2018 Y6 H2 Prelims Examiners Report PDF

Raffles Institution
Nurturing the Thinker, Leader & Pioneer
ECONOMICS
Higher 2
Syllabus 9757
Examiner’s Report
Year 6 Preliminary Examination 2018
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@RI 2018 9757/Preliminary Examination/Y6/18 [Turn Over

ECONOMICS
Y6 H2 Preliminary Examination 2018
Paper 9757
Paper 1
Question 1
(a) With reference to Table 1,
(i) Using the data from 2008 and 2009, calculate the PED value of vanilla. [2]
• Definition of PED: measure of responsiveness of change in Qty demanded of a good to a

change in its price, ceteris paribus.
• Formula for PED = % change in Qty dd / % change in price
• % Change in Qty dd = (1150000 – 1300000)/1300000 = -11.54%
• % Change in Price = (23 – 21.5)/21.5 = 6.98%
• PED =-11.54/6.98 = -1.65 (3 sf)
OR
• PED = [1300,000 – 1150,000/1150,000] / [21.5-23/23] = - 1.99 (3 sf) or - 2
OR
• PED = {[1150,000 – 1300,000] / [(1300,000 + 1150,000)/ 2] } / { [23-21.5]/ [(23+21.5) /
2] } = -1.82 (3 sf) (based on the formula for calculation of arc elasticity)
Examiner’s comments:
- Perhaps the most disappointing point to note is the fact that a shocking number of candidates had not
brought their calculators to the examination hall when they sat for the case study paper. Candidates
ought to be reminded that such complacency is dangerous and the failure to bring a calculator would
cause unnecessary stress in an already stressful examination setting.
- Common errors for this question include the failure to use the correct formula for calculation. Many
candidates used absolute changes in quantity demanded and price instead of percentage figures for
both in the calculation of PED.
- Other errors include careless mistakes made in substituting the values given in the table into the
formula. Many candidates were unable to score the full mark for this part due to the inability to recall
and hence state the formula for PED.
- A large number of candidates also failed to show their steps in deriving the PED figure and their failure
to do so had caused them to lose marks in this question the moment they made careless mistakes in
the calculation process.
- Errors were also made in the expression of PED values in their answers, candidates are to note that
PED values are expressed without units and that expressing PED values as % is erroneous.
- Finally, candidates are to note that strictly speaking, the intention of this question is to assess the
candidate’s ability to calculate the PED value, hence, definition of PED should not be credited as
opposed to the formula for calculating PED.
(ii) To what extent can your answer in (ai) allow predictions to be made to total export revenue
as prices decreased between 2009 and 2010? [4]
Thesis: PED value calculated in (ai) can allow predictions to be made about change in TR with
a fall in price of vanilla.
• According to answer in (ai), eg. │PED│vanilla= 1.65 > 1, this means that demand for vanilla is
price elastic. Hence, a decrease in price leads to a more than proportionate increase in quantity
demanded, ceteris paribus.

• Total revenue = Equilibrium P x Equilibrium Q. With respect to Table 1, given the fall in price
of vanilla between 2009 and 2010, this means that total export revenue is expected to increase.
This is so because demand for vanilla is calculated to be price elastic in (ai), hence a fall in
price will lead to a more than proportionate increase in quantity demanded, ceteris
paribus. This results in an overall increase in TR since the rise in TR due to the increase in
Quantity demanded will exceed the fall in TR due to the fall in price.
Anti- thesis: PED value calculated in (ai) cannot help to predict the change in TR with a fall in
price of vanilla.
• However, there are limitations in using PED value calculated in (ai) to predict change in TR
from a fall in price because the ceteris paribus assumption might not hold. PED is only
relevant in the prediction of changes in TR if the fall in price of vanilla is a result of increase in
SS of vanilla (ie. Holding all other factors constant OR ceteris paribus)
• However, it is important to note that a fall in price of vanilla can also be a result of a fall in DD
for vanilla, ie. Changes in non-price demand factors for vanilla. For eg. a fall in income – which
violates the assumption of ceteris paribus – could also result in a fall in both price and quantity
demanded of vanilla, and if this was what had actually happened, then PED cannot be used to
predict change in TR since the ceteris paribus assumption is violated and also TR for vanilla
producers should fall instead of rise as PED would have predicted.
OR
• PED calculated in (ai) may be susceptible to changes in value over time due to factors that
affect PED values such as changes in the availability of substitutes, time period in consideration,
proportion of income spent and habitual consumption etc. This makes the PED value calculated
in (ai) less relevant/accurate in the prediction of TR when price of vanilla falls.
For eg, Extract 3 mentions the development of synthetic vanilla – a substitute to natural vanilla.
With the development of substitutes to natural vanilla, it is expected that the PED value will
increase ie. Demand for natural vanilla should become more price elastic. This being the case,
the eventual effect on TR is more pronounced than what would have been calculated using
PED derived in (ai) since the PED value has changed.
OR
• PED value in (ai) was calculated using only 2 years of data, this makes the value of PED less
reliable in predicting changes in TR since 2 years of data is insufficient in deriving a value of
PED that is representative of the nature of vanilla. Hence, the use of PED value in (ai) cannot
help predict changes in TR well accurately.
- Note that errors carried forward had been credited accordingly as long as the candidates were able to
apply the right economic analysis from using the erroneous PED value calculated in (ai) to predict the
effect on changes in quantity demanded and hence TR from the sale of vanilla.
- That said, many candidates were unable to score full credit for the “Thesis” part of this question as
there were gaps in their analysis of the TR concept – many were unable to express TR as Pe x Qe.
- Common errors among candidates include the inability to understand the requirements of the question.
The command word "to what extent" suggests the need to present both cases of how PED can be used
to predict changes in TR from sale of vanilla as well as the limitations of PED data in helping to predict
changes in TR. This resulted in many one-sided responses.
- One common error amongst candidates who had presented a balanced answer was the failure to
recognise that changes in non-price supply factors e.g. cyclones destroying vanilla crops etc. make
the use of PED relevant in predicting changes in quantity demanded with a fall in price of vanilla,
hence allowing predictions to be made on TR. Hence, changes in non-price supply factors should
not be used in the anti-thesis as an argument against the relevance/usefulness of PED in predicting
changes in TR.
- Gross conceptual errors were made by candidates who did not understand the concept of PED and
had incorrectly suggested that PED > 0 meant that demand for vanilla is price elastic.
- A small handful of candidates incorrectly analysed that TR increased more than proportionately when
price falls and PED>1. Correct analysis can only go as far as stating that TR increases. To claim that

TR increases more than proportionately is an indication of poor mastery of mathematics or elasticity/TR
concepts.
(b) Using a diagram, identify and explain two factors that will affect the size of the government’s
expenditure in its price fixing programme, in which surplus stocks were purchased. [6]
Candidates may write any two of the 3 factors given below.
1. A higher minimum price fixed by the government

• The higher the price floor guaranteed by the government through its buyback
programme, the more vanilla producers will be incentivised to raise Qs (Law of Supply)
• However, with a higher min price that is fixed, Qty demanded will fall as consumers
consume less vanilla (Law of Demand)
• This leads to a larger surplus that has to be purchased by the government, increasing
G expenditure. Government expenditure also increases as the price paid per unit of
surplus is also higher.
2. Demand or supply changes

• Holding Pmin constant, an increase in supply, possibly caused by positive supply
shocks such as an unanticipated good harvest, would cause an even larger surplus as
the ability and willingness of farmers to produce vanilla at every price level increases.
In order to maintain the price floor, the government would have to spend more to buy
back the larger surplus, increasing G expenditure.
• Alternatively, a rise in DD, possibly caused by a change in taste and preference among
vanilla users such as General Mills, Hershey's, Nestle etc, will result in a smaller
surplus as consumer’s ability and willingness to purchase vanilla falls at every price
level. This means that the government has to spend less on buying back the surplus
stocks of vanilla at Pmin, reducing G expenditure.
3. PED or PES values

• Holding Pmin constant, the PED and/or PES values for vanilla can affect the size of
the surplus at Pmin, hence affecting the size of G expenditure on the buyback
programme.
• For e.g. A relatively price inelastic supply due to the long production period in planting
and harvesting vanilla decreases the amount of G expenditure on buying the surplus
stocks. This is because, with an increase in price brought about by the price floor, there

is a less than proportionate decrease in Qs, creating a smaller amount of surplus that
has to be bought back by the government, increasing G expenditure.
• However, since vanilla is an agriculture commodity whose demand is relatively price
inelastic due to the lack of many close substitutes and supply is also price inelastic due
to the long gestation period, an increase in price brought about by the price floor tends
to create a smaller surplus at Pmin, hence reducing the size of G expenditure needed
to buy back the surplus stocks.
- Most candidates had sound knowledge of price floor policy and drew the appropriate diagram.
However, it is disappointing to see that diagrams were poorly drawn in some scripts. Candidates ought
to know that credit will be given to the diagram drawn especially when the question had instructed
candidates to “use a diagram” in their answers. Loss of marks due to sloppy diagrams does no justice
to one’s efforts and understanding. Sloppy diagrams that were seen in many scripts include:
• the inability to draw straight lines and the failure to use a ruler.
• Drawing a Pmin line that is not straight
• Not labelling the demand or supply curves
• Not labelling the axes
- Conceptual errors in the use of the diagram were also evident in some scripts and these include:
• Identifying the surplus amount as a triangle (✗). Candidates are to note that the surplus is
actually the distance between two x-co-ordinates (✓)
• Erroneously suggesting that the price fixing policy is a price ceiling (✗) instead of a price floor
(✓).
- That said, majority of the candidates were able to present logical and relevant response to this question
as long as they were able to identify that the price fixing programme with the government's purchase of
surplus stocks is that of a price floor or minimum price policy. Many were able to draw the correct
diagram and identify the area depicting the government's expenditure on the purchase of surplus stocks.
Once the diagram is drawn, most candidates were able to make use of it to explain 2 factors that can
change the size of G spending on the surplus stocks.
- A handful of candidates did not have a clear idea of what the price fixing policy was and had
erroneously drawn a market equilibrium diagram with shifts of SS and DD curves. These candidates
then went on to erroneously identify the size of G expenditure as the total revenue made by producers
of vanilla/total expenditure spent on vanilla (ie. Pe x Qe).
- Weaker scripts also reflected candidates’ inability to relate the size of G expenditure as Pmin x surplus
amount.
- Other common errors include the failure to realise that the size of government expenditure spent on
buying up the surplus stocks seen in the price fixing programme is independent of its opportunity cost
incurred in purchasing the surplus stocks or whether it manages to sell the surplus stocks overseas
(exporting overseas) to recoup some of its expenditure or even the government's budgetary position.
Candidates ought to remember that the question had instructed them to make use of the diagram to
explain 2 factors that could influence the size of government spending on the surplus stocks, and that
these answers could not be referenced back to the diagram.
- Candidates were also given a lower score (due to the lack of scope and clarity in their answers) if their
answers explained that the relative size of PED relative to PES affected G expenditure. Technically,
this is incorrect. The absolutely sizes of PED and PES affected G expenditure. There is no need to
look at the relative size of PED to PES. Use the term “relative” judiciously and with understanding. This
analysis is not similar to the one analysing the incidence of taxes/subsidies.
- Finally, candidates are reminded that in order to score the top range of the marks allocated to this
question, reference to relevant case evidence when discussing the factors.

(c) Extract 2 mentions that the Government of Madagascar created the "Vanilla Alliance" with
two neighbouring countries.
Discuss the view that such cartels are detrimental, given that prices are “significantly higher
than the welfare-maximizing level”. [8]
Introduction:
• Define cartel and explain how cartels work to determine equilibrium price and output.
o Cartel - a formal agreement among oligopoly forms to collude in order to reduce
uncertainty arising from mutual interdependency between sellers in the oligopoly. In
colluding, sellers agree to maximize joint or cartel’s profits.
• Cartels act like a monopoly, joint profits are maximised at the profit-maximising output level
where the cartel’s MC = MR. The cartel’s marginal cost curve is the horizontal sum of the
individual members’ marginal cost curves while the cartel’s MR curve is derived from the
industry demand.
Body:
Thesis - Agree that cartels like "Vanilla Alliance" are detrimental, since prices are significantly
higher than welfare-maximising level.
• Detrimental to society
o As a result of formation of vanilla cartel which reduces the availability of vanilla
substitutes in the market, demand for vanilla cartel’s vanilla becomes relatively less
price elastic compared to the demand for individual producer’s vanilla before the
formation of the cartel.
o Assuming the objective of profit maximization, the profit maximizing output level is
determined to be Qm where MR=MC, and firms in the vanilla cartel charge up to the
maximum price consumers are willing and able to pay at this output level, ie. price Pm
along the AR curve.
o Assuming that cost and revenue structures are similar in a PC industry, the welfare
maximising price would have been P* with output level at Qpc since this occurs where
AR (P) = MC; in which consumers’ valuation of the last unit of vanilla produced = the
opportunity cost to the producers of producing the last unit of vanilla.
o From the above diagram, it can be seen therefore that a cartel such as the "Vanilla
Alliance" is detrimental to the society and consumers since Pm is higher than P*, which
is the price at welfare maximizing level.
o As seen from the diagram, since Qm < Qpc, the cartel’s output is also lower than
socially optimal, leading to allocative inefficiency. This can be corroborated by the fact
that at Qm, Pm > MC ie. benefits received by the society for the consumption of vanilla >

opportunity costs to the vanilla producers in producing the last unit of vanilla. Hence,
the cartel is under-producing vanilla and society will benefit if more vanilla had been
produced. As a result, the society suffers a welfare loss/DWL from the under-production.
• Detrimental to consumers
o At the welfare maximizing price of P*, consumers would have been able to obtain
vanilla at a lower price and they would also be able to consume a larger quantity.
Consumer are worse-off as consumer surplus is lower in the vanilla cartel compared to
the welfare maximizing level.
Anti-thesis - Disagree that cartels such as "Vanilla Alliance" are detrimental ie. Vanilla cartel can
be beneficial to society
• Beneficial to Producers/Farmers:
- Given that incomes for vanilla farmers are generally unstable due to dramatic fluctuations
in prices of vanilla as a result of the price inelastic nature of vanilla as well as the fact that
vanilla production is often vulnerable to changing weather conditions (Extract 1), the
formation of a vanilla cartel, with the objective of keeping equilibrium prices high and stable
equilibrium, provides farmers with a higher TR, ceteris paribus profits, hence benefitting
producers/farmers by improving their SOL. By contrast, if the cartel had not been formed,
farmers will be subject to volatile vanilla prices that will negatively affect their TR/incomes
and hence SOL. Given that there are 80,000 vanilla farmers in Madagascar (Extract 3), the
cartelisation would positively affect the Madagascan economy.
• Benefits to the Society (in terms of Dynamic efficiency)/Producers/Consumers:

- With the vanilla cartel in place, equilibrium prices will be higher than before cartelisation in
order for the cartel to maximise joint profits. That said, the supernormal profits reaped from
the vanilla cartel can potentially be channelled into research and development to find better
ways to producing the crop in the future so as to raise productivity levels in vanilla farming,
given that Extract 1 states that "the lack of investments in new farming practices ...
compromised productivity levels in farming". Besides, these supernormal profits could also
be channelled into R&D to develop vanilla pods that may be more weather resistant, hence
giving producers a greater assurance of the output levels regardless of changing climatic
conditions. All these efforts to R&D will then help to improve dynamic efficiency.
- R&D of more weather resistant vanilla can benefit producers in helping to raise their
revenue and profits.
- If R&D efforts results in more productive methods of growing and harvesting vanilla, this
can help lower the COP of vanilla. Some of this cost-savings could be passed on to
consumers, resulting in lower vanilla prices over time, benefitting consumers.
• Macro-Economic benefits:
- Despite the high price brought about by the vanilla cartel, it was created with the intention
of "bringing more stability and equity in the distribution of gains from vanilla farming". Given
that Extract 3 said that the "25 million people in Madagascar share a GDP per capita of
barely US$400", the Vanilla Alliance helped to raise the GDP in Madagascar through
"swelling exports". With increase in X, AD will rise in Madagascar and through the multiplier
effect increases RNY more than proportionately. This means that (assuming population
grows slower than the increase in real GDP) material SOL for its citizens can be raised.
This is especially so since Extract 1 states that "vanilla accounts for 20% of Madagascan
exports... is a significant contributor to Madagascar's GDP". Hence, the formation of the
"Vanilla Alliance" need not necessarily be detrimental to the Madagascan economy.
Conclusion:
• In the case of Madagascar, the formation of the cartel in the form of the "Vanilla Alliance" might
have been a necessary way to boost SOL especially for the farmers/producers facing volatile
and low incomes in the short run.
• However, it is not a good long run solution as consumers in other countries, facing excessively
high prices might choose to switch away from natural vanilla, which impacts the viability of the
cartel.

