Answers to H2 Economics 2007 GCE A Level Exam Paper 1 CSQ1: OECD report on China, Brazil and the Russian

Federation, 2005 ai) Chinas budget was in deficit but this deficit was declining throughout. (N.B.: Answer like budget is negative and rising at a decreasing rate 0 m since negative sign was given in the data and stating this does not mean that student has a grasp of the significance of the figures) Russias budget was in surplus and improves from 2003 2004. After which, the budget surplus was declining. This was in contrast to China where even though its budget was in deficit, it has improved throughout. Nominal GDP growth includes inflation rate while real GDP growth does not. Russia with nominal GDP growth of 18% Brazils projected C/A surplus worsens from 2005 2006 due to: The depreciation of Chinas currency means that these Chinese goods entering into Brazil will be relatively cheaper and hence drive up Brazils import Recovery in employment and wages implies higher consumer spending. This in turn lead to higher economic growth (since GDP = C + I + G + X M) in 2004 which implies higher income. Since imports are dependent on income, this leads to higher imports. This is especially so if the goods imported have high income elasticity and the Brazilians have a high marginal propensity to import. The appreciation of the Brazilian currency will also have an impact on the C/A. Appreciation would make imports entering into Brazil cheaper and Brazilian export less competitive in world markets (esp. in China which is a major destination for Brazils exports). Assuming Marshall-Lerner condition where sum of price elasticities was greater than 1, then import expenditure would rise and export revenue would fall leading to fall in C/A surplus. Brazils inflation rate relative to the other countries. Although Brazils inflation has been falling steadily over the years while Chinas has been rising (albeit marginally in the later 3 years), the latters is still lower than Brazil. Hence this may mean that Brazils exports may be less competitive in the world markets. SOL: defined as both material and non-material well-being. Material aspects: In general, real GDP growth rate fell from 2004 onwards ie. real GDP is rising less rapidly. This means that while materially, people are better off than before (and hence higher SOL) but the extent of this is tapering off. C/A balance shows improvement in China and Russia (except for 2006) but decline in Brazil. However, the higher imports in Brazil could lead to higher SOL since this is due to strong private consumption. However, if the imports are primarily due to investments, then this could translate into higher SOL only in the future. While C/A improvement means higher export earnings, however, goods produced are meant for foreigners and hence may not translate into higher SOL. Budget balance: both China and Brazils budget are in deficit but in general they are declining. On the other hand, Russias budget surplus has worsened since 2004. From the data, this may improve SOL as Russia embarks on expansionary 1

ii)

bi) ii) c)

d)

Hence the data does provide an indication of the changes to the material aspect of the SOL over the time period. However it provides an incomplete picture. Eg: per capita income figure should be considered to take into account population changes. Other indicators to take into account non-material aspect could be: Gini coefficient to account for differences in income distribution on living standards Pollution index esp. as there is high level of production in China which could contribute to increased pollution Amount of leisure time: high economic growth may mean better material wellbeing but this could imply more stress, less leisure time and hence possibility of lower SOL.

e)

Effects of an unexpected decline in world economic activity: Decline in world activity will mean countries will import less. Thus worlds export / import volume will fall and trade will be badly affected. Since (X M) is a component of AD, AD will fall and through the multiplier effect, slower growth results (using AD-AS framework). Demand-deficient unemployment occurs. The extent of the impact on each country depends on o its openness to trade and degree of dependence In the case of Brazil, its trade is very dependent on the OECD markets and China. This means that it could be more badly affected than China which is driven by its investment expenditure in the private sector. On the other hand, strong consumer demand in Brazil could cushion the effect of the fall in external demand and made Brazil less affected by the world economic slow-down. Russia could be badly affected since it is a commodity exporter in hydrocarbons and metals. With the unexpected decline in world activity, production will slow down and this translates into slower demand for these commodities and hence lower export volume. This will further worsen the already slower investment and export volumes and the weak business sentiment experienced by Russia. o size of the multiplier. A country with higher MPW ( ie. lower multiplier) will have lesser impact on GDP. So a fall in AD due to the world activity may not affect the country so badly o the countrys ability to implement policies to reduce the negative impact. In the case of China, the depreciation of the Yuan makes its exports cheaper. This could offset the decline in export volume due to the fall in world activity. The expansionary fiscal policy used by Russia could help to cushion the negative impact if its multiplier is large. Conclusion: While all 3 countries ( choose only 2 as indicated by the qn) may experience a slow-down in their economies, China is likely to be able to cushion these negative effects better due to its buoyant domestic business climate and huge consumer market that could serve as alternative engines of growth.

