extended response questions from ib test bank responses micro macro nkv2zc

PAPER 1: EXTENDED RESPONSE QUESTIONSMICROECONOMICS Resource Allocation

QUESTION 1Explain the importance of price in allocating scarce resources.(10)(a) definition of scarce resources

price is determined by supply and demand

price acts as a signal to producers and consumers

price acts as an incentive to producers to reallocate resources

Examiners should be aware that candidates may take a different approach, which if appropriate should be rewarded. Evaluate the possible consequences of implementing maximum and minimum price controls.(15) (Total 25 marks)(b)definition of maximum price

definition of minimum price

diagrammatic analysis of both maximum and minimum prices

discussion of price controls as forms of government intervention

discussion of the problems associated with the shortages that develop due tothe setting of maximum prices:

queues

waiting lists

rationing

black markets

discussion of the problems associated with the surpluses that develop due to the setting of minimum prices:

producers can ignore price controls and cut their prices

firms can become productively inefficient

firms are discouraged from producing alternative goods which can be produced more efficiently but which may have a lower free-market price.

signalling role of prices is distorted and there is a misallocation of resources.

discussion of who suffers from price controls

Up to a maximum of [7 marks] if only maximum or only minimum price controls are considered.

Examiners should be aware that candidates may take a different approach, which if appropriate should be rewarded.

QUESTION 2Briefly outline the various methods of price control open to governments. (10)(a)Possible points for discussion:

maximum (ceiling prices)

minimum (floor prices)

subsidies/indirect taxes

price support schemes

buffer stocks

minimum wages.

Two methods, well covered, with relevant examples, would be sufficient to reach the highest mark band. Candidates who confuse methods of price control with methods for controlling inflation should be limited to Band 2 and below.

Evaluate the effectiveness of using price controls to reduce poverty.(15) (Total 25 marks)(b)Possible points for discussion:

definition of poverty, perhaps involving absolute and relative poverty

the ability to provide relatively cheap necessity goods

the ability to provide merit goods

the ability to provide cheaper accommodation

the ability to ensure reasonable wage levels

the cost to the government of implementing price controls

parallel and black markets

any reasonable answer

The best candidates will relate their discussion to the reduction of poverty. Candidates whoevaluate controlling inflation and the reduction of poverty should be limtted to Band 2 and below.

QUESTION 3Explain the concepts of maximum and minimum price controls. (10)(a)Responses should explain what maximum prices are, i.e. price ceilings set by the government or some other agency. The price is not allowed to rise above this level, although it is allowed to fall below it. Better responses will give examples of when this may be appropriate, e.g. for rent controls or for basic goods to keep low for the lower wage earners. The best responses will also include a diagram.

Responses should explain what minimum prices are, i.e. price floors set by the government or some other agency. The price is not allowed to fall below this level, although it is allowed to rise above it. Better responses will give examples of when this may be appropriate, e.g. for wages or to protect producers incomes. The best responses will also include a diagram.

Candidates who only deal with one of the concepts should be limited to a maximumof [5 marks].

Evaluate the idea that government intervention in the form of price ceilings and price floors is well intentioned, but often leads to undesirable side effects. (15) (Total 25 marks)[10 marks]

(b)This part of the question asks the candidate to assess the effects of the imposition of maximum/minimum prices. It is best approached by taking examples and then evaluating their success in terms of achieving the desired outcome. Candidates might refer to several of the examples in each section but it is equally acceptable to have a well developed discussion on one example only in each section.

Examples and areas for discussion might include:Minimum prices

setting minimum prices to protect producers incomes. The aim is usually to provide stability and to give a guaranteed minimum return to important producers. However, the effect is often to create a glut of the product, which the government will then have to buy and possibly store.

protecting wages leads to an excess supply of labour

firms with surpluses on their hands may try to evade the price controls and cut their prices

black markets may evolve to clear the surpluses

high prices may cushion inefficiency

high prices may discourage firms from producing alternative goods that they could produce more efficiently.

the above may be explained and then the candidate may go on to explain how the glut might be used as a buffer stock in future times when production is short.

Maximum prices

setting a maximum price below the equilibrium price in a market will lead to excess demand. For example setting rent below the equilibrium rent in a market will lead to an excess demand for rented accommodation.

the government may have to instigate rationing

black markets may develop

maximum prices reduce the quantity of an already scarce commodity.

queues may develop

Examiners should be aware that candidates may take a different approach, which if appropriate should be fully rewarded.

Candidates who only deal with one of the concepts should be limited to a maximum of [8 marks].

QUESTION 4Explain how a buffer stock system might be used to stabilize agricultural prices.(10)(a)Reasons for the creation of a buffer stock scheme could include:

buffer stock schemes are intended to provide a stable framework of prices to benefit both producers and consumers

buffer stock schemes are generally used in the case of commodities where the price is very volatile

because many developing countries are dependent on the export of commodities, they are therefore very vulnerable to such volatility

To explain how the scheme would work:

a graph should be drawn to illustrate the maximum and minimum range of prices set by the scheme

should also note what might occur to cause the price to move out of the acceptable range and then explain what an organisation would have to do to bring it back

a buffer stock manager and suitable resources would have to be established

[12 marks]

Discuss the view that intervention in agricultural markets causes more problems than it solves.(15) (Total 25 marks)(b)Possible areas for discussion include:

the high costs of storing the goods

the necessity of holding large amounts of financial reserves

the difficulty of choosing an appropriate price range which can be sustained

the possibility of cheating by individual members who might seek to sell a larger amount by reducing the price

the growing availability of synthetic substitutes for many commodities causing downward pressure on prices

the increasing supply of many commodities as a result of improved technologies causing downward pressure on prices

[13 marks]

QUESTION 5Explain how, in a market economy, the price mechanism assists in the allocation of resources.(15)(a)Possible areas for discussion

what is meant by the terms

market economy

price mechanism

resource allocation

demand and supply analysis to explain how the price mechanism allocates resources

explanation of

the rationing function

the incentive function

the signalling function

Note: appropriate credit should be given to students who compare the pricemechanism with command and mixed economies.

