Marshall Cavendish Education - MODEL ESSAYS 160719...Chapter 2 Demand and Supply The rising cost of...

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ESSAYS Chapter 2 Demand and Supply The rising cost of laying electrical pipes, increasing preference for clean energy and continued income growth, have contributed to the significant increase in the price of electrical pipes in Singapore. This is expected to affect the operations of the manufacturing industry. Explain why the rising cost of laying electrical pipes and continued income growth may have contributed to the sharp increase in the price of electricity. [10] Firstly, the sharp increase in the price of electricity can be attributed to demand factors such as continued income growth and supply factors such as the rising cost of laying electrical pipes. Secondly, the supply factor of the rising cost of laying electrical pipes (WETPIGS) have contributed to the large increase in the price of electricity due to it being a factor of production of electricity. As the price of the factor input increases, the unit cost of production for electricity increases. As the factor price of electricity increases, the producers of electricity face rising marginal cost. Holding demand constant, the suppliers of electricity will cut down on their production to avoid the negative marginal profits. The demand factor of continued income growth (EYGPT) may have contributed to the increasing demand for goods and services as consumers now have a higher purchasing power to consume more goods such as luxury goods, i.e. cars and designer clothes. As electricity is a factor of production for manufacturing, the increase in demand goods results in an increase in the demand for electricity.

Figure 1


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As shown in Figure 1, with demand increasing and supply decreasing at the same time, there will be a shortage of Q0Q2 created at the original equilibrium price P0. Given the limited supply of goods, the utility-maximising electricity buyers bid up prices in order to get their goods. The higher prices allow for electricity producers to produce goods that can only be produced at a higher marginal cost, increasing the quantity supplied. On the other hand, consumers that are constrained by their budget or unwilling to pay the higher price drop out of the market, decreasing the quantity demanded. The adjustment will continue until the price increases enough to eliminate the shortage of electricity. The price increases from P0 to P1. Producing electricity requires the laying of electrical pipes. In other words, significant time is required to increase the supply of electricity (MINTS) and producers cannot simply produce more electricity immediately to keep up with the increase in market demand. Electricity is price inelastic in supply.

Figure 2

Using Figure 2 as an illustration, the initial equilibrium is at P0Q0. With an increase in demand, it is clear that when the production of electricity is price inelastic, an increase in price to PIE results in a less than proportionate change in quantity supplied to QIE. This might be due to the long building period of pipes that cause electricity producers to be unable to respond to price changes immediately. Thus, there is a sharp increase in the price of electricity. Therefore, due to the way the market works and the relationship between the various goods, continued income growth and the rising cost of laying electrical pipes may have contributed to the sharp increase in the price of electricity.


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Chapter 3 Elasticity Concepts Explain the factors that determine the price elasticity of demand, income elasticity of demand and cross elasticity of demand for a good. [10] The Price Elasticity of Demand (PED) refers to the degree of responsiveness of the quantity demanded of a good to the change in its own price, ceteris paribus. The Income Elasticity of Demand (YED) refers to the degree of responsiveness of the quantity demanded of a good to the change in income, ceteris paribus. The Cross Elasticity of Demand (XED) refers to the degree of responsiveness of the quantity demanded of one good to the change in price of another good, ceteris paribus. One factor that determines the PED of a good is the availability of substitutes (PANT). This refers to the degree of the closeness of goods that fulfil the same needs and wants. The closer the alternatives are in fulfilling the same needs and wants as a good, the more price elastic the good is. For example, in the sportswear industry, between Nike and Adidas, the shoes are price elastic as the shoes of both brands enable runners to run and therefore fulfil the same needs and wants.

Figure 1

Therefore, should either Nike or Adidas increase the price of their shoes as shown in Figure 1 from P0 to P1, consumers will switch to a cheaper alternative — i.e. other shoe brands — due to the high degree of closeness between the shoes, causing a more than proportionate decrease in the quantity demanded of Nike or Adidas shoes from Q0 to Q1’. Therefore, the availability of substitutes affects the PED of a good.


