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H2 Economics Tampines Junior College Preliminary Examination

Suggested Answers Paper 2

Section A

1. An exceptionally large number of new homes are currently being built as part of the cooling measures for the housing bubble. The housing bubble benefits no one and hurts many when it bursts. This allocation of land would hopefully moderate housing prices, so that it would remain affordable for most residents.

Source: Minister Khaw Boon Wan on Housing Policies, Budget Debate 2013

(a) Distinguish between public and private goods, and determine if public housing is a public good. [10]

(b) Using concepts of scarcity, opportunity costs and production possibility curves, discuss if the allocation of land use for public housing is justified. [15]

Suggested answer

a) Distinguish between public and private goods, and determine if publichousing is a public good. [10]

Public Goods Private Goods 1. State Definition • Non-rivalrous

• Non-excludable• Rivalrous• Excludable

2. List Examples • Street lighting,lighthouses, flood-control dams, public drainage, public services such as national defence and police

• Education, Healthcare, housing, cars, alcohol

3. Explain characteristics in relation to example

Example of Street lighting i. Public goods are

non-rivalrous in consumption(i.e. quantity available forconsumption does notdiminish with more users) consumption of thestreet light by one persondoes not deprive othersfrom consuming it It does not matter if 1individual, 10, 100 or 1000individual utilizes the

Example of Public housing i. Private goods are

rivalrous in consumption(ie. Quantity available forconsumption diminisheswith more users)

consumption of housing by one person deprive others from consuming it.

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streetlight cost of providing the good to 100 people is the same as the cost of providing the good to 1,000 people quantity of lighting remains unchanged regardless of the number of users

(ii) Public goods are non-excludable in consumption. (it is impossible to exclude a non-payer consuming the good) Individuals can free-ride and utilize the streetlight once it is installed without need of payment

(iii) Gives rise to issue of free-ridership there is no expression of demand, P=0. Price mechanism fails, there is no signal to producers and no incentive for producers to produce.

ii. Private goods areexcludable inconsumption(it is possible to exclude anon-payer consuming thegood) Individuals will need topay the unit beforereceiving their keys.

(iii) Housing is considered a private good by the government of Singapore since it is both excludable and rivalrous in consumption.

4. Highlightproblem if left to the free market (private sector)

• \ If left to the free market,there would be nilprovision of publicgoods. Hence there is amissing market for publicgoods. The market hasfailed because noresources will be allocatedto the production of publicgoods like street lights.

• Complete market failure justify a greater extent ofgovt intervention

• \ If left to the free market,there would beproduction/consumptionof private goods.

Public housing is a private good. • Consumption is rivalrous, since a consumer’s consumption would reduce

amount of flats available for the next consumers.• Furthermore, there are regulations restricting the consumption of public

housing. In Singapore, public housing is only available for married couples orsingles above the age of 35, with combined monthly income below SGD10,000.

Singapore government intervenes in the market of housing because they perceive there is market failure in the provision of housing. Housing could foster sense of belonging to Singapore, and promote racial harmony among its diverse population. These external benefits suggest that consumption of housing could be viewed as

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having positive externality on the economy. Thus, the government would intervene in this market.

Synthesis Government tends to intervene in the markets for both public and merit goods since both these goods provide substantial benefits to the society. In the context of Singapore, the government has stepped in to provide for these goods directly as can be seen from its allocation of resources to national defence and public housing.

Level Descriptors Marks L3 Elaborated and rigourous explanation detailing the differences

between public and private goods. Good analysis of whether public housing is a public good.

7-10

L2 Comparison made between public and private good. Analyse if public housing is public good.

5-6

L1 Attempt to explain public and private goods with little/no comparison made. Did not identify if public housing is public good.

1-4

b) Using concepts of scarcity, opportunity costs and production possibilitycurves, discuss if the allocation of land use for public housing is justified. [15]

Dissecting the preamble “An exceptionally large number of new homes are currently being built as part of the cooling measures for the housing bubble. The housing bubble benefits no one and hurts many when it bursts. This allocation of land would hopefully moderate housing prices, so that it would remain affordable for most residents.”

Points we can learn from preamble: 1) There is a large increase in supply of public housing in current time period doesnot address current shortage/problem Supply of public housing tends to be price inelastic increase in DD will lead to an increase in prices to a larger extent worsens housing bubble 2) There is a problem of housing bubble unsustainable increase in housing prices detrimental effects on the economy if it was to burst unemployment, loss of savings/wealth/assets, recession, worsen investors/consumers’ confidence [AD-AS analysis required] 3) There is a need to ensure housing prices remain affordable to most residence equity/merit good/goods with positive externality

Introduction • Scarcity refers to the situation where there are limited resources which

cannot satisfy unlimited wants. As such, there is a need for choices to bemade.

