towards infrastructure
o has a self-reinforcing effect — both exports and inward foreign investment fuel growth
o strong empirical evidence in favour of trade (e.g. Asian Tigers) as strongly pro-
developmental
• criticism/limits of trade
o many barriers still exist
o the severest barriers are still aimed at the goods which are the staple industry in many
developing countries; textiles and agricultural goods
o 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 are
simply suffering from aid fatigue

Diagram(-s):

Note: A few central points — for each side — well-developed and clearly linked to development should
be able to earn full marks.

4. a) Explain how developing countries can acquire investment funds for development. (10
marks)
Basic answer: Two basic methods present themselves; domestic funds and foreign funds. Domestic
funds arise from savings while foreign funds are the result of inflows of foreign investment. Various
forms of saving present themselves; simple bank deposits, shares (equity market), bills and bonds
issues by both firms and government. Incoming foreign investment entails FDI and portfolio
investment. There are a number of barriers in developing countries to acquiring investment funds
which might be commented on.

Possible points:
• domestically acquired funds
o increased saving
ƒ increase in income, for example demand-side policies
ƒ increase in income, for example supply-side policies
o possibility of issuing bills and bonds (securities)
o micro credit schemes
o incentives to domestic firms to re-invest
ƒ lower corporate taxes
ƒ tax breaks for re-investment
• funding from abroad
o attracting FDI
o attracting portfolio investment
o outward/export orientation
o foreign loans — development banks, World Bank
o aid
o NGOs
• barriers to acquiring investment funds
o reference to poverty cycle
o reference to savings gap
o increased saving in the economy may have a dampening effect on AD
o high debt servicing may lead to lack of funding
o unattractive investment opportunities for foreign firms, i.e. poor infrastructure, non-
convertible currency etc
o lack of well-functioning banking institutions
o large parallel economy
o capital flight
o 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 and

development. (15 marks)
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Basic answer: Define multinational companies (MNCs) as companies having production in more than
one 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 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 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 opportunities
o and increases the capital stock of the country
o increase in AD and thus GDP (HL: possible multiplicative effects)
o subsidiary companies generate possible inward flows of profits from abroad
o 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 deficit
o not all capital put to use in LDCs is appropriate
ƒ highly capital intensive production does not create many jobs
ƒ capital intensive production does not utilise comparative advantage, i.e.
labour
ƒ imported capital is often demanding in terms of technological expertise in set
up, maintenance and repairs — such services are often imported from abroad
o a number of MNCs have been accused of heavily marketing inappropriate products
o a goodly proportion of profits might be repatriated abroad and thus not be re-invested
in the local community
o it is possible for MNCs to avoid a proportion of taxes by, for example, internal pricing
of goods within the company
o very large and powerful MNCs might simply use there power as leverage and
bargaining power in land/rent/tax/labour negotiations with firms/unions/governments
in developing nations
• other possibilities, for example that MNC presence might create the need for functioning
infrastructure/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 should
not be able to earn full marks.

5. a) Explain three major barriers to development experienced by developing countries. (10

marks)
Basic answer: Well, the scope of possible answers here is, em, wide, to say the least. The issue is not
to simply list three barriers, but to show and explain how they impact on the development process. For
example, the poverty cycle of low income Æ low savings Æ low investment Æ low income etc is a
good 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 income
might remain below potential; Lorenz curve and Gini-coefficient (HL); investment schedule showing
that keeping interest rates high in order to set exchange rate higher will have a negative effect on
domestic investment.

Note: There are many possibilities here — and most of the variables put forward above are strongly
interlinked! Higher grades should be reserved for students who clearly show how both economic
growth and development suffer as a result of barriers put forward.

b) What strategies might developing countries adopt in order to overcome these barriers? (15
marks)
Basic answer: Again, there are a number of possible approaches to this question. A student might refer
to each barrier put forward in a) and address each one in turn, or simply address the issue by going
through 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 certain
sectors and utilising infant industry protection
• market-led strategies; privatisation, increased use of market mechanism in setting prices and
output etc
• reference to commodity agreements in order for small suppliers in developing countries
dependent on commodity exports to stabilise/increase prices
• Harrod-Domar; increase growth by either increasing savings (and thus investment) and/or
increasing productivity (and thus decreasing the capital-output ratio)
• dual sector model; unlimited labour in traditional sector is a resource in accelerating growth
via the modern (industrial) sector
• various types of aid; can alleviate some of the most immediate problems in infrastructure and
poverty, 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 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) protection enabling the country to gain
benefits of scale
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Note: The answer should address the development barriers rather than simply listing all the possible
development paths. Really good answers will contain an element of discussion on the difficulties in
implementing 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 while
correlated 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 from
recessionary period.