CSQ 2 (a) Compare the change in retail sales in Singapore by type of outlet between 2000 and 2004. All have grown (1) Supermarkets have grown the most (1) Department stores have grown the least (1) [2]

(b) Explain two reasons why supermarkets are growing so quickly in China. 1m for identification of the factor + 1m for explanation: Rising incomes (1) greater demand for imported goods(1) Chinas entry into the WTO (1) liberalization of licensing requirements and state monopolies (1) (c) (i) Describe the type of market structure operating in the UK grocery store in 2004. Oligopoly (1) Due to the top four supermarkets capturing the majority of market share (1)

[4]

[2]

(ii) Explain how the firms in this market might compete against each other. Students need to explain how the features of Oligopoly lead to distinctive competitive behaviour (up to 4m). Must be able to point out about the rivalry /mutual interdependence of firms.

[4]

Firms in this market, due to mutual interdependence may choose to compete in terms of non-price competition since they will react to any pricing decisions that each other makes. They can compete via intensive advertising to gain brand loyalty or to attract new consumers. They can also choose brand proliferation, the provision of after sales support, greater variety etc to make their product more attractive.

(d) Discuss the policy of divestment in the case of Tesco explaining clearly how this might affect consumer welfare L1 (1-3) Shows an understanding of divestment but will only explain one possible outcome in terms of Consumer welfare.

[8]

L2 (4-8) Shows an understanding of divestment and is able to explain why it can either raise/lower Consumer Welfare.

Tesco Market leader. Divestment is the process of selling off stores. Bad for Consumers: 1)EOS Loss of EOS previously enjoyed(Managerial EOS and bulk buying) Show the increased AC and MC in the short run. The increased price for consumers & decreased convenience due to the fall in the number of outlets both lead to the loss in consumer welfare 2) Market Share Divestment of Tesco may make the industry more competitive But instead of following suit & decreasing prices, other firms may keep their current prices. Might lead to a further loss of market share of Tesco. Should Tesco close down, it may lead to consolidation of power of the other 3 firms in the long run Leading to increased P and loss of consumer welfare. Good for Consumers P may actually fall if Tescos market dominance is reduced. Show in diagram when Monopoly moves towards more competition. Can consider also about the Law of Comparative advantage, that firms should concentrate on producing what they are more efficient at.

(e) In the light of the data provided, if you were an economic advisor to the Singapore government, would you recommend that it should follow the example of the Chinese authorities and encourage supermarket development? Justify your answer. L2 (4-6) Balanced view and includes both adv and disadv of further supermarket development in Singapore. These will be considered in the context of Singapore economy. L1 (1-3) 1-sided, discusses only the adv and disadv to the Singapore economy. And/or with limited reference to the Singapore economy. E2 (3-4) Will make a recommendation based on sound examination of the costs and benefits for the Singapore economy of further supermarket development. Shows comparisons between Singapore, China and UK. E1 (1-2) Will make a recommendation but only the costs or benefits are considered. May bring in points not based on the evidence and show limited comparison with China and UK. Singapore is a small and open economy dependent on the foreign countries for most of our goods, especially consumer goods like rice and vegetables that are sold in the supermarkets. But there might be gains if Singapore allows for consolidation: 1) Large firms mean these firms will enjoy EOS through bulk buying or managerial EOS or advertising. These reduction of costs can be passed on to consumers in terms of lower prices. Non-price advertising can be an advantage. Although one of the reasons why Chinas supermarkets is prospering is due to the variety of goods. 2) Increased and better facilities. 3) China consolidated to gain CA into that industry to allow those firms to compete in the world market. Not feasible as for SIngapoure our local supermarket has no control over resources, no agriculture production. Conclusion: best if Singapore can allow a range of firm sizes.