Critically evaluate how the price mechanism deals with the problem of non-renewable resources.(10) (Total 25 marks)(b)Possible areas for discussion

what is meant by non-renewable resources

the use of properly labelled diagrams to

explain how the price of non-renewable resources is determined by the interaction of supply and demand

explain that as population and income increase demand will shift rightwards

explain that as the stocks of non-renewable resources decline the supply curve of these goods will shift to the left

explain how the price for these products will increase

a discussion of the role of income and price elasticity of demand in determining theextentof the price increase

the incentive to develop substitutes

a discussion of the rationing/conserving effect of the increases in prices

a discussion of how the burden of conservation is passed on to the least able to pay

a discussion of how present prices might reflect the value of these resources forpresentgenerations but not for future generations

problem of depletion where its impossible to find substitutes e.g. water

limits of pricing in general when seeking to assess environmental worth or value,e.g.concepts like the commons

Note: appropriate credit should be given to any other relevant points.[10 marks]

QUESTION 6

What are the main characteristics of a free market economy and a centrally planned economy?(a)Centrally-planned economyall decisions about what to produce, how to produce and for whom to produce are made by central planners

state ownership of factors of production

responses may note what is absent in a CPE such as profits, incentives, competition, role of prices in allocating resources

motive for production is social welfare, rather than profit

Free-market economy

all decisions about what to produce, how to produce and for whom to produce are made according to the price mechanism

no government intervention

profit motive provides incentives

private ownership of factors of production

responses may note the existence of market failure

Responses may certainly be awarded full marks even if not all points are covered. There is no obligation to discuss disadvantages of each system.

[10 marks]

Evaluate the possible consequences that may be encountered when an economy makes a transition from central planning towards a free market.(b)Responses are likely to discuss the following:

On the negative side

inflation, as a result of shortages which occur because choices are being made by consumers, rather than the government.

unemployment, as a result of privatization and increased competition. Increased competition arises as a markets open up to trade and FDI.

income inequality, through the introduction of market forces.

growth of parallel markets, resulting from shortages.

possibility of budget deficit and trade deficit.

On the positive side

greater efficiency

wider competition

increased trade and FDI.

Responses should make use of examples, possibly noting differences between Asian transition economies, Eastern European transition economies and developing country transition economies.

[15 marks] Elasticity1. Carefully explain what it is that price, income and cross elasticities of demand are meant to measure. (10)(a)Good answers should contain accurate definitions and formulae. Candidatesmust address at least 2 of the 3 types of elasticity for band 2 or above, andall 3 for band 3 or above.

Discuss the practical importance of the concept of price elasticity of demand for

(i)business organisations,

(ii)the government. (15) (Total 25 marks)

(b)Possible areas for discussion include some of the following:

(i)For business organisationsrelationship between PED and sales revenue

PED and sales revenue in different market situations, e.g. perfect competition, monopoly, discriminating monopoly, oligopoly

importance of PED for agricultural business organisations

(ii)For the government

PED, expenditure taxes and government tax revenue

importance of PED in relation to government subsidies

PED and the effectiveness of tariffs

PED and the effectiveness of devaluation (the Marshall/Lerner condition)

2. What are the various factors that determine the value of (i) price elasticity of demand and (ii) income elasticity of demand? (12)

(a)PED determined by the availability of substitutes / degree of necessity / proportion of income accounted for by the good / habit / the time period etc. YED tends to be relatively high in the case of services and manufactured goods and low in the case of primary commodities. YED and normal/inferior goods.

Assess the importance of price elasticity and income elasticity of demand for business decision-making. (13) (Total 25 marks) (b)Possible areas for discussion include:

PED relationship between price increases/decreases and total revenue, hence profits

YED relationships between higher/lower income levels, necessity/luxury, boom/recession, and total revenue, hence profits.

Reward good use of relevant examples. Provided some reference is made to both types of elasticity, an unbalanced answer thoroughly dealing with one type can reach the higher bands.

3. Explain the factors which influence price elasticity of supply. Illustrate your answer with reference to the market for a commodity or raw material.(13)(a)Candidates should define price elasticity of supply. Some factors which influence the PES of commodities are:

the number of producers and barriers to entry into the industry e.g. oligopolistic oil industry

the relationship between producers, e.g. cartels, commodity agreements etc.the availability of producer substitutes

the time period (distinction between very short, short and long run)

storage of stocks - possible with minerals but not with foodstuffs

elasticity of supply of factor inputs - factor endowments, lead times etc.

N.B. Candidates who explain the factors which influence PES without any reference to a commodity or raw material should be restricted to a maximum of [6 marks].

Candidates who confuse PED with PES should be limited to a maximum of [4 marks], providing there is something of relevance.

Discuss the importance of price elasticity of supply and price elasticity of demand for producers of primary commodities in less developed countries. (12)(Total 25 marks)(b)This part of the question asks the candidate to apply the knowledge provided in response to (a) using the problems of LDCs as commodity producers.Reference to real world examples should be rewarded.

Candidates might be expected to consider the effects of degrees of inelasticity of supply and demand on:

export revenues and the external balance

the exchange rate

fluctuating effects on local employment and investmentReward any other reasonable argument or example.

N.B. Particular credit should be given to those candidates who are able to relate the importance of PED and PES to primary commodity producers in LDCs, rather than just discussing the importance of the concepts in general terms.

Also give credit to those candidates who widen their answer by examining the importance of PED and PES for the economy at large for LDCs, e.g. in relation to the terms of trade, balance of payments, depreciation, government revenues etc.

Theory of Firm

1. Using suitable diagrams, explain why there is likely to be an absence of long-run economic profits in perfect competition. (12)(a)The explanation might include the following:

definitions of perfect competition (including its assumptions),economic profitand the long-run

absence of barriers to entry as the principal feature in the elimination oflong-runeconomic profits

short-run economic profit is possible within this model, while long-runeconomicprofit is not

description of the process by which long-run profits are eliminated

correctly used and labelled diagrams, incorporated into the response.