Note: Higher marks should be reserved for answers clearly outlining the distinction between growth
and 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 theory
of import-substitution might still have adherents, the reality is that this strategy has been largely
abandoned 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 industries
which 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 costs
for domestic producers
o cronyism and corruption often became commonplace in these protected inner markets
o growth was dismal — and often negative in real per capita terms
o 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 and
subsidies) 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 on
the part of the student in order to evaluate an import substitution strategy. Be prepared to give marks
to students who evaluate by comparing the results of import-substitution with the relative success of
export-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 increased
imports — while focusing on international export markets. Benefits include choice/consumption etc for
consumers, while firms have access to a broader (international) market. Society gains from economic
growth, improved resource allocation and the spread of knowledge/technology.

Possible points:
• firms
o specialisation and increased use of comparative advantage
o possibility of benefits of scale
o spread and knowledge of technology — production gains
o spread of skills and labour capital
o access to new/wider markets
o foreign investment via multi-national companies provides capital
• consumers
o increased choice, i.e. variety
o lower prices
o overall consumer welfare (consumer surplus — outside of syllabus) in lower prices and
increased consumption
o increase in standard of living
• society in general
o political issues; cooperation, peace-dividend
o improved global resource allocation
o 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 trade
liberalisation. (15 marks)
Basic answer: Definition/outline of trade liberalisation — decreased barriers to trade, relaxing
restrictions on foreign exchange (convertibility of currency), allowing market forces to set exchange
rate (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

ƒ creates jobs and thus tax bases
ƒ funnelling resources towards human capital
ƒ resources towards infrastructure
ƒ enabled investment in human capital, merit/public goods
ƒ
o can help a developing country diversify output
o industrialisation might enable
ƒ initial focus on relatively simple industrial goods enabled technological
advances leading to higher level goods
ƒ increased value-added
ƒ improved productivity
o focus on key growth industries in which comparative advantages existed has been
broadly successful
ƒ Japan in 1950 s and 1960 s, Korea in 1970 s and 1980 s
o specialisation enables
ƒ benefits of scale
ƒ firms to move along learning curve
o has a self-reinforcing effect — both exports and inward foreign investment fuel growth
o broadened production base enabled these economies to move away from commodities
and into higher income elastic goods
o strong empirical evidence in favour of trade (e.g. Asian Tigers) as strongly pro-
developmental
o the increase in free trade has improved relations between countries ( peace
dividend ); possibility of reciprocal trade barriers and trade war; declining relations of
nations in trade dispute; there is ample evidence that trade is not a zero sum game
and that jobs are in fact not saved in the LR
• criticism/limits of increased trade
o possibility that initial effects of increased openness to trade are negative
ƒ competition with more efficient foreign firms might increase unemployment
ƒ domestic industries and markets could be overtaken in part by foreign
suppliers
ƒ infant industry argument — protect fledgling industries, allow them to get up to
scale
ƒ worsening of current account in balance of payments (HL: reference to
Marshall-Lerner condition and/or J-curve)
ƒ possible loss of government revenue from tariffs
o many covert barriers still exist in many developing countries (textiles and agricultural
goods), yet strong pressure from developed countries may force developing countries
not to do the same
o 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
o externalities such as pollution and increased income inequality
o dependency on foreign markets and international business cycle
o 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 show
effects 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 to
get full marks.
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8. a) Explain how foreign aid might help in the development process of a developing country. (10
marks)
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 developing
country governments can be used for any number of development issues, such as education and health
care, infrastructure etc.

Possible points:
• definition/outline of aid
o bilateral/multilateral
o tied aid
o donor aid
• benefits of aid
o enables SR stimulation of an economy
o can be vital in providing basic necessities and SR relief
o can help close the savings-investment gap
o can help in education and transferral of knowledge
o 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 present
OECD 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 to
development.

b) Critically examine the claim that Trade is better than aid in the development process. (15
marks)
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 highlighted
before examining the merits of each in the light of real world examples.