[10]

Paper 2 Q1
In 2005 the rate of Goods and Services Tax (GST) in Singapore rose from 3% to 5%. Incomes rose by approximately 4.5% in 2005. a. Explain the likely effect of this change in GST on expenditure by consumers on different types of goods. [10] b. Discuss whether the combined effect of the rise in incomes and the rise in GST is likely to cause the quantities of different types of goods sold to rise or fall. [15] a.

Consider consumers expenditure = P x Q Rise in GST to 5% implies SS curve shift left with steeper slope ( since it is ad valorem tax) Impact on expenditure depends on price elasticity of demand (Ep) o Brief mention of factors affecting Ep o If good is inelastic in demand (provide egs), a rise in price will lead to a less than proportionate fall in Qd and hence TR rises. o The reverse applies for goods with elastic demand This question requires students to consider a fall in supply curve combined with a range of potential shifts in the demand curve. The extent (ie. elasticity concepts / magnitude) and the direction of change ( ie the sign) will have to be considered. The rise in incomes will shift DD and rise in GST will reduce SS. The overall impact on qty will depend on the nature of the goods: whether it is inferior / luxury / necessities. (Note that the classification of these goods will depend on ones perception or relative to ones income level ie a persons inferior good might be another persons luxury. Hence it is wrong to say that the concept of luxury goods only applies to the rich and inferior goods only to the poor!) o If the good is perceived to be inferior (has negative income elasticity), then a rise in income will reduce DD by a large extent. This effect combined with a fall in SS will reduce the equilibrium qty. o If the good is perceived to be a luxury, then DD will rise by a large extent due to rising income and income-elastic nature of the good. Hence qty will rise in this case. However, the rise in GST will reduce qty. The combined impact will depends on which impact is stronger. In all likelihood, the rise in qty due to rise in income is likely to outweigh the fall in qty due to tax rise so that the overall qty is likely to rise. o In the case of necessities, the impact on qty is not so clear cut / indeterminate since qty will rise marginally (income-inelastic good) coupled with a fall in qty due to tax rise. Hence the combined impact of income and tax changes will cause qty to rise / fall in either direction. This depends on the strength of the income effect (which in turn depends on the nature of the goods) as against the tax effect.

b.

(Note: Its good to use diagrams for illustration purpose in this Qn. A rise in GST will not cause a fall in disposable income since it is not a direct tax!)

Q2 (a) Explain how, in economic theory, a monopolist would determine the price that would maximize profits. (b) Discuss whether firms in the real world set prices at profit-maximising levels. Approach [8] [17]

Students should be able to explain clearly the various concepts of market structures that are relevant to this question. Stronger answers would be bringing in real world examples to aid the answers. Finally for (b), to score the highest level of marks, a student would need to display an insight on why there may be a discrepancy in how real world firms may not entirely behavior as what is studied in the lectures notes and how to reconcile the two. (a) Intro Define Monopoly. Explanation needs to include barriers to entry and the profit maximizing aim of the firm. Body In explaining the how, need to explain why that particular output is profit maximizing. This will require reference to the cost and revenue curves in the diagram. To score: Mainly in the detail and clarity of explanation. (b) Explain that traditional aims of firms is to profit maximize and most firms aim to do so. But the ability of firms to do so depends on the type of market structures they are in. Monopoly: Usually able to since pricing policy is not dependent on other firms Unlike other types of market structures: Oligopoly is dependent on other firms due to the presence of other large firms with market power (Explanation of the Oligopoly and its pricing policies is needed) Explain that in such cases, P increases would not be matched by competitors and instead see consumers switch to substitutes. Any shift in supply by firm would lead to a retaliation by other firms and a change in demand curve, leading to a change in profit maximizing output.