If no appropriate diagrams, no more than five marks should be awarded

To what extent might consumers benefit from increased competition between firms?(13) (b)Issues that could be raised include:

factors that influence competition (e.g. barriers to entry, number and size offirmsetc.)

model of perfect competition and its outcome

productive efficiency

allocative efficiency

lower prices and higher output

consumer sovereignty

general benefits from increased competition

lower prices

lower production costs

a more diverse range of products

improvements in quality

greater responsiveness to consumers

potential for greater innovation and technical change

Note: Appropriate credit should be given to students who elaborate on the limits of competition, e.g. distribution of income, pollution etc. Recognise the value of the candidates critical awareness

2. Monopoly price is higher and output smaller than is socially ideal. The public is the victim. (J.K. Galbraith, 1974)

Explain the economic reasoning behind the statement that monopoly price is higher and output smaller than is socially ideal. (12)

(a)Monopoly price and output

Relevant points might include:

definition of monopoly

explanation of socially ideal, perhaps in terms of different aspects of efficiency

monopoly equilibrium diagram

explanation of monopoly equilibrium

equilibrium in perfect competition

comparisons between perfect competition and monopoly.

Do you agree that the public is always the victim of monopoly? Justify your answer. (13)(Total 25 marks)

(b)Victim of monopoly.

Areas of discussion could include:

higher prices and consumer surplus

redistributive effects of monopoly pricing

impact on choice and quality

importance of productive and allocative efficiency

possibility of economies of scale and lower prices

impact of dynamic efficiency under monopoly

importance of research and development

importance of abnormal profits, level of certainty and investment

natural monopolies and public utilities

domestic monopolies versus international monopolies in areas of

national importance

dynamic efficiency under monopoly.

3. Under what conditions is price discrimination possible and profitable? (12)(a)Relevant points might include:

definition of price discrimination

existence of an imperfect market

splitting and separation of market (e.g. according to geography, timeand customer type)

differing price elasticities of demand

costs of segmentation less than likely benefits Candidates who use the three market discriminating monopoly equilibrium diagram to answer this question should be highly rewarded

[12 marks]

Who gains and who loses from price discrimination? Illustrate your answer with examples. (13)

(b)Possible areas for discussion:

effects on consumers, e.g. in captive markets/non-captive markets

effect on consumer surplus/producer surplus

redistributive effects

effect on profits

possibility of consumers and producers gaining if a loss-making firm isturned into a profitable one

links with natural monopoly Reward candidates highly who respond in a technical manner, e.g. in terms of changes in consumer/producer surplus.

[13 marks]

4. Explain the differences between monopolistic competition and oligopoly as market structures. (10)(a) large number of firms (m.c) versus a few dominant firms (oligopoly)

differentiated product (m.c) versus differentiated or standardized (oligopoly)

low barriers to entry (m.c) versus high barriers to entry (oligopoly)

interdependence of firms in oligopoly

comparison of the demand curves


Discuss the differences between a collusive and a non-collusive oligopoly. (15) (Total 25 Marks)Collusive Oligopoly

formal (cartel) or informal agreement (tacit collusion) among producers to limit competition between themselves

they act as if they were a monopoly

discussion of the consequences of the firms acting as a monopoly

impact on consumers

members may compete against each other using non-price competition

regulations to prevent collusion

Non-Collusive Oligopoly

no agreement exists between producers

existence of non-price competition with the possibility of price wars

the kinked demand curve as one model to describe oligopoly behaviour

game theory

contestability of markets prevents firms from exploiting monopoly power

It would be possible to earn full marks on this question without using diagrams, however use of appropriate diagrams should be rewarded.

Discussion (in part (b)) of only a collusive or only a non-collusive oligopoly should be awarded up to a maximum of [7 marks].


[15 marks]

5. How does a monopoly maintain supernormal (or abnormal) profit in the long run? (12)

(a)The aim of the question is to have candidates show their understanding of monopoly as a market structure. The most essential part of any answer must be that barriers to entry prevent abnormal profit being reduced by competition. Good candidates will develop this point by considering patents, trademarks, product differentiation, cost advantage, etc. For the highest marks expect candidates to identify abnormal profit through a diagram, properly explained.Is monopoly always undesirable?(13) (Total 25 marks)

(b)The question is meant to draw attention to arguments for and against monopoly.

The arguments for monopoly are:

natural monopoly, and the associated ideas of economies of scale and minimum efficient scale

the research and development argument, which may be fine in some monopoly markets. This can be linked to innovation and cost saving.

The arguments against monopoly are:

allocative and productive inefficiency

higher price and lower output

For the highest marks candidates should include diagrams, properly explained.

6. Discuss and evaluate the proposition that perfect competition is a more efficient market structure than monopoly. (Total 25 marks)

This question requires a candidate to give an accurate definition of both market structures and how the concept of efficiency applies to each.

Accurate definitions of allocative and technical (productive) efficiency should also be expected with better candidates referring to diagrams.

Arguments which support the proposition are:

lower price

allocative and productive efficiency

output is maximised

price equals marginal cost

Arguments which do not support the proposition are:

economies of scale/natural monopoly

research and development

positive effects of price discrimination7. What does an economist mean by efficiency in the operation of a firm? (10)(a)This calls for basic definitions and requires students to identify and explain two key types of efficiency.

(i)Allocative efficiency occurs where marginal social cost = marginal social benefit;

where P = MC.

(ii)Productive (technical) efficiency occurs

when firms produce at the lowest cost per unit.

at the minimum of the average cost curve.

Students may introduce/explain concept of Pareto efficiency but this is not necessary for full marks. Diagrams should be rewarded.

(b)Discuss whether the achievement of efficiency is possible and desirable. (15) (Total 25 marks)

Students should distinguish between different types of market structure.

In perfect competition, in the short run, a firm will be allocatively efficient but not necessarily productively efficient.

