tjc paper 2 answer

2014 TJC Preliminary Examinations H2 Economics

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Essay Question 1

Topics: Scarcity, Choice and Opportunity Cost, Market Failure, Government Intervention, International Trade, Protectionism, Role of Government

Past A Level Questions H1 N2011 EQ 4: Explain how the concept of opportunity cost can be used to analyse the basis for trade between countries. [10] H2 N2010 EQ 4: In the UK, entry to national museums and art galleries is free of charge and tickets to see the opera are heavily subsidised. In contrast, in Japan, entry to national museums and art galleries comes at a high price and a ticket to see opera is among the most expensive in the world. Assess the economic case for these two different approaches. [13]

a) Using the concept of opportunity cost, explain why countries trade. [10] b) In Singapore, the government levies a sales tax on cigarettes and tobacco products, and

is amongst the highest in the world. In contrast, the Chinese government levies a comparatively lower sales tax and an additional import duty on cigarettes and tobacco products. Assess the economic case for these two different approaches. [15]


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a) Using the concept of opportunity cost, explain why countries trade. [10]

Introduction Opportunity cost refers to the next best alternative forgone when a choice is made. The theory of comparative advantage states that a country is able to enjoy higher

consumption levels if it were to specialise goods in which it has comparative advantage in, and trade the good for other goods in which it has a comparative disadvantage in.

Thesis statement: this essay will explain, via the theory of comparative advantage, that countries engage in international trade because of differences in opportunity cost.

Explain how differences in opportunity cost explains why countries trade Figure 1 shows the production possibility curve of the USA (PPCUS) and Mexico (PPCM).

On the left, USA can produce either 500 computers or 500 shirts or any combination of computers and shirts along PPCUS. One the right, Mexico can produce either 100 computers or 400 shirts, or any combination of computers and shirts along PPCM.

United States Mexico

Figure 1: Consumption of Production Possibilities for US and Mexico

The slope of PPCUS = 500500 = 1, which shows that USAs opportunity cost of producing 1

computer is 1 shirt. The slope of PPCM = 400100 = 4, which shows that Mexicos opportunity cost of producing 1 computer is 4 shirts. USA has a lower opportunity cost and hence a comparative advantage in producing computers. Conversely, Mexico has a lower opportunity cost and hence a comparative advantage in producing shirts.

If both countries were in autarky, USA produces and consumes 100 shirts and 400 computers (Point C), while Mexico produces and consumes 200 shirts and 50 computers (Point A).

Assume the terms of trade to be: 1 computer : 2 shirts. With complete specialisation, USA produces 500 computers while Mexico produces 400 shirts. Trade then enables USA to consume at any point along its new post-trade consumption possibilities curve CPCUS, while it enables Mexico to consume at any point along its new post-trade consumption possibilities curve CPCM. Both CPCUS and CPCM have the same slope, which is equivalent to the exchange rate, 1 computer : 2 shirts.

If USA exports 75 computers and imports 150 shirts from Mexico, it now consumes at Point D with 425 computers and 150 shirts. This is better than its autarky consumption level at Point C, where only 400 computers and 100 shirts were consumed.


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From Mexicos perspective, if it exports 150 shirts and imports 75 computers from USA, it consumes at Point B with 250 shirts and 75 computers. This is also better than its autarky consumption level of Point A, where only 200 shirts and 50 computers were consumed.

Conclusion Therefore when opportunity costs of producing different goods differ between the 2

countries, specialisation and trade according to comparative advantage is beneficial to both countries.

If the slopes of both countries' PPC's were identical, then there is no difference in the opportunity costs of producing either good. Neither country has comparative advantage in either good so there is nothing to be gained from international specialisation and trade. Trade between the two countries will not occur.

Level Description Marks L3 For an answer that uses diagrams and/or tables to effectively illustrate

opportunity cost and comparative advantage 7 10

L2 For an answer that displays good understanding of opportunity cost and comparative advantage

3 6

L1 For an answer that displays knowledge of opportunity cost and comparative advantage, or for a brief and undeveloped answer

1 2

b) In Singapore, the government levies a sales tax on cigarettes and tobacco products, and is amongst the highest in the world. In contrast, the Chinese government levies a comparatively lower sales tax and an additional import duty on cigarettes and tobacco products. Assess the economic case for these two different approaches. [15]

Introduction Market failure refers to the situation where the free market fails to achieve an outcome

that maximises societys welfare However, the governments intervention in a market might not necessarily be restricted

to correcting market failure, and instead choose to pursue other economic objectives Thesis statement: this essay would examine the economics issues inherent in the

tobacco market and use economic theory to justify the two contrasting approaches

Explain how negative externalities results in market failure Negative externalities refer to the adverse effects imposed on third parties from the

production or consumption of a good. A person who smokes in public harms the people nearby, and these passive smokers are third parties who run the risk of getting health problems even though they are not consuming any cigarettes.


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Marginal External Costs (MEC) is defined as the additional costs imposed on third parties from the production or consumption of a good. When there are negative externalities, the full costs incurred by society include both the private costs and external costs. Marginal Social Cost is therefore equal to the sum of Marginal Private Costs and Marginal External Costs: MSC = MPC + MEC When there are negative externalities, the MSC curve lies above the MPC curve by the

amount equal to MEC. Assuming that there are no positive externalities, the market demand curve is identical to the MPB and MSB curves.

Without government intervention, the free market equilibrium occurs where MPB = MPC at output QP. The social equilibrium however, is where MSB = MSC at output QS. Between QS and QP, as MSC > MSB, negative welfare (deadweight loss) of area A is generated. Since QP > QS, the good is said to be over-produced.

A demerit good explanation is also acceptable

Explain how a sales tax corrects the market failure and restore the market to socially optimal equilibrium By imposing a sales (specific) tax that is equal to the MEC, MPC would pivot to MPCTax.

The new private equilibrium QS, where MPCTax = MPB now coincides with the social equilibrium QS where MSB = MSC. Allocative efficiency is achieved as the output has been reduced to the socially optimal level.

Explain how an import duty helps protect the domestic Chinese tobacco industry In Figure 3, at the world price, PW, domestic tobacco producers will produce Q1 while the quantity demanded by consumers of tobacco products is Q4. If an import duty is imposed, the supply curve of imported tobacco shifts vertically up from SW to SW+t raising the price of imports by the amount of the tariff, i.e., PW to PW+t. At PW+t, domestic tobacco production rises from Q1 to Q2 while domestic consumption falls from Q4 to Q3. As a result tobacco imports fall from (Q4 Q1) to (Q3 Q2).

Quantity

Pric

e, Co

st,

Ben

efit

($)

MEC

MSC = MPCTax

MPC

E1

E2PS

PP

QS QP MSB = MPB = DD

Figure 2: Negative Externality and a Sales Tax

Quantity

Pric

e

Q1 Q4Q2 Q3

Sw+t

Sw

Sd

Dd

Pw

Pw+t

Figure 3: Market Effects of an Import Duty


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By reducing the quantity of tobacco imports, the import duty has effective allowed domestic tobacco producers to increase their production and continue to operate in the market. This could also be used to protect the employment opportunities of the domestic Chinese tobacco farmers and workers.

Discuss the effectiveness of the two policies in helping the respective governments in achieving the policy objectives While a well designed sales tax could potentially restrict the consumption of tobacco

products, the addictive nature of these products could imply that the demand function of these goods are relatively more price inelastic and hence sales tax could have limited deterrent effect on the consumers.