Finally, explain about the case in the real world show a comparison between reality and theory and how in reality firms do not have the required information needed to accurately calculate their marginal revenue and costs. Student may also include the alternative aims of the firms and explain them.

Q3
With reference to examples, discuss whether there is a need to change the current policies adopted by the Singapore government to deal with market failure caused by externalities Overview Market failure caused by externalities is a subsection of all market failure. All externalities generate market failure but not all market failure is caused by externalities. There is no need to discuss monopoly power or failure of information. This means discussion of merit goods should focus only on free riding/spillovers, not ignorance (for example in the case of demand for education, or drugs). [25]

Market failure comes in the following forms and examples: 1. Negative externalities (demerit goods): pollution (e.g. chemical, noise), smoking, spread of communicable disease (e.g. dengue via aedes mosquito), traffic congestion. Drugs would not get on the list unless you can clearly identify a spillover ignorance about their effect is not relevant to this essay, and 'morally reprehensible' is at best tricky as an externality, so leave it alone. 2. Positive externalities (1) merit goods: education, vaccination, rose growing 3. Positive externalities (2) public goods: defence, flood control. Law and order very probably qualifies but it's tricky to explain well and you have plenty here, so leave it. Note: Public goods have sometimes been referred to as 'goods with 100% spillover', and so they are substantial examples of externalities. The policies come it two broad forms: 1. Market driven policies: price-raising policies such as ERP, cigarette tax, and price lowering policies such as subsidy of vaccines and education. Note: The essay is about externalities, not taxes/subsidies where they are applied in other areas to other goods with no externalities. Don't go down an irrelevant track on e.g. the inappropriate use of subsidy for private goods. 2. Command controls: enforced attendance at school between certain ages, banning of smoking in certain places, banning of noise pollution at certain times, banning of certain polluting industrial activities from certain areas, setting of standards for pollution, direct government provision of public goods.

The evaluation comes in two broad forms; 1. Does the policy achieve allocative efficiency with MSB = MSC? 2. Does the cost of implementation of the policy outweigh the benefits of adjusting quantities sold to the optimum level?

So in the body we need to 1. Examine and explain how the specific policies work (L1, L2 and L3) and 2. Evaluate which policies could be improved and why others are OK (E1 + E2)

Examples to look at and critique: 1. Why school fees are subsidised more than uni fees (Because schools create more externality don't assert this, explain. So it's an efficient strategy, MSB nearer MSC. Would it be improved if subsidy were dependent on child's continued improvement?) 2. Why we use COE and ERP for traffic congestion (Explain that COE is crude but cheap, ERP currently q expensive but likely to get cheaper, and certainly better at reflecting externalities so that MSB=MSC again explain this don't just assert it. Also look at why petrol tax is simple to administer but crude in effect on congestion.) 3. Why we use air pollution standards rather than taxes or tradable permits (Explain that standards are simple and relatively cheap to administer, have similar monitoring costs to permits and taxes, but do not allow for reduced emissions at minimum cost and are therefore productively inefficient) 4. Compare controlling where people smoke (regulations) with influencing how much people smoke (through tax). (Explain why the regulation is better designed to consider externalities than the tax is. If you have time compare, parallel this with where industry is allowed to locate and where it is not.) 5. Compare control of noise pollution using standards for level and timing with Coase's solution property rights and negotiation. (Explain that Coase's solution is very neat for one on one negotiations between neighbours e.g. retrofitting an apartment but most impractical for noise having widespread impact on passers by from a large building site. How could negotiation possibly take place? So for most but not all circumstances the policy is practical and realistically the most efficient available.)

