Millennia Institute PU3 Economics 2011

MOCK EXAMINATION I SUGGESTED ANSWERS 1 Assess the usefulness of price elasticity of demand, income elasticity of demand and price elasticity of supply to a government in formulating microeconomic policies. [25] INTRODUCTION Aim of microeconomic policies: To achieve efficiency in allocation of resources, equity in income distribution and price stability. BODY 1: Explain the PED concept Definition Significance of negative sign of PED value Significance of PED value Price elastic demand vs. Price inelastic demand BODY 2: Explain the YED concept Definition Significance of signs of PED value Normal good vs. Inferior good Significance of YED value Income elastic demand (Luxury good) vs. income inelastic demand (Necessity) BODY 3: Explain the PES concept Definition Significance of positive sign of PES value Significance of PES value Price elastic supply vs. Price inelastic supply SYNTHESIS: In the free market, the forces of demand and supply will determine the equilibrium price and output. Unfortunately in some instances, the equilibrium price may be too high or too low, or fluctuates widely such that it leads to undesirable effects on the economy (loss of societys welfare). As such, the government will have to intervene by imposing price controls (i.e. to ignore market prices completely) or to manipulate prices. Regardless of the microeconomic policies, the concepts of PED, YED and PES are useful to the government in deciding the actions to be taken.

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BODY 4: Usefulness of PED and PES concepts in implementation of price controls (You may explain either price ceiling or price floor.) Objective of price ceiling: To keep the prices of some goods (especially necessities) at affordable prices. What is a price ceiling?: It is a legally established maximum price that firms are permitted to sell at. It is effective only if it is set below the equilibrium price.
P S

P Pc Price ceiling D Q1 Q Q2

Price ceiling will result in a shortage. This shortage will persist because the market is prevented from adjusting itself. The more elastic the demand and supply, the greater the resultant shortage.

Shortage

The shortage may lead to black markets where the goods are sold illegally at prices above the price ceiling. This happens because buyers are willing to pay higher prices to obtain the goods. Also, profits can be made by those who buy at the controlled price and later resell them at a higher price in the black market. Implications on government: The government can use the concepts of PED and PES to estimate the extent of the resultant shortage so as to better deal with the problems that may arise. For instance, the government can use rationing methods to allocate the goods more equitably. This can be done through the distribution of coupons to match the available supply and may be distributed equitably among the population according to age, family income, or family size.

BODY 5: Usefulness of PED concept in implementation of taxes or subsidies. (You only need to explain one case.) Objective of tax: To discourage consumption of socially undesirable goods (E.g. Cigarettes).

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Pi Pe P

Imposition of taxes Increase COP Lower expected profits Lower supply Increase price Reduce quantity demanded Usefulness of PED: The use of tax to discourage consumption of socially undesirable goods will be more successful the greater the PED. S2 Initial equilibrium: Q produced at price P. S1 reduce Implications To quantity to Qt, on government: tax of (Pe P) has to be The government use imposed if demandcan is price the PED concept to elastic. determine the to amount To reduce quantity Qt, of tax to be imposed. tax of (Pi P) has to be De For if demand instance, imposed is price Di Q undesirable goods like inelastic. Qt Q that are (Pi cigarettes, P) > (Pe P) Higher also addictive, tend to have price inelastic demand. tax needed if demand is As such, a high tax has to be imposed to discourage consumption of those goods. Even then, the fall in quantity demanded for the goods may be small so it may be necessary for the government to compliment the taxes with national campaigns to educate or to impose legislation to ban the sale of the goods.

BODY 6: Usefulness of YED concept in implementation of microeconomic policies (in general). The YED concept can guide the government in planning its expenditure on social goods and services. This is to ensure that it can provide more and better social and community services to meet the increasing demand of the public. For example, as NY increases, demand for recreational amenities, medical care and educational facilities will increase because they have positive YED values. BODY 7: General limitations of using the different elasticity concepts. Elasticity values may not be accurate due to changes in consumers tastes and preferences over time or changes in the types of goods available in the market. Difficulty in collecting data or small sample size that may not be reflective of true elasticity values. Time lag between the collation of data and the implementation of appropriate measures may render the measures ineffective.