Similarly for the import duty, if the local Chinese tobacco producers are very inefficient and incur a relatively exorbitant cost of production, the import duty would not be as effective in protecting the local tobacco industry.

Account for the difference in approaches Even though the two governments are faced with a similar market, their intervention

approach is quite different. However, there could an economic case for their contrasting approaches.

Demand conditions might be different for both tobacco markets, hence the need to impose different sales tax rates. Due to differences in taste and preferences, and information imperfection, tobacco in Chinese society tends to be viewed as a more socially acceptable good than in Singapore, and hence the demand for tobacco in China might be more price inelastic, and hence a higher tax rate is justifiable.

Singapore does not have a domestic tobacco industry while the tobacco industry in China plays a non-trivial role in the Chinese economy. From Singapores point of view, an additional import duty is not necessary. This is in contrast with China as an import duty can effectively shield the domestic tobacco market from overseas competition and help protect the interests of the Chinese tobacco producers and workers.

Other points could include: o Different extent of government failure o Difference in belief

Conclusion Ultimately, it is hard to conclude that one approach possess a stronger economic case

than the other, as the fundamental economic condition of these two countries are vastly different.

Governments intervene in markets for a variety of reasons and the pursuit of allocative efficient outcomes might not necessarily be the only objective that the government is trying to achieve. These perspectives are made more complex when different governments are presented with varying economic and political conditions. It could well be true that both cases are equally justifiable from an economic perspective.

However, if the belief is for market forces and price mechanisms to function efficiently (and how this would result in favourable macroeconomic conditions), then Singapores approach of market correction could arguably bear more economic weight. Moreover, since China National Tobacco Corporation (a Chinese state-owned monopoly) is one of the worlds largest tobacco products manufacturers, protectionism could arguably be construed as a politically motivated policy decision rather than an economically sound one.


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Level Description Marks L3 For an analytical answer that justifies the economic case for the two

approaches. This could include discussions on the limitations and unintended consequences of the policies. In order to score the full 11 marks, candidates must compare and analyse the economic case for the two different approaches.

8 11

L2 For an answer that displays good understanding of the economic objectives and the respective policies used to tackle these economic issues

3 7

L1 For an answer that displays knowledge of negative externality or demerit good, or for a brief and undeveloped answer

1 2

E2 Evaluative points that are well substantiated with evidence and clear theoretical analysis.

3 4

E1 Evaluative points that are not substantiated and without economic analysis 1 2


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2 Casual video game publisher G5 Entertainment has reported growth of 500% in mobile game downloads in 2011. Mobile games tend to be cheap or free with game upgrades that can be bought. That makes a mobile game cheaper than a $60 console game.

Adapted from: News10, 29 Feb 2012 (a) Using relevant economic concepts, explain the likely reasons for the proliferation of mobile

games downloads. [10] (b) Assess how related markets might be affected by the growth in mobile gaming. [15]

(a) Using relevant economic concepts, explain the likely reasons for the proliferation of mobile games downloads. [10] This answer seeks to explain the likely reasons for the proliferation of mobile game downloads using demand and supply analysis, and also price elasticity concepts. The increase in mobile games downloads may be caused by increases in both demand and supply while the extent of increase can be accounted for by the price elastic demand and supply of mobile games. Increase in Demand Change in taste and preference in favour of mobile games: As mobile phones are portable, one is able to play mobile games on the go. Due to the busy lifestyles, the convenience of mobile gaming has led to a favourable change in taste and preferences towards mobile gaming. Also, viral games like Angry Birds and Flappy Bird have influenced the masses to download mobile games, hence increasing the demand for mobile games. Increase in income As the global economy experiences a recovery from the Global Financial Crisis, national income levels have increased. This may result in an increase in demand for smartphones, which are normal goods. Smartphones offer a more accessible and compelling mobile gaming experience that has even attracted consumers who have not traditionally been gamers. Hence, the increase in demand for smartphones may increase demand for mobile games as well.

(Increase in size of population, increase in price of substitutes and decrease in price of complements are also acceptable reasons for the increase in demand) PES analysis: Compared to PC or console games, mobile games generally take lesser time to develop, and can be produced cheaply by individual and small developers supply of mobile games is relatively more price elastic with an increase in demand, the increase in quantity is more than proportionate to the increase in price. Increase in Supply Increasing number of firms: The introduction of many easy-to-use game-developing tools that do not require heavy coding has enabled novices to create their own games easily using the simple user interface. This has led to the entry of many indie game developers. Furthermore, the profitability of the mobile gaming industry may be attracting other types of game developers into the market. For instance, Eutechnyx, the developer of NASCAR games, is moving some of the teams of developing console games to mobile games. Hence, with the increase in the number of developers in the mobile game market, the supply of mobile game is likely to increase.


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(Improved technology is an acceptable reason for the increase in supply) PED analysis: Demand for mobile games are likely to be elastic because unlike the avid computer gamers, mobile gamers are relatively less addicted and committed to the game, mostly playing the games to kill time. with an increase in supply, the increase in quantity is more than proportionate to the increase in price. Analysis should include a diagram to show how a simultaneous increase in demand and supply may result in an increase in equilibrium quantity, and how price elastic demand and supply of mobile games have resulted in the rapid increase in mobile game downloads.

(b) Assess how related markets might be affected by the growth in mobile gaming. [15] As mobile gaming grows rapidly, its impact will be felt across several markets that are related to it, as well as market that are related to markets that are affected.

Explain the impact on market for inputs of mobile gaming:

e.g. software for game developers, game engineers

As the demand for mobile game rises, demand for software that are used to develop these games may increase as well since the demand for software is derived from the demand for mobile games. Equilibrium price and quantity increases.

Explain the concept of CED

Cross price elasticity of demand (CED) refers to the degree of responsiveness of demand for a good to a change in the price of another good, ceteris paribus. If the related good is a substitute, the CED will be a positive figure. An increase is price of the substitute will increase the demand of the good. The figure will be negative for a complement.

Explain the impact on market for complements and their related markets

e.g. game merchandise, smartphones, portable chargers

Game merchandise like t-shirts, stuffed animals and phone covers are complements of mobile games, with a negative figure for CED. The growth in mobile gaming is likely to increase the demand for game merchandise Increase in equilibrium price, quantity, and total revenue.

Knowledge, Application, Understanding and Analysis L3 For an answer that explains demand and supply factors of mobile gaming with

appropriate use of examples and diagrams AND uses elasticity concepts to account for the proliferation of mobile games downloads.

7-10

L2 For an answer that explains demand and/or supply factors of mobile gaming with appropriate use of diagrams.

4-6

L1 For an answer that shows some knowledge of demand and/or supply factors influencing mobile game downloads.

1-3


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With the increasing demand for game merchandise, demand for services of fan product providers such as PopAppStore, is likely to increase too Increase in equilibrium price, quantity, and total revenue in the game merchandise market.

As smartphones are required to play the mobile games, the demand for smartphones may increase with the growth in mobile gaming. Non-smartphone users may switch to buying smartphones so that they can play mobile games. Smartphone users may also buy a new smartphone that has a larger screen, better graphics and larger memory capacity to enhance their gaming experience Increase in equilibrium price, quantity, and total revenue in the smartphone market.