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One factor that determines the YED of a good is the nature of a good. A good that is considered to be a necessity is less income elastic as compared to a good that is considered to be a luxury. For example, basic necessities such as food and medicine would be less affected by the change in consumers’ income. As consumers require these goods, they are hence less responsive to a change in income as consumers are willing to pay to purchase these necessities. On the other hand, luxury goods such as branded handbags and sports cars are considered less of a necessity and are therefore more income elastic. This is because these goods are not necessities and are not required in our everyday lives. As a result, luxury goods are more income elastic as consumers will only purchase these goods should they have the earning capacity to do so. Therefore, the nature of a good affects the YED of a good.

One factor that determines the XED of a good is the degree of necessity for the joint consumption of goods and services. This refers to the necessity of a good when consuming other goods, which are complements of one another. For example, goods such as SIM cards and handphones are strong complements. This is because consumers can only use their phones to call and message people when they have SIM cards. As a result, this causes the quantity demanded of SIM cards to be inversely proportional to the change in price of handphones. When the price of handphones decreases as shown in Figure 2 from P0 to P1, this causes the demand curve for SIM cards to shift to the right from DD0 to DD1 as shown in Figure 3 as they are both strong complements and experience joint consumption. Therefore, the degree of necessity for the joint consumption of goods and services affects the XED of a good. In conclusion, the above mentioned factors are important in determining the pricing decisions of firms with respect to the PED, YED and XED of a good.

Figure 2: Handphones Figure 3: SIM Card


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Chapter 5 Market Structure (For H2 Only) Distinguish the characteristics of firms operating in oligopolistic and monopolistically-competitive markets. [10] Oligopoly refers to a market structure with substantial barriers to entry and exit where a few large firms dominate the industry with substantial market share. On the other hand, monopolistic competition refers to a market structure with barriers to entry and exit where numerous small firms exist, each selling a differentiated product; and where none of those firms has a dominant market share. Operating under the assumption that all firms aim to maximise profits, these market structures differ in terms of the size and number of firms, barriers to entry and types of profit made. Firstly, an oligopolistic market differs from an Monopolistically-Competitive (MPC) market in its size and number of firms. In any type of market structure, the size and number of firms can help to contribute to the amount of market power a firm is able to yield. In oligopolistic markets, there are a few essentially dominant firms. As an illustration, petrol retailers in Singapore consist of only Shell, Esso, Caltex, and Singapore Petroleum Company (SPC). Esso, Caltex, and SPC are Shell’s competitors. In particular, Shell and Esso control the greater proportion of the market, leading to a greater market share of the petroleum industry. These four firms are well-established where product recognition reinforces their market power. In contrast, MPC firms tend to be small, each of which offers slightly differentiated products for sale. There is no dominant firm in the huge industry of an MPC market, although each firm may seek to carve a niche market via product differentiation. For example, in Singapore, most bubble tea retailers target students as their consumers and would set up in neighbourhoods to make their product accessible to students. Secondly, an oligopolistic market differs from an MPC market in its barriers to entry. Barriers to entry refer to obstacles that prevent potential firms from entering the industry. Potential entrants to oligopolistic markets face high barriers to entry. For example, the complexity of the necessary safety precautions for the transportation and storage of petrol adds to the high start-up costs for the potential entrants. This creates high barriers to entry in an oligopolistic market. Potential entrants in an MPC market, however, face low barriers to entry. The start-up costs incurred, for instance, may be lower when compared to an oligopolistic market. Lastly, an oligopolistic market differs from an MPC market in the types of profit made. Oligopolistic firms have a higher tendency to earn and sustain a supernormal profit in the long run, due to the presence of strong barriers to entry and exit. The barriers deter potential entrants from entering the industry despite being enticed by the profits made. Hence, oligopolistic firms are able to earn a supernormal profit in the long run since average revenue is more than average cost. An example of this is petrol retailers where there are only a few big retailers earning a supernormal profit in the long run. Conversely, MPC firms tend to earn a normal profit in the long run due to weak barriers to entry and exit. In the event of a short run supernormal profit, potential entrants are attracted to enter the industry. This dilutes the market share that each MPC firm possesses and erodes their profit to become a normal profit in the long run.


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In conclusion, oligopolistic firms and MPC firms differ in terms of the size and number of firms in the industry; the barriers to entry; and the types of profit made in the long run.