• This gives rise to the concept of opportunity costs, which refers to thenext best alternative forgone. When choices are made, there will beopportunity costs incurred, since there are alternatives forgone.

• Opportunity costs could be represented as implicit and/or explicit costs.• Implicit costs refer to costs which cannot be expressed in monetary terms

such as time wasted. Explicit costs are costs that can represented inmonetary terms such as prices of goods.

• In allocating land to be used for construction of public housing, thegovernment would have necessarily made choices and forgo certain

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alternatives. Through examining some of the choices forgone, it can shed lights on whether the choice to allocate land for public housing is justified.

• The presence of a housing bubble has garnered concern from thegovernment. The bubble would cause property prices to rise rapidly, pricing itout of affordability for Singaporeans and residents. This suggests that there isa shortage of housing in the market, since scarce commodity wouldexperience increase in prices. The act of allocating land to public housingwould have meant that there are alternatives forgone.

• These choices could be analysed through the use of production possibilitycurves [PPC], which illustrates the maximum amount of 2 goods aneconomy can produced, assuming that this is within the same timeperiod, using the same level of technology, the same amount ofresources and that all resources are fully and efficiently used.

Main body

Thesis the allocation of land to public housing is justified

1) Consider opportunity costs incurred when resources are fully and efficientlyused

• Assuming all resources are fully used and Singapore is currently producingon the PPC at point E.

• As government allocates more land to public housing, changing theproduction point towards point A on the PPC, the resources remain efficientlyused, however, the change in allocation represents opportunity costs amount of consumer goods have to be given up in order for Singapore toproduce more public housing.

• Since resources are not perfectly substitutable, there will be increasingopportunity costs incurred thus the PPC is concave in shape.

• From E to A, opportunity costs incurred is at a decreasing rate allocatingmore land to public housings could be justifiable.

Public housing

Consumer goods

A

B

C

D

E

Figure 1: Singapore’s PPC between public housing and consumer goods

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2) Consider opportunity costs incurred when resources are not fully andefficiently used

• At C, there is underallocation of resources to consumer goods and publichousing.

• The economy possess idle resources allocation of more resources topublic housing will not incur opportunity costs.

• Allocating resources towards to public housing allows economy to engageresources more efficiently production shifts to B

• There is pareto improvement in the economy the increase in publichousing is not at the expense of consumer goods from C to B

• Allocation of land towards public housing is justified.

3) Consider opportunity costs incurred when qualilties/quantities of factorinputs or state of technology is improved

• Point D which lies outside the PPC is not attainable due to scarcity,Singapore does not possess sufficient resources to attain production at D.

• However, improvement in technology could allow Singapore to attainproduction at D if the PPC shifts out improvement in productive capacity of the economy

• Similarly, this could be achieved if there are improvement in factorquality/quantity of resources

• These could be the result ofi) land reclamation increases factor quantity of landii) improvement in construction techonology able to build more publichousing in given period of time iii) increase in labour force more construction workers availableiv) through trade better quality of resources cement/steel able tobuild higher structures

• Thus, allocating more land towards public housing could be justified.

4) Cooling measures for housing bubble• Singapore has been experiencing a housing bubble phenomenon whereby

the prices of public housing have been driven sharply, partly due tospeculations. there is scarce amount of housing available for theconsumers.

• Allocation of land of land towards public housing would increase the supply ofpublic housing. There is an increase in quantity of factor inputs for publichousing.

• As supply increases from S1 to S2 in figure 2, a surplus would be generatedat P1. This exerts a downward pressure on price. Quantity demanded wouldincrease and quantity supplied would decrease as price falls. This continuestill the market clears with a higher output at Q2 and a lower price at P2.

• The lower price would contribute to affordable prices of public housing andaddress the shortage experienced. allocation of land is justified.

• Evaluation: However, as the supply of housing tends to be price inelastic,since housing requires time for construction, any further increase in demandwill only lead to higher increase in price. This would also mean that theincrease in supply of public housing would not address the housing bubble incurrent time period adequately the moderation of prices may not besignificant.

• While there is a need to allocate more land for public housing, this may not beeffective in moderating the prices allocation of land may not be justified,considering time period.

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5) Public housing is considered to be a merit good by Singapore government• Public housings are a form of asset investment for Singaporeans, which can

be utilized as retirement collaterals retirement funds in future.• This leads to underestimation of true benefits in the consumption of public

housing from the government’s POV.• The consumption is currently set at Qpte where effective demand for public

housing intersects supply of public housing.• The government sets desired demand higher and therefore Qsoc is derived

from the intersection of desired demand and supply.• Since Qsoc is greater than Qpte, there is underconsumption of public

housing in the eyes of govt. insufficient housing produced housing is in scarce amount

• This leads to development of welfare loss as indicated by shaded region inFigure 3, thus the market fails.

• To address this market failure, the allocation of land to public housing isjustified as government do indeed provide merit goods. In Singapore,government has provided for other merit goods such as education andhealthcare.