As the demand for smartphone increases, the demand for its factors of production, such as rare earths metals, may also rise as their demand is derived from the demand for smartphones Increase in equilibrium price, quantity, and total revenue

Explain factors that may affect the extent of impact

Magnitude of CED o eg. As Singapore has a high smartphone penetration rate of 87% and many

mobile games can be downloaded onto one smartphone, mobile gamers do not need to buy an additional phone to play a new mobile game. Therefore, they are weak complements and the impact of growth in mobile gaming is likely to be limited. However, in countries with low smartphone penetration rate such as Indonesia or India, smartphone and mobile games may be close complements and the growth of mobile gaming may result in a significant increase in demand for smartphones.

Nature of complements o eg. The more gaming-centric a smartphone is, the greater the extent of impact.

For example, Sony Ericsson launched the Xperia Play in 2011, a gaming-centric smart phone, which features a 4-inch touch-screen and a slide-out controller reminiscent of Sony's PlayStation Portable controls. The growth of mobile games is likely to result in a greater increase in demand for Xperia Play compared to other smartphones.

o eg. the operating system - not all mobile games are compatible on all operating systems. Certain games are only released on the iOS, for example, Tiny Wings and Clumsy Ninja. Hence, for smartphones with an operating system that offers a greater variety of mobile games, the extent of impact is likely to be greater.

(PES analysis is also accepted) Explain the impact on market for substitutes and their related markets

e.g. handheld games, console games, books

With the growth in mobile gaming, demand for other forms of gaming or entertainment may fall, resulting in fall in price, quantity and total revenue. For instance, in 2012, consumers spent more on iOS App Store and Google Play games than on software for dedicated gaming handhelds like the 3DS and PlayStation Vita..

Explain factors that may affect the extent of impact

Magnitude of CED - proximity of the substitute to mobile games o eg. Most mobile players are just casual gamers who are trying to kill time

whereas console game players may be avid gamers who want a more immersive gaming experience that comes with better storyline, character development and


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intricate soundtracks. Hence, mobile games and console games are likely to be weak substitutes and the extent of impact is limited.

The strategies taken by the competitors o eg. Console game producers may choose to release mobile versions of their

console games to keep up with the competition from mobile games. For example, Activision brought the console game Call of Duty into the mobile game market while Electronic Arts brought in Plants vs Zombies. By entering the mobile gaming market, console gaming firms can also advertise and promote the console version of their game to the emerging audience of casual players. This may potentially intrigue the mobile gamers to buy the console version and increase demand for console games. (There is a possibility for the two goods to become complements.)

(Time period or PES analysis is also accepted)

Evaluation

(Make a judgement on which market is likely to have the most significant impact, whether substitutes or complement markets will be affected more, or which factor is the most important in influencing the extent of impact) eg. The overall impact on the related markets is eventually dependent on tastes and

preferences of the consumers as taste and preferences influences the proximity of the related goods to mobile games, the success of the strategies taken by the competitors and whether console games can eventually become a complement of mobile game.

Level Description Marks L3 For an answer that provides a well considered, balanced and well justified

argument on how the related markets might be affected by the growth in mobile gaming.

9 - 11

L2 For an answer that provides an adequate analysis of the impact on related markets but answer lacks in scope and depth. There are also attempts to provide a balanced argument.

4 8

L1 For an answer that is mostly descriptive, with some inaccuracies. 1 - 3 E2 For a judgment based on economic analysis / adequately substantiated. 3 - 4 E1 For an unexplained judgment, or one that is not supported by economic

analysis. 1 2


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3. The theory of natural monopoly has been criticised as an excuse for defending monopolistic privileges, and has no place in the 21st century. Explain the theory of natural monopoly and discuss to what extent is the statement valid for the case of 21st century Singapore. [25] Introduction:

The theory of natural monopoly has long been used in economic analysis to justify the presence of monopolies in certain industries within an economy. It is also thanks to this theory that these firms continue to enjoy supernormal profits and insurmountable barriers to entry. However, as the global economy continues to evolve and technological advancements are made, the once impenetrable walls of this theory has begun to show cracks in reasoning.

Thesis Statement:

This essay shall attempt to firstly explain the theory of natural monopoly, before providing detailed discussion on the validity of the theory in the context of 21st century Singapore.

Explain theory of natural monopoly:

A natural monopoly refers to a market where economies of scale are so substantial such that average costs are falling throughout the entire range of the market demand.

In such a market, the fixed cost incurred in setting up the infrastructure is very large relative to the marginal cost of supplying the product. Hence the shape of the AC curve tends to follow the shape of the AFC curve, which explains why AC is downwards sloping throughout.

In such a market, it is less costly for one firm to supply the entire market than for two or more firms. Furthermore, the market may only be large enough to profitably support one firm.

Figure 1: Natural Monopoly

In Figure 1, the average cost AC is decreasing over the whole range of market demand D1. If there is only firm producing 1000 units of output at an average cost of $5, the total

Price, Revenue

Costs ($)

Outp

ut

AC

D1 =

AR1

D2 = AR2

10

5

1,000 500

A

B


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cost is $5 x 1000 = $5,000. If there are two smaller equal sized firms producing 500 units each at a higher average cost of $10, the total cost incurred is $10 x 2 x 500 = $10,000. Thus it is less costly for one firm to supply the market than for two or more firms.

Besides being most cost efficient to have only one supplier, Figure 1 also shows that market can only profitably support one firm. With a single firm, the market demand D1 is also the firms demand curve. This firm can make supernormal or at least normal profits, anywhere from point A and B because its average revenue curve AR1 lies above its average cost curve AC. If there were two equal sized firms, the market demand curve D1 would be split into two, with each firm facing a demand curve of D2 [market dd is equally shared]. Since D2 lies entirely below the AC curve, both firms end up making losses.

A natural monopoly applies to industries where the fixed cost incurred in setting up the infrastructure is very large relative to the marginal cost of supplying the product. Hence the shape of the AC curve tends to follow the shape of the AFC curve, which explains why AC is downward sloping throughout.

Typical examples of natural monopolies include telecommunications, rail transport and public utilities (supply of gas, water and electricity). In these industries, it is very expensive to install the pipes, cables and tracks for the distribution grid / network required to serve the entire city or country. On the other hand, the marginal cost of supplying a telephone call, pumping a litre of water or carrying an extra passenger on a train is very low in comparison.

In such networked industries, having more than one set of infrastructure may result in wasteful duplication of resources. For example, for rail transport, it would be quite wasteful to have two parallel rail tracks running the same route, especially if one set of tracks is sufficient to meet the demand. It would be more efficient to let a monopoly rail operator build one set of tracks and be the sole supplier of that route.

Even in the absence of significant economies of scale, a natural monopoly may arise if the size of the market demand is so small such that it is only viable for one firm to operate. For example, if the demand for bus services between two small towns is only about 20 passengers a day, even though there is inherently not be much economies of scale involved, there is simply too little demand to support more than one bus service operator.

In view of the theoretical underpinning of the concept, it seems to justify the existence of the market structure seen in these industries even in Singapore. Historically speaking, clear examples of monopolies were those of SingTel (telecommunication industry) and Singapore Mass Rapid Transit (SMRT) (rail services).

SingTel was initially granted 15 years of monopoly status, from 1992 to 2007, as the conventional wisdom then was that telecommunication was a natural monopoly given the prevailing state of technology. SingTel was tasked to upgrade Singapores telecommunications infrastructure, and it was granted a guaranteed domestic market to enable it to recoup its infrastructural costs.

Likewise, in terms of rail transportation, there are strong arguments for not having duplicated services, hence, lending itself nicely as a natural monopoly. The provision of mass rapid transit (MRT) services involves a high initial capital outlay to cover the cost of infrastructure such as tracks and station boxes. Economies of scale are likely to be so significant that unit costs are only minimised if the entire line is operated by a single producer. This paved the way for a singular operator - SMRT.