In the long run, a firm in perfect competition will be productively and allocatively efficient.

In all the other market structures, neither allocative nor productive efficiency will be achieved.

Diagrams are very useful in illustrating these points.

Allocative efficiency is desirable because welfare is maximised; the economy produces the goods and services most valued by society.

Productive efficiency is desirable because it means that products are being produced at the lowest cost possible; this represents the most efficient allocation of resources.

However, efficiency may not be desirable because:

firms which are efficient (i.e. those in perfect competition) may not be able to afford investment in research and development because they cannot earn abnormal profits in the long run.

such firms do not offer the variety of products because the products are not differentiated.

although not efficient, a monopolist may produce more than any single firm in perfect competition as a result of economies of scale.

Candidates who write that the whole idea of efficiency is problematic to economists should be rewarded, especially if they substantiate it.8. Explain how profit is determined in perfect competition. (10)

definition of profit/normal profit/abnormal profit/loss

definition of perfect competition

abnormal profit in the short run only

losses in the short run only

normal profit in the short and long run

diagrams to illustrate the above Examiners should be aware that candidatesmay take a different approach, which if appropriate should be rewarded.

Whatever the type of market structure, profit maximization will always be the only goal of firms. Discuss. (15) Total 25 marksPoints for discussion might include:

different market structures

explanation of profit maximization in terms of MC/MR, TC/TR

profit maximization in perfect competition and imperfect competition

profit maximization diagrams

importance of profit maximization in reality

other goals of firms, e.g. sales, volume or output maximization, revenue maximization, environmental concerns

managerial goals

preservation of dominant market position

collusion, creation of barriers to entry

contestable markets where firms may not profit maximize due to the threat of competition

Examiners should be aware that candidates may take a different approach, which if appropriate should be rewarded.9. In what ways do firms operating in different market structures compete? (10)

in perfect competition competition is on efficiency as firms are price

takersand goods are homogeneous

monopoly single producer, no competition, emphasis on maintaining barriersto entry

in oligopoly product differentiation, advertising and other forms ofnon-pricecompetition; price competition/price wars; exploitation oflarge scaleproductionas an entry barrier; collusion

in monopolistic competition non-price competition.

Answers which simply describe each of the market structures should be limited toBand2andbelow.

Discuss the view that the more competition there is within each industry the better. (15) (Total 25 marks)(b)Possible advantages of increased competition:

Lower price

Better quality

Greater efficiency

Greater choice

More innovation

Any reasonable answer.

Possible disadvantages of increased competition:

No incentive to invest

Natural monopolies

Ethical issues

Increased external costs

Worker exploitation

Falling quality from cost-cutting

Merit/public goods


Market Failure 1. What role do prices play in the allocation of resources in free market economies? (12)(a)Candidates might include the following:

explanation of resource allocation

definition of a market economy

definition of a market

characteristics of a market economy

price determination

role of prices in resource allocation (signalling, rationing and incentive functions)

demand and supply diagrams to illustrate resource allocation

consumer sovereignty/producer sovereignty. Evaluate the options available to governments to overcome the failure of markets arising from the production and consumption of demerit goods. Illustrate your answer with examples where possible. (13) (Total 25 marks)(b)High scoring answers should not only explain the options available, butshould also evaluate them in terms of potential strengths and weaknesses.

Issues and areas for discussion might include:

definition of demerit good

explanation of how the market fails in the case of demerit goods

suitable diagram to show overproduction of demerit goods

use of persuasion/negative advertising to shift the demand curve to the left

explanation of taxation on demerit goods shifts supply to the left

evaluation of taxation policy in terms of

a market-based solution

difficulty of assessing the value of negative externalities

inelastic demand for demerit goods

explanation of different forms of regulation e.g. complete ban, spatial andage restrictions

evaluation of regulation in terms of

a direct means of tackling the problem

interference with market forces

problem of unofficial markets arising in the case of a complete ban

the problems of enforcement.

2. Explain how the existence of positive externalities may cause free markets to misallocate resources.(a)Candidates would be expected to discuss the allocation of resources under afree market, including discussion of some of the following:

free market scissor diagram

assumptions that underpin the theory of competition, particularly profitmaximisation and self-interest

linking the concept of equilibrium quantity to the allocation of resourcesrequired to produce that quantity of a good

consumer sovereignity

Discussion of the impact of externalities on the free market allocation ofresources may include:

definition of positive externalities

examples of positive externalities

social benefits

the effect of including positive externalities on equilibrium quantity andthe allocation of resources required to produce that quantity of the good

meaning of socially optimum

Candidates might include some discussion of the following:

diagrams referring to deadweight loss or welfare triangles

merit goods

the existence of negative externalities

reference to real world examples of externalities

positive externalities and income distribution

Evaluate the options available to governments to overcome the failure of markets to take account of positive externalities. Refer to real world examples in your answer.

(15)

(Total 25 marks)

(b)Candidates should be rewarded for the evaluation of options. An answer that evaluates well several options would be expected to outscore an answer that described a full range of options without evaluation. It is acceptable to use historical examples of countries which have experienced inflation but examples should not go backmore than 25 years.

As a general guide, candidates should be rewarded more for using specificrather than generalised examples to illustrate their answers.

Possible areas for evaluation are:

use of maximum prices e.g. for rented accommodation

legislation e.g. to wear seat belts

provision of goods/services free at the point of contact e.g. education/health

a mixture of free and market provision

use of subsidies

positive advertising campaigns

tax subsidies

Candidates might also include discussion of some of the following:

problems in identifying social optimality

measurement problems such as valuing intangibles and the issue of time(current versus future generations)

the influence of cultural perspective on valuing externalities.3. The basic economic problem is one of scarcity of productive resources. Explain how resources are allocated between competing uses in a market economy. (10)(a)Answers may include:

an explanation of the economic problems in terms of consumer wants being greater than scarce resources.

an outline of the different productive resources/factors of production

a description of the characteristics of a market economy, e.g. Private capital, limited role of government, consumer sovereignty, etc.

an explanation of the role of the price mechanism in the allocation of resources through:

the interaction of demand and supply

the signalling function of price

the incentive function of price

the rationing function of price

an explanation of the role of profit in allocating resources

use of correct diagrams, e.g. demand and supply, production possibility frontiers, etc.Discuss the view that there is strong justification for government intervention in the market for health care.(15) (Total 25 marks)(b)It is important to mark this question with an understanding that candidateswill live in countries, which have a variety of different types of healthcare system and their answers will reflect this.