Q4 a) To be considered successful, an economy needs to achieve low unemployment, low inflation and stable economic growth. Explain this statement. [12] b) Discuss whether fiscal policy is the most effective way for Singapore to sustain a successful economy. [13] Part a) Although the question only stated 3 macroeconomic objectives, we know that the success or performance of an economy is subject to its performance in the various macroeconomic goals. Therefore it is important for the answer to not only examine the importance of achieving the goals of the domestic sector but also how the performance of the domestic sector may impact the external sector (BOP and foreign exchange). Introduction - Identify and explain the 4 or 5 macroeconomic objectives of the economy and identify low unemployment, low inflation and stable economic growth as the internal goals of the economy. Body -

Explain what it means to have low unemployment, low inflation and stable economic growth. Explain the effects of achieving low unemployment, low inflation and stable economic growth on the domestic sector. o i.e. explain how it will affect C and I and in turn affect AD and/or AS) - Explain how achieving the 3 internal goals of the economy will affect the external goals of the economy (BOP equilibrium or surplus and stability/confidence in the currency. o Ie, explain how COP may be reduced reducing the price of export improving export performances o Or how reduction in COP and increasing confidence in the macroeconomic management more FDI or capital inflow improving BOP Conclusion Since achieving low unemployment, low inflation and stable economic growth has positive impact on the domestic sector (the consumers and investors) and also the external sector, it is important for a successful economy to achieve these objectives.

Part b) It is important for the answer to recognize the nature of the Spore economy and the main causes/factors which will help achieve all the macroeconomic objectives. In the development of the essay, the answer should show that FP can help to achieve some of its goals but it may also worsen others (conflicting objectives). The answer should also highlight that due to the nature of the Spore economy, FP by itself may not be adequate to all the goals. The answer should then go on to address how adopting a policy mix might be more effective for Spore. Introduction - Apply the explanation of the various macroeconomic objectives in 4a) to the case of Spore. - Answer should also showcase some awareness of the Spore economy (in particular, the nature/main cause of the macroeconomic problems) o Inflation is largely imported inflation o Growth is normally affected by performance of external dd and there is emphasis on sustainable growth o Unemployment is usually structural but can also be dd deficient in periods of regional/global recession o BOP is usually affected by weakening X and inflow of capital (both FDI and hot money) Body Thesis - Explain how expansionary FP (through reduction in taxation and increasing G with supply side policies elements) can help Spore achieve some of it macroeconomic objectives (increase actual and potential growth, reduce dd deficient unemployment, may reduce structural unemployment if the G is in education and skills training, capital acc may improve through FDI inflow) Anti-thesis - Explain how the nature of the Spore economy may reduce the effectiveness of FP o i.e. small and open nature of the economy, heavy dependence on external dd, small k, mindset and resistance to changes in the workforce - Explain how (the same) expansionary FP may worsen some of it macroeconomic objectives (worsens dd pull inflation, current acc may worsen due to higher import expenditure). - By now, we would have established some form of conflicting objectives and limitations of the use of FP in Spore to address the macroeconomic problems or achieve its goals. Synthesis - We will now introduce other policies which may complement the use of FP to help Spore achieves its goals (eg. exchange rate policy, more supply-side measures) o i.e. Use of expansionary FP to attract FDI and foreign talent (to retain domestic investors and talent) and boost potential growth through developmental expenditure eg. R&D, infrastructure, skills training. Such efforts may also move the economy up to a higher level on the comparative advantage ladder and may continue to enjoy strong export performances. Combine the use of FP with the gradual appreciation of the Singdollar, we will be able to manage imported inflation and reduce the rate of increase in the prices of exports and hence promote non-inflationary growth. Conclusion Although FP does a fairly good job in encouraging both actual and potential growth, complementing FP with other policies such as exchange rate policy and supply-side policies will enhance the effectiveness in the use of FP to achieve the various macroeconomic goals for the economy.