Knowledge, Application, Understanding, Analysis
L1  Smattering of points not directly linked to question 1–3
 Weak theoretical framework and/or glaring conceptual errors
 No reference to concept of AE/DWL (=no thesis)
 Limited development of analysis
o Eg. Only stating that cartel results in P > MC without explaining
the implications of P>MC.
 One-sided analysis, only supporting the view that cartels are
detrimental.
L2  Rigorous economic analysis wrt the monopoly diagram drawn 4–6
o Accurate and well-labelled diagram
o Clear explanation of how the collusive oligopoly in the form of a
cartel can result in under-production and over-charging where P
> MC and allocative inefficiency occurs and consumer welfare is
compromised.
o Well-balanced answer that includes the advantages to the
Madagascan society of the formation of a cartel.
 Good use of case evidence to develop and to support analysis.
Evaluation
E1  An unexplained conclusion /judgment or mere repetition of points 1
discussed.
E2  A judgment/conclusion supported by reasons / economic analysis 2
 Judgment included SR vs LR considerations of the cartel's effects
on Madagascar.
 Good application to the context of the Madagascan economy.
 E.g. of Evaluation:
- With the entry of Indonesia that is attracted by the
supernormal profits made in the vanilla cartel, demand for
vanilla from Madagascar may fall and become more price
elastic over time, hence supernormal profits made in the
SR made be eroded hence negatively affecting the vanilla
producers in Madagascar.
- Majority of the candidates did not score very well for this question as they had failed to address the
question’s proposition - that prices were “significantly higher than the welfare maximising level”.
Addressing this aspect - being the thesis of the question - is necessary as it demonstrates the
candidates’ ability to analyse the detrimental consequences of cartels to the society in terms of its effect
on prices and output and hence allocative inefficiency, resulting in welfare losses on the society. Instead,
many candidates chose to elaborate at length on a range of other negative consequences of
cartelisation, such as the cartel’s effect on productive inefficiency, the entry of Indonesia into vanilla
trade or inequity caused by the formation of the vanilla cartel. These points, while valid, should not take
priority over the question’s proposition, that of allocative inefficiency. Candidates who had omitted an
economic analysis on how cartelisation leads to “prices that were significantly higher than welfare
maximising level” hence leading to allocative inefficiency were heavily penalised as their answers
lacked balance in analysis.
- The key analysis of allocative inefficiency/DWL is the under-production of vanilla such that the MB of
an additional unit of vanilla is greater than its MC. This implies that society is worse-off as it did not
produce these additional units of vanilla which would have contributed to increasing its social welfare.
Allocative inefficiency is not simply loss of CS due to higher prices and smaller quantities consumed
- While some candidates had addressed the "thesis" part of the question, their analysis of the how
cartelisation leads to allocatively inefficient outcomes with "prices being significantly higher than welfare
maximising" lacked depth and rigour.
- Some conceptual errors evident in the scripts include:
• the assertion that cartelisation results in the ability among vanilla producers to reap IEOS, which
are cost savings from large scale production, hence enabling vanilla producers to pass on the
cost savings to consumers in terms of lowered prices, benefitting consumers. (✗) Candidates
ought to note that cartelisation is NOT similar to mergers & acquisitions (M&A) and that vanilla

firms had not grown in size nor scale of production! Hence, cartelisation does not change the
scale of production for vanilla producers, making this assertion invalid.
• Cartels work by limiting members output to raise prices. If anything, it is more likely that cartel
producers reap less iEOS as a result of the need to reduce output to keep to quotas mandated
by cartel.
• A handful of candidates also asserted that cartelisation resulted in illegal trading and the
formation of black markets. This point can be valid if candidates went on to justify how such a
development is beneficial or detrimental to consumers/producers/society.
• Some candidates raised the point that cartels were productive inefficient from society’s
perspective as it was not producing at Qmes. Firstly, this is not technically true as a cartel
could be producing at Qmes by coincidence. Secondly, the fact that it may not be producing at
Qmes is not a key point as it was equally likely that these countries were not doing so before
the cartel was formed. In short, the formation of cartel had little to do with this issue of whether
firms were producing at Qmes.
• Many candidates made a simplistic assertion that cartel producers were X-inefficient/not
productive efficient from firm’s perspective/producing above LRAC. Firstly, all profit-maximising
firms, whether in cartels or not, are X-efficient/productive efficient from firm’s
perspective/producing on LRAC. To claim that cartel firms are X-inefficient, candidates must
provide justifications why these firms may not be profit-maximising. For example, they might
be complacent from the lack of competition and the cushion provided by supernormal profits.
(d) Assess whether a country like Madagascar should continue to focus on exporting vanilla
just because it has a comparative advantage in producing vanilla. [10]
Introduction:
• Define theory of comparative advantage - The theory of CA states that international trade and
exchange would be mutually beneficial to countries if they specialise in the production of
goods/services that they incur a lower opportunity cost in producing (ie. greater relative
efficiency in production) and exchange it with other countries, for goods/services that they incur
a higher opportunity cost in production (lower relative efficiency in production).
Body:
Thesis - Madagascar should continue to focus on exporting vanilla because it has a CA in vanilla
production
• Madagascar has a natural comparative advantage in the production of vanilla because it is a

crop that is "highly labour-intensive" in nature since it requires the “laborious process of hand
pollination” (Extract 3)
o Possessing a large pool of unskilled labour, labour costs tends to be relatively low in
Madagascar. This, coupled with its suitable climate means that the opportunity cost of
producing vanilla is low in Madagascar, as can be corroborated by Extract 3 "one of
the only places on earth poor enough to make the laborious process of hand pollination
worthwhile". Hence, Madagascar has a CA in the production of vanilla and should
specialise in producing it for export.
• By focusing on its comparative advantage in producing vanilla, world output increases due to
efficient allocation of world’s resources to produce goods that these resources are most suited.
By then trading vanilla for other goods which it does not have a comparative advantage in
producing, Madagascar would be able to consume outside of its PPC. Having access to more
goods and services would then improve its material SOL.
• Specialising in production of vanilla and then exporting vanilla also helps to increase
Madagascar’s export revenue. According to Extract 1 "vanilla accounts for 20% of Madagascan
exports and is a significant contributor to its GDP".
o Given that "Madagascar is the main exporter of vanilla in the world" and that X-M is a
component of AD, AD would rise in Madagascar. As AD rises, firms raise production to
meet the increase in demand, hiring more FOPs including labour since it is a derived
demand, hence raising employment levels in the Madagascan economy and reducing
cyclical unemployment.
o This effect is likely to be significant since "the vanilla industry and agriculture sector ...
employs 82% of its labour force" (Extract 1).

o As employment levels rise, factor incomes rise, bringing about increases in induced C
which generates further rounds of increases in incomes and induced spending since
one man's spending is another man's income. This continues until the multiplier
process stops where all the initial increase in AD (X) is withdrawn in the form of savings,
taxes and import spending, such that eventually, RNY increases more than
proportionately via the multiplier, creating actual growth for the Madagascan economy
as national income increases from Y1 to Y2.
o This effect is likely to be significant since Extract 1 states that the vanilla and agriculture
sector accounts for 30% of the country's GDP.
• Assuming that GDP growth outstrips population growth, real per capita GDP will rise in
Madagascar, hence raising material SOL of its citizens, where "seventy-five per cent of the
population live below the World Bank's poverty line of US$1.90 per day..." (Extract 3)
Anti-Thesis: Madagascar should not continue to focus on producing vanilla just because it has
CA in production
• Over-specialising in a commodity such as vanilla “correlates with poverty”

o Vanilla is a commodity with unfavorable terms of trade
o This is because there are many substitutes to vanilla produced in Madagascar, such
as Vanilla produced in Indonesia, as well as synthetic vanillin.
o This implies PED for Madagascan vanilla is greater than one
o Madagascar is unable to raise prices for its exports.
o With a low price for vanilla, and hence, a weak terms of trade, revenue of farmers is
likely to be low.
o Because revenue is equal to the product of price and quantity, ceteris paribus, a lower
price leads to lower revenue, which thereafter leads to lower profits.
o This means farmers receive a very low income, which means a lower material standard
of living.
o Hence, over-specialization is unadvisable, as it “correlates with poverty”
• Over-specialisation also leads to lower investments, which hurts potential growth in the long
run.
o This may be especially so since the vanilla industry is plagued with "lack of investments
in new farming practices” and most parts of the production process are still labor
intensive.
o Also, because of the size of the vanilla market, most workers employed by the vanilla
industry do not find the need to learn other skills, and hence, the country is also plagued
by low “human development” performance and “poor education”.
o A lack of investments in the production process harms the capital accumulation of a
country, and over time, as capital depreciates, the capital stock will shrink.
o In addition, without an emphasis on education, the human capital of the country will not
develop, as workers will not learn skills required to improve either on the vanilla
production process or contribute more productively in other sectors.

o Both the fall in capital stock and the stagnation of human capital, will harm
Madagascar’s potential growth as it limits the maximum amount of goods and services
that it can produce and its productive capacity.
• Over-specialising in the production of vanilla might cause the Madagascan economy to be

susceptible to fluctuations in its national income.
o The development of Vanillin as a synthetic substitute to vanilla as well as the entry of
Indonesia into the Vanilla trade, could potentially cause a fall in demand as consumers
switch to these substitutes.
o In addition, fluctuations in vanilla prices "from US$20 a kilo to a peak of US$600" can
cause huge fluctuations in export revenue.
o The lack of diversification of export industries in Madagascar can lead to significant
fluctuations in national income. Madagascar may suffer a fall in X and hence AD and
in turn a more than proportionate fall in RNY via the multiplier effect, if it over-
specialises in vanilla and had no other exporting industries that could potentially help
to offset the fall in vanilla exports on AD.
• Vanilla farming also generates costs “such as deforestation and soil erosion”. This leads to
market failure, and also slowly erodes the country’s comparative advantage.
o Excessive vanilla farming imposes external costs on third parties that are not borne by
vanilla farmers, nor consumers. For eg. soil erosion affects the viability of soil to grow
other crops and may lead to loss of livelihoods for other farmers. Deforestation and the
loss of natural habitats might cause the tourism sector to suffer a loss of potential
earnings.
 These external costs are not accounted for in the decision to specialise and
produce vanilla, hence under free market conditions, this might lead to an
overproduction of vanilla beyond socially optimal level. This misallocation of
resources in turn results in allocative inefficiency which then creates
deadweight losses on the society.
o In addition, soil erosion and deforestation reduce the fertility of the soil, and might mean
the gradual loss of Madagascar’s comparative advantage as it requires more resources
and time to produce vanilla.
 With an increasing amount of resources needed to produce vanilla, the
opportunity cost rises, and with the emergence of Indonesia, Madagascar may
lose her comparative advantage in the production of vanilla.
 The decline of this industry might lead to structural unemployment.
 When farmers and farm workers lose their jobs in vanilla farming industries.
The fact that they tend to be low-skilled in nature and do not possess relevant
skills to be employed in other industries make this a serious problem for
Madagascar in addition to the deterioration in the SOL of such labour.
Conclusion:
o Madagascar should continue to focus on exporting vanilla. It remains a very important
component of its exports and growth.
o However, it should use part of the export earnings to develop other sectors of the
economy eg. To source for a new area of CA. This would prevent huge fluctuations in
export earnings and also decrease the extent of other problems (e.g externalities)
occurring within the economy.
o Alternatively, the government could look into ways to attract FDI in order to gain from
transfer of tech/skills as well as new areas of CA for growth and meanwhile spend on
its education sector to build up skills required for new areas of CA.