For the view that there is strong justification for government intervention in the market for healthcare answers may include a discussion of:

types of government intervention: state provision, subsidies, compulsory health insurance, maximum price of healthcare products, regulation of healthcare providers, e.g. licensing of drugs, care as a merit good

under-provision of healthcare as a merit good market failure

the positive externalities associated with health care, e.g. productive workforce.

under-provision of healthcare to the less well-off people in society.

the provision of healthcare education and information, e.g. HIV, diet, contraception, etc.the importance of government planning in healthcare, e.g. future provision of health resources

the correct use of MSC/MSB diagrams to illustrate the need for governmentintervention in healthcare.

The arguments against government intervention in healthcare may include the discussion of:

higher taxation to pay for state provision

the opportunity cost of resources for other areas of government intervention e.g. education

inefficiency of state provision, e.g. bureaucracy, political decision making, etc.the problem for government of judging and meeting the socially efficient level of output for healthcare.

how free markets may lead to a more efficient provision of healthcare through the interaction of demand and supply (signalling and incentive functions of price).

For an evaluative approach candidates should consider the advantages and disadvantages of Government intervention.


4. What role do prices play in the allocation of resources in free market economies? [12 marks]

(a)Candidates might include the following:

explanation of resource allocation

definition of a market economy

definition of a market

characteristics of a market economy

price determination

role of prices in resource allocation (signalling, rationing and incentive functions)

demand and supply diagrams to illustrate resource allocation

consumer sovereignty/producer sovereignty.

Evaluate the options available to governments to overcome the failure of markets arising from the production and consumption of demerit goods. Illustrate your answer with examples where possible. (13)(Total 25 marks)(b)High scoring answers should not only explain the options available, butshould also evaluate them in terms of potential strengths and weaknesses.

Issues and areas for discussion might include:

definition of demerit good

explanation of how the market fails in the case of demerit goods

suitable diagram to show overproduction of demerit goods

use of persuasion/negative advertising to shift the demand curve to the left

explanation of taxation on demerit goods shifts supply to the left

evaluation of taxation policy in terms of

a market-based solution

difficulty of assessing the value of negative externalities

inelastic demand for demerit goods

explanation of different forms of regulation e.g. complete ban, spatial andage restrictions

evaluation of regulation in terms of

a direct means of tackling the problem

interference with market forces

problem of unofficial markets arising in the case of a complete ban

the problems of enforcement.

5. Carefully distinguish between merit goods and public goods, illustrating your answer with examples. (12)(a)Key features of merit goods are: can be provided through the market but not in sufficient quantities because of: positive externalities / income distribution problems / information/foresight problems. Non-excludability and non-rivalry are the key features of public goods (unlikely to be provided through the market).

To what extent is it desirable that the government should provide merit goods and public goods? (13) (Total 25 marks)(b)Possible areas for discussion include:

government provision of merit goods on grounds of

positive externalities and underprovision at the free market price

income distribution and lack of effective demand

lack of present and future information

danger of private monopoly power arising

market provision of merit goods on grounds of

government failure

general arguments for market provision in terms of competition, profit motive, costs, prices, efficiency and consumer choice

alternatives to government provision and the free market such as subsidies, maximum prices etc.

arguments for state provision of public goods in terms of unlikelihood of market provision / the free-rider problem / optimal resource allocation.

Mark part (b) as a whole.An unbalanced answer in terms of coverage of both public and merit goods can still enter the higher mark bands if at least one area is of sufficient quality.

6. Why do markets sometimes fail to set socially acceptable prices? (12)(a)Among the factors responses are expected to consider are:

the presence of externalities, especially negative externalities, which lead to overconsumption at undesirably low prices. Better responses will illustrate this with a diagram illustrating equilibrium at prices and quantities lower and greater than is socially desirable.

the difficulty of providing merit goods through free markets: these would be underconsumed because of higher-than-desirable market price, though not all societies or people would agree on what should be considered a merit good.

the abuse of monopoly power. Monopoly power gives the firm greater sovereignty leading to a deadweight loss of output at higher price and lower efficiency. Again, good responses might be expected to draw a diagram illustrating this.

less important points (because the question is wider than plain market failure) might include difficulties that markets themselves experience in finding equilibrium or market-clearing price due to time-lags, supply inelasticities, etc.; the distorting influence of government intervention through taxes and subsidies, etc.

To what extent can governments overcome this form of market failure? Illustrate your answer with examples.(13) (Total 25 marks)(b)To some extent the answer to (b) will depend on what has been written in response to (a). Bearing in mind this is a Standard Level question, responses might include:

the use of taxes and subsidies to adjust levels of price and output into line with social costs. Better responses will again illustrate this with a diagram. Examples might be drawn from goods with consumption externalities such as cigarettes, or environmental externalities such as petrol.

tradable permits. Explaining this is challenging and examples are relatively rare, so responses covering this clearly should be well-rewarded.

anti-monopoly/anti-trust legislation to reallocate sovereignty in markets from producers to consumers. Examples here could be from the airline, oil or telecoms industries, among many others.

adjustments to the legal framework in which markets operate, such as the establishment of property rights.

N.B. To reach bands 4 and 5 there must be some evaluation of the arguments and an analytical approach overall.

[13 marks]

7. Is economic growth compatible with the protection of the environment? Discuss with reference to sustainable development.