Possible points:
• benefits of aid
o enables SR stimulation of an economy
o can be vital in providing basic necessities and SR relief
o can help in education and transferral of knowledge
o has been shown to be beneficial in countries with strong institutions and functioning
government/administration
• criticism/limits of aid
o inefficient
ƒ monies are squandered by inept/corrupt govt
ƒ capital flight
ƒ aid does not reach the neediest most of the time
ƒ poorly planned projects
ƒ high costs of experts from developed (aiding) country
o aid can knock out local investment and businesses
o creates dependency and entrepreneurial lethargy (= laziness)
o political aspects
ƒ aid may serve to help dictators stay in power
ƒ 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

ƒ creates jobs and thus tax bases
ƒ funnelling resources towards human capital
ƒ resources towards infrastructure
ƒ enabled investment in human capital, merit/public goods
o can help a developing country diversify output
o industrialisation might enable
ƒ initial focus on relatively simple industrial goods enabled technological
advances leading to higher level goods
ƒ increased value-added
ƒ improved productivity
o focus on key growth industries in which comparative advantages existed has been
broadly successful
ƒ Japan in 1950 s and 1960 s, Korea in 1970 s and 1980 s
o specialisation enables
ƒ benefits of scale
ƒ firms to move along learning curve
o has a self-reinforcing effect — both exports and inward foreign investment fuel growth
o broadened production base enabled these economies to move away from commodities
and into higher income elastic goods
o strong empirical evidence in favour of trade (e.g. Asian Tigers) as strongly pro-
developmental
o the increase in free trade has improved relations between countries ( peace
dividend ); possibility of reciprocal trade barriers and trade war; declining relations of
nations in trade dispute; there is ample evidence that trade is not a zero sum game
and that jobs are in fact not saved in the LR
• criticism/limits of increased trade
o possibility that initial effects of increased openness to trade are negative
ƒ competition with more efficient foreign firms might increase unemployment
ƒ domestic industries and markets could be overtaken in part by foreign
suppliers
ƒ infant industry argument — protect fledgling industries, allow them to get up to
scale
ƒ worsening of current account in balance of payments (HL: reference to
Marshall-Lerner condition and/or J-curve)
ƒ possible loss of government revenue from tariffs
o many covert barriers still exist in many developing countries (textiles and agricultural
goods), yet strong pressure from developed countries may force developing countries
not to do the same
o 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
o externalities such as pollution and increased income inequality
o dependency on foreign markets and international business cycle
o imports of inappropriate/harmful goods
• general discussion of aid vs trade; reference to real world examples of successes and failures
of 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 awarded
to any clear line of argumentation based on core economic reasoning. Real world examples should be
amply 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 of
output, prices and also limits to free trade (and possible references to notable exceptions — for example
Singapore). Market-led strategies commonly focus on decreasing/removing barriers and limits on trade
and capital, with non-intervention by government as a guiding general principle.

Possible points:
• interventionist strategies may include
o government ownership of industries
o centralised planning of major (key) industries
o frequent use of subsidies targeted at infant-industries
o demand-side policies
o other — international —issues could include
ƒ infant industry protectionism
ƒ inward-oriented strategy (import-substitution)
ƒ tightly controlled exchange rate
ƒ capital controls
ƒ limits on FDI
• market-led strategies may include
o privatisation of nationalised industries
o use of market mechanism in setting output and prices
o implementation of policies allowing and guaranteeing private property rights
o reference to structural adjustment policies at the behest of the IMF/World Bank
ƒ reference to the Washington Consensus
o international issues
ƒ decrease/removal of barriers to trade
ƒ outward-oriented strategies (export orientation)
ƒ non-intervention in exchange rates
ƒ convertibility of currency
ƒ loosening of capital controls
ƒ 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 and
evaluated.