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Chapter 6 Market Failure There are various types of market failure. A market failure provides one of the major justifications for government intervention in the economy. Explain how market dominance and immobility of factors of production in a country can lead to a market failure. [10] A market failure is a situation where the free market fails to allocate resources efficiently resulting in a lack of maximisation of social welfare. The government’s aims of achieving efficiency and equity will prompt them to intervene when a market failure arises. Both market dominance and immobility of factors of production are causes of a market failure. Market dominance occurs when firms have significant market share, dominating the market, as a result of strong barriers of entries and exit. When a firm monopolises the market, it is able to control the output of the market and hence, the price. Profit-maximising firms hence restrict the output and produce at a profit maximising level, MC = MR where MC cuts MR from below. At this point, P > MC, which is allocative inefficient.

Figure 1

Referring to Figure 1, the firm produces at output level Q0 and charges the maximum price that consumers are willing and able to pay for the good which is P0. However, the allocative efficient level is at QAE where the price is PAE. At P > MC, the marginal cost of producing one unit of a good is higher than the price consumers are willing and able to pay for the good. In this case, society’s welfare can be maximised by lowering the amount of production. An example of a monopoly would be Grab: after monopolising the market, the prices of their rides increased as there were no longer any competitors. The stronger the market


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dominance, the steeper and less price elastic the curve is as consumers will have fewer substitutes to switch to. Given that societal welfare is not fully maximised, a market failure occurs.

Yet another source of market failure would be factor immobility. There are two main types of factor immobility: occupational immobility and geographical immobility. Occupational immobility refers to the barriers to the mobility of factors of production between different sectors of the economy. These factors remain unemployed resulting in allocative efficiency where the factors of production are not being utilised. An example would be structural unemployment where there is a mismatch between the skills demanded by the employer and those offered by the employee.

On the other hand, geographical immobility refers to the barriers that hinder people from moving to another area to find work. These barriers include the financial costs of relocating or the administrative work people have to go through to relocate. As a result, they are unable to respond to job offers at other locations. Subsequently, this leads to allocative inefficiency.

In conclusion, governments intervene in a market failure to achieve both efficiency and equity. With adequate enforcement and policies, a market failure will ease.


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Chapter 7 Introduction to Macroeconomics Explain how a global recession would affect the circular flow of income in an economy. [10] Global recession is defined as two consecutive quarters of negative economic growth. Good examples of a global recession are the 2008 global financial crisis and the 2010 eurozone crisis. Additionally, the circular flow of income illustrates the flow of income from household to firms in return for the products that firms supply; and the flow of income from firms to households in return for the factor services rendered. As illustrated in the diagram, the circular flow of income in a four sector economy comprising of households, firms, government and the foreign sector, shows the flow of goods and services and their payments around the economy. Injections into the circular flow of income is defined as the addition to the circular flow that does not come from the expenditure of domestic households. Components of injections include Investment (I), Government Spending (G) and Exports (X). On the other hand, withdrawals from the circular flow of income are defined as any part of income that is not passed on within the circular flow of income. Withdrawals include Savings (S), Taxes (T) and Imports (M). When withdrawals = injections in an economy, an equilibrium in the national income is achieved.

A global recession, however, would cause the circular flow of income in an economy to contract. Specifically, when instigated by the lower profitability of investment projects which is to be expected during a global financial crisis, firms would have a pessimistic outlook, causing the level of investment expendiuture to fall. Similarly, due to perceived high default risks, firms would have lesser access to bank credit, leading also to a fall in I.


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Furthermore, a global recession will lead to a lower level of economic activities in the world. Given a recession, government spending is likely to be counter cyclical and likely to rise as a result to combat the recession. However, the level of injections will fall, as a fall in I & X is likely to dominate the increase in G as illustrated in the diagram. As such, firms’ output would decrease and in turn, so would their demand for factors of production from households. In addition, the factor incomes of households decrease, consequently decreasing the size of the circular flow of income. Due to a fall in the factor income, household consumption will also fall. As the income level falls, households will save less and thus spend less on imports and therefore incur less tax. The level of withdrawals also falls. The process will stop until the initial fall in injections is equal to the fall in withdrawals.