o Gaps in the development of arguments for and against
specialisation on vanilla production for export in Madagascar.
Little attempts to link to macroeconomic or microeconomic
effects/goals.
 One-sided analysis, only supporting the view that Madagascar
should focus on its CA in production of vanilla for exports OR
should not specialise in exporting vanilla.
L2  Rigorous economic analysis wrt the diagram/s drawn 5–7
o Accurate and well-labelled diagram/s to supplement economic
analysis eg. AD/AS curve
o Clear explanation of how the theory of CA supports the view that
Madagascar should specialise and export vanilla due to its
factor endowments.
o Well-balanced answer that includes both arguments for and
against the specialisation of vanilla by Madagascar for exports
based on its CA as well as the limitations of specialisation.
 Good use of case evidence to develop and to support analysis.
 An answer that includes both microeconomic as well as
macroeconomic analysis.
Evaluation
E1  An unexplained conclusion /judgment or mere repetition of points 1
discussed.
E2  A judgment/conclusion supported by reasons / economic analysis 2-3
 Judgment made based on the context of the Madagascan
economy and its characteristics.
 Suggestions on policy implications on the part of the Madagascan
government so as to mitigate the problems caused by
specialisation and to enhance its growth and development as a
nation.
- Many candidates failed to use appropriate economics concepts and framework to anchor their answer.
In this context, SOL, AD/AS and 4 KEIs should be used to analyse whether Madagascar should
continue to focus on exporting vanilla.
- A significant number of candidates made the mistake of over-lifting the case material. Perhaps this
stemmed from the perception that by lifting and placing them in some order, the material would
somehow be self-explanatory. However, candidates ought to know that the case material is used to
support or corroborate their economic analysis and should not be lifted directly as their answers to the
questions. A good way to understand how case material should be used would be to scrutinize the
difference in the 2 answers presented below:
• “The over-focusing on vanilla created the “common curse of commodity dependency” and this
“heavy dependency on exporting a small number of commodities correlates with poverty, high
mortality rates, low “human development” performance, poor education, corruption and high
levels of income inequality”. This shows the costs of over specialization.” (✗)
• “The over-focusing on vanilla created the “common curse of commodity dependency”. This
meant that most of vanilla’s net export revenue, and hence aggregate demand, is based heavily
on vanilla. Hence, if there was a fall in demand for vanilla, perhaps due to the development of
its substitute, synthetic vanillin, this would mean a large fall in net export revenue, and thereafter,
a multiplied fall in national income. A fall in national income further erodes income of farmers
and citizens, which lowers purchasing power, and hence material standard of living. This is
especially impactful, given the low “human development” performance of the country. (✓)
- A recurrent mistake, similar to the one made in part (c), was the failure to address the
proposition/thesis of the question. In this question, the emphasis is on the use of the theory of

comparative advantage in explaining both the source of Madagascar’s comparative advantage,
as well as the benefits of specialization in accordance to the theory of comparative advantage.
• For the former, some candidates did not make any reference to opportunity cost as a basis
for comparative advantage, instead referring to less appropriate terms like “efficiency” or
“productivity”. Candidates had also failed to relate to Madagascar's factor endowments
given in the case material, when establishing the country's comparative advantage in the
production and export of vanilla.
• For the latter, many candidates failed to explicitly explain that the specialisation in vanilla
production would lead to Madagascar exporting and then trading vanilla for other goods
that it incurs a high opportunity cost in production in order for it to benefit from consuming
beyond its own PPC. Many merely stated that exporting vanilla would allow Madagascar to
consume beyond its PPC, totally disregarding the part about trading in order for
consumption possibilities to lie beyond its PPC. Other candidates failed to expound on the
benefits of specialization and trade in accordance to the theory of comparative advantage
ie. consuming beyond the PPC curve, as well as the enjoyment of a wider range of goods
and services. These points were often left out despite the implied emphasis in the question.
- A surprising number of candidates had also adopted an indirect approach to answering the “thesis”
part of the question. For example, instead of expounding on the economic advantages to Madagascar
of specializing and exporting Vanilla, hence justifying the focus on vanilla production, candidates went
on to discuss at length, the problems Madagascar might face if it were to shift its focus away from
specializing and exporting vanilla ie. Structural unemployment, loss of economic growth etc. Candidates
are to note that the latter is an indirect way to justify Madagascar’s continued focus on vanilla production
and export and is not preferred by examiners.
- The common error in the anti-thesis part of the answer, where candidates were supposed to expound
on the disadvantages of specializing and exporting vanilla, many candidates were unable to score the
full range of marks due to a lack of scope in their answers – many had only focused on problems
associated with over-specialisation of vanilla production and had ignored the case evidence which had
suggested the generation of negative externalities such as soil erosion and deforestation and its effects
on the Madagascan society.
Question 2
(a) Describe the trend in the balance of trade position of the UK with EU countries [2]
between 2007 and 2015 shown in Figure 1.
The UK’s BOT with EU countries is in a deficit between 2007 and 2015. [1]
The deficit is worsening/increasing during this period. [1]
OR
The deficit decreased from 2007 – 2011 before increasing from 2011 – 2015. [1]
Examiner’s Comments:
1. Many candidates have done well by identifying the BOT position, followed by accurate
refinements. Some provided several refinements. Note that only 1 refinement is
required.
2. A significant number of candidates did not identify the BOT position before describing
the trend. Candidates are reminded that for data response questions on BOT, current
account, capital and financial account, and BOP, the position (deficit or surplus) must
be identified as part of the answer.
3. Some candidates quoted the data from the wrong time frame and had wrong
expressions such as BOT balance has increased or fallen were penalised as a result.
4. Some candidates cited data but did so inaccurately. For example, units (% of GDP)
were omitted.

(b) With the help of a diagram, explain the impact on the total expenditure and welfare [4]
of EU consumers given a tariff on UK’s dairy products.
Market for dairy products in EU

Price
Ss
C
A Pw + tariff
D Pw
B
Dd
Qty of dairy
Q1 Q2 Q3 Q4 products
EU consumers will see an increase in price of dairy products from Pw to Pw+tariff, given a
tariff on UK’s dairy products. Assuming PED of dairy products to be less than one (price
inelastic) due to habitual consumption of dairy products in the EU, an increase in price
of dairy products will cause a less than proportionate decrease in quantity demanded
for dairy products from Q4 to Q3. Since total expenditure (TE) equals to price paid by
consumers multiplied by quantity consumed by consumers, TE of EU consumers on
dairy products will increases. Consumer welfare (surplus) will also falls by area
ABCD because the price EU consumers pay for dairy products has increased and the
quantity consumed of dairy products have decreased.
Mark Scheme:
Effects on TE: explained effect on TE with assumption of PED – 2m
Effects on consumer welfare: explain why consumer welfare falls– 2m
No/wrong diagram – max 2m
1. Most candidates were able to illustrate the tariff diagram but there are a number
of glaring conceptual errors regarding the diagram:
• Wrong market identified - the market should be the dairy products in EU
instead of the UK. Some candidates labelled the axis of the diagram
wrongly as “qty of dairy products in UK” instead of “qty of dairy products
in EU”. Candidates are reminded that the tariff is imposed by the EU hence
the economic effects should be analysed from the point of view of EU
market.
• Wrong price labelled - the price should be the world price and world price
+ tariff. Some candidates labelled the price on the vertical axis wrongly as
P(UK) and P(UK + TARIFF).
2. Quite a significant number of candidates did not realise that the impact on total
expenditure on all dairy products of EU consumers depends on the PED of all dairy
products and made an unjustified guess (either increase or decrease) of the
change in TE which did not gain any credit. Some errors regarding TE include:
• The question is asking for impact on total expenditure on all dairy
products, including domestically produced dairy products and imported
dairy products. Some candidates misread this to mean import expenditure.
There is a clear difference between total expenditure of consumers (i.e.
consumer’s total spending on quantity of dairy products consumed) versus
import expenditure into the EU on dairy products imported from the UK.
• Some candidates simply stated that total expenditure rose since world
price increased. Such answers disregarded that TE = P x Qty. It is not
enough to just look at unit price to determine TE.

3. Errors regarding consumer welfare include:
• Most candidates were able to identify a fall in consumer surplus (CS) but
there were a number who did not justify why there’s a fall in CS.
Candidates are reminded to explain the change in CS by linking to change
in price paid by consumers and quantity consumed by consumers in order
to get full credit.
• Some candidates also did not mention that a change in consumer welfare
is measured by looking at a change in CS.
(c) “Post-Brexit, the UK’s agriculture and foods sectors face enormous challenges.”
(Extract 4 Paragraph 4).
Comment on the likely “challenges” on profits faced by British agriculture and foods
[6]
producers post-Brexit.
Thesis: Profits of British agriculture and foods producers may fall post-Brexit
• Post-Brexit, UK will no longer be in the custom union with EU hence her agriculture
exports to the EU will face existing tariffs as shown in Table 2. British agriculture
and foods producers will also “lose access to EU farm subsidies, European export
markets and access to European workers” according to Extract 4.
• Demand/revenue factor: Given the tariff, consumers in the EU will consume less
of UK’s agriculture imports. Post-Brexit, British agriculture and foods producers will
also “lose access to European export markets” hence causing them to see a fall
in average revenue or fall in demand from AR0 (DD0) to AR1 (DD1).
• Cost factor: The loss of “access to EU farm subsidies and (cheaper) European
workers” will cause British producers to see an increase in variable cost (hence
MC) and AC of production from AC0 (MC0) to AC1 (MC1).
• Link to profits using firm-level analysis: Profits will fall from P0ABC0 to P1DEC1.
Antithesis: Profits of British agriculture and foods producers may not fall post-Brexit
• British agriculture producers export their goods to non-EU countries as well and
based on Figure 1, BOT with non-EU countries is improving over the years,
possibly indicating that export revenue to these countries are rising. “Opportunities
in other international export markets” (Extract 4) may potential offset the fall in
demand/AR from EU countries.

• UK is negotiating new FTAs with EU as well as countries around the world (Extract
4/5). This can lead to larger markets for British exports hence demand/AR for
British agriculture products may potentially increase post-Brexit instead.
• From Table 2, EU does not impose tariff on cotton imports so British cotton
producers will not see a fall in demand/AR for cotton hence the extent of impact
on its profits may not be significant.
L1 • Several glaring conceptual errors and/or lack of economic 1–3

framework
• No reference to case material
L2 • Good scope (revenue and cost) and depth of economic 4–6
analysis which shows application to relevant case materials
• Balanced answer with AT
1. Most candidates performed poorly for this question. However, there were a handful
of candidates who demonstrated strong grasp of firm-level analysis and were
awarded the full credit. Candidates are reminded that for questions on profits of
producers, the framework used should be the firm-level analysis instead of the
market demand and supply analysis. This is because the firm-level analysis can
illustrate changes in profit areas of the individual firm while the market demand
and supply analysis illustrate changes in industry’s total revenue and changes in
industry’s producer surplus (which is only a proxy for industry’s profits).
2. To score the full credit, there needs to be an antithesis because the command
word for this question is “Comment”. Quite a significant number of candidates
somehow did not include an antithesis in their answers.
3. For those who adopted firm-level analysis, while majority were able to link the loss
of farm subsidies and loss of access to EU labour to higher average costs, not all
were able to recognize that marginal costs would have risen too, due to the fact
that the above factors involved variable inputs. Candidates should preferably
explain why the above factors affect variable costs.
4. For those who adopted the market-level analysis, there were a few who incorrectly
related the total revenue areas to profits. Only a minority correctly referred to the
producer surplus area, a proxy to industry’s profit.
(d) Discuss the view that the UK economy has more to lose than gain from a more [8]
restricted immigration flow post-Brexit.
Introduction:
• Clarify ambiguity – Brexit ends the free movement of labour and entails imposition
of tariffs on goods& services in both directions.
• Clarify a more restricted immigration flow – fewer foreign workers will be allowed
to work in the UK
• Impact of a more restricted immigration flow will be measured in terms of
macroeconomic benefits and costs, and it depends largely on the nature of the UK
economy.
Thesis - The UK economy has more to lose from a more restricted immigration flow
as it fuels inflation, adversely affects economic growth and balance of payments, as
well as deteriorates standard of living.
• A more restricted inflow of labour from the EU into the UK (both skilled and
unskilled) as part of a hard Brexit to protect domestic workers (especially low-
skilled workers) from ongoing wage depression due to excessive supply of non-

UK labours will result in a tighter labour market. The policy will reduce the supply
of labour in the UK, assuming demand for labour remains unchanged in both
skilled and low-skilled industries, the shortage of EU labours will result in a
higher wage rate (Extract 3 “The UK food industry is facing a dearth of workers
amid the Brexit vote.”). Additionally, local workers may be unwilling to move to new
jobs left behind by migrant workers because of the lack of skills and increasing
uncertainty post-Brexit. As such, local workers will have to be offered higher wages
to fill up these vacancies, pushing up wages even further.
o Therefore, with a shortage of labour, particularly in the agriculture industry,
which “...relies heavily on manual labourers, especially from poor
European countries like Romania and Bulgaria…” firms will face a
significantly higher cost of production. As such there will be a decrease in
profitability at each and every price level causing AS to fall from AS0 to
AS1 as reflected by an upward shift of the AS curve. This will have an
adverse effect on actual economic growth as real nation income falls
from Y0 to Y1. The is further corroborated by evidences in Extract 3 which
mentioned “…a government committee said that the UK economy will very
likely grow more slowly if immigration from the EU is drastically
restricted….”
o The shortage at the original price level P0 will cause consumers to bid for
the limited supply of goods and services. The price adjustment process
continues until the GPL rises to P1. However, for wage-price spiral inflation
to occur, the rise in GPL must persist over time. With the rise in GPL,
workers will see a fall in their real income and will negotiate for higher
wages, pushing up cost of production even further from AS1 to AS2 and
hence exacerbating inflationary pressures from P1 to P2.
o At the same time, a possible Brexodus will shrink the size of the resident
population the UK due to an outflow of EU workers back to their home
country. As such, there will be a fall in autonomous consumption,
assuming inflow of workers from non-EU countries and growth in domestic
population is smaller than the outflow of EU workers. This will reduce AD
from AD0 to AD1 due to a significant fall in autonomous consumption. As a
result, there will be an unplanned increase in inventories as planned
withdrawals exceed planned injections. Subsequently, firms will step down
on production in the next period. When firms reduce production, they hire
fewer factors of production from households and pay out less factor
incomes. The fall in real national income leads to many rounds of fall in
induced consumption because one person’s fall in spending is another
person’s loss in income and less income leads to less spending. The fall
in injection thus leads to a more than proportionate fall in real NY, ceteris
paribus. As real NY falls, induced withdrawals will fall because ability to
save, pay taxes and buy imports will fall. Real NY will continue to fall until
the initial fall in autonomous consumption equals the cumulative fall in
induced withdrawals. Hence real NY will fall more than proportionate from
Y0 to Y1 to the initial fall in injections, adversely affecting actual economic
growth of the UK.
o Assuming the size of population remains unchanged, there will be a fall in
real GDP per capita, resulting in a lower material standard of living as
UK citizens are less able to consume the same quantity of goods and
services as before. At the same time, with the rise in unemployment due
to lower derived demand for labour may trigger an increase in crime rates
that may deteriorate the non-material standard of living. According to
the more specialized theories on crime and unemployment, being
unemployed represents in itself a situation that increases both motivation
and opportunity for crime – inducing an agent to weigh his cost/benefit in
engaging in a crime. As such, the likelihood of an individual committing a
crime increase when the benefits from stealing/engaging in an illegal
activity to make monetary gains outweighs the cost of imprisonment.
Therefore, unemployment increases criminal activity because it reduces
the cost of imprisonment, contributing to a lower non-material standard of

living. This increases the UK government’s burden as it must allocate
more financial resources to clamp down on illegal activities and provide
more unemployment benefits, reducing its ability to implement policies to
revive the declining economy.
• At the same time, firms may be forced to relocate to other parts of the world to
source for cheaper low-skilled labour without restrictions, while those unable to do
so might go out of business. According to Extract 3, “Employers were "fearful" over
how their businesses would be affected by tighter restrictions with many planning
to relocate to Asia or other parts of Europe where the operational cost will be
lower”. Therefore, labour shortages in sectors of the economy with a large
presence of EU migrant production could move abroad for tradable sectors. In
extract 3, it is mentioned that “There are worries that the production of fresh
produce could eventually shift to major competitors in the Netherlands, Poland and
Ireland, or that supermarkets will increasingly turn to imports”. As a result, there
will be a fall in private investment as firms see a fall in their future expected rate of
returns from operating in the UK due to the poor business climate and rising cost
of production. As such, there will be fewer available projects that are as profitable
as before, leading to a fall in I and hence AD in the short-term.
• Additionally, with a lower inflow of FDI is likely to cause a decline in accumulation
of fixed capital assets. Therefore, there will be a fall in productive capacity of the
economy if replacement investments outpace gross investments. This will
adversely affect UK’s ability to achieve sustained economic growth in the long-run.
• At the same time, a more restricted access to high-skilled foreign workers from the
EU could potentially lead to an outflow from productive sectors such as tech
industries, pharmaceutical sectors, health services. This leads to less innovation
and slower productivity growth, disproportionately harming the productive and tradable
sectors of the economy which makes key exports less competitive.
o With firms leaving the UK, there will be a deterioration in the KFA and
hence adversely affecting the balance of payments account.
o At the same time, with a relatively higher domestic inflation rate
stemming from a higher cost of production, British goods will become
less competitive. Assuming PEDX> 1, there will be a more than
proportionate fall in quantity demanded of British exports such as
pharmaceuticals and food items as foreigners switch to the large number
of relatively cheaper substitutes available from other parts of Europe and
Asia. Meanwhile, UK consumers will switch to relatively cheaper imports,
increasing demand for imports. According to Extract 3 “…farmers
interviewed said that they were already raising wholesale prices because
of increased labour costs” and “.... supermarkets will increasingly turn to
imports…”. The extent of increase in M and fall in quantity demanded of
domestically produced goods will depend on the degree of closeness
between M and C. As a result, there will be a fall in export revenue and a