• Since land is scarce in Singapore, there is a need for government tointervene to ensure the best allocation of resources maximize thewelfare/benefits the economy can enjoy from the use of land

• The allocation of land to public housing would lend to increase inconsumption of public housing and therefore correct the market failure.

Price of public housing

Quantity of public housing

S1

D1

Figure 2: Market for public housing

S2

P1

P2

Q1 Q2

surplus

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Figure 3: Underconsumption of Public housing in Singapore

• Ownership of public housing would instil a sense of rootedness for newresidents

• Reinforce national identity reduce brain drain OR retain the foreigntalents SG has attracted to stay on.

• Racial quota for HDB flats would reinforce racial harmony amongst residents Ethnic integration policy

• Promotes social cohesion contributes to social security and diversity.• This gives rise to external benefits of public housing consumption in

Singapore positive externality in consumption of public housing.• In the consumption of public housing, the consumers would only consider

their private costs and benefits.• Private costs include the price of the property and the associated opportunity

costs of options forgone in the consuming public housings, such as cars,holidays. Private benefits would include possible revenue from renting of therooms and having personal space.

• Many consumers tend to disregard the possible external benefits generatedlike racial unity/national identity. Thus, the consumption would be set at Qpte,where MPB = MPC.

• As such, there will be social and private benefits curves, such that MSB =MPB + MEB

Price of public housing

Quantity of public housing

Effective DD

SS

Desired DD

QsocQpte

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Figure 4: Positive externality in the consumption of public housing

• The social optimal level of consumption is set at Qsoc, where MSC = MSB.There is underconsumption public housing in the market. At Qpte,MSC>MSB, additional units of public housing produced would add more tosociety’s benefits than costs.

• Welfare loss to society develops from the underallocation of resources topublic housing public housing is in scarcity.

• Allocation of resources to public housing is justified if the total benefits thesociety experiences would outweigh the total costs inccurred

Anti-thesis allocation of land to public housing is not justified

1) High opportunity costs Land scarcity• Refer to figure 1 as production shifts from A to B, allocation of land to

public housing would incur high opportunity costs, since Singapore hasto give up more units of consumer goods imperfect substitutability ofresources.

• Since land is scarce and a primary factor input, there has to be efficientallocation of this resource.

• Consider allocation of land for commercial purposes One Marina• Opportunity costs of rental of offices, creation of jobs, attracting FDIs

analyse impact through AD-AS.• Allocation of land to public housing would not generate as much tangible

returns to the country.• HDB makes hundreds of millions of losses with each year factoring land

costs and construction and govt subsidy construction of public housingworsens fiscal position of government in contrast to revenue generatingprojects like commercial offices high opportunity costs incurred forprovision of public housing

Costs/benefits of public housing

Quantity of public housing

MPB

MSC = MPC

MSB

QsocQpte

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2) Provision of other merit goods• Other merit goods could benefit society R&D develop new sectors of

growth lend to export competitiveness improves resilience to externalshock which is crucial in current economic conditions where recessions areoccurring with higher frequencies.

• Consider land allocated for One North Research facility for development ofbiomedical hub new area identified as key sector of growth opportunitycosts chance to develop key sector of growth and improve resilience ofeconomy

• Education another form of merit goods which can contribute toimprovement in productive capacity of economy. Furthermore, establishededucation facility could attract better FDI and foreign talents

• Consider land allocation for SUTD 4th public university in Singapore toincrease proportion of graduates in Singapore improve factor quality oflabour attract foreign investment opportunity costs expansionaryeffect on economy

• Healthcare merit goods and key sector of growth medical tourism FDIto start up medical services in SG good reputation of high quality medicalservices in South East Asian region.

• Consider land allocation for Khoo Teck Puat hospital infrastructurerequired to cater to increase in population and aging population establishing more healthcare providers in housing estates. Opportunitycosts of revenue from medical tourism and attracting FDIs

3) Possibility of overcorrection• Information lag As government does not possess all information

likelihood that there are error in the derivation of Qsoc may have led tooverallocation of scarce resources to the market of public housing resulting in further welfare losses and therefore greater inefficiency in theallocation of resources government failure results incurs greateropportunity costs

• Time lag the construction of many public housing in current time periodmay be remedy the shortage experienced. market of public housing wouldlikely experience greater increase in demand for public housing and thereforehigher increase in prices before the supply of public of housing could increase possibility of surplus of public housing in the future reinforce bursting ofbubble in the future incurs greater opportunity costs

• Implementation lag HDB is a large government body bureaucratic redtape which could hinder the administrative process leads to higher costs ofproduction, more time required for vetting processes etc. leads to slowerresponse to current shortage in the market problem of housing bubblewould worsen before intervention is applied. worsens the opportunitycosts incurred.