Possible points:
• in favour of interventionist strategies
o planning often a necessary element in development, due to weak institutions and lack
of goods considered missing markets such as education and roads
o possibility of focusing national resources on target areas
o issue of sustainability perhaps better addressed by government than private enterprise
ƒ externalities such as pollution, deforestation and soil erosion
ƒ use of limited resources
ƒ 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
ƒ weaknesses of institutions and governments in many cases did not enable
good use of resources
ƒ government deficits and debt quite often resulted
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ƒ poor growth rates were the norm in many countries using mainly
interventionist strategies
o mentioning the shift from interventionism to market strategies in the 1980 s
o view of IMF/World Bank (e.g. Washington Consensus)
o general results of import-substitution
ƒ tariff protection and subsidies created comfort zones for domestic firms to
operate behind
ƒ forward linkage effects
ƒ government decisions as to which industries to sponsor have been notoriously
poor — based, as they frequently were, more on political manifests rather than
economic reasoning
ƒ few of these chosen industries became winners — and fewer still survived
when the step towards open markets was taken
ƒ lower consumer welfare — less choice, fewer goods, higher prices
ƒ general failure of import-substitution
ƒ real world examples, e.g. China (until 1980 s) and India (until 1990 s)
ƒ other issues; countries which have implemented export orientation policies
have in some cases had any number of accompanying problems; externalities
in the form of pollution and environmental degradation, speculative inflows of
funds which have fuelled bubble economies, harsh labour policies designed in
favour of employees, bans on unions, poor labour rights
• in favour of market-led strategies
o clear correlation between market-openness and economic growth in, for example,
China and India in the 1980 s and 1990 s
o privatisation and individual ownership provides incentives for both entrepreneurship
and efficiency in the economy
o general market arguments, i.e. efficiency in production and resource allocation
o 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;
ƒ negative results
• inflation, falling output and unemployment in the CEEFSU
economies
• debt burden of developing countries which were forced into adopting
stabilisation/structural adjustment policies by, respectively, the IMF
and the World Bank
• widening income and wealth gaps in, for example, Argentina and
Brazil
• speculative bubbles with near-collapsing economies as a result, SEA
and Argentina as examples
ƒ 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
ƒ focus on key growth industries in which comparative advantages existed has
been broadly successful
ƒ Japan in 1950 s and 1960 s, Korea in 1970 s and 1980 s
ƒ specialisation enables benefits of scale
 108/110

ƒ industrialisation and FDI

• initial focus on relatively simple industrial goods enabled
technological advances leading to higher level goods
• increased value-added
• improved productivity
ƒ broadened production base enabled these economies to move away from
commodities and into higher income elastic goods
ƒ 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 policies
often 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 another
country by a firm — for example establishing a subsidiary production plant abroad. Foreign direct
investment inflows helps developing countries by making accessible capital which might not be
available 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 Æ increased output potential
o reference to savings-investment gap
o income from sales and increased exports
o multiplicative effects (HL)
• other possibilities
o decrease in unemployment
o wider tax base in the economy
o re-investment by foreign firms
o 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 positive
and negative effects of FDI .

b) Evaluate whether foreign direct investment is more important than aid in attaining
growth/development. (15 marks)
Basic answer: Define/outline aid; donor aid, tied aid, multilateral aid etc. The evaluation might build
on 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
ƒ enables SR stimulation of an economy
ƒ can be vital in providing basic necessities and SR relief
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ƒ can help in education and transferral of knowledge

ƒ has been shown to be beneficial in countries with strong institutions and
functioning government/administration
o negative aspects
ƒ 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
ƒ aid can knock out local investment and businesses
ƒ creates dependency and entrepreneurial lethargy (= laziness)
ƒ political aspects
• aid may serve to help dictators stay in power
• aid was often politically motivated during cold war period
• assessment of FDI
o positive aspects
ƒ a way to fill the savings gap (possible reference to Harrod-Domar model)
ƒ both FDI and portfolio investment in fact create job opportunities
ƒ and increases the capital stock of the country
ƒ increase in AD and thus GDP (HL: possible multiplicative effects)
ƒ subsidiary companies generate possible inward flows of profits from abroad
ƒ it is possible that MNCs transfer not only capital, but also technology,
knowledge and experience to developing countries
o negative aspects
ƒ inflow of FDI may cause current account deficit
ƒ 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 abroad
o a number of MNCs have been accused of heavily marketing inappropriate products
o a goodly proportion of profits might be repatriated abroad and thus not be re-invested
in the local community
o it is possible for MNCs to avoid a proportion of taxes by, for example, internal pricing
of goods within the company
o very large and powerful MNCs might simply use there power as leverage and
bargaining power in land/rent/tax/labour negotiations with firms/unions/governments
in developing nations
• other possibilities, for example that MNC presence might create the need for functioning
infrastructure/institutions, real world examples of countries which have shown strong/growth
development due — or in spite of — aid

Diagram(-s):

Note: Good answers can land anywhere between a definite statement ( thus, aid is in fact
inferior ) to answers which allow for the vagaries often found in the real world ( so, it depends
on the situation and the type of FDI/aid ).

2005 Copyright 'IBID Press, Victoria & McGee, M.