For both industries, their status as natural monopolies provided them with clear justifications to continue enjoying monopolistic privileges as mentioned in the statement, even in the context of Singapore, which has in place the Competition Commission of Singapore (CCS) that enforces the Competition Act. The Competition Act prohibits anti-competitive activities, such as the existence of monopolies. Therefore, it is observed that


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the theory of natural monopoly has a place in Singapore as it supports the existence of monopolies such as SingTel and SMRT.

Discussion of validity:

The command phrase lends itself to a thesis antithesis approach Thesis: Statement is valid and natural monopolies no longer have place in the case of

21st century Singapore. Antithesis: Statement is invalid and natural monopolies still have a place even in the

case of 21st century Singapore.

Connecting/Linking Statement:

However, we have seen a change in the situation of these industries. While SingTel and SMRT still have a relatively dominant position in their respective industries, we are seeing a movement away from them being monopolies. As such, there is a strong argument for the validity of the statement, which claims that natural monopolies no longer have a place in the 21st century Singapore.

Thesis: Statement is valid and natural monopolies no longer have place in the case of 21st century Singapore.

Case of SingTel:

The telecommunication market in Singapore was for a long time supplied by SingTel a natural monopoly. However, as the Singapore economy grew, more competition was subsequently introduced in the mobile telecommunication market with the entry of M1 Mobile and subsequently Starhub.

Even though prices of mobile services and handsets fell substantially due to increased competition, all three companies remained profitable, proving that the former natural monopoly had already evolved into a more competitive market. The earlier concerns that SingTel would collapse with the dismantling of its monopoly business did not materialise. Instead, it has taken on an external business orientation, growing to become a regional and global telecommunications player with investments in over 20 countries and territories, and showing steady gains in net profit and revenue.

This clearly violates the theory of natural monopoly where the introduction of competition will lead to the firms suffering from subnormal profits.

Further de-monopolisation would also happen in other aspects of the telecommunication industry, such as Internet provision in Singapore Several factors has allowed multiple firms beyond the 3 major mobile phone providers to be set up and provide fibre optic broadband services. As part of the Intelligent Nation 2015 blueprint by Infocomm Development Authority of Singapore (IDA) for galvanising Singapore into a sophisticated city with seamless high-speed connectivity, OpenNet was tasked the responsibility for building, managing and operating a high quality and high-speed fibre network.

Given that OpenNet has absorbed the high set-up costs, other downstream operators (i.e. MyRepublic) are able to bypass this natural barrier to entry and compete effectively in this market. The level of competition that exist in the market is evident given the recent price war that saw M1 slashing the price of its 1Gbps broadband service in response to MyRepublics pricing.

Therefore, the case of SingTel not only illustrates that natural monopolies no longer have a place in the 21st century Singapore, it also pushes the argument for more competition in such industries that might have been natural monopolies previously.


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Case of SMRT

If we are taking a broader view on MRT services in Singapore, one can argue that there is clear evidence that higher level of competition now exists in the provision of MRT services where there are several routes that have been opened up since the start of the MRT line in Singapore.

However, these routes are no longer being operated by a single firm SMRT. Instead, Singapore Bus Service Transit (SBS) has entered the fray and is providing MRT services for both the North East Line as well as the upcoming Downtown Line.

This is evident that competition is being introduced into the MRT market since consumers can now compare between two providers in terms of service quality.

The concept of contestability is further introduced in the MRT market by a government policy in 2008. Operators now are to bid to operate an MRT line for a fixed period of time. Operators can be selected based on the costs, the quality of the services they offer, or both. Operators who do not perform up to the mark risk losing their licences at the end of the fixed term. This threat of losing their licences to other operators provides a stronger incentive to be efficient and cost-effective in operations. This is a clear signal by the government that a market that is dominated by a single firm indefinitely is not in line with the aims of Singapore in the 21st century.

Once again, we have an authentic example of how the theory of natural monopoly is irrelevant in the case of 21st century Singapore.

Case of Singapore Power (SP) Singapore Power (SP) was established as a company, which owned and operated all

electricity undertakings, including power generation, transmission, distribution and retailing.

When SP was set up, it was part of the corporatisation of Public Utility Board (PUB), which was to gradually introduce competition in the electricity generation and retail markets so as to encourage investment, increase production and reap the benefits of competitive electricity prices. This move in itself was already a signal by the government that Singapore is moving away from the concept of natural monopoly in the electricity market to embrace greater levels competition.

However, the move failed to attract new entrants because of the market dominance of SP. SPs ownership of the transmission grid conferred it de facto monopoly powers since it was clearly not viable for new entrants to set up a parallel grid.

As such, the government adjusted the structure of the industry to enable competition by separating the contestable segments (i.e. generation and retail) from the non-contestable segments (i.e. transmission and distribution).

The government further ensures a level playing field through Energy Market Authority (EMA) by regulating the non-contestable segments to ensure that they keep the infrastructure accessible to all parties on equal terms and that they do not have commercial interests in the parts of the market that are open to competition. This effectively reduces the barriers to entry for new firms to compete in the market.

As a result of increased competition, firms involved in the contestable segment are thriving, refuting the claim that the electricity market has to remain as a monopoly in order for the industry to be profitable.


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Antithesis: Statement is invalid and natural monopolies still have a place even in the case of 21st century Singapore.

Case of Public Utility Board (PUB) Public Utility Board (PUB) is a statutory board in Singapore that is responsible for the

collection, production, distribution and reclamation of water in Singapore. As the provision of utilities such as water will usually result in the presence of a natural

monopoly given the high fixed costs involved in the processes involved, PUB still exists as a nationalised natural monopoly in Singapore. One reason is that water is a strategic resource of Singapore, with one of Singapores water sources involving state-to-state relations. A second reason, which is more relevant to this essay, is that the monopoly character of the water industry is particularly strong.

As such, the very existence of a publicly owned and operated natural monopoly backs the purpose of the theory of natural monopoly, refuting the statement that the theory has no place in the case of 21st century Singapore.

Case of SP

While the electricity market has been opened to competition, there is still a large segment of the market that is non-contestable. A clear example would be the transmission aspect, which requires a large amount of fixed costs to set up a power grid for the whole of Singapore to rival SPs ownership of the existing power grid.

As such, the companies that operate in the non-contestable sector are still deemed as natural monopolies.

Case of MRT

If one takes a closer look at the MRT market, it is also evident that while there is some semblance of competition in the market, it still exists predominantly as a natural monopoly. This is especially clear when we are looking at the routes that the companies (SMRT and SBS) provide services for. There is no direct competition between the firms for the same route as it is definitely inefficient to have parallel rails running across the same route in Singapore.

While the government has attempted to introduce competition into the market, the traditional sense of competition has been eschewed in favour of having two operators each running different MRT lines. This operator will then be the sole provider (monopoly) for the route so as not to end up with a duplication of routes by competing firms, resulting in wastage of resources.

Therefore, individual firms are still operating based on the theory of natural monopoly, illustrating that the presence of such a theory is not redundant in the case of 21st century Singapore.

Evaluative Conclusion

The theory of natural monopoly is one created through observations by economists at the point in time. As time passes, the theory will begin to sound less resolute as circumstances change. Nonetheless, it is still too premature to make the claim that there is no place for the theory in the 21st century Singapore since we are still seeing signs of industries that do abide by the characteristic patterns of a natural monopoly.