rise in import expenditure, leading to a fall in NX, worsening balance of
trade and hence balance of payment position
• The rising number of hate crimes reported post-Brexit has also increased the real
possibility of a further spike in hate crimes, creating a climate of hostility and
greater uncertainty which may deteriorate the non-material SOL.
Anti-thesis: The UK economy has more to gain from a more restricted immigration
flow because it raises employment, improves SOL, and reduces income-inequality.
• With a more restricted immigration flow, firms will be more inclined to employ
homegrown UK workers and reduce the supply chain dependency on importing
low skilled unskilled EU migrant workers– raising employment of local workers
(Extract 3 “….those who voted for leave still hold the view that a drop in immigration
could mean more jobs for the people who remained….”).
• With a stable source of income, local workers are likely to enjoy a higher material
standard of living as they can purchase a greater quantity of goods and services.
At the same time, they can afford recreational activities and better-quality health
services that serve to raise their non-material standard of living.
• Most of the EU migrant workers were hired in labour intensive industries such as
the catering, hospitality, construction, farming and food processing sectors – with
a restricted supply of migrant workers, firms struggling to recruit workers to fill up
vacancies are likely to pay a higher wage to low-skilled domestic workers as
they no longer have access to cheap source of European labour from Romania
and Bulgaria. As such, the wage disparity between the skilled and low-skilled will
narrow, resulting in lower income-inequality.
• EU membership along with open borders and lax immigration policy entitles low
wage EU immigrants who were previously staying in the UK to enjoy benefits in
the form child benefit, affordable housing, and family tax credits, NHS, subsidized
nursery care. With higher employment of local workers and reduction in surplus of
EU migrant workers, there will be less strain on government budget as less
resources need to be allocated for the provision of welfare benefits.
Conclusion and Synthesis:

• The UK economy has more to lose than gain because of a more restriction
immigration flow.
• This is mainly because low-skilled EU immigrants tend to cluster in agriculture,
low-tech manufacturing, construction and private households. They are
disproportionately less likely than unskilled locals to hold managerial roles.
Meanwhile, skilled EU immigrants tend to be occupationally polarized relatively to
UK natives. If the ensuing gaps in the labour market were filled by a higher supply
of UK-born workers and non-EU immigrants, wages and employment in these
sectors would remain unchanged. However, this is unlikely given that UK-born
workers are imperfect substitutes for immigrants. Moreover, firms may resort to
hiring workers from Asia (Filipino nurses) who are not affected by Brexit and are
likely to be cheaper source of labour compared to the locals.
• Furthermore, for given skills and industries, UK-born workers are unwilling to work
for the same wages as immigrants. It is therefore reasonable to expect labour
shortages in sectors of the economy with a large presence of EU immigrants. Food
manufacturing, domestic personnel and the parts of the public sector already
exposed to skill shortages such as health, social care, and education. One can
thus expect an increase in prices and wages and/or further shortages in these
sectors.
• A further outcome might be greater mechanization and automation in some
sectors, most notably low-tech manufacturing, as reduced migration may
encourage slower growth in low-skilled labour supply and the adoption of labour-
saving technologies and productivity growth. As such, low-skilled locals may
remain unemployed despite the lack of access to cheaper source of EU low-skilled
workers. Thus, the UK workers involved in these sectors may lose out further. It
could even lead to the loss of low-skilled manufacturing jobs.

• Given the rise in populism around the world and economic uncertainty, it seems
that anti-globalization policies suggested by the UK government will not fully
address the adverse consequences of globalization. Therefore, demand-
management policies like expansionary fiscal policy and monetary policy should
or can also be implemented given the ongoing global uncertainty.
• There is also a real possibility that anti-globalisation policies such as a more
restricted immigration flow will worsen the current state of the UK economy as it
may bring about fewer economic benefits in the short-run, but the long-run
consequences will eventually outweigh these benefits. Hence, anti-globalisation
policies should only be a temporary measure because according to the theory of
comparative advantage, they reduce the gains from specialisation and trade. In
the long run, supply-side policies should be implemented.
• In conclusion, the UK should therefore, encourage freer labour flow to reap the
economic rewards in the long run. However, it is worth noting that given the social
and political pressure faced by the UK government in an era of Trumpism and
populism in Europe, such an embrace of globalization may seem too hopeful and
optimistic.

 No or weak theoretical framework and/or glaring conceptual
errors
o Listing of macroeconomic goals
o No use of case materials
L2  Rigorous economic analysis with reference to the AD/AS 4 – 6.
framework.
o Accurate and well-labelled diagram
o Clear explanation of how a more restricted immigration flow
affects inflation, economic growth, unemployment and
balance of payments position of the UK
 Well-balanced answer that includes the benefits and costs of
a more restricted immigration flow on the UK economy.
 Effective use of case evidence to develop and to support
analysis.
 One-sided answer that only addresses either the benefits or
costs to the UK economy
Evaluation
E1  An unexplained conclusion /judgment or mere repetition of 1

points discussed
E2  A judgment/conclusion supported by reasons / economic 2

analysis
 Judgment included SR vs LR considerations of a restricted
immigration flow on the UK economy.
 Suggested policies to address the challenges that
policymakers likely to face due to a more restricted
immigration flow.
Most candidates did well for this question and provided a balanced answer. Best answers
developed analysis with help of AD-AS framework, linking to a range of economic goals to
determine if UK economy’s losses and gains. Answers that provided limited depth of

economic analysis with narrow scope in terms of economic yardsticks or effects had not
scored well. Best answers also gave evidence to link to a higher labour cost as a result of
a more restricted immigration policy and a possible fall in quality of labor, thereby analyzing
the effects with respect to a fall in aggregate supply. Poor scripts just copious amounts of
case material without sufficient economic analysis. A handful of students simply stated and
failed to elaborate on the benefits and costs using economic analysis.
1. A common error that was evident in some scripts was that a more restricted
immigration flow results in a fall in demand for labour (). A more restricted
immigration flow will result in a fall in supply of labour relative to the previous
period. Assuming demand for labour continues to grow in the various industries, a
fall in supply of labour as a result of “Brexodus” will result in a fall in supply of
labour. As a result, there will be an upward pressure on the wage rate due to the
shortage of labour ().
2. Some candidates focused their explanation on how a higher unit labour cost of
production will reduce the export competitiveness and hence reduce the quantity
demanded of exports more than proportionately. As such, there will be a fall in
export revenue and hence a leftward shift of the AD (). This leads to severe
misinterpretation of the consequences of higher labour costs because it should
lead to a fall in AS which is represented by an upward shift of the AS curve,
followed by the rise in GPL and then the fall in AD (which is reflected by a
movement along the AD curve). A more accurate and complete explanation would
require the candidates to explain how a higher cost production of domestically
produced goods and services will cause local consumers to switch to imports. As
a result, the demand for imported goods and services will fall at each and every
price level. As such, there will be an increase in import expenditure. This couple
with fall in export revenue will cause NX to fall and hence cause a leftward shift of
the AD curve at each and every price level ().
3. Many candidates focused on the measures that firms can adopt following a
more restricted labour policy to explain the losses to the UK economy (). To
explain the losses to the UK economy, the focus should be on how a fall in quantity
of foreign labour directly impacts the UK economy in terms of the macroeconomic
goals.
4. Another common error that was observed was that some candidates explained
that an increase in employment of local workers will raise their income and hence
consumption expenditure. This will raise AD. While this is not incorrect, the
candidates should not explain how real NY increases more than proportionately
via the multiplier process when there is an increase in consumption expenditure
due to higher levels of employment (). This the multiplier process is only triggered
by autonomous consumption and not induced consumption that arises due to an
increase in disposable income ().
5. A handful of candidates are unclear of the components of balance of payments.
Some stated that an outflow of investments from the UK will deteriorate current
account balance (). While others stated that, an outflow of FDI will result in an
outflow of hot money and hence KFA (). While, an outflow of FDI causes the KFA
position to worsen, it does not lead to an outflow of hot money. Candidates need
to familiarize themselves with the difference between short-term and long-term
capital flows. Hot money is short-term capital flows, while FDI is long-term capital
flows.

(e) Post-Brexit, the UK policymakers have begun to negotiate new free trade
agreements (Extract 5) with non-EU countries and focus more on supply-side
measures to improve productivity of the British workforce (Extract 7) in light of a
more restricted immigration flow.
Discuss whether the above policies are effective in achieving sustained and
inclusive economic growth in the UK. [10]
Introduction:
• Clarify ambiguity – define sustained and inclusive economic growth
• Clarify Free-Trade Agreements and supply-side measures that are used by the British
policymakers.
Thesis: The above policies - signing new FTAs and focusing on supply-side measures- are
effective in achieving sustained and inclusive economic growth.
Explain how removing tariffs and non-tariff barriers by signing FTAs are effective in
achieving sustained and inclusive economic growth.
• Post-Brexit, UK policymakers signed new trade agreements as part of the policy

dubbed as “Global Britain”, allowing the UK to have unilateral trade agreements
with a host of countries across the globe– with the US, China, India, Australia and
Canada.
• As postulated by the theory of comparative advantage, countries should
specialize and export g/s that they can produce at relatively lower opportunity cost
and import g/s that they have a comparative disadvantage in. Since UK has an
abundance of skilled labor and infrastructure, they can produce higher value-
added goods such as pharmaceuticals, refined oil, aircraft & space craft and will
export these to the other countries.
• A removal of trade barriers would therefore enhance the price competitiveness of
British exports to these new markets that previously imposed tariffs and non-tariffs
barriers on British g/s. As a result, the volume of exports increases.
• Furthermore, UK firms can now also import cheaper raw materials from its trading
partners. This will lower the cost of producing g/s, boosting export price
competitiveness. If PEDX > 1 due to a presence of large number of close
substitutes, a lower price of British exports relative to those offered by other
countries that sell similar g/s, will increase the quantity demanded of British exports
more than proportionately. At the same time, local consumers will switch to
domestically produced goods and services, reducing demand for imports. As a
result, export revenue will increase and import expenditure will fall, causing net
exports and hence AD to increase.
• FTAs also allow firms to gain access to larger markets outside of EU without
tariffs (Extract 2 “With an independent trade policy, Britain can put itself in a strong
position to benefit, opening up access to fast-growing markets across the world.”).
Therefore, by signing independent trade policies with countries that were not part
of its trading sphere previously, will serve to expand its export market, increasing
demand for exports (assuming YED>0). This will increase export revenue and AD
even further.
• At the same time, FTAs facilitate FDI into the UK by lowering regulations which
are barriers to entry for foreign firms. Firms will therefore see an increase in
expected rate of returns from expanding its operation and production facilities in
the UK, increasing I and hence AD in the short-run. However, in the long-run, FDI
inflow also leads to capital stock accumulation (eg. building of factories,
manufacturing plants, promote greater diffusion of modern technologies, human
resources development and capacity building). This expands the productive
capacity of the economy despite the growing uncertainty amid Brexit.
o With the expansion of production facilities and purchase of capital
equipment to step up production, firms will also enjoy a lower unit labour

cost of production because of capital deepening. A more efficient labour-
capital ratio will raise the productivity of labour. If productivity of labour
grows faster than wage growth, unit labour cost will fall. This will increase
AS and shift it down.
o Additionally, with greater availability of better quality and quantity of factors
of production, the productive capacity of the UK economy will expand. This
will shift AS to the right.
o An increase in export revenue and investment will increase autonomous
AD which will lead to planned expenditures exceeding the actual level of
production in the economy, resulting in an unplanned decrease in
inventories. Assuming spare capacity, firms respond by stepping up
production in the next period by employing more factors of production,
including labour and pay them factor income. The increase in real national
income triggers the multiplier process as one man’s spending generates
income for another. The increase in real NY causes an increase in induced
consumption which gets successively smaller with each round because of
withdrawals (savings, imports and taxes). The process eventually stops
when the cumulative increase in withdrawals equal the initial increase in
autonomous exports and investments at a higher level of real NY from
Y0 to Y1 which has increased more than proportionately, creating
actual economic growth. There will also be an increase in potential
economic growth as indicated by an increase in the full-employment
level of national income from YF0 to YF1. Hence, signing FTAs is
effective in achieving sustained economic growth.
o Additionally, with greater inflow of FDI, more jobs will be created in the
construction, manufacturing, farming and food processing sectors for the
low-skilled workers. These workers will also enjoy higher wages
because of a higher demand for workers in these industries, lifting
many from poverty while narrowing the income gap between the high-
skilled and low-skilled workers in the UK. Hence, FTAs are effective in
achieving a more inclusive economic growth.
Explain how supply-side measures are effective in achieving sustained and

inclusive economic growth.
• Improving labour productivity through education, apprenticeship and skills

upgrading – Extract 4 “….UK has long lagged our competitors on the training of
technical skills…” and “our sights should be firmly set on raising the skill level of
our own domestic workers, employing domestic whenever we possibly can and
automating” & “Enterprise Minister announced £4.36 million of joint government
and industry funding to improve skills for the NHS’s 600,000 support workers”.
• Govt subsidies to increase capital investment in sectors like farming and
construction – Extract 4 “…. Agriculture and Horticulture Development Board