(Total 25 marks)

Areas for discussion could include:

definitions of economic growth/sustainable development

conceptions of development, e.g. industrialisation, urbanisation, social needs etc.

indicators of development (e.g. GDP, GNP, HDI, GPI, GEM etc.)

environmental costs of economic growth

pollution

land degradation

deforestation

ozone depletion

hazardous processes

depletion of non-renewable resources

Effects that different income groups have, through their different consumptionpatterns, on the environment

urban against rural dwellers

large landowners versus marginal peasants

consumers from more developed countries compared with more populousbut less affluent consumers from less developed countries

Role of multinational corporations

exporting hazardous practices and materials to less developed countries(e.g. pollution in the Rio Grande region in Mexico, Bhopal in India, etc.)

Global economy

higher level of debt associated with high levels of environmentaldegradation

World Bank and IMF policies, e.g. structural adjustment policies andExport Oriented Industrialisation encourage the export of natural resources

Global solutions

an awareness of the Earth Summit in Rio and the Kyoto convention

GEF

global concerns

Perspectives on the environment

neo-liberal (e.g. markets in tradeable emissions permits)

difficulties with pricing the future and applying traditional market conceptsto non-renewable resources sustainable development(e.g. Brundtland Commission definition)

anti-development (e.g. Sachs view that sustainabledevelopment is merelythe repackaging of traditional views ofeconomic growth)

[25 marks]

MACROECONOMICS

GDP Growth and Development

1. Briefly explain the various major objectives of macroeconomic policy. (10)(a)Candidates should briefly explain the goals of price stability, full employment, satisfactory balance of payments, economic growth and a more equal/unequaldistribution of income and wealth.

Critically examine the view that the control of inflation should always be the most important objective of governments. (15)

(b)Possible areas for discussion include some of the following:

justification of the view in terms of the various ill-effects of inflation

challenging the view in terms of

situations in which inflation may not be a problem

the trade-off between inflation and unemployment

reasons why full employment should be the priority

reasons why economic growth should be the priority

reasons why the balance of payments should be the priority

reasons why income and wealth distribution should be the priority

2. To what extent is GNP per capita an appropriate measurement to use to compare living standards in different countries?(12)

(a)Possible areas for discussion include:

increases in GNP often associated with improvements in living standards but this is not necessarily the case; economic growth is not the same as economic development

GNP alone not a good statistic to use to measure living standards, let alone compare countries

statistic does not indicate the distribution of income

statistics may not be accurate; degree of accuracy will vary from country to country

different countries have different conventions for calculations

extent of black, hidden, informal economy may differ, leading to varying levels of underestimation in different countries

work at home/subsistence agriculture not included amounts will vary, leading to varying levels of underestimation

the type of output/spending not clear some types of spending are more likely to improve living standards than others

statistics may be converted at official exchange rates which will not necessarily reflect purchasing power

Discuss other measures which might be used to compare living standards. (13) (Total 25 marks)The following could be mentioned:

composite indicators such as: Human Development Index, Human Suffering Index, Physical Quality of Life Index, Index of Sustainable Economic Welfare, Human Poverty Index

GNP per capita refined to take account of purchasing power parity rates

the need to look at other indicators of living standards: e.g. life expectancy, infant mortality, literacy rates, access to safe water, daily calorie supply, number of doctors per 100 people, number of televisions etc.

the desirability of being able to value the more intangible indicators such as gender equality, political freedom, freedom of speech, civil rights. However, answers based entirely on non economic indicators and which ignore HDI, HPIetc. should not score more than [6 marks]

the need to account for the negative aspects of growth such as resource depletion, externalities

[13 marks]

3. Discuss the main problems involved in measuring the national income of a country. (12)(a)Problems of measuring the national income

Relevant points might include:

definition of national income

inadequate information, e.g. because of tax evasion and the parallel/hiddeneconomy

the problem of double-counting

the subsistence/non-money part of the economy

valuation of government services

allowances for market prices/factor cost, property income,

imports/exports

the problem of timing etc.

Why do many economists prefer to use composite indexes, such as the Human Development Index and the Human Poverty Index, as well as national income figures, to indicate living standards? (13) (Total 25 marks)Issues and areas for discussion could include:

definition of living standards

the need to use real GDP (GDP at constant prices) to take inflation into account

the need to use purchasing power parities which compare living costs

the distribution of income

the impact of externalities

production does not equal consumption (the composition of output)

the size of the informal economy

the production of de-merit goods

non-marketing goods

living standards influenced by wealth not just income

tastes and needs may be different in different countries

degree of accuracy of data varies between countries

living standards also influenced by factors such as human rights,democracy, etc.

composite indexes provide a broader measure of living standards,e.g. HDI (literacy and health), HPI, GEM (gender empowerment) etc.

Identify the components of aggregate demand and briefly explain two factors which might determine each of these components.(10) (a)Answers may include:

a definition of aggregate demand (AD)

a definition of the components of AD: Consumption, Investment, Government Expenditure, Exports Imports (net Exports), (candidates may use C+I+G+X which is rewarded in the same way)

an explanation of any two factors that determine:

consumption e.g. real income, consumer confidence, interest rates and availabilityof credit, attitudes to saving, wealth, etc.

investment factors e.g. business expectations, interest rates, level of profit,available finance (level of savings)

government spending e.g. political priorities (improve public services, defence,)rate of economic growth, unemployment/inflation, tax revenue

exports minus imports e.g. rate of economic growth, exchange rate changes,domestic producer efficiency, foreign producer efficiency, changes in the terms oftrade, protectionism.

It is important to award candidates for showing an understanding of the factors which affect AD rather than just listing factors. Where candidates just write list factors the maximum mark should be level 2.