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Chapter 8 Macroeconomic Goals Explain why a government seeks to achieve sustained economic growth, low inflation and external stability. [10] Sustained economic growth occurs when an economy is producing at the maximum possible/potential output, where both potential growth and actual growth exist. Low inflation is defined as a situation where the prices of goods and services do not increase rapidly. External stability refers to a stable Balance of Payment (BOP) position and is a desirable situation where countries are able to pay their international transactions, without the burden of these overseas payments causing severe problems that could lower the Standard of Living (SOL). The reasons for a government seeking to achieve sustained economic growth, low inflation and external stability are discussed below. Firstly, a government seeks to achieve sustained economic growth to improve the SOL of people in the country. SOL is defined as the level of well-being enjoyed by the average person of a country. It measures both material and non-material aspects of life. Material aspects measure the quantity and quality of goods and services available for consumption whereas non-material aspects measure the qualitative aspects of life, such as happiness levels and health. Achieving sustained economic growth results in an increase in national income and thus consumers’ purchasing power. In turn, consumers become more willing and able to consume goods and services. All of this means, in sum, an improvement in the material SOL of people living in the country as they are able to afford more goods and services of higher quality like more luxurious items, i.e. cars and mobile phones. Similarly, citizens may also enjoy a higher level of non-material SOL where they stand to benefit from better quality healthcare to improve their lives. Secondly, a government also seeks to achieve low inflation to promote a higher level of savings and investments in a country. With price stability, savers will have a greater assurance that savings deposited in banks retain future purchasing power. Thus, this will prompt a higher level of savings, which translates to a higher level of loanable fund. This will exert a downward pressure on borrowing cost, which in turn prompts a higher level of consumption of big ticket items like cars and a higher level of investment due to a higher expected rate of return. Additionally, the Aggregate Demand (AD) increases because of a higher level of consumption and investment. Subsequently, in order to meet the increase in AD, producers increase production, causing the demand for labour to be higher, since labour is a derived demand. As a result, structural and cyclical unemployment decreases, creating low unemployment in an economy, a benefit of achieving the goal of sustained economic growth. Finally, a government also seeks to achieve external stability in order to attract investment which promotes economic growth. Achieving external stability in terms of having a stable exchange rate causes investors’ confidence to increase as Foreign Direct Investments (FDIs) are unlikely to suffer from exchange rate losses due to a sudden depreciation when they invest in the domestic country, which then improves the growth in investment. As a result, since investment is a component of AD, AD increases. Through the multiplier process, this


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leads to economic growth which causes an increase in national income, in turn leading to an increase in GDP levels. Similar to the mutilplier effects under the first point, a government seeks to achieve external stability to promote investment and economic growth. In conclusion, governments seek to achieve the macroeconomic goals of sustained economic growth, low inflation and external stability to influence AD to benefit the economy. However, as governments seek to achieve these goals, this may cause other conflicts to arise, making it necessary for governments to weigh the pros and cons of achieving each of these goals.


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Chapter 9 Macroeconomic Policies Over the past few years, social spending has increased significantly in the face of rising income inequality and an ageing population. Yet, no country has been able to offer free healthcare and social services without raising taxes for middle-income earners. Explain the factors that limit the effectiveness of fiscal policy in reducing unemployment. [10]

Fiscal policy refers to the deliberate usage of taxation and government spending to influence economic activities. Unemployment refers to people who are willing and able to work but cannot find a job in a given time period. This essay will briefly illustrate how fiscal policy can reduce unemployment and uncover three factors which limit its effectiveness.

Figure 1

One of the factors that affects the effectiveness of fiscal policy is the size of a multiplier. A multiplier measures how much real national income changes due to an initial change in autonomous expenditure and is inversely related to Marginal Propensity to Withdraw (MPW). MPW can be further categorised into Marginal Propensitity to Save (MPS), Marginal Propensitity to Tax (MPT) and Marginal Propensitity to Import (MPM). When the government conducts an expansionary fiscal policy by increasing government spending on public infrastructure projects to reduce unemployment, it results in an outward shift in AD from AD0 to AD1 (Figure 1). This leads to an unplanned inventory depletion and an increase in production level in the next time period. Accordingly, since labour is a derived demand, there will be a fall in unemployment from Y0 to Y1 (insert in Figure 1) through the multiplier effect. However, if the country is experiencing a huge leakage, i.e. high MPS due to mandatory savings for the future, the multiplier effect will be dampened as AD will not experience the full shift to AD1 and instead to AD1’ as a higher saving rate results in a lower level of induced consumption. At such, employment may be potentially lowered from Y0 to Y1 due to a low multiplier effect.