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CONCLUSION Since the different elasticities will affect the extent to which price and output will change, it is important for the government to take them into consideration when formulating microeconomic policies. 2(a) Explain how public goods and merit goods cause markets to fail. [10] INTRODUCTION Definition of market failure Brief mention of the different causes of market failure BODY 1: Explanation of how public goods cause markets to fail. Public goods are non-rival in consumption and nonexcludable. Explain the characteristics with examples. No demand, no supply Missing market(s) for public good(s) BODY 2: Explanation of how merit goods cause markets to fail. Explain the characteristics of merit goods, with examples and with the aid of a diagram. Underallocation of resources to the production/consumption of merit goods Deadweight loss CONCLUSION Despite the different causes of market failure, the government usually intervenes to correct the situation. (b) Consider whether market-based solutions are the best way for the Singapore government to correct market failure that results from the existence of a negative externality. [15] NOTE: Since negative externality was not discussed in part (a), you have to explain it in this part before suggesting at least one market-based solution and one other solution in dealing with its existence. INTRODUCTION

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Definition of negative externality. Market-based solutions are measures that reduce the consumption or production of a good by influencing the market forces of demand and supply. Other solutions Regulations Moral suasion/Education/Campaigns/ Ads

Market-based solutions Pigouvian tax Tradable pollution permit

BODY 1: Explanation of negative externality with example(s). Explain the characteristics of goods that impose negative externalities, with examples and with the aid of a diagram. Overallocation of resources to the production/consumption of merit goods Deadweight loss BODY 2: Implementation of Pigouvian tax Explain how Pigouvian tax works, with the aid of a diagram. If Pigouvian tax = MEC, negative externality has been internalised, Qs can be obtained and societys welfare is maximised. Evaluate this market-based solution. BODY 3: Implementation of tradable pollution permit system Explain how the tradable pollution permit system works. Evaluate this market-based solution. EVALUATION OF MARKET-BASED SOLUTIONS & SYNTHESIS Manipulation of market still allows the market to work. Protection of consumer sovereignty. Fair because these solutions force the responsible parties to internalise the full social costs of their actions. May encourage parties involved to take necessary actions to reduce the production of negative externalities. Since market-based solutions are not all-solving, there is a need to implement other policies too. BODY 4: Regulations enforced to correct market failure E.g. Stipulated bus lane hours, Requirement for industries near urban areas to use fuel with lower sulphur content. Evaluate this solution.

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CONCLUSION In the case of market failure caused by the existence of negative externalities, both market-based solutions and other types of solutions are important. This is because they are not all-solving when implemented individually. Instead they seem to complement one another in correcting the market failure.

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3(a) Explain why governments should be concerned about a fall in real GDP. [10] INTRODUCTION Definition of real GDP Fall in real GDP: The country is producing less goods and services. It also implies a fall in the level of economic activity. Governments are usually concerned about a fall in real GDP especially if it occurs for a prolonged period of time. BODY 1: Fall in real GDP will lower the material SOL of the residents. Fall in real incomes Lesser funds available for consumption of goods and services (domesticallyproduced/imported) Variety of goods and services consumed will be limited. Fall in real income Amount of goods and services consumed will be less than before. BODY 2: Fall in real GDP will lower economic growth. Fall in real incomes (personal incomes and profits) Fall in governments tax revenues Lesser funds available for expenditure on infrastructure e.g. Roads, hospitals, schools Hinders potential economic growth. BODY 3: Fall in real GDP will lower the level of confidence in the economy. Loss of consumer/investor confidence due to fall in expectations of future profits Fall in investments and capital flight. BODY 4: Fall in real GDP may lead to social instability. Fall in real GDP usually occurs with a rise in unemployment. May result in petty crimes and social discontent. Not a conducive business environment. CONCLUSION It is important for the government to be concerned with real GDP figures, regardless of the direction of change. This is because real GDP figures are the easiest way for the government to keep track whether the economy is on the right track to achieve its macroeconomics aims. 7

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(b)

To achieve high and sustained growth, low inflation is an essential condition. Hence its attainment should be the man aim of government policy. Discuss. [15] INTRODUCTION Low inflation is defined as a period of relative price stability. Inflation is mild. Generally a good sign of the health of an economy. Many other factors needed to achieve high and sustained economic growth Quantity and quality of factors of production (FOP), level of technology, infrastructure, business environment, social and political stability. Incidentally, low inflation happens to influence the abovementioned factors to create a conducive environment for investments and hence economic growth. THESIS BODY 1: Explain what is meant by high and sustained growth. Actual economic growth (AD) vs. Potential economic growth (AS) BODY 2: Explain how low inflation can help to attain actual economic growth Low inflation Increases savings because the real value of savings is protected since there is greater certainty over real interest rate. More funds for capital formation. Increase Investments (I) Increases AD Actual economic growth achieved If investments in infrastructure is increased, AS may increase Potential economic growth achieved Low inflation Px relatively cheaper Increased demand for the countrys exports Increase in export earnings Increased AD Actual economic growth achieved ANTITHESIS BODY 3: Possible trade-off(s) If the country enjoys actual economic growth without any improvement in AS, it may face inflationary pressure. If the government implements contractionary demand-side policies to deal with the greater inflationary pressure, it will not be able to enjoy actual economic growth. 8