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Instead of saying that the theory is irrelevant, I believe that it would make more sense to alter the theory such that it will continue to evolve with the dynamic nature of the economy. Flexibility needs to be incorporated to provide a better application model for this theory in the 21st century.

Apart from that, governments need to understand that they theory has its flaws and to not overly defend a firms monopolistic position and privileges by blindly imposing the theory on the industry, especially if the industry has shown signs that competition can be supported.

A government must accept that some of its industries are much better off as natural monopolies while some should be de-monopolised to increase the efficiency in the market itself. All we are doing is to look at which end of this evolutionary spectrum the industry is resting on.

In the case of Singapore, the government has done a fair job in opening up markets for further competition regardless of its traditional position as a natural monopoly, and I truly believe that this should be the way forward in the 21st century.

NOTE: Requirements of the question:

(1) One needs to understand how this theory of natural monopoly helps in defending monopolistic privileges and what these privileges are. This can be illustrated from the theoretical analysis of a natural monopoly and how the firm is able to earn supernormal profits in the long run.

According to the theory where it is costly and unprofitable for a competitive firm to enter the market, governments may have intervened to facilitate in sustaining the monopolistic status of the firm. In doing so, it justifies the defence of monopolistic privileges, allowing these firms to continue earning supernormal profits at the expense of the consumers.

(2) Next, the essay needs to tackle the validity of the statement in the Singapore context. Students will have to provide examples of natural monopolies in Singapore and argue (with clear analysis) that these examples either still exist, or no longer exist in the 21st century.

Level Description Marks L3 For an analytical answer that conveys understanding of what the theory

of natural monopoly means and assesses whether the theory of natural monopoly is still relevant in the 21st century Singapore context, well substantiated with authentic evidence. Assessment of the statement should be based on the understanding of past and present situations.

15 21

L2 For a developed understanding of the theory of natural monopoly but shows an unbalanced argument on the validity of the statement, with clear application to the Singapore context OR a balanced argument on the validity of the statement, without clear application to the Singapore context.

6 14

L1 For an answer that briefly displays knowledge of the theory of natural monopoly without any analysis of the statement.

1 5

E2 For a well-substantiated opinion with economic analysis. 3 4

E1 For a non-substantiated opinion without economic analysis. 1 2


17

4 The Monetary Authority of Singapores [MAS] traditional defence of a strong Singapore dollar policy is built on balancing imported inflation against export competitiveness.

The Straits Times, 29th July 2014

Assess the extent to which an improvement in the living standards of an economy requires that managing inflation be the top economic priority. [25]

Introduction

Living standards of an economy can be in terms of material and non-material. In the narrow, measurable sense, material standard of living refers to the amount of goods and services that an average citizen can consume over a period of time, usually a year. Non-material living standard can be defined as the quality of life and measurements usually include stress levels, amount of leisure and the state of environment.

As stated in the preamble, the MAS uses a gradual appreciation of the singapore dollar through the use of exchange rate (monetary) policy to manage imported inflation while ensuring at the same time that Singapores exports remain competitive.

However to enjoy an improvement in living standards, governments generally aim to achieve the following macroeconomic goals; price stability, sustainable economic growth, low unemployment and healthy balance of payments but a governments policy decision inevitably leads to conflicts, or trade-offs in macroeconomic objectives and it is impossible to achieve all the goals simultaneously.

Hence in light of the above, this essay will assess the extent to which managing inflation be the top economic priority to improve the living standards of an economy.

Body Thesis: Managing inflation should be the top economic priority to achieve better living standards [One can choose to either explain the problem of inflation OR explain how managing inflation will improve living standards]

Inflation is defined as a sustained increase in the general price level, and becomes a problem when it is inordinate. Both demand and cost pressures can lead to demand-pull and cost-push inflation respectively.

Cost-push inflation refers to inflation caused by persistent increases in production costs, independent of demand.

If firms face a rise in costs, they will probably respond by raising prices, partly by passing the costs on to consumers, and partly by cutting back on production. This can be modelled by continual upward shifts in the horizontal AS curve (explain with diagram). This would cause general price levels to rise and a fall in real national income.

Inflation would erode the internal value of money, leading to a fall in purchasing power. With the same amount of money, consumers can now purchase lesser units of goods and services and hence their material living standards fall.

Explain how singapore exchange rate policy works to increase net exports to increase AD and improve material living standards.

In addition, for cases where if inflation levels are high (> 5%) and unexpected or cost-push in nature, investment may be reduced.

This is because such inflation adds to much uncertainty. As a price increase may be due to inflation or increased demand levels, prices no longer serve as accurate signals for efficient resource allocation. Businessmen would find it difficult to make long-term plans and may be deterred from investing in Singapore.

This fall in investment would lead to a multiplied fall in aggregate demand and real national income through the reverse multiplier effect.


18

Since GDP growth is a key factor in influencing per capita income, governments aiming to achieve better living standards may have to leverage on managing inflation using a gradual appreciation of the Singapore dollar to manage costs of imports and export competitiveness to drive economic growth (explain/elaborate).

Anti-thesis: Managing inflation should not be the top economic priority to achieve better living standards [One can choose to either explain that due to trade-offs, conflicts in macroeconomic objectives, managing inflation alone will not improve material living standards OR explain that other macroeconomic objectives are also as important to improve living standards OR explain how managing inflation alone will not improve non-material living standards]

However, for Singapore, managing inflation using the exchange rate policy may lead to conflicts with other macroeconomic objectives.

Singapores exchange rate policy the gradual and modest appreciation of the Singapore dollar by the MAS, would cause foreign imported consumer and producer goods to become cheaper. The lower prices of imported inputs would decrease costs of production and hence mitigate imported inflation.

With lower inflation rates, households purchasing power would not fall as much, and their material living standards are raised. The caveat, is that an appreciation of the Singapore dollar causes export prices to rise in terms of foreign currency, hence Singapore may lose export competitiveness.

Due to the relatively close substitutes of Singapores exports from other countries, the demand for Singapores exports is likely price elastic (depending on industry, candidates may argue otherwise).

The rise in export prices can thus cause a more than proportionate fall in the quantity demand of her exports, resulting in a fall in export earnings.

Ceteris paribus, there will be a fall in net exports, leading to a multiplied fall in AD, hence lowering material living standards.

With Singapore being heavily reliant on trade, the fall in net exports could be substantial and have serious repercussions on the economy.

The Singapore government hence has to balance imported inflation against export competitiveness.

A severe fall in AD could also lead to fall in employment levels. With labour a derived demand, there will be a fall in the demand for labour and employment level will also decline. With a fall in disposable income, material living standards will again fall.

In this case, where export competitiveness is adversely affected, managing inflation may not be the top economic priority to improve living standards.

To improve living standards, price stability may not be the foremost economic priority as addressing high unemployment levels could be more pertinent.

As high unemployment levels has an adverse effect on living standards. With less disposable income, the unemployed would experience a fall in material living standards as they are only be able to consume fewer goods and services. This may also affect their non-material standard of living as there is undesirable stress associated with unemployment especially with large financial commitments such as mortgage payments and the inability to find jobs to provide for themselves and their families.

This was seen in the US during the 2008 subprime mortgage crisis that saw unprecedented increase in unemployment levels. During the global financial crisis, Americans reported high levels of depression and the experienced low living standards from the gloomy economy outlook.

One thus may argue that managing unemployment be the top economic priority in improving both material and non-material living standards.


19

Evaluative Conclusion While managing inflation is no doubt important to improve living standards, especially in the

face of high imported inflation which Singapore faces, it may not always be the top economic priority.