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The second factor that affects the effectiveness of fiscal policy is time lags. There are three different types of time lag: a recognition lag, an administrative lag and an operational lag. For instance, it may take time for the government to recognize that there is unemployment in the first place, prolonging the duration of unemployment. Similarly, an administrative lag may occur at the second phase when the government has to decide the fine details of government spending within the parliament, further prolonging the duration of unemployment. Lastly, an operational lag may occur after the increase in government spending is implemented. This is because it takes time for the policy to take full effect in the general economy. In short, it is these three time lags that limit the effectiveness of fiscal policy to reduce unemployment immediately.

Figure 2

The last factor that affects the effectivenss of fiscal policy is the crowding out effect. The crowding out effect refers to public spending crowding out private investments. In a scenario where public spending is primarily financed by external bank borrowing, the availability of loanable funds is reduced, driving up borrowing costs and interest rates. Consequently, due to higher borrowing costs, private firms are less likely to make investments to build plants and capital goods due to a lower expected rate of return. As illustrated in Figure 2, an initial increase in public spending, denoted by the rightward shift towards ADG, will reduce unemployment from Y0 to YG. However, the crowding out effect reduces the level of investment, resulting in a fall in AD from ADG to ADCO. As workers are a derived demand of investment, this will result in a higher level of unemployment level of YCO.

To conclude, governments have to be mindful of the above three limitations when they implement expansionary policies to correct unemployment.


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Chapter 10 Conflict of Macroeconomic Goals Explain the possible conflicts in government macroeconomic objectives caused by a policy of pursuing price stability. [10] Price stability is defined as the situation in which the general price level in an economy is increasing at a low, stable and expected rate. In the pursuit of low inflation, governments could adopt contractionary policies like a contractionary fiscal policy. A contractionary fiscal policy aims to reduce expenditure in an economy: particularly government expenditure, investment expenditure, consumption expenditure and expenditure on net imports. It is done through the reduction of spending and the increase in taxes by the government. As the government adopts a contractionary fiscal policy, this causes less amount to be available for spending in the economy.

The first conflict that can arise is the conflict between price stability and full employment. Full employment occurs when the economy is operating at the natural rate of unemployment without any demand deficient unemployment. From Figure 1, assuming the reduction of government expenditure on public infrastructure, the Aggregate Demand (AD) decreases, causing the AD curve to shift to the left from AD0 to AD1, causing the inflationary pressure to be eased from P0 to P1. The use of a contractionary policy to achieve price stability causes an unplanned inventory accumulation due to a fall in demand for goods and services, resulting in firms stepping-down production to reduce output. Since labour is a derived demand, demand deficient unemployment increases. As a result, there is a decrease in


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purchasing power as consumers are less willing and able to afford goods and services. This leads to a further fall in AD as a result of pursuing a contractionary policy, causing demand deficient unemployment to increase further. In the long run, this causes the economy to contract further due to the reverse multiplier effect. However, at the same time, since there is a fall in the demand for workers, wage and cost pressure subsides as there is spare capacity in the economy and the producers are able to pass off additional cost savings to the general economy. This results in a conflict between price stability and full employment.

The second conflict that can arise is the conflict between price stability and economic growth. Economic growth is defined as a sustained increase in the income and output level. It is brought about by actual growth, which is further defined as the increase in the actual output and potential growth, i.e. the increase in the production capacity. As noted earlier, through the reverse multiplier, this results in a multipled fall in the income and output level and actual growth from Y0 to Y1. In addition, the fall in public infrastucture spending as mentioned above might lead to a fall in public capital accumulation, resulting in a fall in production capacity and full employment output in the future as the economy has fewer public capital goods to operate with, worsening potential growth. Therefore, the pursuit of price stability may be at conflict with economic growth. In conclusion, since there are clearly trade-offs when attempting to fulfill different macroeconomic objectives, governments have to weigh the extent of the relevant costs and benefits in order to determine the different goals that they desire for the economy.