Synthesis Government has to employ cost-benefit analysis in order to allocate land use most efficiently. Furthermore, government has to consider the short and long run implications of the allocation of land. While Singapore has been active in land reclamation, this is neither a feasible nor sustainable option.

Evaluative conclusion Public housing are sold with a lease of 99 years govt would be able to re-possess the land and can re-allocate the land for other uses in future poor planning could lead to wastage of resources in construction and tearing down of buildings.

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In lieu of housing bubble concern could be centered on ensuring prices of public housing remain equitable primary objective of public housing consumption of HDB flats even for the low-income foster Singaporean sense of rootedness. More importantly this is an opportunity for the government to demonstrate its resourcefulness in reducing the bubble before it threatens the economy with likelihood of recession and poor investment outlook. Complementing policies Regulations in housing market to ensure equity and reduce speculation on housing has been imposed. However, as there are no perfect policies, there remains a need for govt to implement a basket of policies.

Level Descriptors Marks L3 Elaborated and rigourous explanation detailing the pros

and cons of allocating land for public housing with constant references made to the concepts of scarcity, opportunity costs and production possibility curves.

9-11

L2 Clear explanation as to why the allocation of land use to public housing is justifiable, with consideration to alternative land use and other goals of governance. References to opportunity costs and production possibility curves are required.

6-8

L1 Attempt to explain why provision of public housing is desirable, with some economic analysis on merit goods/positive externality. References to opportunity costs incurred must be addressed.

1-5

Evaluation Descriptors Marks E2 Reasoned judgement with insights on current economic

development and how decisions made by government could be affected by long run and short run objectives.

3-4

E1 Conclusion with stance made, which lacks economic analysis.

1-2

2. Using economic analysis, discuss the effects of an improvement in technology in the computer tablet industry and its related markets. [25]

INTRO

- Improvement in technology affects both demand and supply in the industry. Need to use demand and supply analysis as well as various elasticity concepts to analyse the change. Relevant elasticity concepts that can be used here are price elasticity of demand, price elasticity of supply and cross elasticity of demand.

BODY

1) Demand Factor: There has been a favourable change in tastes and preferencesdue to the improvement in technology in the computer tablet industry, causing the demand for tablets to increase, ceteris paribus.

There has generally been an improvement in technology in the computer tablet industry where tablets get lighter and more portable. Also, tablets now have a longer battery life as compared to before. This is important to users because they might not

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always be able to charge their tablets freely. Furthermore, tablets are now more sensitive to the touch of the user’s finger, allowing users to navigate more easily. Technology has also allowed tablets to become more flexible, allowing the surface to twist and turn, according to the user’s requirement. These improvements have resulted in a favourable change in tastes and preferences for tablets, causing the demand for tablets to increase and the demand curve shifts to the right, ceteris paribus.

2) Supply Factor: Improvement in technology has caused the supply for tablets toincrease, ceteris paribus.

Improvement in technology has allowed tablets to be produced more efficiently. This is because producers have found new ways to produce tablets at a cheaper cost, maintaining the same level of quality. The improvement in technology has caused the cost of production of tablets to fall and profit margins for producers to increase. This raises the supply for tablets and shifts the supply for tablets to the right, ceteris paribus.

3) Price elasticity of Demand: The demand of tablets is price elastic- Since there is a shift in supply, the price elasticity of demand would be relevant. Demand of tablets would be price elastic. Price elasticity of demand is negative and its magnitude is greater than one. This is because tablets have many other close substitutes, for example, notebooks. They are close substitutes because they are both portable and allow users to go online even when they are out. Furthermore, tablets are luxury goods as users usually do not need them to do work, but usually use them for leisure purposes. This contributes to the high price elasticity of demand for tablets.

4) Price elasticity of Supply: The supply of tablets is price elastic

- Since there is a shift in demand, the price elasticity of supply would be relevant. Supply would tend to be more inelastic in the short-run than in the long-run. This is because, in the short-run, computer tablet manufacturers can only increase production by increasing the variable factors of production such as labour. Therefore, when there is an increase in the price, quantity supplied will only increase by less than proportionately. However, in the long run, supply of tablets would be more price elastic. Price elasticity of supply is positive and its magnitude is greater than one. Firms are able to vary all factors of production. For example, instead of relying just on an increase in labour, computer tablet manufacturers can set up more factories to produce more goods.

Furthermore, the price elasticity of supply also depends on the degree of factor substitution. Much of computer tablet production tends to require low-skilled workers who do not require much training. Thus, it would be relatively easily for tablet producers to hire more workers if the price were to increase. Supply of computer tablets would tend to be price elastic in the medium term and the long term.

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5) Market Adjustment Process

At the original price, P1, quantity supplied is greater than quantity demanded. There is a surplus. There would be an downward pressure on price. As price falls, quantity supplied falls and quantity demanded increases. This causes the surplus to gradually fall until the market clears and final equilibrium is reached. The equilibrium quantity has increased to Q2 and the equilibrium price has fallen to P2. As demand and supply are both price elastic, the % change in Pe is small relative to the % change in Qe.