Evaluate the likely impact on an economy of a substantial rise in the level of interest rates.(15) (Total 25 marks)(b)Answers may include a discussion of the impact of a rise in interest rates on:

consumption spending

saving rates

investment spending

government spending (government borrowing costs increase)

rate of inflation

level of unemployment

rate of economic growth

balance of payments

current account (imports and exports)

capital account (capital flows)

exchange rates

use of AD/AS analysis to illustrate impact of shifts of:reducing AD (reducing C, I, etc.)reducing AS (increasing costs of production)

for an evaluative approach candidates may discuss:

costs and benefits of higher interests rates

the short and long term consequences of higher interest rates

the significance of the impact of higher interest rates on different factors


InflationExplain the costs of inflation and the costs of deflation. (10)

(a)Definitions of both inflation and deflation

Costs of inflation include:

effects on those who rely on fixed-income or are in a weak bargaining position

implications of higher export prices

inflation harms lenders and benefits borrowers

uncertainty

inflation may lead to high nominal interest rates

menu costs

shoe-leather costs

Costs of deflation include:

falling prices may cause consumers to defer spending leading to greater deflationary pressure

investment spending is discouraged

benefits lenders and harms borrowers.

Examiners should be aware that candidates may take a different approach, which if appropriate should be rewarded.Evaluate demand-side policies as a means of reducing inflation. (15) (Total 25 marks)(b)definition of demand-side policies: fiscal policy and monetary policy

explanation of how demand-side policies can be used to reduce inflation

discussion of the problems associated with deflationary fiscal policy e.g. difficulty of fine-tuning, time-lags

discussion of the problems associated with contractionary monetary policy: an increase in interest rates slows economic growth and negatively affects exports due to increase in exchange rate.

not effective in reducing cost-push inflation

an evaluation of demand-side policies versus supply-side policies

For a discussion of only one policy up to [7 marks].

For a full discussion of two policies (e.g. Fiscal and Monetary policy) up to [15 marks].

Examiners should be aware that candidates may take a different approach, which if appropriate should be rewarded.Describe the main causes of inflation. (10)(a)definition of inflation

explanation of the cost-push causes of inflation

rising unit labour costs

rising raw materials costs, e.g. rising oil price

rising capital costs

profiteering by businesses

explanation of the demand-pull causes of inflation

rising consumer demand

expansionary fiscal policy

expansionary monetary policy

correct application of AD and AS diagram to illustrate the causes of inflation


If inflation is a major problem faced by governments it must follow that the opposite, deflation, is desirable. To what extent do you agree with this statement?(15)(Total 25 marks)(b)Points for discussion might include:

definition of deflation

distinction between inflation and deflation

the consequences of inflation on:

re-distribution of income e.g. fixed incomes, borrowers and lenders

business investment

economic growth and development

international competitiveness

menu costs

shoe leather costs

beneficial effects of inflation e.g. business profitability

the consequences of deflation on:

economic growth and development

unemployment

impact on borrowers and lenders

business profitability

international competitiveness

beneficial effects of supply-side deflation


Discuss the possible consequences that might occur when a government attempts to reduce inflation.(Total 25 marks)

Responses should include a definition of inflation and note that there are several causes.

Better responses will note that the policies used to reduce inflation will depend on the cause of inflation.

Government attempts to reduce inflation will include deflationary monetary and fiscal policies as well as supply-side policies.

If solution is deflationary monetary policy (higher interest rates), consequences include

higher loan repayments

lower purchasing power of income

appreciation of currency reducing competitiveness of exports, leading to trade balance problems

decreased investment, with negative implications for economic growth.

If solution is deflationary fiscal policy (higher taxes and decreased government spending), consequences include

lower disposable income

less consumption

disincentive effect

fall in spending on health and education and other public/merit goods.

If solution is supply-side policies, consequences include

increased efficiency

reduced trade union power

reduced social security benefits

greater privatization

more competition

increased flexibility in labour markets.

Responses should note that the deflationary polices are likely to lead to increased unemployment. There might be some reference to the trade-off between inflation and unemployment and the Phillips curve.

UnemploymentUnemployment remains persistently high in a majority of countries throughout the world.

Explain the economic problems that high unemployment may cause for a country.(10)(a)The economic problems of high unemployment include:

opportunity cost in terms of output foregone and inefficiency

impact on government finances more expenditure and less tax revenue

individual and social costs

the impact on poverty and income distribution

unequal impact of unemployment in terms of region, urban/rural, gender, race and age


Discuss the reasons why governments find the goal of full employment difficult to achieve.(15)(Total 25 marks)

(b)In responding to this question, answers could:

an appropriate definition of full employment should be included

candidates need to be familiar with the various types of unemployment, but need to be aware that frictional, structural unemployment and seasonal unemployment constitute the natural level of unemployment and exist beyond the full level of unemployment

problems which occur as a result of trying to reduce demand-deficient unemployment are inflation and current account issues

appropriate diagrams would be a keynesian AD/AS model showing an increase in AD and/or a Phillips curve showing the trade-off between inflation and unemployment

Limitations of using fiscal policy to raise AD e.g. time lags, crowding out

Some awareness of conflicting opinions of the shape of the LRAS and the implications of trying to achieve full employment should be highly rewarded.

What are the consequences of unemployment in an economy?(10)(a)Candidates may define unemployment. Credit should be given forexamination of the different types of unemployment with brief mention ofcauses.

Consequences

A variety of approaches may be taken by candidates and the following may beconsidered by them.

lower output and standard of living this may be considered at both theindividual and macro levels. Candidates may use PPC diagrams to illustrate.

personal costs such as self-esteem, health, etc.

social costs, such as disruption to family units, crime, etc.

lost tax revenue for governments and higher expenditure by governmentson welfare payments and the provision of basic support

In discussion, candidates should be rewarded for drawing on theory in theiranswer, such as labour market diagrams, AS/AD diagrams, the Phillips curveand PPC diagrams.

Reward candidates who distinguish between private and public costs instructuring their answer.

Examine the strategies that may be used to reduce unemployment, referring to more developed countries and less developed countries in your answer.(15)(Total 25 marks)

(b)Candidates may examine strategies generally, with reference to the situationfound in MDCs and LDCs. Alternately, candidates may choose to discuss thesituation in MDCs and LDCs separately. Either approach is acceptable, withcandidates being rewarded for recognising that the strategies used in MDCsare not necessarily appropriate for LDCs, and vice versa.

