PJC 2013 H2 Paper 1 Suggested Answers 1

PIONEER JUNIOR COLLEGE

2013 PRELIMINARY EXAMINATION
ECONOMICS
SUGGESTED ANSWER TO H2 P1
Question 1
(a) (i) Compare the change in fuel prices in UK between 2000 to 2011. [2]

Suggested Answer:

Overall increase for all 3 fuels [1] with gas rising the most between the
identified period. [1]


(ii) With the aid of a demand and supply diagram, account for the price change
identified in (a)(i)
[4]

Suggested Answer:
World Supply
The Middle East is a major fuel producer in the world. The unrest in the
Middle East has led to a decrease in supply of fuel in the world and the
Fukushima nuclear crisis in Japan has also led to a diversion of the energy
resources to Japan instead. These events decrease the supply of energy
resources in the world.

Demand
Due to the Fukushima nuclear crisis, there was also a higher demand for
fuel in general causing the world demand for fuel to rise.

With a lower world supply and higher demand, the overall world fuel prices
will increase. This higher price will mean a higher cost in importing oil to UK,
thus decreasing the supply of fuel in UK shifting its supply curve from S1 to
S2. This overall leads to an increase in prices of fuel in UK.


P



















S2
D1
S1
Quantity
PJC 2013 H2 Paper 1 Suggested Answers 2

(b) (i) Describe the type of market structure operating in the UK energy market. [2]

Suggested Answer:

The UK energy market is operating as an Oligopoly market structure.[1]


The industry consists mainly of a few producers. With reference to the case
material, the market place is being dominated by Britain's six largest utilities
and the fact that they could be forced to auction off more than one fifth of
electricity they produce shows that they own large market shares of the
industry. [1]



(ii) Explain how firms in the UK energy market might compete against each
other.
[4]

Suggested Answer:

Being in an oligopolistic market structure where there are a few large firms
each with substantial market share, the UK energy firms tend to avoid price
competition because they are mutually interdependent and there is no real
incentive to do so. Any form of price cutting would mean an erosion of
revenue as competitors will match such price cuts to prevent a loss of
market share and any attempt to raise price will likewise see a fall in total
revenue as competitors are unlikely to follow with the expectation of a gain
in market share. This result in price rigidity illustrated by the firms kinked
demand curve.

Therefore, firms in such a market will favour the use of non-price
competition. The non-price competition in the UK energy market is reflected
in how the firms compete against each other through different billing system
and discount structures which makes it hard for consumers to understand to
switch demand to its rival firms. It is also mentioned in Extract 3 that the
electricity and gas firms can offer a mix of products, emphasising the
differentiated products and marketing strategies adopted to gain a greater
market share and revenue.



(c) The third tank is an infrastructure that cements the future for multiple
parties.
Comment on the economic impact of constructing the third tank on the
Singapore economy.
[8]

Question Analysis:

Comment: Requires the need to evaluate the validity of arguments
presented, based on the context given by the extracts

Economic Impact on Singapore Economy: Identified current and future
positive and/or negative, and how does it affect the economy. May want to
analyse impact via the use of AD/AS diagram to show the impact onto the
economy towards achieving the macro aims


Suggested Answer:


PJC 2013 H2 Paper 1 Suggested Answers 3

Evidence:

Construction of 3
rd
tankfuel current Investment

catalyse new business opportunities, international LNG traders
long run investment, Building productive capacity of the nation

Intro: With the construction of the 3
rd
Tank, it would help to fuel current and
future growth in the economy, lowers unemployment and promote price
stability, through the combination of increase in Aggregate Demand (AD)
and Aggregate Supply (AS)

By building the 3
rd
tank, it leads to an increase in the level of investment in
the economy. Since I is a component of AD, it leads to an increase in AD,
shown by a rightward shift from AD1 to AD2, leading to an increase in
output from Y1 to Y2. Producers will hire more factors of production to meet
this increase in aggregate demand, leading to an increase in derived
demand for labour.

Also, with the increase in the productivity in LNG storage and handling
facilities, it may improve our comparative advantage in the processing and
re-exporting of natural gases, explaining why many international traders are
turning to Singapore. Thus, this comparative advantage might lead to us to
price our re-exported LNG more competitively, and assuming demand for
such good is price elastic, it would increase our export earnings more than
proportionately. Since net exports are also a component of AD, such
increase will provide a stronger growth.

However, with the increase in competition for factors of production, it leads
to possible higher wage costs, which is passed to the consumers in forms of
higher prices, shown by upward increase of general price level from P1 to
P2 in the short run.