(ADHB) suggested increased capital investment and automation is a
possibility….”
o Workers will become more skilled and efficient in their assigned
responsibilities with retraining, education and the ability to work with
machines to enhance their productivity. As such, output per unit of input will
increase. Therefore, as the quality of the workforce improves, the
productive capacity of the UK economy will expand and shift the AS
curve to the right.
o Adoption of technology also raises the productive capacity of the
economy as firms acquire more fixed capital assets and improve on process
innovation.
o At the same time, assuming labour productivity grows faster than wages,
there will be a lower unit labour cost and hence unit cost of production. This
will shift the AS curve down.
o As a result, there will be actual economic growth as real NY increases from
Y0 to Y1 and potential economic growth as reflected by an increase in the full
employment level of national income from YF1 to YF1. Hence, supply-side
measures are effective in achieving sustained economic growth.
o Firms will also be more willing to hire the more productive local workers who
now possess better set of skills. As such, low-skilled workers can now move
to higher value-added industry that pay much higher. According to the
Marginal Productivity Theory of Wage determination, wages are determined
according to the marginal product of the labour and hence the theory
postulates that there is a positive correlation between labour productivity and
wages. Therefore, if wages of the low-skilled workers grow faster than the
high-skilled workers, there will be a smaller wage gap between these
workers. As such, it will reduce the income inequality and serve to promote
o Hence, supply-side measures are effective in achieving inclusive
economic growth.
Anti-thesis: However, the above policies are limited in their effectiveness in ensuring
sustained and inclusive economic growth.
• Limitations of signing new Free-Trade Agreements:

o It creates trade diversion as it results in trade being diverted away from the
non-member countries with a comparative advantage to member countries
of the FTAs with a relatively higher opportunity costs. This results in welfare
loss to the society as a result of allocative inefficiency.
o It can also create strain in trade relations between UK and other countries
that are not part of these bilateral or multilateral agreements, possibly hurting
the demand for their exports. As such, these non-member countries may
retaliate by imposing tariffs on British exports due to the poor political and

trade relations. Therefore, the net gain from signing new independent free
trade agreements may not necessary be beneficial if the extent of trade
diversion outweighs trade creation.
o With the rise in protectionist sentiment globally in an era of Trumpism and
populism in Europe, other countries may be under increasing pressure to
use protectionist measures as well to protect their domestic industries from
foreign competition because of herd behaviour. As such, UK policymakers
will find it challenging to negotiate successful trade deals with other
countries, particularly at a multi-lateral level.
o Also, with Brexit, other countries may become doubtful about UK’s ability to
commit to a multilateral or bilateral cooperation in the long-run and may fear
possible deviation from the agreement in times of crisis. As such, these
countries may be unwilling to sign FTAs with the UK because of the lack of
trust. Therefore, the success of FTAs largely hinges on members’ ability to
trust each other and the credibility of the signing parties for FTAs to be
mutually beneficial.
o Additionally, industries with comparative advantage in the UK such as
pharmaceuticals, financial services and technology-based companies will
experience an increase in demand for their goods and services. As such,
there will be an increase in derived demand for labour, causing wages to rise
in these industries. Meanwhile, non-comparative advantage sunset
industries such as agriculture and food processing will lag behind or
experience a fall in demand for their goods and services. This results in lower
wage or slower wage growth in these industries. As such, this will widen
the income gap between the skilled and low-skilled workers, worsening
the income inequality. Therefore, signing new FTAs is ineffective in
achieving its intended goal of inclusive economic growth.
o FTAs will also make the UK vulnerable to external shocks. For example,
should new trading partners like the Japan and South Korea were to face
economic recession because of weak domestic demand. The fall in RNY
experienced by these trading partners will reduce their purchasing power
and hence their ability to buy UK’s exports (YED>0). The fall in demand for
exports will fall significantly, adversely affecting actual economic growth. At
the same time, MNCs tend to downsize and cut back on their operation in
times of economic crisis because of contagion effect, resulting in an outflow
of FDI and hence adversely affecting the productive capacity of the UK
economy.
o As a result, signing new FTAs is ineffective in achieving sustained and
inclusive economic growth to some extent.
• Limitations of supply side measures:

o Effectiveness of skills upgrading, education and apprenticeship largely
depends on the mindset as well as receptivity of workers. This is especially
for low-skilled and older workers, who may not actively sign up for such
retraining and skills upgrading programmes due to their steep learning curve.
Hence such schemes may not necessarily achieve their intended effects of
increasing the skills levels of such workers and hence raising their incomes
to reduce the income gap and achieving sustained economic growth.
o Besides, skills training and upgrading is long term in nature as it takes time
to acquire new skills and to be adept at them, hence the policy may not be
as effective in addressing the issues and may only materialize in the long
term.
o In addition to all the above limitations, it is perhaps also important to note
that the burden of financing such supply-side measures may pose to be a
huge financial burden on a government that is already struggling with other
overriding priorities such as tackling the declining National Healthcare
Services.
o Meanwhile, automation is likely to lead to structural unemployment as firms
replace workers with machines to cut back on the labour cost. This will

increase wage disparity, making such supply-side measures ineffective in
achieving inclusive growth in the short-run.
o As a result, supply-side measures are ineffective in achieving
sustained and inclusive economic growth to some extent.
Conclusion and Synthesis:
• Signing new FTAs and implementing supply-side measures are effective in

achieving sustained and inclusive economic growth in the long-run.
However, the choice of macroeconomic policy options depends on the UK
policymaker’s assessment of the degree of severity and urgency of economic
problems facing the country in light of Brexit and external events.
• In the selection of the appropriate macroeconomic policy option, there is also a
need to weigh the possible trade-offs that would arise. In the case of UK, it is facing
a rising labour cost due to a more restricted immigration flow. This makes UK an
unattractive destination to investors and makes exports less competitive. At the
same time, the UK is also facing cuts in fiscal expenditures. Thus, its ability to
implement supply-side measures to raise the productivity of the local workers to
offset the rise in labour costs arising from restricted labour flow may prove to be
unsustainable in the long-run.
• UK policymakers may consider implementing other measures, including a looser
monetary policy to stimulate the economy by raising domestic demand to offset a
possible decline in external demand. However, the effectiveness of lowering
interest rates would largely depend on the business climate. If investment is
interest-inelastic, the Bank of England may need to accommodate a significant fall
in interest-rates to raise investments to achieve sustained economic growth in the
long-run.
• The UK policymakers could also consider a more targeted approach to reduce
income inequality to achieve a more inclusive economic growth. One such
measure would include implementing a more progressive tax structure and using
the revenue collected for redistributive purposes to reduce the income gap.
However, the effectiveness of the policy will depend on the UK policymaker’s
ability to collect taxes from the high-income earners who tend to declare inaccurate
income data. Also, according to Okun’s “leaky bucket” theory, the administrative
costs of redistribution as well as the disincentive among the lower-income groups
to work harder due to complacency caused by the receipt of transfer payments
make such redistribution efforts inefficient and ineffective in addressing the income
gap.

L1  Smattering of points not directly linked to question 1-4

o Gaps in the development of how FTAs and supply-
side measures are effective in achieving and
 One-sided analysis, only explaining how both supply-side
measures and FTAs are effective OR only explaining how
only one of the two policies are effective/ineffective in
achieving the goals.
 No reference to case material.
L2  Rigorous economic analysis with reference to the diagram/s 5-7
drawn
o Accurate and well-labelled diagram/s to supplement
economic analysis eg. AD/AS diagram.
o Clear explanation of how signing FTAs and supply-side
measures are effective in achieving sustained and inclusive
economic growth using relevant economic analysis.
o Well-balanced answer that includes explanation of how
both FTAs and supply-side measures are effective as well
as are limited in achieving the intended goals.
 Effective use of case evidence to develop and to support
analysis.
Evaluation
E1  An unexplained judgement/evaluative conclusion/comment 1
E2  A judgment/conclusion supported by reasons / economic 2-3

analysis
 Judgment made based on the context of the British economy.
1. Insufficient time to complete the essay which translated into a lack of detailed economic
analysis and use of appropriate economic framework. Some candidates also used a
number of unexplained shorthand notations (such as ↑X, ↑AS and ↑AD, ↑RNY) in their
essays with the assumption that these notations are universally understood.
Candidates are reminded to spell out these notations and explain what they mean at
the first instance when they are used so as to avoid hindering the fluency of economic
arguments and essay flow.
2. Illegible handwriting which worked to the candidates’ disadvantage since the
examiners are unable to comprehend the arguments made in the essay hence limited
credits are given to such scripts. Candidates are reminded that legible handwriting is
essential to avoid undue penalties in examinations.
3. Quite a number of candidates were unable to provide a balanced discussion for both
sustained and inclusive growth. Analysis for free trade policy is limited to actual growth
only for many scripts.
4. Very few had attempted to analyze how free trade policy can help UK achieve potential
growth. For free trade policy, majority were able to link to actual growth via an increase
in exports. However, for quite a number of candidates, there is no or insufficient
explanation of how free trade policy results in an increase in exports.
5. Better scripts related to the increased access to non-EU markets that would enlarge
the market size for UK’s exports, bringing about a rise in demand for UK’s exports and
therefore a rise in export revenue. Better scripts also considered the impact free trade
policy has on foreign direct investments in the UK. For supply-side policy, majority of
candidates were able to relate to potential growth and thus sustained growth.
6. However, the quality of analysis varied. There were some scripts which did not even
link to a rise in aggregate supply and hence did not analyze the effectiveness with AD-

AS framework. There were a few scripts that did not even provide examples of supply-
side measures given in the case material. Meanwhile, there were some others that
simply copied case materials to answer the question without providing any form of
economic analysis.
7. Some candidates demonstrated lack of understanding of free trade agreements and
went on to explain how it will increase consumption expenditure as a result of more
competition. While this is not absolutely incorrect, the explanation was largely
incomplete and flawed.
8. Discussion for inclusive growth was poorly developed as some candidates
demonstrated poor understanding of income inequality and inequity.
9. Many candidates provided analysis on policy options that were theoretically sound.
However, the key marking discriminant between a higher against a lower mark range
answer was how candidates couched their analysis based on a good grasp and
reference to the context with effective use of case materials – the UK economy.
10. The framing of supply-side policies seemed rehearsed and predictable. Many
candidates simply regurgitated what they know of supply-side policies on training and
education or automation without any mention to any case issues of diversification,
reducing reliance on foreign workers, or attempted to frame their supply-side measures
to answer the question. Candidates should not think that all policy questions can be
answered with a one-size-fits-all answer i.e. answering the merits and limitations of
arbitrarily selected policies.
11. The limitations discussed for supply-side measures were largely generic and does not
really address the inherent limitations/ineffectiveness of the measures themselves in
achieving sustained and inclusive economic growth. Candidates should try to
familiarize themselves with the various yardsticks of assessing policies and not simply
lump them together. For example, the assessment word in the question was “effective
in achieving sustained and inclusive economic growth”. Therefore, in addressing
the limitations of the policies, the students should have focused their analysis on the
how the policies are ineffective in achieving the intended goals/objectives of the
policies rather than focusing on the other yardsticks – desirability, feasibility and
sustainability – explaining the unintended consequences of the policies.
12. In terms of evaluative comments, the quality of responses was often poor that they
were rather summative rather than one that demonstrates a synthesis that is well-
formed and insightful which shows a clear understanding of issues that a government
would have to grapple with in its policy choice and formulation. It is not the intention of
the question for a candidate to solve, UK’s myriad of problems post-Brexit, but for the
candidate to demonstrate thoughtful policy options discussion.
13. Candidates are reminded to explain and elaborate on each idea presented. Instead of
just stating the relationship between variables, candidates should explain why:
o An increase in AD will lead to an increase in real NY
o An increase in I or (X-M) leads to an increase in AD.
o An increase in quantity and quality of fop and/or technology advancement will lead
to an increase in productive capacity.
o An increase in actual growth via an increase in AD will lead to higher GPL, ceteris
paribus, and if the increase in GPL persists, inflation will occur but why an increase
in potential growth via an increase in AS can lead to a fall in GPL.
o An increase in actual growth leads to higher current material and non-material SOL
but an increase in potential growth leads to higher material and non-material future
SOL.
o A movement towards the PPC reflects actual growth but an outward shift of the
PPC curve reflects potential growth.
14. Full employment level is not full employment level of national income. Potential growth
is an increase in full employment level of national income, not an increase in full
employment level.
15. Some candidates unduly emphasized that potential growth was about an increase in
output in the future. While it is true that potential growth allowed for an increase in
output in the future (provided AD increased as well), the focus of potential growth
should be about the increase in maximum output that can be produced in an economy,
that is its productive capacity.

Paper 9757
Paper 2
Question 1
A roundtrip flight ticket from Singapore to Kuala Lumpur costs S$183. Meanwhile, a roundtrip
train ticket from Singapore to Kuala Lumpur costs $33.
a) Explain how producers and consumers act rationally to determine the market [10]
equilibrium price of flights.
b) Discuss the effects of a rise in flight prices on the airlines market and other related [15]
markets.
Part (a)
Introduction
Rational-decision making assumes that consumers and producers make choices that maximize their
self-interest. The decisions of producers determine the supply of a commodity while those of buyers
determine demand. The interaction of demand and supply determines the price.
Body
Consumers (Passengers)
Rational consumers use marginal analysis when deciding how much to buy. This is represented by the
demand curve which is also the marginal private benefit (MPB) curve of the consumers. (Assuming that
there is an absence of externalities, MPB=MSB.)
The demand curve indicates the marginal utility (or benefit/satisfaction) that consumers derive
from the marginal units (or additional units) of the good.
• Consumers are less willing and able to pay for subsequent units of good X because they derive
less utility (or benefit/satisfaction) from each increase in quantity.
• This means that their marginal utility from consumption is decreasing (total benefit is increasing
at a decreasing rate).
• This is because of the Law of Diminishing Marginal Utility, which states that, the utility gained
by the consumer from each successive unit of the good consumed diminishes
• (OR use of substitution effect to explain DD curve also accepted: It is the effect of a change in
the price of the good on its quantity demanded arising from the consumer reducing amount
purchased due to a fall in real income (a.k.a income effect) and switching to alternative products
(a.k.a substitution effect). Hence, the income and substitution effect will cause consumers to
buy fewer plane tickets when the price of plane rides increases).
• The consumer, being a rational maximiser, will consume up to the point where the last unit
of the good bought gives him a value of satisfaction (marginal benefit) equal to the price
he pays (the marginal cost of the purchase).
• Consumers’ surplus is the difference between the maximum amount that consumers are
willing and able to pay for a given quantity of a good and what they actually pay. Every point
on the demand curve represents the best decision a consumer can make at different
price levels. By consuming on the demand curve, consumers are maximising their
consumer surplus at different given price levels.
Producers (Airlines)
Producers also use marginal analysis when deciding how much to produce.
The supply curve shows the amount of a good that producers are willing and able to make
available for sale at each given price over a given period of time. It represents the optimal level of
production for the producer at each price level. The supply curve is also the marginal private cost (MPC)
curve for the producers

• The quantity supplied is directly related to the price of a product. The higher the price of a good,
the greater the quantity supplied and vice versa, ceteris paribus.
• A higher price is needed to induce firms to increase production and quantity supplied of the
good as increasing the quantity supplied will result in a higher marginal cost of producing the
additional unit.
o This is because as production increases beyond a certain output level, there is
overutilization of the firm’s resources (e.g. existing machines reach their working
capacity) making them less efficient in production thus causing the marginal cost of
production to rise.
o The firm needs a higher price received from the sale of the good to cover this higher
marginal cost of production.
• If the airline aims to maximize profits, it will continue producing if an additional flight adds more
to the firm’s revenue than to its costs. It should keep on producing additional flights until
the additional revenue from selling that last flight is equal to the additional cost of
producing that last flight; thus his profits are maximized.
• Producers’ surplus refers to the difference between the amount received by producers for
selling their good and the minimum prices that they are willing and able to accept for supplying
additional units of the good. Every point on the supply curve represents the best decision
a producer can make at different price levels. By producing on the supply curve,
producers are maximising their producer surplus at different given price levels.
Excess SS
Price of flights ($)
(surplus)
S
$20
0
$18 Fig 1: Price Adjustment Process

3
$175
Excess DD
(shortage)
D
Quantity of flights
14 16 20 24 26
Equilibrium P and Q is achieved in the free market when there is no tendency for P and Q to change.
There is equilibrium in the free market when Qd = Qs.
[Surplus] At prices above (e.g. $200) the equilibrium price, there is a surplus in the market since
quantity supplied exceeds the quantity demanded resulting in a downward pressure on the price. This
is because to sell their surplus, producers would begin to lower prices. Eventually as price falls,
consumers are willing and able to buy more. Quantity demanded would increase, while quantity
supplied would decrease until the equilibrium price ($183) is reached. At this equilibrium price,
quantity demanded is equal to quantity supplied at 20 units.
OR
[Shortage] The opposite would happen if price was initially below (e.g. $175) the equilibrium price. There
is a shortage in the market as quantity demanded exceeds quantity supplied and consumers would
be unable to purchase all they would like. This would put an upward pressure on the price as
consumers try to outbid one another for existing supplies and producers react by increasing price and
expanding output. Quantity supplied would increase, while quantity demanded would decrease until
the equilibrium price ($183) is reached. At this equilibrium price, quantity demanded is equal to
quantity supplied at 20 units.