6) Relative shifts: The increase in supply is greater than the increase in demand

It has been observed in the real world that prices for tablets have generally been dropping, therefore it is very likely that the increase in supply is greater than the increase in demand. This could be because even though there are many innovations for tablets that are very attractive to users, causing the demand for tablets to increase, the increase in demand is limited because many of these innovations have also been applied to notebooks and even desktops and therefore may not be unique to tablets alone. Furthermore, due to the high level of competition between the different tablet makers such as Apple and Samsung, producers always resort to research and development to find new ways of making the costs of making their tablets lower, so that their products can compete on the international market.

7) Effects of improvement in technology in the tablet market on substitutes

Notebooks are close substitutes to tablets. This means that the cross elasticity of demand for tablets and notebooks would tend to be positive and high. Since price of computer tablets falls, Qd for tablets increases Since tablets and notebooks are close substitutes consumers switch from using notebooks to using computer tablets instead DD for notebooks will fall by m.t.p Pe and Qe of notebooks drop quite significantly

Evaluation: However, with increasing innovation resulting in a greater amount of product differentiation, it is likely that the cross elasticity of demand between tablets and notebooks will fall. For example, making it easier and more convenient to play games on the tablet will reduce the substitutability between tablets and notebooks. Also, if tablet producers are able to create products which allow users to read without

D1

Q1

P2

Q2

Pri e m uter ta lets

uantity m uter tablets

D2

S1

P1

S2

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discomfort, tablets may eventually replace books, a function that notebooks are unlikely to be able to fulfil.

8) Effects of improvement in technology in the tablet market on complements

Internet services are close complements to tablets. This means that the cross elasticity of demand for tablets and notebooks would tend to be negative and high. Since price of computer tablets falls, Qd for tablets increases Since tablets and internet services are close complements consumers use more internet services along with their increased usage of tablets DD for internet services will increase by m.t.p Pe and Qe of internet services increase quite significantly

Another complement is that of online video games such as those produced by Zynga. It is also a close complement of computer tablets. This is because many users prefer to play these video games on tablets as tablets use touchscreen technology which allows users to simply touch the screens to play the game instead of having to use a mouse which may be more inconvenient. Therefore, it is likely that online video games are a closer complement of computer tablets as compared to notebooks. Therefore, the demand for online video games will increase by m.t.p Pe and Qe of online video games increases quite significantly.

Evaluation: Between internet services and online video games, it is likely that internet services are a closer complement to tablets than online video games. This is because almost every user with a tablet would require internet services in order to use the basic functions of the tablet. On the other hand, not every tablet user plays video games. Therefore, a fall in the price of tablets would generally cause a greater increase in demand for internet services as compared to online video games, resulting in a larger increase in Pe and Qe for internet services.

CONCLUSION

It is highly likely that the trend towards improvement in technology will continue, resulting in a continued increase in demand and supply for tablets in the industry. However, the relative extent of shifts in demand and supply may not stay the same. For example, in the future, there could be ground-breaking innovations for tablets that could cause demand to increase substantially more than the supply. Or, it is possible that one of the tablet manufacturers gains a strong dominance, and possibly even a monopoly over the tablet market. Such a monopoly may reduce the incentive to engage in further R&D to reduce costs as the competitive element in the industry no longer exists, and therefore limit increases in supply in the tablet market.

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Marking Scheme

Level Descriptors

Level 1

1 - 5

6 - 9

• Answers are mostly irrelevant.• Listing of points

• Very little contextualization• Errors and misconceptions shown throughout explanation• Little elaboration on demand and supply factors, mainly listing

Level 2

10 - 11

12 - 14

• Must examine the computer tablet market, as well as the market of a complement ORsubstitute good

• Answer shows adequate knowledge of demand and supply forces and how these affectequilibrium price and/or equilibrium quantity.

• Answer may not be balanced when considering demand and supply factors• Little use or incorrect use of elasticity concepts• Lack of economic analysis and development• Response lacks contextualization• Little analysis of markets

• Must examine the computer tablet market, as well as the market of a complement goodand a substitute.

• Answer shows adequate knowledge of demand and supply forces and how these affectboth equilibrium price and equilibrium quantity.