This is because the achievement of price stability may not improve non-material living standards and that there could be trade-offs which could lower living standards as a whole.

There is hence a need to balance negative impact on the quality of life from managing inflation. Policies could be implemented alongside the exchange rate policy to also address issues of environmental degradation for instance, to improve living standards of an economy.

Whether the attainment of a goal is the top economic priority, I believe depends on the state the economy.

For instance, when an economy like the US is facing high unemployment levels, the top economic priority then could be to stimulate economic growth and provide job opportunities to raise employment levels as taking steps to achieve this macroeconomic goal would likely improve material living standards the most.

Given the dynamic nature of economies, it is not necessary that the achievement of a particular goal will always be the top priority.

Level Description Marks L3 A balanced answer that displays strong economic analyses and conveys

good understanding of question requirements by assessing the extent of improvement in living standards through the management of inflation.

15 21

L2 For an undeveloped discussion or unbalanced argument on how managing inflation will improve living standards.

6 14

L1 For an answer that briefly displays knowledge of macroeconomic objectives and living standards OR a brief and undeveloped answer.

1 5

E2 For well-substantiated opinions with economic analysis. 3 4 E1 For non-substantiated opinions without economic analysis. 1 2


20

Preliminary Examination Paper 2 Q5

In response to the global financial and economic crisis that started in 2008, countries around the world embarked on an unprecedented level of intervention with the aim to keep the economy buoyant and stop a full-scale assault on the labour market. Explain the major macroeconomic indicators used by the government of Singapore to guide economic policy decisions. [10] Discuss the view that short-term fiscal interventions create more problems than they solve. [15]

[unprecedented level of intervention is often described in each economy as the stimulus package; government action to stimulate growth and employment.] (a) Explain the major macroeconomic indicators used by the government of

Singapore to guide economic policy.

Introduction

Most economies have four major macroeconomic goals. These are; price stability, low unemployment rates, sustainable economic growth and healthy balance of payments.

The performance of the economy, in relation to these objectives, indicates the need for policy adjustment.

In recent years, many economies have also attached increasing importance to income equality for inclusive growth and financial prudence.

Body

o Inflation rate Singapore is a small open economy with no natural resources. With international trade an essential element of the economy, price stability (low inflation

rates) has been a central objective of the government to ensure the price competitiveness of Singaporean goods and services.

Inflation, defined as general increase in the price level, is hence a major macroeconomic indicator used by the Singapore government to guide economic policy.

Changes in the general price levels can measured in a number of ways. One of the most common measurement is the Consumer Price Index (CPI). The CPI measures the change in prices of the basket of goods and service bought by a typical Singaporean household.

The core CPI gives a more accurate picture of the impact of price change on households as it removes the distorting influences of accommodation and private road transport.

Generally in Singapore, the government aims to keep inflation under 3%.

[The government has a range of indices it uses to measure price changes across the economy. Students can also include the GDP deflator as one of the useful measurements used by the government.]


21

o Unemployment rate The unemployment rate is another major macroeconomic indicator. The unemployed can be defined as members of the labour force who are actively

seeking employment but without work. The unemployment rate is calculated as a percentage of the number of unemployed over

the labour force, and is usually around 2% in Singapore. This is as good as it gets FULL employment.

Singapore experiences a net labour inflow and the major government concern has been to reduce structural unemployment among Singaporeans.

Nonetheless, during times of economic crisis, such as the recent 2008 global financial crisis, cyclical or demand-deficient unemployment can also be of concern.

o Economic growth Economic growth, usually referred as long-term changes in the productive capacity of the

economy, is also a major indicator. In the short term, actual growth can be defined as increases in real output. The Gross Domestic Product (GDP) is the most common measure of output. It measures

the value of all final goods and services produced within the geographical boundary of a country over a period of usually a year.

However, real GDP per capita is probably the best measure of growth. In the past Singapore has grown at an approximate average rate of 8% per annum During the take-off and growth stages of an economy the annual rate of GDP is faster. A

successful, or developed economy, means that expected future growth rates will be typical of most other developed economies at around 3% p.a.

o Balance of payments The final major indicator of success is the international balance of payments (BOP). This is simply a statement of the economic transactions (inflows and outflows) between

Singapore and the rest of the world over a period of time. The account is always balanced and sums to zero, but may not be in equilibrium. While the BOP is a major indicator, it is specifically the current account position which is

important to Singapore. This is because of Singapores heavy reliance on international trade due to the small domestic market.

In the case of Singapore, current account surpluses have been consistently recorded and this reflects the competitiveness of her exports.*

[* A current account or trade deficit may not always indicate that the economy is doing badly. For instance, the US has run trade/current account deficits for more than 30 years, but is still considered a relatively successful economy.] Conclusion

All four macroeconomic indicators explained above are crucial in helping policy makers decide appropriate policies to implement to achieve their goals.

While these indicators may not be perfect, they are still of value.

[Possible evaluative remarks which may gain you additional marks but not required in this question:


22

Currently in Europe, and to some extent the US, debt has become a major issue. Financing growth by borrowing is regarded by many as unsustainable. The amount of debt or fiscal position can hence also be a major indicator of an economys performance.

In Singapore, public policy is giving more attention to income equality and policies are enacted to lower the Gini co-efficient to reflect a more equal distribution of income. Thus income inequality can be another indicator.]

Level Description Marks L3 The writing conveys a strong understanding and provides developed

explanations of the four major macroeconomic indicators in relation to the Singapore context.

7 10

L2 For an answer which is underdeveloped (explanations for indicators are incomplete) OR some explanations for the indicators are inaccurate.

3 6

L1 For an answer that has insufficient scope and breadth (only 1 2 indicators are mentioned), displaying brief knowledge and poor understanding of the indicators.

1 2


23

(b) Discuss the view that short-term fiscal interventions create more problems than they solve.

[Just like the previous question 4, a discussion question of this type generally has many possible answers. A tip is to define the scope to guide your approach and explicitly convey this to the marker. As time is scarce, especially under exam conditions, you need to prioritise and choose pertinent points to develop. A detailed discussion is better than a narrative that contains a list of points. It impresses upon the examiner that you have a good understanding of the subject.] Introduction

Fiscal interventions are associated with John Maynard Keynes. Keynes believed that government intervention could be used to lift the economy out of cyclical depressions.

Essentially, short-term fiscal interventions, also known as fiscal policy, involves the manipulation of government expenditure (G) and taxes (T) to deliberately influence aggregate demand (AD).

Fiscal policy can be expansionary or contractionary in nature. The former involves raising G and decreasing T while the latter includes decreasing G and increasing T.

In light of the limitations and hence problems that fiscal interventions can cause, this essay will discuss the view that more problems are created than solved when fiscal policy is implemented.

Body

o Short-term fiscal interventions may solve unemployment and low economic growth The 2008 global financial crisis, which had a contagion effect on many other economies,

was one of the most serious economic problems in living memory. Today, many economies are still suffering from the consequences of the rapid decline in global demand.

The situation of the 2008 crisis was similar to the Great Depression of the 1930s, where there was a period of low growth and excessive rates of unemployment.

As businesses (firms) and households were not spending due to the poor economic outlook, Keynes suggested that the government should spend its way out of the recession.

For example, assume the government spends $500 million to build a hospital. This means an injection of $500m into the economy, and income to the factors of production used to build the hospital.

Unemployed factors (labour) can be used to construct the hospital and households will receive factor incomes (wages), which will trigger consumption expenditure.