At the market equilibrium of a perfectly competitive market, societal welfare, which is the sum of
consumer and producer surpluses, is maximised. This is assuming perfect information, absence of
externalities in the market.
Conclusion
In conclusion, rational decision making by consumers and producers guide resource allocation via the
price mechanism which determines what to produce, how much to produce, how to produce and for
whom to produce.

L1 • Smattering of valid points; glaring conceptual errors. 1-4
• Fail to show sufficient economic analysis in tackling the question.
L2 • Explanation either contains gaps or lacks clarity 5-7
• Only price adjustment process OR of how the demand and supply curves represent
the maximization of welfare
• Demand and supply framework and/or price adjustment process are not always well
explained and fully elaborated.
• Demand and supply framework is not explained together with the marginalist principle
L3 • Clear use of framework and well elaborated answers. 8-10
• Well-developed analysis of how the demand and supply curves represent the
maximization of utility and profits for both consumers and producers respectively.
• Addresses price adjustment process adequately (Either shortage or surplus would be
sufficient)
• Many candidates did not know the fact that every point on the demand/supply curve
represented the best decision a rational consumer/producer could make (at every price
level). These same candidates thought that consumers and producers were only making the
best decision at equilibrium P/Q, and that all other points on the demand and supply curve were
sub-optimal decisions made by consumers and producers respectively.
• Some candidates were unable to explain how the marginalist principle is connected to the
DD/SS framework. The demand curve only represents the marginal benefit for consumers, not
for consumers and producers. Likewise, the supply only represents the marginal cost to
producers, not for both consumers and producers. The marginal cost to the consumer is the
price that he/she pays for an additional unit of the good/service. As a result, a number of
candidates used the demand and supply curves interchangeably with the MB/MC framework.
They are related and should be explained together but they are not the same.
• A handful of candidates neither stated nor explained the marginalist principle. Some candidates
also did not state what producers want (maximize profits) and what consumers want (maximize
utility).
• Candidates are reminded to use the price adjustment process when asked to explain how an
equilibrium price is reached.
• The equilibrium P and Q in the perfectly competitive free market comes about from the price
mechanism eliminating shortages and surpluses in the market. It did not come about because
it maximised society’s welfare. If A=price mechanism that eliminates shortages and surpluses,
B=free market equilibrium, C=socially optimal outcome, then A brings about B which happens
to be C. It’s not C that brings about B, which some candidates seemed to be explaining.
Part (b)
Introduction
The markets include the market for flights, trains and hotel/accommodation. (Other related markets may
also be included e.g. pilots)
The effects of a price increase of flights would affect the revenue of firms in various markets differently,
depending on:
• PED values of the plane rides
• Whether the firms are selling complements or substitutes.

Body
Reason(s) for price rise for plane rides: Fall in supply*
Price of flights ($)

S1
E2 S0
P2
E1
P1
P0 E0
Delastic
Dinelastic
0
Q1 Q2 Q0 Quantity of flights
Fig 2: Market for flights [Candidates can use either Fig 2 or Fig 3 & 4]
*Rise in price of plane rides can be due to (i) Fall in supply OR (ii) Increase in demand
Thesis: Impacts on the market for flights
As a result of a decrease in supply of flights, prices of flights increased ceteris paribus. This corresponds
to a leftward shift of the SS curve. One possible reason for the decrease in supply could be due to a
rise in the price of cost of production eg. increase in jet fuel prices. As flight prices increase, the quantity
demanded of flights fall.
Anti-Thesis for Airlines market: Justify the value of PED and/or extent of shift in SS
Whether the total revenue TR increases or decreases depends on the PED. The PED value may differ
based on the types of passengers – Business travellers may still travel because of work (PED factor:
degree of necessity) whereas leisure travellers may not travel due to rise in price. It may also depend
on the airline in question e.g. full-service carrier vs. budget carrier.
The rise in prices of plane rides may be due to DD shift (e.g. tastes and preferences) and not SS.
Demand conditions may change because of other concurrently occurring events. Also, the analysis only
holds if ceteris paribus assumption is fulfilled.

|PED| < 1 |PED| > 1
• If the demand for plane rides is price • Conversely, if the demand for plane
inelastic (|PED| < 1), we would expect tickets is price elastic (|PED|> 1), we
that airlines that raise prices will would expect that airlines that raise
receive an increase in total revenue, prices will incur a decrease in total
ceteris paribus. revenue, ceteris paribus.
• E.g. Flights by budget airlines like • E.g. Flights by full-service airlines like
AirAsia Singapore Airlines
• Mention any PED factor to • Mention any PED factor to
substantiate why |PED| < 1 e.g. % of substantiate why |PED| > 1 e.g. % of
income, habitual consumption income, habitual
• The lower the proportion of income • The higher the proportion of income
spent on a ticket, the less passengers spent on a ticket, the more
will be forced to reduce their passengers will be forced to reduce
consumption when price increases; their consumption when price
hence the more price inelastic will be increases; hence the more price
the demand. elastic will be the demand.
• Thus, consumers are unlikely to switch • A given price increase would cause
to substitutes when AirAsia increases consumers to switch to the many
its price, thus, quantity demanded substitutes available because they do
would fall less than proportionately to not perceive any differences, resulting
the price increase. in a more than proportionate fall in
• In the diagram below, an increase in quantity demanded.
price from P0 to P1 causes a less than • In the diagram below, an increase in
proportionate decrease in quantity price from Pa to Pb causes a more
demanded from Q0 to Q1. TR than proportionate decrease in
increases from P0AQ00 to P1BQ10. quantity demanded from Qa to Qb.
• TR decreases from PaAQa0 to
PbBQb0.
Fig 3: Market for flights provided by AirAsia Fig 4: Market for flights provided by Singapore
Airlines
Price of budget plane rides
Price of SQ plane rides
SS1
SS1
B
Pb SS 0
A
Pa SS 0
DD elastic P1
P0
DD inelastic
0 Qb Qty of budget plane rides 0 Q1 Q0 Qty of SQ plane rides

Qa

Thesis: Impacts on the market for substitutes – train tickets or any suitable substitute
• For travellers, train rides are substitutes with plane rides.

• CED: When CED is positive (CED > 0), the two goods are substitutes. An increase in the price of
one good will lead to an increase in the demand for the other good.
• This results in a rightward shift in demand curve for train rides. Thus, an increase in the price of
plane rides would cause an increase in the demand for train rides (D0 to D1).
• As there is a shortage at the current price P0, consumers bid up prices and this causes upward
pressure on price.
• As price increases to P1 and quantity increases to Q1, total revenue increases from P0AQ00 to
P1BQ10.
Price of train rides
P2 S0
C
P1 B
P0 A
D2
D1
D0
0 Q0 Q1 Q2
Quantity of train rides
Fig 5: Market for train rides [Substitute]
Anti-thesis: Impacts on the market for train rides – Justifying the value of CED
• The extent of an increase in total revenue depends on the flight destination. The degree of
substitutability may change depending on the route, i.e. Long haul vs. short haul trips.
o The larger the absolute value of the positive CED, the greater is the substitutability between
the two goods.
o If CED is positive but less than one (0<CED<1), the two goods are not very close
substitutes since the demand for one does not respond very much to changes in the price
of the other. For example, it is not feasible to take a train from Singapore to New York City
so train rides are poor substitutes. Total revenue will increase but by a small extent (P0AQ0
to P1BQ1).
o If CED is positive and greater than one (CED>1), then the two goods are close substitutes.
Assuming that flights and train rides to KL from SG are relatively close substitutes to one
another since they both ferry travellers from Singapore to KL under 7 hours. Total revenue
will also increase but by a larger extent (P0AQ0 to P2CQ2)
• It also depends on the type of passengers. Travellers who need to arrive at their destination in a
shorter duration (e.g. business travellers) may see train rides as a poor substitute to plane rides.
Thesis: Impacts on the market for complements – Market for hotel rooms/accommodation or any
suitable complement
• Complements are in joint demand

• For travellers, hotel rooms and other types of accommodation (e.g. Airbnb) are complements with
plane rides. Most business and leisure travellers need a place to stay during their trip.

35
• CED: When CED is negative (CED < 0), the two goods are complements. This is because an
increase in the price of one good leads to a fall in the demand for the other good.
• The demand curve for hotel rooms/accommodation will thus shift to the left.
• As there is a surplus at the current price P0, producers will be willing to accept lower prices and
this causes a downward pressure on price.
• As prices fall to P1, total revenue decreases from P0AQ00 to P1BQ10.
Price of hotel rooms/accommodation
S0
P0 A
B
P1
D0
D1
0
Q1 Q0 Quantity of hotel rooms/accommodation
Fig 6: Market for hotel stay [Complement]
Anti-Thesis for market for complement– Justifying the value of CED
• The extent of a decrease in total revenue depends on the good and the degree of
complementarity.
• The larger the absolute value of the negative CED, the greater is the complementarity between
the two goods.
o If CED<-1, the two goods are close complements. For example, transit hotels (hotels
located at airport) and flights are usually consumed together. Transit hotels, such as
Crowne Plaza at Changi Airport, are often for passengers who have an extended stopover
and need a place to rest. Due to a rise in prices of flights, demand for transit hotels will fall
by more than proportionately. Thus, total revenue will decrease to a great extent
o If -1<CED<0, then the two goods are not very close complements. For example, hotels
located far away from the airport and tourist attractions may not be very close complements
to flights. Due to a rise in prices of flights, demand for transit hotels will fall by less than
proportionately Thus, total revenue will fall but by a smaller extent
(Other markets that were accepted include the market for suitcases/luggage, neck pillows, travel/flight
insurance and goods and services sold at duty-free stores in airports)
© RI 2018 9757/Preliminary Examination/Y6/18 [Turn Over

36
Conclusion
• [Overall stand] Analysis depends on the root cause of the change in prices of plane rides. It could
be due to a change in DD or SS. Markets can be further sub-segmented e.g. budget airlines vs.
full-service carriers. It serves as a useful guide for analysing the effects on different markets
• Firms in the various markets might choose to engage in strategies to mitigate the fall in revenue.
o Airlines may choose to practise price discrimination.
o A rise in price of air tickets is likely to produce a substantial decrease in holiday hotel
occupancy. Hotels may want to cater more to domestic tourists through staycations as
these tourists may not need to fly to the hotel and are thus unaffected by higher flight prices.
o Alternatively, airlines can also collaborate with hotels to take advantage of such
complementarities to create package deals, thus increasing revenues. Some offer
additional perks such as frequent flier miles (e.g. Krisflyer miles) for both hotel stays and
flights.
• Firms also need to account for cost as they ultimately care about profits.
Additional Remarks
• Students may choose to use PED, CED, YED and/or PES in their analysis whenever
appropriate.
• Markets analysed can include markets for factor(s) of production e.g. market for pilots
• Students are not required to use the preamble and limit the analysis to the Singapore-Kuala
Lumpur route. Other travel routes can also be used as examples
• The impacts on related markets would be different if flight prices rose due to an increase in
demand.
L1 • No theoretical framework. 1-4

• Smattering of points, glaring conceptual errors.
L2 • Scope and depth can be improved 5-7
• Only 2 markets discussed
• No link to effects, i.e. total revenue (TR)
• Unbalanced/One-sided discussion
L3 • Rigorous economic analysis that consider how PED and CED values may differ 8-10
for different segments of the market
• Effects are clearly explained and illustrated
• Full discussion of at least 3 markets
Evaluation
E1 Unexplained assessment. 1
E2 Evaluative assessment supported by economic analysis. 2-3
E3 Evaluative assessment supported by economic analysis and insightful comments based 4-5
on situations found in the real world

37
• Quite a number of candidates provided a straightforward explanation of the effects on the various
market. This did not fulfil the command word requiring responses to “discuss” the effects. A
discussion of the effects required candidates to go beyond basic analysis of
substitute/complement/FOP markets to explore the degree of substitutability/complementarity and
its consequent impact on the different markets.
• It was shocking that many candidates did not/could not distinguish the use of the terms “QUANTITY
DEMANDED” and “DEMAND”. Quantity demanded refers to the amount of goods purchased by
consumers at a given price. Graphically, Quantity demanded is represented as a single point on
the demand curve. Demand refers to the amount of goods purchased by consumers at different
prices. Graphically, it is a downward sloping line that comprises different “quantity demanded”
points.
• Following from the above point, a change in price brings about a change in quantity
demanded. For example, an increase in price caused quantity demand to fall which is represented
by a downward movement along the demand curve. On the other hand, a change in a non-price
determinant brings about a change in demand. For example, an increase in income causes
demand to increase which is represented by a rightward shift of the demand curve.
• Many candidates are confused between complements and factors of production. Complements
refer to a pairing of goods which are typically consumed together to fulfil a want. FOP refers to
labour and raw material required for the production of a good. Hence, pilots and cabin crew are
FOPs required for the production of airline services. They are not complements. Instead, the
demand for labour (pilots) is a derived demand.
• When discussing how complements like hotels will be affected by a rise in flight prices, many
candidates did not explain that the demand for complements will fall. If a point was made that hotels
and air flights were close complements, subsequent analysis must emphasise that demand for
hotels fell more than proportionately for a given increase in price of air flights. Merely stating that
demand for hotels would decrease would not be able to reflect the closeness of complementarity
of these two goods.
• A significant number of candidates are still confused between YED and PED. YED is used when
there is a change in income whereas PED is used when there is a change in price. Also, factors
that affect YED are different from those that affect PED. “Proportion of income spent on the good”
is a factor that affects PED. It is not the same as “luxury goods” or “inferior goods”.
• CED values can be either positive, negative or even non-negative. The modulus sign is
unnecessary.
• Candidates are once again reminded to include analysis on changes in equilibrium P, equilibrium
Q and TR/TE when the question specifically asks for effects. Many candidates attempted TR/TE
analysis without analysing changes in equilibrium P and Q, or vice versa.