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Chapter 11 International Trade (For H2 Only) Explain how countries can mutually benefit from free trade, including those countries that are the most efficient at producing all products. [10] Free trade refers to international trade with no government intervention restricting exports or imports. Free trade brings about benefits such as a greater world output, a higher consumption of goods and services, and the reaping of economies of scale through specialisation. Firstly, countries can mutually benefit from free trade through a greater world output. Based on the theory of comparative advantage, specialisation leads to increased world output. This is due to the fact that specialisation allows each country to concentrate on producing goods and services that it is efficient at producing; while trading allows a country to obtain goods that it does not produce efficiently. In this way, countries engaged in trade can gain from higher quantities of goods and services consumed. Therefore, countries can benefit from free trade through a greater world output. Secondly, countries can mutually benefit from free trade through a higher consumption of goods and services. Acquiring the goods and services they lack through the trade channel will allow consumers to gain access to a wider variety of goods and services to suit every taste. For example, consumers in tropical countries can enjoy imports from temperate countries, in addition to their own domestically produced goods. Therefore, countries can mutually benefit from free trade through a higher consumption of goods and services. Lastly, countries can mutually benefit from free trade through the reaping of Internal Economies of Scale (IEOS) through specialisation (MR FAST). Countries such as Singapore and Israel, whose domestic markets are too small to exploit IEOS, would find it prohibitively expensive to become self-sufficient because they have to produce everything at a high cost. However, free trade allows these smaller countries to specialise in producing a limited range of commodities on a larger scale such that they reap the available cost savings from IEOS by raising labour productivity through specialisation and lowering the unit cost of production. Exporting to other nations helps to widen the market for their products and allows IEOS to be realised from the intial C0 and Q0 to a higher output at QMES and a lower cost at C1.

Figure 1


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Therefore, countries can mutually benefit from free trade as it brings about a greater world output, a higher consumption of goods and services, and a reaping of IEOS.


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Chapter 12 Globalisation (For H2 Only) The withdrawal of the United States from the Trans Pacific Partnership is a setback, but the collective commitment of the remaining 11 partner countries towards greater liberalisation and regional integration may bring some positive outcomes through increased trade, labour and capital flows. Explain why countries may opt out of free trade agreements. [10] Free trade agreements are agreements where two or more countries cooperate to reduce trade barriers and increase the trading of goods and services with each other. Firstly, countries might choose to opt out of free trade agreements to protect infant industries (BID). A country might have a potential comparative advantage in a new industry. However, it cannot compete with the established foreign industries due to a lack of economies of scale that her rivals enjoy. As shown in Figure 1, at the initial stage of production, the infant industry faces a high initial cost of production at C0Q0 unless output is expanded sufficiently to reap economies of scale and to establish a global market share at C1Q1. This may lead to domestic infant firms being uncompetitive in the long run and unemployment may arise. Therefore, it is necessary to opt out of free trade agreements and to protect the infant industry until it is able to produce as cheaply as foreign rivals and until it is able to compete without protection.

Figure 1

Secondly, countries may choose to opt out of free trade to prevent dumping (BID). Dumping refers to the selling of the same good, though imported, at a lower price compared to a local good, often below the marginal cost, in order to drive out local competitors and monopolise the market. If dumping is allowed, the cheaper imports will outsell the domestic goods, leading to a decrease in demand for domestic goods as domestic consumers will switch to cheaper imports. Hence, domestic firms will close down. This will lead to cyclical


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unemployment as labour is a derived demand for domestic goods. Similarly, dumping may also lead to potential market dominance of the foreign firm in the domestic market in the future due to a lack of compeitition and accordingly, raising prices in the future may harm the interest of consumers. Therefore, to prevent dumping and its consequences, countries may choose to opt out of free trade. Another reason why some countries may choose to opt out of free trade would be to maintain a healthy Balance of Payment (BOP) position (BID). Price competitive imports may result in consumers switching from local goods to imported ones when both are close substitutes for one another. Assuming that the demand for imports are price elastic, i.e. PED > 1, this would lead to a more than proportionate increase in quantity demanded for imports, worsening the net exports and ultimately, worsening the balance of trade position. Hence, in order to maintain a healthy BOP, countries may choose to opt out of free trade agreements. In conclusion, every economy has its own unique set of problems and while free trade could benefit certain economies, it could jeopardize others.

Marshall Cavendish Education - MODEL ESSAYS 160719...Chapter 2 Demand and Supply The rising cost of...

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