This new investment would catalyse new business opportunities and attract
future investment into the economy as shown by extract 4 and improve their
storage capabilities. This increase in investment leads to increase in
productivity and thus increase the productive capacity of the country, shown
by an increase in AS from AS1 to AS2. This raises the potential output of the
nation from Y2 to Y3 and cushion off the inflationary pressure earlier on by
bringing general price level down to P3. The increase in potential output also
creates more jobs in the future.

Yet, this is at the expense of possible structural unemployment as higher
skilled workers would be demanded to manage the LNG cargoes due to
possible replacement, especially in sectors that are still using conventional
fuels as firms shift their focus.








PJC 2013 H2 Paper 1 Suggested Answers 4


Thus, in the short run, while the building of the 3
rd
tank might lead to higher
growth and lower unemployment rates, it comes at the expense of raising
general price level, which would only be reduced in the future. Also, the
government might need to impose various measures to mitigate the possible
structural unemployment.















(d) Ofgem has reiterated its determination to "radically overhaul" the retail
energy market. Discuss the extent to which an overhaul of the retail energy
market increases consumer welfare.
[10]
Suggested Answer:

The extent to which an overhaul of the retail energy market increases
consumer depends on the effectiveness of the policies and unintended
consequences the policies may bring about.

State the policies to radically overhaul the market

1. From Ext 2 Para 1, Britain's six largest utilities face tough retail
power market reforms next year which could force them to auction off
more than one fifth of electricity they produce.
2. From Ext 2 Para 5, More clarity in billing
3. From Ext 2 Para 5, Sweep away the barriers to new companies
entering the energy market- Deregulation of the UK energy market

Explain how the overhaul of the energy market can increase consumer
welfare

With Ofgem forcing the 6 largest energy producers in UK to auction off more
than one fifth of the electricity they produce, it reduces their dominance on
the market and hence their ability to control prices will be limited. The extent
to which how much prices can be raised will also be less as energy
producers face a greater degree of competition posed by the smaller energy
retailers. With more retailers competing with the traditional larger utility
producers in the energy market head on, prices will fall, resulting in higher
consumer surpluses and choices will increase for consumers. Therefore, this
increases the level of consumer welfare in the market.

However, The extent to which consumer welfare can be increased is small

AD1
AS2
AD2
AS1
P1
P3
P2
GPL
Output
Y1
ut
Y2
ut
Y3
ut
PJC 2013 H2 Paper 1 Suggested Answers 5
because as large energy producers and retailers, the top 6 UK energy firms
are able to reap substantial amount of EOS compared to the smaller energy
retailers in the market, which allows them to enjoy lower average costs of
production and compete more aggressively with the smaller energy retailers
in terms of price. Smaller retailers that could not withstand this competition
will shut down, and the top 6 UK energy firms will regain their market share,
providing them with greater ability to restrict output and control prices once
again.

Secondly, with Ofgem dictating how billing should be done with complex and
complicated structures to be removed, comparison between different
contracts offered by the various energy retailers becomes easier. The
amount of imperfect information is reduced, leading to consumers being
more able to make well-informed decisions. This will maximise the level of
consumer welfare and consumers will be able to sign up for contracts which
better suit their needs and requirements, reducing the amount of welfare
loss.

Last but not least, Ofgem sought to reduce the barriers to entering the UK
energy market in order to make the market more competitive. As barriers to
entry are lowered, this attracts more firms into the market, reducing the
market share of the existing energy producers. The existing energy
producers are forced to be more productive efficient in order to compete and
maintain their foothold on the market. This drives energy prices down and
will allow for more consumer surplus, thereby increasing the level of
consumer welfare. It may also motivate energy producers to conduct more
R&D to develop more environmentally friendly and efficient sources of
energy as part of product differentiation, leading to better and more energy
choices for consumers, raising their level of consumer welfare.

However, the deregulation of the market may not necessarily result in a
higher level of consumer welfare as EOS reaped may now be less, affecting
the extent to which how much cost savings firms can pass on to consumers
in the form of lower prices. In addition, the loss of market share due to the
entrance of more firms may dampen profit margins, reducing the ability of
energy providers to engage in R&D and in the process leading to possible
lower consumer welfare in the long run.

Synthesis and Evaluation
It is important to note that the very nature of this industry requires a firmt o
be large in the first place to enjoy substantial EOS, in order to offset the high
fixed cost. Furthermore, in view of rising oil prices worldwide and concerns
with climate change, it may be even more appropriate for energy firms to
remain large. These advantages can then be channelled into R&D to
develop more efficient sources of energy to satisfy our needs in the longer
term. Also, one must also note that Ofgem might have intervened, but it may
not be able to correct this market failure fully due to several considerations
as mentioned above.