38
Question 2
The China National Salt Industry Corp (CNSIC) controls all salt mines in China. It decides production
levels, prices and distribution channels in China’s salt industry. China Salt is the only brand in the
market. In order to raise competition, the government will allow licensed producers to produce salt,
determine prices, and establish their own branding.
Adapted from the Straits Times 2016
a. Explain the barriers to entry that exist in China’s salt industry. [10]
b. Discuss whether raising competition is the best policy to bring about desirable outcomes in the
salt industry. [15]
Part (a)
Introduction:
The China National Salt Industry Corp (CNSIC) is a monopoly with high price setting ability, i.e. the ability
to raise prices without seeing significant fall in quantity demanded of salt.
It is able to earn a huge amount of supernormal profits which are protected by high barriers to entry. Barriers
to entry are obstacles that prevent new competitors from easily entering an industry or area of business
and competing away the supernormal profits and dominant market share of the incumbent, in this case,
CNSIC.
Body:
In China’s salt industry, the following artificial or natural barriers to entry could exist:
1. Statutory barrier prior to 2016 in the form of a license to operate in the industry. This is an artificial entry
barrier by force of law. CNSIC has the legal right to prosecute any private producer of salt as it has
been given the exclusive right to produce and distribute it in China. To qualify for licenses that were
issued in order to raise competition in the market, potential firms have to incur a huge start-up cost in
the purchase of proper mining technology and capital equipment, proper distribution network and skilled
miners. Only firms with sufficiently large financial capital to start-up, will not be deterred by such a high
barrier to entry.
2. Gaining control over the supply of salt as the essential raw material from the control of salt mines
can be considered a strategic barrier. Stated in the extract, CNSIC controls all salt mines in China. No
private producers will have access to any of these salt mines and hence, cannot threaten its monopoly
position. Potential producers may seek to import salt from foreign sources, and incur higher production
costs compared to the incumbent. They will not be able to price salt as competitively, and end up losing
revenue, and together with higher production costs, subnormal profits.
This strategic barrier is further fortified by CNSIC control of the distribution channels of salt in China.
Such vertical integration involves firms in the first stage of salt production via mining all the way to the
last stage of production in terms of salt distribution. New firms are surely deterred by the lack of
prospects of obtaining salt mines, as well as distribution channels for salt.
3. Natural or structural barriers arise from differences in production and costs between
incumbent/existing firm and potential entrant. The incumbent or existing firm operating on a
relatively large scale of production is able to more fully exploit available internal economies of scale so
that its own long run average cost is lower than that of a potential entrant.
For example, this firm could experience technical economies of scale such as factor indivisibility, which
involves the purchase of very expensive mining equipment and spreading the equipment cost over
large level of output, resulting in significantly lower average cost of production. In large scale production
where miners can specialise and divide the work, each miner can do a simpler and more repetitive job.
Less training is needed and miners become more efficient in their particular job. Less time is lost in
workers switching from one operation to another. Miners are equipped with specific skills that can be
39
employed in those specific areas. If the incumbent firm can transfer such cost savings to consumers in
the form of lower price of salt, then any potential entrant will end up making losses if tries to match the
price of the incumbent firm but is unable to experience equivalent cost savings due to its low level of
output. Entry of new firms is hence deterred.
OR
The salt industry could possibly accommodate a natural monopoly, where internal economies of scale
is substantially experienced over such a huge level of output, and internal diseconomies never set in.
Figure 1 illustrates the revenue and cost curves of a natural monopoly. The LRAC curve of the natural
monopoly falls continually over the entire market demand, resulting in a very large minimum
efficient scale of production (MES) relative to market demand. In such a situation, the market demand
is large enough to support only one large firm operating at or near its MES (for eg OQe). With the lower
unit cost at OQe, the incumbent can deliberately reduce the price of its product to ward off potential
entrants who tend to operate on a smaller scale (less than output OQe) incurring a higher unit cost.
They are unable to compete effectively with the incumbent firm. This natural barrier thus discourages
potential new firms from entering.
Price/Revenue/Cost
Figure 1
Pe
AC
MC
MR ARmonopoly = market demand
O Qe Quantity
4. Sunk costs are costs, which once committed, cannot be recovered. Sunk costs could arise because
salt mining requires specialized capital inputs. New entrants risk making huge losses if they decide to
shut down after having already purchased such specialised inputs that cannot be utilised in any other
markets.
Conclusion
Knowledge, Application/Understanding and Analysis

L1 • Knowledge of relevant concepts 1–4
• Unexplained concepts, listing
• Critical errors in concepts
L2 • Application of knowledge 5–7
o Identification and explanation of the types of BTE in China’s salt
market
o Clarity about the role of BTEs in protecting profits of incumbents
• Some gaps and errors in analysis
L3 • Complete coverage of question. 8 – 10
o BTEs suggested must be clearly explained.
o Good contextual examples of BTEs should be given
• Detailed analysis

40
Candidates generally did well for part (a). They were able to identify relevant barriers to entry, elaborate on
them, albeit their theoretical features and function of deterring potential entry.
The best answers were able to use contextualised examples to bring clarity to the identified barrier to entry.
Candidates should:
1. Make full use of the preamble provided. While theoretical BTEs are acceptable, one should avoid a
theoretical rant of the possible types of BTEs in the salt industry. As far as possible, make use of the
BTEs suggested in the preamble to develop your case.
2. Categorise the types of BTEs accurately. There were quite a number of candidates who incorrectly
named the type of BTE that was described later on in the same paragraph. For example, stating that
the control of salt mines by the CNSIC was a natural barrier to entry.
3. Avoid confusion between limit and predatory pricing. Whilst limit pricing is the pricing strategy of the
incumbent to price its output below that which is profit maximising, predatory pricing is the pricing
strategy of the incumbent to price below cost (or technically, to price below average variable cost).
Part (b)
Introduction:
Define desirable outcomes as improvements in the performance indicators of a market.
These indicators are: improvements in economic inefficiency (reduction in economic inefficiency – both
allocative and productive inefficiency), distributive inefficiency (or inequity), dynamic efficiency and finally,
consumer choice.
Body:
Thesis: Raising competition is effective in bringing about desirable outcomes in the salt industry.
By allowing licensed producers to contest the salt monopoly, desirable outcomes could result.
1. The contested monopoly could become less allocative inefficient, i.e. price nearer to its marginal cost
of production.
Figure 2 below presents profit maximising output and pricing of the monopolist for which P>MC at output
0Q, at where marginal cost = marginal revenue.
Since the salt monopolist cuts back output from 0Q*, and prices above 0P*, that for which a perfectly
competitive industry would produce and charge, it is allocative inefficient.
Society values that last unit of output at 0Q more highly than the opportunity cost of producing it. More
resources should be channelled into the increased production of salt. There is deadweight loss (ABC)
from the underproduction of salt by the monopoly.
• With increased competition from private producers, CNSIC would possess less market power – lower
demand, a more price elastic demand curve, with consumers that are more price sensitive due to the
availability of cheaper substitutes. It has no choice but to reduce profitability from price dictatorship, and
decide toward charging lower prices relative to marginal cost. Hence becoming less allocative inefficient.
• Together with the existence of cheaper substitutes offered by private producers, the whole industry
would become less allocative inefficient, and deadweight loss reduced.

41
Figure 2
Price/Revenue/Cost
At 0P and 0Q (where MR = MC), price
(P)>MC and deadweight loss is ABC.
LRMC With more competition from private

producers, DD shifts leftward to DD’ and
LRAC becomes more price elastic. MR shifts
P A
leftward to MR’.
P’ D
P* B Where MR’ = MC’, a lower price (P’) will be
E
charged relative to MC’, there is less
allocative inefficiency and deadweight loss
MC C reduced to DEF.
MC’ F
DD’=AR’ DD=AR
MR’ MR
O Q’ Q Q* Quantity
2. The contested monopoly could become more x-efficient or less productive inefficient
• Increased competition and loss of market share would force the salt monopolist to produce on its
LRAC in the attempt to minimise losses or retain profits. This means less wastage of resources
which could be put into better use such as innovation of better quality salt.
• Dynamic efficiency could also result from rising intensity of competition as CNSIC diverts its
resources into innovation of cost-saving technology to produce salt. This could lead to lower AC at
every output level.
3. The loss of market share to private competitors would mean that
• The share of previously significant amounts of profit will go to these competitors (refer to figure
2).
• Together with lower price charged for salt to consumers. Consumer surplus rises.
Distributive inefficiency (inequity) is improved.
4. Finally, consumer choice is enhanced with the variety of brands that come with the entry of private salt
producers.
Anti-thesis: There are limitations that could arise from raising competition. Other ways of
government intervention could be more effective in bringing about desirable outcomes in the salt
industry.
The limitations that could arise from raising competition are:

• The ability of the monopolist to engage in predatory pricing to eliminate small private producers because
of its past accumulated supernormal profits. This means that the monopolist can set the price of salt
significantly below cost (technically average variable cost) and drive out its competitors who will suffer
subnormal profits and exit the industry, entrenching its monopoly position once again.
Evaluate: this could happen, unless the government prevents it from doing so. Predatory is considered
illegal in many countries. Given that the government has decided to raise competition in this industry
by inviting private producers, it could prosecute any form of predatory pricing by this monopoly.
• The monopolist has the financial capability of acquiring these small enterprises that contest its position
in the industry.
Evaluate: hence, anti-competitive regulation needs to be in place if the government truly desires to see
competition benefit consumers in this industry.
• A greater number of producers in the salt industry might not mean a greater variety of output. It could
be terribly challenging to try to differentiate types and quality of salt produced. Moreover, given that

42
these private small producers have little supernormal profits to start with to engage in quality innovation,
consumers could simply remain loyal to salt produced by CNSIC.
• Higher average costs for all producers, including the incumbent. If the production of salt entails high
fixed costs, then CNSIC would need a large domestic market to exploit all possible internal economies
of scale in order to experience cost savings. This would also apply to all salt producers that enter the
market. With reduced market size, consumers might not benefit from lower prices of salt, as producers
are unable to experience significant cost savings from smaller scale production.
• The erosion of supernormal profits from CNSIC means that the firm has less ability to engage in
research and development of better quality salt, or more efficient ways of producing salt. This
compromises on the desirability and performance of the industry.
In light of the limitations of raising competition in the salt market, better ways of government intervention
would be:
1. MC-AC price regulation: since the prevalent complaint against the salt monopolist could be high prices
for salt, with MC-AC pricing regulation, consumers benefit from significantly lower prices and higher
consumer surplus. In Figure 3 below, Pmc is significantly lower than P (at where MC cuts the AR curve)
Evaluate: however, MC pricing could mean that the monopolist has less supernormal profits available
to be used for innovation of new products. Or the possibility of subnormal profits which will require
government help via subsidy.
But economic inefficiency is reduced significantly.
Figure 3
Price/Revenue/Cost With MC pricing, the monopolist earns less
supernormal profits when it prices at Pmc
and produces at Qmc
LRMC Original amount of profit is CPAB. Final profit

amount is PmcFGE
Note:
LRAC
A
P • Diagram need not be that for a
Pmc F natural monopoly.
C B
G • AC pricing can also be explained
E
MR DD=AR
O Q Qmc Quantity
2. Corporatisation
Allow CNSIC to be government owned but to have a corporate structure, i.e. with a board of directors,
shareholders etc. This leads to less layers of bureaucracy associated with government bodies and
possible improvements in the performance of the firm in terms of better quality and lower priced salt. .
3. Allowing an anti-competitive legislative body to monitor the behaviour and performance of CNSIC in
the salt industry. This body can prosecute price or non-price decisions of CNSIC that significantly
compromises on the welfare of consumers and improves distributive efficiency.
4. Opening up the market to free trade (similar to raising competition). The advantage of subjecting the
salt industry to foreign competition, such as competition from the Netherlands and the United States is
that CNSIC would be subject to foreign firms with large global presence and low average costs of
production. Translated into lower prices in the domestic Chinese market, the imports of cheaper salt
would force CNSIC to price their salt competitively as well, incentivising R&D efforts to produce cheaper,

43
and better quality salt. A disadvantage of opening such a market to foreign competition is the loss of
government revenue from the sale of salt
5. Any other logical policy that brings about desirable outcomes.
The advantage of retaining the monopoly position of CNSIC is that substantial internal economies of scale
can still be reaped while consumers benefit from lower prices due to transferred cost savings that may not
happen if market demand is reduced for this company due to the influx of private producers.
Synthesis and Conclusion:

Raising competition would be the best policy if the government regulates anti-competitive behaviour of
CNSIC to oust out new competitors. If CNSIC however, remains a strong contributor to government revenue
from the sale of salt, then there is very little incentive for the government to monitor its price and non-price
behaviour towards smaller private producers. It remains that the least costly way of extracting salt requires
the ownership of salt mines, and that would mean that private producers find it difficult to manufacture salt
without the access to these natural resources. Their unit costs are higher and they are unable to price any
lower than CNSIC unless they find cheaper ways of manufacturing salt. Hence, raising competition without
the support measures of the government in favour of smaller producers will not lead to significant desirable
outcomes in the salt industry.

L1 • Some knowledge of desirable outcomes of raising competition 1–4
• Unexplained listing of alternative policies
• Critical errors in analysis of how the market could move towards better
performance
L2 • Sufficient knowledge of outcomes of raising competition 5–7
o Less allocative inefficiency
o Less productive inefficiency, possible x-efficiency
o Less distributive inefficiency
o More consumer choice
• Provides limitations to raising competition in the salt industry
• Sufficient discussion of alternative policies: how it works and why it may be a
better policy
• Some errors/gaps in analysis
L3 • Good scope of coverage of desirable outcomes in raising competition in the 8 – 10
salt industry
• Good scope of coverage of limitations in raising competition.
• Good scope of discussion of alternative policies.
Evaluation
E1 • Unsupported judgments made about raising competition as a way to improve 1
performance/desirability of the salt industry
• Unsupported judgment made on merits of alternative policies
E2 • Substantiated judgment, suggestion, comment. 2-3
E3 • Insightful and perceptive evaluation 4-5

.