• Response considers both demand and supply factors• Some effective use of elasticity concepts• Some economic analysis• Response lacks contextualization• Little analysis of markets

Level 3

15 – 18

19 - 21

• Response must have examined both the computer tablet market and at least eithersubstitutes or complements

• Answer demonstrates good knowledge of demand and supply forces and how theseaffect equilibrium price and equilibrium quantity, and shows knowledge of marketequilibrium

• Answer considers both demand and supply factors• Good use of elasticity concepts. Students must have considered Eab and Ep OR Es• Good economic analysis• Effective use of diagrams• Good contextualization

• Response must have examined both the computer market as well as both substitutesand complements

• Answer demonstrates excellent knowledge of demand and supply forces and how theseaffect equilibrium price and equilibrium quantity, and shows knowledge of marketequilibrium

• Both demand and supply factors very well-explained• Excellent use of elasticity concepts. Students must have considered Eab and Ep and Es.• Excellent economic analysis

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• Very effective use of diagrams• Very good contextualization

E1 (1-2) Mainly unexplained judgement. E2 (3-4) Judgement based on analysis.

3. Microsoft invests billions on Research and Development (R & D) which has contributed to a stream of innovations that have transformed business and the homes. To encourage innovation, intellectual property rights are given to innovators for a period of exclusivity to earn a reasonable return on their investment.

Source: The Straits Times “ASK: NUS ECONOMISTS” 16 Nov 2011

(a) Explain how barriers to entry affect a firm’s pricing behaviour and profits earned. [10]

(b) To what extent is Microsoft’s market power justified? [15]

Part (a)

Introduction: The key factors that affect the structure of a market are number of firms in the industry, nature of product, knowledge of the market and the existence of barriers to entry (BTE). BTE are obstacles that prevent entry by potential competitors into the market. BTE play a key role in determining firms’ pricing decisions and profits earned in the long run.

Development:

1. Consider market structure with no/weak BTE vs market structure withstrong BTE

(a) Market structure with no BTE – e.g. Perfect Competition and Monopolistic Competition • Under perfect competition and monopolistic competition, with no barriers

to entry, firms can enter and leave the industry easily. This gives rise to many small firms in the industries.

Consider Perfect Competition

• In the extreme under perfect competition, where product ishomogenous and with the existence of perfect knowledge togetherwith no BTE, firms are price takers in the market. Illustrate with theLR equilibrium adjustment process.

With many buyers and sellers trading a homogeneous product, eachbuyer and seller is a price taker. The firm is unable to affect market priceby changing its output. It has no control over the market price becausemany other firms are offering the product that is essentially identical. If

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he charges more than the market price, buyers will go elsewhere. The firm may sell any quantity it likes but only at the market price.

Assume the PC firms are making supernormal profits in the short run

Figure 1: Adjustment process from supernormal profits to normal profits

The PC firms take the initial market price P determined by the market forces of DD and SS. Assuming that these existing PC firms are making supernormal profits, new firms will be attracted to the supernormal profits and enter the industry. This is made possible as there are no barriers to entry for the industry. Market supply thus increases resulting in a shift of the market supply curve to the right from S to S1. Consequently, market price will fall from P to P1 and there will be a downward shift of the individual firm’s demand curve from D to D1 since they are price-takers.

The gradual fall in an individual firm’s price will continue until price exactly equals AC at P1 and all supernormal profits are wiped out. Normal profits are now achieved. At this point, there is no more entry of new firms and long run equilibrium is attained.

Thus, perfectly competitive firms will take the price set by the market demand and supply of the industry and sell at the prevailing market price and due to no BTE, PC firms can only make normal profits in the long run.

Consider Monopolistic Competition

• For monopolistic competition, where product is slightly differentiated andwith no BTE, the firms face a fairly elastic demand curve.

• Monopolistic competitive firms have some market power and can setprices but not high prices as with no BTE, competition will be stiff

• In the long run, similar to PC firms, firms in monopolistic competitivemarkets can only make normal profits due to freedom of entry as any

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supernormal profits earned in the short run will attract entry of new firms which compete away the supernormal profits.

(b) Market structure with strong BTE – e.g. Monopoly & Oligopoly • With imperfect information, unique product under Monopoly and

differentiated/homogeneous product under Oligopoly, firms under these 2 market structures have market power i.e. it is able to set prices which is further enhanced by their high barriers to entry.

• Examples of barriers to entry are large economies of scale in production,network effects and government policies

Consider Monopoly

• With high BTE, in the extreme, a single firm (pure monopoly) or adominant firm exist in the market. With only a single or single dominantfirm in the market => the product is unique or with no close substitutes.The demand for the product is inelastic

• Monopoly will be able charge high prices to earn more and even possibleto earn supernormal profits in the long run as rival firms can be preventedfrom entering the market to erode away the profits.

Figure 2: A monopolist is a price setter and given substantial BTE it can earn supernormal profits even in the long run

The profit-maximising condition, where MR = MC and MC cut MR from below, occurs at point E. The monopolist restricts output at OQe and charges an equilibrium price at OPe. With high barriers to entry, it can keep its rivals out and thus able to earn supernormal profits even in the long run.

ut ut

A MC

MR = AR

Pe

QeO

B C

D

E•

Cost, Revenue,

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Consider Oligopoly

• High BTE can also give rise to a few dominant firms existing in theindustry. This gives rise to an oligopoly. In an oligopoly, as each dominantfirm has a significant share of the market, they are mutuallyinterdependent in their pricing and output decision-making i.e. each firmhas to mindful of the reactions of their rivals to its decision-making. Thusin pricing decision, they could either act in a non-collusive or collusivemanner.