Discussion may include:

the role of aid in creating employment

the role of trade in creating employment

structural adjustment policies designed to align labour skills with the needsof employers, such as retraining schemes, use of appropriate technology,government initiated projects designed to employ labour directly or toprovide infrastructure that will create employment in the private sector

labour market reforms designed to remove barriers to the free market forlabour (such as removing minimum wage legislation or the abuse of powerby unions and employer organisations)

policies designed to stimulate the level of aggregate demand, such as theuse of fiscal and monetary policy, or the redistribution of wealth andincome

regional policies

distinction between underemployment and unemployment

less scope for government intervention/welfare systems in LDCs.

Candidates should be rewarded for recognising the problems associated withthe strategies suggested. Government Policies

Explain the difference between demand-side and supply-side economic policies. (10)

(a)explanation of demand-side policies in terms of monetary and fiscal policy

explanation of supply-side policies in terms of particular policies, e.g. tax cuts, welfarecuts, privatisation, deregulation and an outward shift of the LRAS curve

use of AD/AS diagram to illustrate the difference

Reward references to the KeynesianMonetarist debate.Higher economic growth can only be achieved through the implementation of supply-side policies. Discuss. (15) (Total 25 marks)(b)Answers may include:

definition of economic growth

illustration of economic growth in terms of an outward shift of the PPC/LRAS curve

distinction between actual and potential growth

explanation of linkages between supply-side policies and growth

importance of AD

Reward references to the KeynesianMonetarist debate

demand-side policies and the multiplier effect

interdependence of supply-side and demand-side policies

This is potentially a big question for candidates to tackle. Do not expect answers to be able to cover the greater part of the above. Good candidates should be able to show how supply-side policies can increase economic growth. They also need to be able to discuss this in the context of alternative demand side policies.


Explain the relationship between the Lorenz Curve and the Gini Coefficient. (10)

(a)Lorenz Curvea curve showing the proportion of national income earned by any given percentage of the population

used to show the degree of inequality of income in a society

the farther from the 45 line is the curve, the greater the degree of inequality

Gini Coefficient

a statistical measure of the degree of income inequality

measures the area between the 45 line and the Lorenz Curve as a proportion of the entire area under the 45 line

ranges between 0 and 1

a Gini Coefficient of 0 represents complete equality; coefficient of 1 represents complete inequality

Up to a maximum of [6 marks] if there is no diagram(s).Up to a maximum of [5 marks] if the relationship between the Lorenz Curve and theGini Coefficient is not examined.


Evaluate the effectiveness of the various methods that governments may use to redistribute income. (15) (Total 25 marks)(b)explanation of the different forms of taxation and how they can be

used to redistribute income

discussion of the issues associated with using taxes to redistribute income

explanation of transfer payments made by government

discussion of the issues associated with transfer payments

subsidies

merit and public goods

Up to [15 marks] can be awarded for a full discussion and evaluation of two methods. Up to [15 marks] can be awarded for a less than full discussion of three or more methods but evaluation must occur; [recognising the time constraint].

Answers which are effectively a list and are without evaluation can be awarded up to [6 marks]. A discussion of one method with evaluation can be awarded up to [7 marks].

Different forms of taxation are to be seen as one method. In the same way different forms of transfer payment, subsidies, merit goods and public goods are to be each seen as one method.


Using suitable examples, explain the difference between the multiplier and the accelerator. (10)

(a)explanation of multiplier

use of numerical examples

explanation of accelerator

use of examples

key differences. E.g. multiplier is autonomous, accelerator is induced

Emphasis will normally be placed on the multiplier. This is acceptable as long as the candidate displays a basic understanding of the accelerator. Reward candidates who appreciate the interaction between them, that the multiplier is investment led and the accelerator is income led.


Evaluate the proposition that the most effective way to reduce unemployment is through the use of demand-side policies. (15) (Total 25 marks)(b)Points for discussion might include:

explanation of demand-side policies

explanation of monetary and fiscal policies

different types of unemployment: equilibrium/disequilibrium and traditional types

evaluation of the appropriateness of demand-side policies to combat types of unemployment, e.g. appropriate to cyclical and demand deficient, but not to seasonal and structural.

AD/AS analysis

problems of demand-side policies

benefits of supply-side policies

drawbacks of supply-side policies

overall evaluation

Examiners should be aware that candidates may take a different approach, which if appropriate should be rewarded,Evaluate the effectiveness of demand-side and supply-side policies in the short and long run.

(Total 25 marks)

Responses should distinguish between the short run and the long run in some way.

Responses should explain demand-side and cover both fiscal and monetary policies. Better answers will use diagrams.

Responses should explain supply-side policies. Better answers will cover both market-based and interventionist policies, as well as using diagrams.

Better responses may consider the Keynesian/neo-classical debate on the shape of the LRAS curve.

Responses should attempt to evaluate the different policies and better candidates will realize that demand-side policies are effective, to an extent, in the short run, although there are costs because of trade-off. They should also realize that the majority of supply-side policies are long term and take a fair amount of time to take effect.

Better responses may also identify the situations that arise when supply-side policies are also demand-side policies and there may be a clash of outcome. For example, lowering interest rates as a supply-side policy may lead to a shift of AD to the right and inflationary pressures in the short run.

[25 marks]

The world economy may be subjected to economic shocks, such as a sudden increase in oil prices and terrorist attacks. With the help of an aggregate demand/aggregate supply diagram, explain the possible economic effects of such shocks.(12)(a)Possible effects:

shift of the AD curve, and/or the AS Curve, to the left

reduction in output

reduction in employment

lower growth

lower standard of living

on the price level

on the balance of payments

on exchange rates

any reasonable answer

Evaluate the main economic policies that governments might use to minimize these effects. (13)(Total 25 marks)

(b)Discussions may include the following:

fiscal policies

monetary policies

trade policies

supply-side policies.