Let us assume that the marginal propensity to consume (MPC) is 0.8. This means that out of every additional ten dollars income, eight dollars is spent on consumer goods and services.

The additional consumption expenditure stimulates more output and greater use of unemployed factors of production. Economists describe this as the multiplier process.

In this example, where the MPC=0.8, the multiplier is 5. In other words the initial injection by government will create a total expenditure of $2,500m.

[Draw either the 45 degree model or AD/AS] With the multiplied increase in national output due to the multiplier effect, an

expansionary fiscal policy stimulates economic growth.


24

Unemployment also falls as there is greater utilisation of resources.

o Short-term fiscal interventions however, may also create problems

Debt Although the Keynesian system as described above appears to work well, it is not

without problems. Firstly, and perhaps most importantly, the financing of the new hospital may require

government borrowing. Borrowing creates debt. Many economies in Europe suffer from indebtedness and this has limited the scope of government expenditure. [You can make reference to Greece, Portugal or Ireland.]

Although Keynes suggested that debts could be repaid in the upswing of the economic cycle, this has tended not to happen.

Instead, the repayment of debt, with interest, incurs opportunity costs. It can require the sacrifice of future consumption as taxes may be raised to service the debt.

Crowding out effect A number of other issues, such as resource and financial crowding-out can be cited as

problems created by intervention. If G is financed by borrowing, the increase in demand for loanable funds would drive

interest rates up, increasing the cost of borrowing. This can crowd out private demand of funds by firms and households, in turn leading to

investment and consumption falling.

Time lag There could also be considerable time lag for the fiscal policy to be implemented and

take effect. For instance, the effects of an expansionary fiscal policy a multiplied increase in

national output, could occur only after the recession and during the upswing of an economy. It would then lead to inflationary pressures and possibly aggravate inflation.

In this instance, we could hence argue that short-term interventions create more problems than they solve.

[Students may also include the small multiplier size in Singapores context, possible trade-off between inflation and unemployment as possible points.] Evaluative conclusion [2 well-substantiated opinions] In the context of Singapore, a fiscal stimulus may increase imports, especially since we

are import reliant. Coupled with the small multiplier size due to our larger marginal propensity to withdraw, this means that the eventual increase in AD and hence national output would be much lesser in reality and limited in its effectiveness.

Despite the potential problem short-term fiscal interventions may cause, my fundamental view is that in modern economies, the resolution of many problems cannot be solely left to market forces.

There are also no perfect solutions to economic problems; there are always opportunity costs. The best example of this has been the recent 2008/9 Great Recession. Through


25

unprecedented government intervention (stimulus packages worth approximately US$2 trillion (1.5% of global GDP and the IMF recommended 2%)), the spectre of a global depression similar to the experiences of the 1930s was averted. The short-term intervention may arguable have prevented years of hardship caused by significant increases in unemployment.

Moreover, the prospect of widespread and severe unemployment is too serious to be ignored.

Government intervention is required, and as Milton Friedman asserted there is no such thing as a free lunch. Problems will always exist and governments have to balance their economic aspirations against the political, social and environmental realities that they face.

Level Description Marks L3 The writing conveys a sense of discussion and demonstrates that the

writer understands Keynesian fiscal intervention and can weigh success against potential trade-offs or consequences. Higher marks can only be awarded if the answer acknowledges the contextual issues raised in the preamble.

8 11

L2 The writing has a sound knowledge base but may exhibit error and/or omission.

4 7

L1 For any responses that make demonstrate incomplete understanding of fiscal intervention and potential problems of policy implementation.

1 3

E2 The writer expresses a sensible conclusion to a discussion that is sensitive to the preamble that pertains to the extraordinary crisis of 2008.

3 4

E1 The discussion is drawn to an evaluative conclusion although the conclusion may lack supporting arguments or contextual accuracy.

1 2


26

Preliminary Examination EQ 6 Suggested Answers

(a) Explain the impact of a quota on a small, open economy.

[8]

(b) Assess the threats and opportunities presented by the openness of the Singapore economy.

[17]

*** *** ***

(a) Explain the impact of a quota on a small, open economy. [8]

Introduction

Protectionism refers to the imposition of economic policies aimed at restricting trade between countries, designed primarily to protect domestic businesses and workers from foreign competition.

There are many types of protectionist measures, such as tariffs and quotas. An import quota is a direct restriction on the quantity of imports. The quota is typically

enforced by issuing licenses to a group of individuals or firms. The quota directly reduces the availability of imports, hence pushing up prices of imported goods.

This paper explains the welfare impacts of a quota on a small, open economy.

Analysis of a Quota

FIGURE 1: WELFARE EFFECTS OF A QUOTA In Figure 1, Dd and Sd are the domestic demand and domestic supply curves of a good.

Assuming that a particular country is too small to affect prices in global markets, it can import as much as it wants of the good at the world price of PW. Hence, SW represents the supply curve of imports and is infinitely price elastic at price PW. At PW, domestic

Quantity

Price

0

A

C

B

Deadweight Loss

Quota

Pw+q

Pw

Q1

Q2

Q3

Q4

1 2 3 4

Sd

Sd+q

Dd

Sw


27

producers will produce Q1 while the quantity demanded by consumers is Q4. The difference is made up of imports of (Q4 Q1).

Suppose an import quota of (Q3 Q2) is imposed. The world supply, SW, ceases to be relevant. Instead the quota results in the combined supply (local supply + quota) to be Sd+q, which is horizontal to the right of Sd by the quantum of the quota, (Q3 Q2). The new equilibrium price is now higher at PW+q, where the new market supply Sd+q meets the market Dd. Local consumption falls from Q4 to Q3 while local production rises from Q1 to Q2. Imports fall from (Q4 Q1) to the quota amount of (Q3 Q2).

Effects on Efficiency

Before the quota, the consumer surplus was area ABPW. With the quota, the price rises from PW to PW+q, causing consumer surplus to fall by the area (1 + 2 + 3 + 4).

Before the quota, the producer surplus was equal to area 0CPW. With the quota, the price rises to PW+q while domestic output rises from Q1 to Q2, causing producer surplus to rise by area 1.

Allocation of the Quota To allocate the quota, the government can do several things. First, the government can choose to sell off the quota licenses; second, give quota

licenses to local importers; and, third, give quota licenses to foreign exporters. First, the government benefits from selling off the quota licenses as it is able to recover

up to the entire area 3 from the revenue generated. Second, if it gives the licenses to domestic importers, these firms can buy imports at PW

and resell them at a higher price, PW+q, thus making profits (known as quota rents) of area 3. However, if the quota licenses are given to foreign exporters, the quota rents are transferred abroad.

The net welfare effect of the government selling the quota licences and giving the licences to local importers = Consumer Surplus + Producer Surplus + ( Government Revenue or Quota Rents) = - (1 + 2 + 3 + 4) + (1) + (3) = - (2 + 4).

Area (2 + 4) is thus the deadweight loss arising from the imposition of the quota. In these two cases, using either a quota or an equivalent tariff results in the same welfare loss to society.

However, if the government gives quota licences to foreign exporters, where the quota rents will flow abroad, society loses an additional area 3 of welfare. Hence the deadweight loss is area (2 + 3 + 4). In this case, imposing a quota results in a greater welfare loss as compared to imposing an equivalent tariff.

Conclusion

In conclusion, the general impacts of a quota on a small and open economy are higher prices, lower consumption, and deadweight losses to society.