• Prices tend to be rigid in an oligopolistic market as it is assumed that rivalfirms will follow a price decrease and not a price increase (acting in a non-collusive manner). That is, if a firm is to decrease its price, it will lead to aless than proportionate increase in its quantity demanded as the otherfirms will follow its price decrease. On the other hand, if the firm increasesits price, it will lead to a more than proportionate fall in its quantitydemanded as the other firms will not follow its price increase.

• Thus oligopolistic firms could practice price leadership (acting in acollusive manner) where the most dominant firm could lead in for e.g.raising prices to its profit-maximising and the other firms will tacitly followthe price increase.

• Due to high BTE, oligopolistic firms are able to earn supernormal profitseven in the long run as the high BTE keep out the rival firms from enteringthe industry to compete away profits.

Note Students can consider how monopoly or oligopoly firms could practice limit pricing or predatory pricing if they have other aims instead of profit-maximising. Limit pricing prevents firms from coming into the market, whereas firms that use predatory pricing try to drive competitors out of the market.

Conclusion: Thus BTE is an important factor affecting a firm’s pricing decision and in particular to the type of profits it can possibly earn in the long run.

Part (b)

To what extent is Microsoft’s market power justified? [15]

Introduction:

Microsoft has high barriers to entry and this enhances its market power i.e. giving it greater ability to alter the market price of its good. When a firm abuses its market power it will result in a less than efficient allocation of resources. In this essay, using the efficiency criteria, we will examine whether Microsoft’s market power is justified.

Development:

1. Define efficiencyEfficient allocation of resources refers to a situation whereby resources areallocated in such a way that no one can be made better off without another beingmade worse off. That is social efficiency or pareto optimality is achieved.

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In the narrow sense, efficiency can be defined as economic efficiency which is achieved when there is both productive and allocative efficiency. In a broad sense, efficiency also takes into consideration dynamic efficiency, economies of scale (EOS) and cost-savings, product variety and consumer choice.

2. Consider circumstances where Microsoft’s market power may not bejustified

(i) Productive and allocative efficiency Microsoft with substantial market power is a dominant firm in the software market. It is productively efficient from firms’ view but productively inefficient from society’s viewpoint and is also allocatively inefficient.

Productive efficiency A profit-maximising firm is necessarily productively efficient since profit maximisation requires the firm to minimise its cost for producing that level of output. In this respect, all firms, regardless of their market structures, are productively efficient.

However a profit-maximising firm with market power produces at the falling portion of the LRAC curve. It produces with excess capacity and not fully utilising the given plant size. Hence from society’s viewpoint, it is not considered productive efficient.

Allocative inefficiency Allocative efficiency is achieved when resources are allocated in such a way that the right quantity of every commodity is produced. It is achieved when for each good produced, its marginal cost of production is equal to its price. That is P = MC.

However, Microsoft with market power is allocatively inefficient. It produces an output where P > MC.

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Figure 3: Existence of market power leading to welfare loss arising from allocative inefficiency

To achieve allocative efficiency, production should take place at the point where P = MC (point c) and the socially efficient level of output is at OQe.

However, given its market power, to maximise its profits, Microsoft restricts output to Qm, charging price at Pm. At Qm, P > MC i.e. the value consumers place on the last unit (Pm) exceeds the marginal cost of producing it (MCm). Comparing OQm to OQe, it is evident that there is underproduction of the good in this case. The welfare loss i.e. the deadweight loss resulting from this underproduction (or misallocation of resources) is given by the area acd. From the welfare point of view, more should have been produced. In other words, Microsoft fails to achieve allocative efficiency.

3. Consider circumstances where Microsoft’s market power may be justified

(ii) Dynamic Efficiency Market power enhanced through BTE allows Microsoft to earn supernormal profits even in the long run. These supernormal profits earned enable the firm to reinvest it to further improve its products. Given a contestable market, there will be incentive for Microsoft to further improve to keep out its potential rivals. That is, Microsoft will be willing to invest in R & D to improve its product which benefits the consumers.

In this context, the market power given to Microsoft to encourage R & D via BTE in the form of intellectual property rights is justifiable as such research required high fixed costs. In addition, this given market power is only short-term in nature as stated in the preamble that the intellectual property rights are given only for a period of exclusivity for the firm to earn a reasonable return on its investment.

Consumers can also enjoy greater product variety and choices as firms undertaken innovation to compete with one another.