Reasoned Conclusion

Hence, to a large extent, the overhaul of the energy market may not result in
higher consumer welfare in the long run although it may still be necessary in
the short run to prevent consumers from being exploited with inadequate
information and higher prices set by the dominant energy producers.
PJC 2013 H2 Paper 1 Suggested Answers 6


Question 2: Rising Prices, falling prices
(a) Using the information in Table 1, compare the inflation rate in Brazil and
Singapore, between 2007 and 2011.

[2]

Suggested answer:
Inflation rates in both countries increase. Inflation rate on average is higher in Brazil
than in Singapore.

(b) Using AD/AS analysis, explain the possible causes of inflation in Brazil.
[4]

Suggested answer:

Brazil is experiencing both demand-pull inflation and cost-push inflation.

Demand-pull inflation occurs when aggregate demand grows excessively given the
constraints of supply. Demand-pull inflation in Brazil is mainly driven by rising domestic
consumption (C) and external demand for Brazilian exports. Demand for Brazillian
resources (e.g. by China) has led to a rise in exports. This raises export revenue (X).
The increase in C and X raises AD. As the Brazil economy is at or near full-
employment, an increase in AD causes firms compete for limited available resources,
driving up the prices of factor inputs. Thus, firms expect higher prices to produce each
level of output and there is a rise in the general price level.

Cost-push inflation is caused by an increase in production costs that are independent
of demand. In Brazil, the rising costs are most notably fuel and food costs. Since these
are necessary inputs in the production of many goods, a rise in fuel and food prices
would raise the cost of production for many firms. This leads to an upward shift of the
aggregate supply as firms try to maintain their profit margins and price level rises.


(c) (i) With reference to data, explain how high inflation is damaging the
competitiveness of domestic manufacturers in Brazil.

[2]

Suggested answer:
If inflation rates are high, i.e. price level is rising, banks have to pay higher nominal
interest rates in order for households to have incentive to save. This attracts net short-
term capital inflows resulting in a rise in exchange rate. [1m]

As the Brazilian real appreciates,
Price of imports become fall in domestic currency, causing consumers to switch
from domestically produced goods to their relatively cheaper domestic substitutes.
OR
Price of exports rise in foreign currency and foreign consumers switch away from
relatively the relatively more expensive goods from Brazil to substitutes produced in
other countries.
Thus goods manufactured in Brazil become less competitive in both foreign and
domestic markets. [1m]

Note:
- Data (Ext 4 Para 2) refers explicitly to impact of rising ER.
- Theoretical answer [max 1m]
PJC 2013 H2 Paper 1 Suggested Answers 7
High inflation rates in Brazil will likely be higher than those of her trading partners,
prices of goods manufactures in Brazil will rise faster than substitutes from other
countries, rendering them relatively more expensive and thus less competitive in both
domestic and foreign markets.


(c) (ii) With reference to Table 2, comment on Brazils economic performance
in 2011.

[4]

Suggested answer:

2007 2008 2009 2010 2011
GDP at 2005 constant prices (US$b) 973 1,023 1,019 1,097 1,127
- Real GDP growth (%) 5.14 -0.04 7.65 2.73
Unemployment (%) 8.1 7.1 8.3 8.2 8.2
Inflation (annual %) 3.6 5.7 4.9 5 6.6
Current account balance (% of GDP)
0.1 -1.7 -1.5 -2.2 -2.1
Government debt (% of GDP) 57.4 56.6 60 52.2 52.8

Real GDP continues to rise in 2011 so the economy expanded in 2011. The
rise in real output would mean that more goods and services were available
for consumption leading to a rise in standards of living.

However, GDP growth rate fell from 7.65% in 2010 to just 2.73%. The
drastic decline in economic growth, coupled with a significant increase in
inflation could indicate that the economy is overheating.

Although unemployment remained steady at a high rate of 8.2%. The
persistently high rate of unemployment also signifies that resources are not
fully utilised and the Brazilian economy is productive inefficient.

Brazils small current account deficit did show a very slight improvement in
2011. However, additional data has be given (e.g. capital account balance)
before the performance of Brazils BOP can be assessed

Overall, the drastic decline in economic growth coupled with rising inflation
and a high rate of unemployment indicate that the Brazilian economy did not
perform very well in 2011.


d Discuss the view that a stronger currency is bad news for Japan but good
news for Singapore.
[8]

Suggested answer:
A stronger currency or a currency appreciation would imply that the domestic currency
is worth more in terms of foreign currency. Whether a stronger currency would be good
or bad news for either economy would depend on the each economys current state of
resource utilization and the nature of the economy.