10

Q5 a) Explain the potential causes of a balance of payments deficit on current account. (10) b) Discuss which measures, if any, a government should adopt when confronted with a current account deficit. (15) Approach: Since current account balance is the sum of visible trade balance and invisible trade balance, the factors raised for this part should come from both components. In the discussion, concentrate on explaining the causes behind a fall in export earnings and/or a rise in import expenditure since this would already cover both merchandize and service trade. Outline Causes of a fall in export earnings and/or a rise in import expenditure: (Explain in details the following factors) - Rise in domestic price level Will lead to deficit if demand for exports is assumed to be price elastic. - Rise in domestic income level - Changes in exchange rates brought about by central bank intervention - Changes in protectionism and tariffs Causes of a rise in property income paid abroad: - Increase in foreign investment now would lead to an increase in property income paid abroad in the next period. Causes of a rise in unilateral transfers paid abroad - Increase in foreign workers in the country. b) Expenditure reducing policies (Contractionary fiscal policy may result in depreciation of currency, hence facilitating expenditure switching. Contractionary monetary policy may result in appreciation when interest rates increase, hence limiting the effects of expenditure switching.) - Aims to reduce the deficit by reducing import expenditure through the reduction of national income. - However, cost of deflation may be high in terms of unemployment, especially if the economy is already experiencing a deflationary gap. Moreover, the fall in AD may fuel business pessimism and may induce businessmen to cut down on investment. Therefore, besides reducing current output and employment, such policies also run the risk of reducing potential output growth. - Good, if the economy is initially experiencing an inflationary gap, a fall in AD will be able to cool down the economy and bring down GPL. This will improve the price competitiveness of exports and will also encourage consumers to switch towards domestically produced goods which are now relatively cheaper than imports. - The effectiveness of the policy is also constrained by the size of the mpm. Eventually, the international multiplier effect may also set in. - However, unlike import controls, it is also less likely to invite retaliation. Expenditure switching policies o Devaluation aims to reduce the deficit through a devaluation. - The success of a devaluation in reducing the deficit depends on a number of factors: i) Marshall-Lerner Condition (|Epm +Epx| > 1) ii) J-curve effect (time lag for consumers to switch to the cheaper local goods, so in the SR, import expenditure may go up, leading to an initial worsening current account deficit. In the LR, as consumers switch to the cheaper local goods, current account will improve). iii) Existence of spare capacity - If the above conditions are met, devaluation will be able be bring about a reduction in the deficit without putting the economy through the consequences of deflationary effects. - However, such a policy may lead to capital flight for fear of further devaluation and this could destabilise the short term capital account.

11

Protectionism - Not as inflationary as devaluation and country also does not have to suffer the consequences of deflation. - Helps to reduce structural unemployment. - However, it cannot be a long-term solution because it doesnt improve the competitiveness of exports, which of course explains the need for supply side policies. Moreover, it also perpetuates the misallocation of resources and provokes retaliation. Supply-side policies - Although it addresses the crux of the problem: lack of competitiveness in some industries, such policies take time to mature. Therefore, countries may still eventually have to resort to other policies for a quicker, but temporary solution.

Conclusion: The types of policies that the government used depend on the causes of the current account deficit. If current account deficit arises due to losing export competitiveness due to domestic inflation, than expenditure reducing policies would be more appropriate than devaluation which can worsen the inflation rate in the country. It also depends on the state of the economy as in situation where an economy is operating at below the full employment level, devaluation may be a much appropriate policy than expenditure reducing policies to prevent any deflationary effect on the economy.

12

Q6 Discuss whether Singapore is among the economies that have most to gain from globalization. [25] Intro Define globalization Globalization brings about both benefits and costs Explain how Singapore is unique as it is neither a developed country (DC) nor less-developed country (LDC), hence, it has the potential to enjoy the benefits of globalization which both DCs and LDCs experience.

Body Benefits of globalization Access to more markets => firms reap EOS => firms and consumers benefit Higher production and consumption possibilities if Singapore specializes in areas of comparative advantage and trade with other countries Vent for surplus Increase in FDI

Costs of globalization Singapore is very vulnerable to external shocks because of her dependence on trade UnN especially structural unN as export-oriented, capital-intensive, high value-added goods sectors flourish while labour-intensive industries decline Income inequality

Conclusion Singapore stands to gain from globalization but it is difficult to determine if she will have the most to gain compared to other nations. Globalization and in particular trade for Singapore is a need rather than a want as cannot rely solely on her domestic market to drive her growth. Singapore will not be spared of the negative effects of globalization but the government can strive to maximize the benefits and minimize the costs by fostering greater economic integration (e.g. through trade talks with various countries) and implementing policies (E.g. training and education to improve workers skills).

13