Quantity

e enue st

Pri e

SSPC

d

b c

a

d

Qm Qe

MCm

Pm

Pe

O MR

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(iii) Economies of Scale (EOS) and cost savings Large firms such Microsoft also produces on a large scale and reaps EOS. Software development is characterised by substantial EOS as the fixed costs of producing software, including applications, is very high. By contrast, its marginal costs are very low. Thus to be cost-efficient it needs a large consumer base to sell its products. In addition, to keep out its rival firms, Microsoft will be incentivised to pass on the cost savings to its consumers.

Figure 4: Price and Output under Perfect Competition and Large Firm which reaps

MCpc = SSpc

MCm = SSm

Ppc

Pm

Qpc Qm

MR AR

O

Revenue/Cost

Output

The perfectly competitive industry would produce an output OQpc and charge a price OPpc as given by the intersection of the PC industry’s demand and supply (SSpc) curves. In a market where a large firm can reap substantial economies of scale, its marginal cost curve (MCm) lies lower than the MC curve of the perfectly competitive industry (MCpc). The large firm’s profit maximising price and output is at OPm and OQm respectively where MCm=MR. This illustrates that large firms such Microsoft can actually produce a larger quantity and charge a lower price as compared to perfectly competitive industries.

Conclusion:

In conclusion, as long as a market is contestable, firms with market power will usually plough back profits earned to improve product so as to keep its rival firms out. This is in particular applicable to industry affected by fast-pace changing technology such as in this context of the IT/software industry. In addition market power that is strengthened through short-term BTE such as intellectual property rights and patents are needed to encourage firms to undertake R & D to benefit the consumers in the long run. In this aspect, Microsoft’s market power can be justified.

However, long term absolute market power is often frowned upon as it can lead to inefficiency and society’s welfare is undermined. Thus it is also important that the

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government put in place anti-trust laws and regulations to prevent the abuse of market power by firms, but one has to be mindful that intervention by the government can at times lead to greater welfare losses than without its intervention as government may not have the necessary information in its decision-making.

Mark Scheme:

Part (a)

Level Descriptors Marks

L3 A well-developed and rigorous explanation on how the existence of BTE can affect a firm’s pricing behaviour and profits earned.

7-10

L2 An underdeveloped explanation of both (i) no BTE and (ii) high BTE affecting a firm’s pricing behaviour and profits earned; lacking in rigour.

OR

A well-developed explanation of either (i) no BTE or (ii) high BTE affecting a firm’s pricing behaviour and profits earned.

5-6

L1 For an answer which shows some knowledge on how the existence of BTE can affect a firm’s pricing behaviour and profits earned. Answer contains errors and inaccuracies.

1-4

Part (b)

Level Descriptors Marks

L3 A competent response containing well-developed analysis of whether market power can be justified showing both scope and depth in the discussion.

Discussion to be centred on efficiency criteria in both narrow and broad sense. Candidates may also include the equity criteria.

High L3 (10 -11m): Insightful analysis based on given context.

Note: No reference to productive efficiency => cap at L3 (max 9m)

9-11

L2 An underdeveloped explanation of the negative and positive effects of market power relating to welfare maximisation.

OR

A well-developed explanation but mainly one-sided view.

OR

6-8

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No reference is made to given context.

Note: No reference to economic efficiency => cap at L2 (max 8m)

L1 For an answer which shows some knowledge of the negative and/or positive effects of market power. Answer contains errors and inaccuracies.

1-5

E2 Judgement based on analysis 3-4

E1 Mainly unexplained judgements 1-2

Section B

4. Discuss the significance of the multiplier size, factor endowment and Marshall-Lerner condition in influencing macroeconomic policy decisions in Singapore. [25]

Introduction: State the characteristics of Singapore economy: Singapore is a small & open

economy, highly dependent on trade. State examples of macroeconomic policies: Demand-management policies (fiscal

policy, exchange-rate based monetary policy), Supply-side policies (market-oriented, interventionist polices), International policies (e.g. trade policies).

Main Development:

Analysis of how the 3 characteristics influence decisions regarding macroeconomic policies in Singapore:

i) The multiplier sizeTopic sentence: The effectiveness of demand-management policies is dependent on the size of the multiplier.

Definition: The multiplier indicates the number of times income changes relative to the initial change in AE.

Formula: Multiplier = 1/(1 – MPC), where MPC = Marginal Propensity to Consume on domestically produced goods & services

Explanation of how a demand-management policy works via k effect: If the government adopts expansionary fiscal policy, increasing G by $100m, then AD also increases by $100m (via it’s affect on G). Firms will experience a fall in inventories, signalling to the firms to increase production. Firms will hire more workers to increase output. This results in increase in employment and income increases. As income increases, spending by the households will increase. As one’s spending becomes another’s income, this increase in spending will lead to an increase in income of another group of people because of the increasing demand for the goods and services they produce. The multiplier effect is triggered off leading to a multiple increase in production, output and national income from Y1 to Y2. This will boost actual growth and employment.