A stronger currency would reduce aggregate demand and lead to a worsening of the
economys balance of trade.
A stronger yen would make Japanese goods relatively more expensive in foreign
markets. Assuming that the demand for Japans imports and exports is price
elastic, quantity demanded for exports falls more than proportionately resulting in a
fall in export revenue (X). On the other hand, imports become relatively cheaper in
PJC 2013 H2 Paper 1 Suggested Answers 8
Japan resulting in a more than proportionate increase in their quantity demanded
and a rise in import expenditure (M). This causes a fall in net exports (X-M) and a
worsening of the economys balance of trade. AD also falls resulting in a fall in
price level and a multiple decrease in NY via the reverse multiplier.

Due to differences in the state of their economies, the stronger currency is bad news
for Japan but good news for Singapore.
Japan is currently in a recession and experiencing deflation due in part to weak
external demand (Extract 4 para 3).
- A stronger yen would decrease the competitiveness of domestically produced
goods, causing a further decline in net exports, AD and NY. This would deepen
Japans recession, raise her level of unemployment and worsen her trade deficit.
On the other hand, the Singapore economy currently suffers from inflation.
- Given that she is likely to be operating near or at full employment levels, a fall in
aggregate demand would lead to a fall in general price level, relieving inflationary
pressures with less or no impact on national income.
- However, given that Singapore suffers from cost-push inflation, the fall in AD
stabilises prices at the expense of economic growth and fails to address the root
causes of inflation.

The stronger currency is will also reduce imported inflation e.g. due to rising oil prices
(Extract 5 para 4) depending on the nature of the economy.
Although the strengthening Yen would help Japanese firms cope with the rising oil
prices, Japan is less dependent on imported inputs and thus there could be
relatively little impact on the cost of production for firms.
Since she is small open, economy dependent on imports, a stronger dollar would
effectively reduce imported inflation in Singapore. As the Singapore dollar
appreciates, the cost of imported finished goods and inputs fall in domestic
currency, this would reduce the cost of production for many firms resulting in a
rightward shift of the AS curve. Assuming that cost savings are passed to
consumers, price of domestically produced goods fall as well. Cost-push inflation is
thus reduced.
- The fall in the price of goods in Singapore dollars will also help to partially offset
the decrease in export competitiveness wrought by the appreciation of the
Singapore dollar. Thus, the negative impact on the Balance of Trade and
aggregate demand is reduced is lessened for Singapore.
- However, Singapore is also currently facing domestic supply-side pressures. E.g.
Government restrictions on foreign labour are leading to a shortage of labour and
increasing labour costs. A strengthening of the Singapore dollar alone may not be
sufficient to curb cost-push inflation but may instead be bad news for this export-
led economy as the fall in export competitiveness could have a larger negative
effect on growth and employment.

Thus, given the current state of Japans economy, a stronger Yen is definitely bad
news as it will worsen her current economic woes of recession, unemployment and
deflation and have a negative impact on its BOP. On the other hand, it is more likely to
be good news for Singapore given her current state of economy dependence on
imports, a stronger currency will help curb imported inflation from rising fuel prices with
relatively less impact on her export competitiveness.



e As a consultant economist, what options would you present to the Japanese
government as a possible response to the economic problems that the data
suggest? Justify your answer.
[10]
PJC 2013 H2 Paper 1 Suggested Answers 9

Suggested answer:
Question analysis
Command words:
Justify: State, explain and evaluate
The data suggest: Use data

Key words:
Policy options: at least 2 or more policy options
Economic problems: at least 2 problems serious fiscal position, ageing population,
low birth rates and low inward migration suggests that Japan is facing a shrinking
labour force and increased strain on the fiscal position. Other possible problems
include stagnate economic growth and deflation. Japans economy is still not
recovering from a long period of depression, thus policy options must take these
factors into account.


The economic problems that Japan may face include (i) the
serious fiscal position and (ii) falling productive capacity.

Go straight to the
question identify
economic problems.

As stated in the extract, the serious fiscal position is due to
many years of higher government spending and lower
government revenue which leads to rising public debt. This
is caused by the many years of depression and the ageing
population. A serious fiscal position is undesirable as it will
put a heavy burden on the future generation to pay back the
debt and reduces their welfare. Furthermore, the serious
fiscal position may affect investors confidence and reduce
investment and economic growth in the future. Thus, the
Japanese government should deal with it as soon as
possible.