Level Description Marks L3 For an elaborated answer that explains the welfare impacts of a

quota with a well-explained diagram. 6 8

L2 For a developed explanation of a quota and its impacts. 3 5 L1 For an undeveloped explanation of a quota. 1 2


28

(b) Assess the threats and opportunities presented by the openness of the Singapore economy.

[17]

Introduction

Globalisation refers to the increasing integration and interdependence of the worlds economies arising from increased trade and greater international mobility of factors of production like capital, labour, and enterprise.

Singapores openness, in terms of its external orientation, implies that globalisation will present threats and opportunities to Singapore.

This paper assesses the threats and opportunities to Singapores economy by increased labour and capital mobility and a heavy dependence on international trade.

Threats from Labour & Capital Mobility

It can be argued that Singapores openness to increased labour mobility and capital mobility could possibly impact Singapore negatively.

First, increased labour mobility may cause structural unemployment and depressed wages for less skilled labour. For instance, Singapore firms, especially construction and electronics manufacturers, arguably prefer to hire cheaper foreign workers from developing countries in order to reduce costs and hence raise profits. This generally harms some workers as it causes structural unemployment and depressed wages.

Second, increased international labour mobility has also resulted in greater income inequality in Singapore. For example, Singapores Gini coefficient, a measurement of inequality, was 0.478 in 2012 and 0.463 in 2013. This is because, being internationally immobile, lower skilled workers for example elderly less-educated workers have little choice but to suffer from lower wages arising from the influx of cheap foreign labour, while internationally mobile high skilled workers like doctors and bankers find their wages pushed up due to global competition for talent. Therefore, one threat of Singapores openness is income inequality.

Third, Singapore also bears the social cost of increased immigration, which strains existing social amenities like housing, public transport, schools and hospitals. Furthermore, if immigrants are unable to integrate with locals, Singapores social fabric is weakened as locals find their culture, values, and way of life threatened. All these problems cause social discontent.

Fourth, as Singapore is an international financial hub, allowing free movement of short-term capital ('hot money') can potentially result in asset bubbles, which arguably threatens macroeconomic stability. During a booming stock or property market, foreign capital adds further to speculative demand, which drives asset prices even higher. Rising residential property prices raise the costs of home ownership for those who genuinely need to buy a house to stay in, for instance, newly-married couples. Rising prices of commercial property raises business costs and reduces the countrys international competitiveness. Furthermore, when such speculative bubbles burst, households would face a sudden drop in wealth, which leads to cutbacks in consumption. Saddled with bad loans, banks could cut back on lending, which further curbs consumption and investment. Aggregate Demand (AD) could fall, leading to an economic downturn.


29

Threats from Dependence on Trade for Singapore

It can be further argued that a heavy dependence upon the external sector implies that Singapore is vulnerable to external demand shocks and imported inflation. Any major economic recession in Singapores trading partners would negatively impact her economy. For instance, if there is a global downturn or prolonged recession, Singapores exports would fall and her AD could fall, leading to an economic downturn and demand-deficient unemployment. Furthermore, Singapore may face the threat of imported inflation as it is heavily dependent on imported goods; any worldwide increases in the prices of commodities, for instance oil and food, may result in imported inflation, which would harm both households and firms. Thus, a heavy dependence on trade is a major vulnerability.

Opportunities from Labour & Capital Mobility

On the other hand, it can also be argued that Singapore benefits from opportunities presented by international factor mobility. First, international mobility of labour and capital allows Singapore to acquire factors of production which it is less abundant in and to also acquire better quality resources. This increase in the quantity and quality of the factors of production shifts Singapores PPC out (or LRAS to the right), thus raising Singapores long-run economic growth.

Second, Singapore firms often invest in developing countries to exploit the relatively cheaper land and labour, typically by setting up export-oriented manufacturing operations. For instance, companies in Singapore are now investing in Myanmar after its opening up to trade, in order to exploit the abundant natural resources and labour there. Thus, Singapore firms that send out FDI enjoy lower costs and higher profits, while their consumers benefit from cheaper imported manufactured goods.

Third, inflows of financial capital into Singapore (foreign purchases of financial assets like bonds and shares) also benefit the country as these inflows provide additional funding for capital accumulation. Owners of such financial capital in Singapore also benefit from higher returns and from risk diversification when they invest their funds in developing countries (emerging markets). Thus, Singapore firms and investors both benefit from Singapores position as a financial centre.

Opportunities from Trade for Singapore

Furthermore, Singapores openness also means that Singapore benefits from international trade. First, Singapore can produce for a much larger world market, which enables some Singapore firms to reap both internal and external economies of scale. Foreign competition also forces local producers to innovate, cut costs, and improve product quality. Local consumers may enjoy lower prices as well as higher product quality. The exploitation of economies of scale and greater competition also reduces both productive and allocative inefficiency, thus enabling Singapore to better utilise its scarce resources in maximising its welfare.

Second, Singapore cannot produce some goods domestically because of unfavourable climate or the lack of key resources. Singapore therefore has to import such goods, which widens consumer choice. In addition, intra-industry trade also enhances the degree of product differentiation as imports allow local consumers to enjoy more variations of a given product.


30

Third, Singapores openness means that trade can be an engine of growth. As Singapore is small, it lacks sufficient domestic demand to enable full utilisation of resources. Trade allows Singapore to overcome domestic demand constraints by providing access to larger world markets. With additional demand from exports, greater utilisation of otherwise unemployed resources raises output, income, and employment. Rising export demand further stimulates investments, causing the AS to shift outwards faster. Seen from these perspectives, trade arguably acts as an engine of growth as it enables both AD and AS to increase faster than under autarky.

Evaluative Conclusion

In conclusion, Singapore faces a myriad of threats and opportunities because of her openness to factor inflows and outflows and trade.

Being a small, open economy, Singapore does not have the option of relying on domestic demand. She has little choice but to embrace globalisation, which however brings an increased risk of macroeconomic instability and a faster pace of structural change. Singapore has managed to cope well so far by focusing on building and preserving long-term productive capacity as well as facilitating factor mobility. This has enabled her economy to be flexible and resilient to better ride the waves of globalisation.

To deal with the threats and opportunities, Singapore generally adopts a managed float exchange rate regime, allowing a gradual appreciation, and a range of supply side policies which ameliorate the threats and maximise the opportunities faced.

To minimise structural unemployment, Singapore controls foreign immigration with a foreign worker levy and mandatory ratios of domestic to foreign workers. This ratio varies across industries with sectors like construction having more lax ratios compared to others like retail. The tax and the ratio are relaxed when the economy is booming but tightened when the economy is faltering. This allows Singapore to expand capacity quickly when demand is rising while preserving jobs when demand is falling.

Another policy to fight structural unemployment and reduce income inequality is to train workers to acquire new skills. The government, through the Workforce Development Agency (WDA) and the National Trades Union Congress (NTUC), subsidises, coordinates and certifies upgrading training.

Therefore, in the final analysis, the threats facing Singapore have to be carefully mitigated by prudent, long term government policies while the benefits of the opportunities have to be pragmatically reaped in Singapores interest.

Level Description Marks L3 For well-developed and balanced arguments with relevant examples that

analyse threats and opportunities from Singapores openness. 10 13

L2 For more developed arguments that explain threats AND opportunities posed by Singapores openness.

6 9

L1 For a one-sided, unbalanced explanation of the threats OR opportunities posed by the openness of Singapores economy.

1 5

E2 For an evaluative assessment of threats and opportunities posed by the openness of the Singapore economy.

+2

E1 For a judgment on whether openness of Singapores economy poses threats or opportunities.

+2

tjc paper 2 answer

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