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CONCLUSION Maintaining low inflation rates is important for most economies but at times, due to the conflict between low inflation and high growth, it may be necessary for the government to forgo the low inflation target to enjoy high and sustained growth.

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

(a) Explain how Singapores balance of payments might have been affected by the global business cycle in recent years. [10] INTRODUCTION Singapore has a small and open economy so its balance of payments (BOP) is more susceptible to changes in the global business cycle. Do note that the BOP comprises of the Current Account (CA) and Capital Account (KA). During the time this question was set, the world was facing the global financial crisis. BODY 1: Fall in foreign incomes and increased unemployment in other countries have affected Singapores BOP adversely. Fall in foreign incomes and increase unemployment in other countries Fall in demand for Singapores exports Fall in Singapores export earnings, worsening CA Ceteris paribus, BOP worsened. BODY 2: Fall in global consumption levels have affected Singapores BOP adversely. Fall in global consumption levels Fall in profits thus resulting in poor business confidence Fall in FDI into Singapore Fall in LT capital inflow KA worsens Ceteris paribus, BOP worsened. BODY 3: Tighter credit conditions have affected Singapores BOP adversely. Subprime crisis and disruptions in financial systems Tighter credit conditions like higher interest rates and stricter rules on lending and borrowing Fall in both exports and investments into Singapore Both CA and KA worsened BOP worsened. BODY 4: Higher prices of raw materials (crude oil, food) have affected Singapores BOP adversely. Demand for imports is price inelastic so when prices of raw materials increase, Singapores import expenditure rose. 10

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Ceteris paribus, CA worsened. Ceteris paribus, BOP worsened. CONCLUSION The recent global financial crisis has affected one of Singapores macroeconomic aims: To have a stable BOP equilibrium. Hence, Singapore, like other economies, had to consider the policy options available to best reduce its BOP deficit.

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(b) Discuss what policy options would best reduce a countrys balance of payments deficit. [15] INTRODUCTION BOP deficit can be caused by CA deficit/KA deficit/both. Huge and persistent BOP deficit is a concern because it means lesser foreign reserves for future economic development, increase in external debt that can lead to lower SOL for future generations and currency devaluation which can cause other macroeconomic problems like inflation, loss of business confidence, capital flight and slower economic growth. POLICY OPTION 1: Contractionary external monetary policy (MP) a.k.a. currency devaluation Explain how a currency devaluation works. Mention the Marshall-Lerner condition. Evaluate the policy. POLICY OPTION 2: Expenditure-reducing policy like contractionary fiscal policy (FP) Explain how a contractionary FP works. Note that there must be reduced government expenditure on imported goods and services or overseas investments. Evaluate the policy. EVALUATION OF DEMAND-SIDE POLICIES The contractionary demand-side policies will be most appropriate if inflation is the cause of the BOP deficit. This is because higher relative inflation rates of a country can cause its exports to be relatively more expensive and imports relatively cheaper than domestically-produced goods. Thus, the countrys CA worsens. Furthermore, the higher inflation rates can also lead to capital flight as people lose confidence in the economy. As such, it is important fo the government to lower the inflation rate via the contractionary demand-side policies to solve the problem. POLICY OPTION 3: Supply-side policies Explain how supply-side policies work. You may want to use a diagram to illustrate the effect of the policies.

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EVALUATION OF SUPPLY-SIDE POLICIES Supply-side policies are especially needed if the cause of the BOP deficit is the loss of comparative advantage. In this age of globalisation, the emergence of new low-cost producers has caused a shift in comparative advantage across the world. As such, a country that experiences a loss of its comparative advantage will suffer a permanent fall in its export demand. Thus, there is a need for the country to restructure its economy to find new products to sell and thus improve its BOP. CONCLUSION The best policy option will be the one that solve the root cause of the problem. In reality, there are many factors that could have contributed to the BOP deficit. This is why most economies are likely to implement a few policies simultaneously to correct the deficit.

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