To reduce this serious fiscal position, the Japanese
government can either reduce government spending or
raise tax revenue. It is difficult to lower government
spending such as its spending on pension due to the social
and political costs of doing so. In addition, natural and
nuclear disasters required increased government
expenditure. Furthermore, government spending on
infrastructure may be long-term and necessary to promote
higher investment. It is also undesirable to reduce
government spending as Japan has not recovered from its
depression and economic growth may still be weak. Thus,
instead of lowering government spending, it may be better
to raise tax revenue instead.

Tax revenue can be raised either by increasing the tax rate
or increasing the tax base (i.e. the object to which the tax
rate is applied which involves mainly income tax on
households and firms, tax on expenditure and tax on capital
gains). It may be usually undesirable to increase tax rate as
a higher tax rate is a disincentive to work and invest, thus
lowering Japans aggregate supply and potential economic
growth. With a shrinking labour force and greater
competition for investment by developing countries, it may
be even less desirable to increase tax rate. Hence, it may
Identify economic
problem 1


Explain why the
government should deal
with it.





Explain policy option
Lower G and raise T

Elaborate on how to
lower G and difficulty of
lowering G








Explain how to raise T
either by increasing tax
rate or tax base.

Evaluate problem of
increasing tax rate




PJC 2013 H2 Paper 1 Suggested Answers 10
be better to raise the tax base by switching away from direct
taxes to a greater reliance on indirect taxes (such as Goods
and Services Taxes (GST) in Singapore).

Indirect tax is a more stable source of tax revenue as it is
not affected by on the shrinking size of working population
in Japan. Even retired workers will need to spend and
contribute to indirect taxes of GST. Furthermore, a fall in
direct tax rate will help to attract more investment to Japan
and thus help to lower its unemployment rate. The higher
foreign investment and more workers being employed will
be able to contribute to higher tax revenue despite a lower
direct tax rate.

However, it should be noted that raising indirect tax may
worsen income distribution as indirect tax is a regressive tax
system and penalized more heavily on the lower-income
households who has to consume a larger proportion of their
income. Thus, it is necessary for the Japanese government
to minimize such undesirable effect on the income
distribution by offsetting the indirect tax burden of the lower-
income households through transfer payments.





Explain why increasing
tax base through
switching to indirect tax
system is better.






Problem of indirect tax
system and how to
avoid the problem
synthesis

The next economic problem is the shrinking labour force
caused by ageing population, low birth rates and little
inward migration which reduces Japans full employment
capacity thus reducing aggregate supply and hence her
potential economic growth.

Increasing birth rates is a challenge in developed nations
due to social and cultural norms. It is difficult to increase
birth rate in a developed country as women become more
educated and participate in the workforce. Attracting more
foreign labour is difficult due to the national language
making it difficult for foreigners to adjust and may also bring
about social problems and increase the competition for jobs
as unemployment in Japan while falling is still high.

Given these reasons, the best option is supply side policy.
The government can raise the retirement age and offer tax
incentives for firms that have in house training centres and
firms that continue to hire their experienced elderly workers.
They can offer subsidies to firms that engage in R&D, and
offer education programmes for workers to improve their
skills. These policies increase the productivity of labour and
improve the productive capacity of the economy. This may
also allow Japan to move up the value-added chain and
reduce its dependence on labour. Currently, Japan may be
losing jobs in the labour-intensive manufacturing industries
as they are shifted to lower labour cost countries while new
jobs are created in the higher value-added manufacturing
industries and tertiary (or service) sector. Hence, the skilled
workforce will enable Japan to reduce possible structural
unemployment caused by the lack of relevant skills and
enable Japan to attract higher value-added investment.
The next economic
problem and its impact
on economic growth.



Explain the option of
increasing quantity of
labour force and its
limitations.





Explan the better option
of increasing the quality
of labour force and its
benefits.













PJC 2013 H2 Paper 1 Suggested Answers 11
While this may involve more spending and tax cuts, which is
a concern given Japans current public debt, it is a timely
option since it can boost Japans economic recovery and at
the same time help it achieve its long term aims.
Furthermore, ensuring long run economic growth will lead to
an increase in tax revenue in the future, and raising the
retirement age and creating meaningful jobs for the elderly
can slow down the drain on government funds via pensions.

Evaluation, consider
limitations and justify
why it is still essential
(good in the long run)

Conclusion
The combination of policies suggested would help Japan to
achieve its long run goals in light of the current problems.
The government needs to do cost benefit analysis and may
need to bear with its public debt for now, increasing indirect
taxes to fund essential government spending on supply side
policies that can help bring a full recovery to Japans
economy, which would help the government reduce its
public debt in the long run as tax revenues increase with
GDP.
Summarise and
synthesize main ideas