44
Candidates who attempted this question, could structure their answers in a systematic way, which was a
pleasant surprise. This structure of the thesis – desirable outcomes, anti-thesis-limitations of raising
competition in the salt industry, alternative policies that could be implemented and their pros and cons was
generally adhered to.
Candidates should:
1. Be careful to draw accurate diagrams. With increased competition in the salt industry, CNSIC should
face a lower and more price elastic demand curve. The final output produced should be lower than its
original level of output, at where the new MR intersects the MC curve.
2. Be familiar with the condition of allocative efficiency, and know how to explain a condition of allocative
inefficiency as well as a condition of improved inefficiency. The state of allocative inefficiency involves
the deviation of price away from marginal cost at the profit maximising level of output for the monopolist
(figure 2 output level 0Q), where MR = MC. The socially desirable output of a competitive market is
where P = MC (figure 2 output level 0Q*). Hence, the value that society places on that last unit of output
0Q (price 0P) exceeds the opportunity cost of producing that last unit of output (MC). With increased
competition, the deviation between price and marginal cost falls as price falls to P’ and marginal cost
falls to MC’. Deadweight loss is also reduced.
A worrying significant number of students are not able to communicate this point well.
3. Not place a decision on the type of market structure that emerges from raised competition in the salt
industry. This leads to answers that are entrenched in oligopolistic behaviour, and off focussed. The
focus of the question is on monopoly behaviour and resulting performance due to the threat of
competition.
4. Focus on the primary effects of raised competition. CNSIC would face lower market demand, followed
by a fall in profits and would be forced to lower price. It would decide to engage in possible price and
non-price strategies. Candidates should not continue with their analysis of what would happen upon
successful price and non-price strategies of CNSIC.
Question 3
The importance of drinking clean water cannot be overstated when it comes to preventing illnesses
and death in developing countries. The Delhi Jal Board (DJB), the government agency responsible
for providing clean drinking water to the residents of Delhi, has announced that it will continue
implementing its free of charge scheme to all Delhittes.
Source: Adapted 2018 Budget Speech in Delhi, India.
Assess the appropriateness of the above policies in overcoming market failure in India’s clean
drinking water market. [25]
Introduction:
• Clarify ambiguity
o Define market failure
 Market failure refers to the failure of the free market to allocate resources in a socially
optimal and efficient manner as well as to achieve equitable outcomes.
o Based on the information in the preamble given, clarify the sources of market failure in India’s
clean drinking water market, which can include positive externalities in consumption, merit
good and excessive income inequality

45
Body:
• Thesis: It is appropriate for the government of India to intervene in the market for clean
drinking water with the above two policies because…:
Note: Any 2 sources of market failure can gain maximum 10 marks. In their responses, candidates
should
- Clarify the source of market failure in the market for clean drinking water in India by using
examples specific to the source of market failure and examples specific to India
- AND explain the derivation and divergence between the free market output and socially desired
output level with reference to a market failure diagram
- AND explain the deadweight loss with reference to the market failure diagram
o Excessive income inequality in India

 Application specific to clean drinking water market in India: In countries with
excessive income inequality like India, there will be groups of people who do not have
the ability to pay for necessities like clean drinking water (that is, on the grounds of
excessive income inequality and hence, inequity). Poverty is a significant issue in India.
5 percent of its 1.3 billion population live in extreme poverty. Recent debates of “water
as a human right” have prompted some to see water supply as a ’merit good’. In this
context, merit goods can be identified as goods to which everybody should have
access regardless of their ability to pay the market price. The underlying sentiment is
that equity in consumption of water across income groups is important to society in
general.
Price ($)
SS
C•
• B
P0 A•
DD1 (without excessive income inequality)
DD0 (with excessive income inequality)

0 Qe Qs Quantity
Figure 1: Excessive Income Inequality in the Market for Clean Drinking Water
 In a free market economy, an individual’s ability to consume goods & services and the
allocation of resources depends on dollar votes, which is dependent on individual’s
income or other resources such as savings. An excessive unequal distribution of
income and wealth may result in a misallocation of resources as the free-market will
not always respond to the needs and wants of people with insufficient dollar votes to
have any impact on market demand. What matters in a market-based system is
effective demand (willingness and ability to pay) for goods and services.
 With reference to Figure 1, the free market will allocate resources based on the dollar
votes, where DD (under excessive income inequality) equals SS and produce at 0Qe
units of output. However, the socially optimal level of output is higher at 0Q1 where DD
(under without excessive income inequality) equals SS. Hence, the free market
allocates too little resources from society’s point of view, resulting in underconsumption
(QeQs) of clean drinking water. This in turn leads to deadweight loss represented by
area ABC because the benefits lost (QeCBQs) from not consuming QeQs is greater
46
than the resources saved (QeABQs) from not producing QeQs. Society’s welfare could
be improved if more resources are allocated to the clean drinking water market in India.
o Positive consumption externalities in the clean drinking water market in India
Price ($)
SS = MPC of producing clean water = MSC
C
• B
P0 A•
MSB
DD = MPB from consuming clean water
0 Qe Qs Quantity
Figure 2: Positive Consumption Externalities in the Market for Clean Drinking Water
 Figure 2 shows the market demand and market supply curves for clean drinking water.
Assuming that there are no production externalities, this means that the marginal
private cost of production curve is the same as the marginal social cost of production
curve (MPC=MSC).
 The demand curve for clean drinking water reflects the marginal private benefit curve
(MPB) of consumption and it shows the additional satisfaction/benefit from each
additional unit of clean water consumed. In the pursuit of self-interest, consumers
only consider their own private benefits and the price they actually pay (which is the
MPC of consumption at price P0 in Figure 2). Clean drinking water prevents illnesses
and death in those who drink it, which in turn enables consumers to enjoy better health,
higher productivity and higher future earnings. The MPC incurred would include the
costs of procuring clean water.
 In the pursuit of self-interest, consumers fail to internalise the positive consumption
externalities generated for the rest of society. For instance, when individuals use clean
drinking water to cook and clean themselves, it reduces or prevents the spread of
water-bourne diseases and thus reduces the medical costs of third parties.
 The presence of marginal external benefits (MEB) from consumption creates a
divergence between the marginal private benefits (MPB) and marginal social
benefits (MSB) from consuming clean drinking water. This means that the marginal
social benefit arising from the individuals’ consumption of the good (MSB) is higher
than the marginal private benefit (MPB) by the amount of the MEB.
 The free market equilibrium is at A with output at 0Qe units, where MPB=MPC. On
the other hand, the socially optimal output level is 0Qs units, where MSB=MSC. At
the free market output level OQe, MSB exceeds the MSC of clean drinking water.
There is underconsumption of output by QeQs. Too little resources are allocated to the
production and consumption of clean drinking water. The deadweight loss is
represented by area ABC as the loss in benefit from not consuming QeQs exceeds the
resources saved by not producing QeQs from society’s point of view. The free market
equilibrium output OQe is thus allocatively inefficient. Hence, from society’s point of
view, there is under-consumption (QeQs) of clean drinking water. Too little resources
are channelled to the production of clean drinking water. By increasing the output of
clean drinking water, society gains more in social benefits than it incurs in social cost.

47
o Imperfect information causing consumers in India to undervalue clean drinking water

 Imperfect information causes the market for clean drinking water to fail. In India,
poverty leaves India with a relatively low literacy rate. Many consumers are thus not
fully aware of the actual marginal private benefits of consuming clean drinking water.
For example, due to imperfect information, these consumers tend to undervalue the
full benefits of consuming clean drinking water which include lowering the probability
of contracting water-borne diseases and risk of death to those who consume it. In
addition, drinking clean water reduces the probability of suffering from stomach-related
ailments.
Price ($)
SS
C
• B
P0 A•
DD1 (under perfect information)
DD0 (under imperfect information)
0 Qe Qs Quantity
Figure 3: Imperfect Information in the Market for Clean Drinking Water

 Figure 3 shows that consumers’ demand under imperfect information (DD0) is less
than consumers’ demand under perfect information (DD1) because they undervalue
clean drinking water. As such, free market output level Qe of clean drinking water under
DD0 will be lower than the socially desired output level under DD1.
 As Qe < Qs, the market fails because there is an under-allocation of resources to
produce clean drinking water such that social welfare is not maximised. Area ABC
represents the deadweight loss in the market for clean drinking water. Deadweight
loss refers to the social welfare loss that results from the under-consumption of clean
drinking water. Additional consumption of clean drinking water will increase social
welfare as the benefits from consuming additional units of QeQs is greater than the
costs of producing clean drinking water from society’s point of view. (Figure 3)
o Natural monopoly
 “By natural monopoly we mean an industry whose cost function is such that no
combination of several firms can produce an industry output as cheap as it can be
provided by a single supplier.” [Baumol et. al. (1977)]
 “Water utilities are monopolies not only because of the economic advantages related
to scale economies but also because of the economic advantages related to technical
considerations that prevent competition between several providers in a given area. The
management of a pipe network, the related heavy investments, the supply and the
treatment of water, and sometimes the sewage plants necessitate a monopoly.”
 Figure 4 shows that the profit-maximising firm will produce OQe units of water (where
MR=MC). The socially optimal output is however higher at OQs where P=MC. Hence
there is underconsumption of QeQs units of water. Identify the area that represent the
deadweight loss in figure 4.

48
Output
Figure 4: Natural Monopoly
• Thesis: It is appropriate for the government of India to intervene in the market for clean drinking
water with direct provision and giving it out free of charge because…
Note: In their responses, candidates should:

- With the help of a market failure diagram, explain how and why each policy in the preamble works
to achieve the intended aims of the government in the market for clean drinking water in India and
other advantages
- Explain limitations or undesirable effects or unintended consequences of the policy
- Evaluate based on the pros and cons of the policy whether it is appropriate for the government to
implement the policy in the given market
With reference to a market failure diagram, explain how and why direct provision works to
achieve the intended aim of the government
o Direct provision
 Direct provision means that the government is the supplier of the good or service for
social or ethical reasons. Direct government provision can take on different forms:
Reading which explains the various ways a government

may intervene in the market.
• In some industries, the government can be the only provider of the good or
service. In other industries, where there is government provision of a good
supplementing the private sector provision of these goods/services (though to
varying degrees).

49
• The government can directly provide the good through the public sector. Public
ownership, or nationalisation, involves direct provision by the government, but
the goods and services produced are sold on the market. When the
government nationalises an industry, it is taking the industry under state
control. Under nationalisation, the goods and services produced are sold on
the market. The government can also directly provide the good by contracting
the private sector to supply the good/service while paying private sector firms
to do so (that is, financing this out of taxation, rather than engaging in direct
production).
 With reference to a market failure diagram, explain how and why direct provision
works to achieve the intended aim of the government: E.g. In order to reduce
underconsumption arising from positive consumption externalities, the government can
engage in direct provision by supplementing what is provided in the private sector. This
will lead to an increase in quantity supplied of clean drinking water at every price,
meaning that market supply of clean drinking water will increase, which is reflected by
a rightward shift of the market supply curve from SS0 to SS1 (Figure 5). The increase
in market supply will lead to a surplus at P0 which will exert a downward pressure on
price, causing price to fall from P0 to P1, which in turn causes quantity demanded to
increase from Qe to Qs because the fall in price will lead to an increase in consumers’
real income which increases consumers’ purchasing power. Hence, at Qs and P1,
allocative efficiency is achieved. The lower prices also mean that clean drinking water
is made more affordable to lower income families.
 Other advantages of direct provision: Government has greater control over the
quality of water, ensuring that it meets a minimum standard.
Price/Cost/Benefit ($)
SS0= MPC = MSC of producing clean water
SS1
C
• B
P0 A•
MSB
P1
DD = MPB from consuming clean water
0 Qe Quantity
Qs
Figure 5: Positive Consumption Externalities in the Market for Clean Drinking Water
 Explain limitations or undesirable effects or unintended consequences of direct
provision
• Government agencies are usually not profit driven, hence the government
agency that provides water might be run inefficiently, incurring higher costs
than necessary, which results in wastage of resources from society’s point of
view. Hence, X-inefficiency arises. Higher costs can also lead to lower profits
which reduces the government agency’s ability to innovate, causing the quality
of water may stagnate in the future. Thus, dynamic efficiency falls.
• In trying to reduce underconsumption from the presence of positive

consumption externalities, government agencies may lack accurate
information on MEB because it is difficult to measure the MEB. This limits the
government’s ability to use direct provision to achieve the socially optimal
amount of clean drinking water.
50
 Evaluation
• Weigh pros and cons and decide if the government should continue with direct
provision and/or suggest and explain alternatives like regulation
o Instead of direct government provision which tends to lead to X-
inefficiency due to the lack of profit-motive, the provision of water
should be left to the private sector but the government can implement
rules and regulations to regulate the behaviour of the firms in the
private sector. E.g.
 The government can conduct regular checks to ensure that
the quality of drinking water meets a minimum standard
otherwise the firm would be heavily fined or would lose its
contract.
 Or in reducing underconsumption arising from a natural
monopoly, instead of nationalising the industry, the
government can regulate the behaviour of the private firm by
regulating the prices that the private monopoly sets, for
example either through MC pricing or AC pricing policy.
Elaborate with reference to Figure 4.
o Making it free of charge to its all citizens:

 With reference to a market failure diagram, explain how and why making water
free of charge works to achieve the intended aim of the government: Assume that
the government supplies clean drinking water to the entire market. In order to reduce
underconsumption arising from excessive income inequality, the government can
make water free of charge to all its residents. When the government set price at zero,
consumers will increase their quantity demanded until the level where their MPB of
consumption equals their MPC of consumption which is equal to zero. According to
Figure 6, when price is set at zero, quantity demanded increases to Qfoc, which
happens to coincide with the socially optimal level at Qs (note that this is usually not
the case).
 If the government also sets output level at Qs, then allocative efficiency is achieved
(Figure 6). In addition, clean drinking water is made more affordable.
Price ($) C •
SS
• B
A• DD1 (without excessive income inequality)

P0
Quantity
0 Qe Qs = Qfoc

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 Explain limitations or undesirable effects or unintended consequences of free of

charge scheme:
• Free water tends to lead to very inefficient uses of water, including
increased wastage. Figure 7 shows that when the price of water falls from P0
to zero price, quantity demanded increases from Qe to Qfoc, Qfoc exceeding
the socially optimal level (Qs).
• Based on Figure 7, if the government sets output level at Qfoc, making water
free of charge will then lead to overconsumption of water from society’s point
of view, resulting in allocative inefficiency. Identify the area that represents the
deadweight loss arising from overconsumption at Qfoc.
• The free of charge scheme is extremely costly to the government. Identify the
area that represents the amount that the government has to incur to provide
water for free at output Oqfoc. High opportunity costs (elaborate).
• If, on the other hand, the government were to set output level at Qs (Figure
7), then making water free of charge will result in a shortage of clean drinking
water where quantity demanded at Qfoc exceeds quantity supplied at Qs. This
will result in sprawling queues for government water tankers and public taps.
Price ($)
SS
C•
• B
P0 A•
DD1 (without excessive income inequality)

0 Qe Qs Qfoc Quantity
 Evaluation
• Weigh pros and cons and decide if govt should continue with its free of charge
scheme and suggest refinements to the policy
o E.g. Explain why subsidies should be targeted only at the poor instead
of everyone
• Evaluation
o E.g. Assess whether other policies should be used instead. Recommend refinements to
existing policies or suggest new and more suitable policies given the changing demographics
of India
 E.g. In terms of tackling excessive income inequality, a more targeted subsidy directed
at the poor because not everyone cannot afford clean drinking water (there is a
segment of the Indian population that is financially well to do and very rich).
 E.g. With reference to the market failure diagram on imperfect information, explain why
education and campaigns might be a better policy.
 E.g. In terms of ensuring that a minimum standard of water is provided by the private
sector, the government can implement regulation and legislation (that is, the private
sector supplies clean drinking water but the behaviour of the private sector is subjected
to rules and regulation)

52
• E.g. In 2001, India’s groundwater authority banned private water extraction in

Delhi due to the looming fear of groundwater depletion. However, the black
market persists. Here’s how dire the situation is: According to scientists at the
National Geophysical Research Institute, Delhi could dry up in a few years.
 E.g. Explain why consumption of clean water should be taxed instead - water
conservation policies
• Negative consumption & production externalities
o E.g. The water supply process produces environmental externalities
which may be damaging such as rivers drying out and depletion of
acuifers. The free market mechanism deos not capture these external
effects, hence clean drinking water might be over-supplied because of
negative environmental externalities.
• Prediction about future demand and supply of clean drinking water
o E.g. Water is a finite, vulnerable and essential resource which should
be managed in an integrated manner. Water having a price will give a
clear signal to the users that water is indeed a scarce good that should
be used sparingly. It will stimulate conservation, may curb demand
and encourages the use of water for high value uses.
o E.g. In India, “a growing population led to the mounting demand for
water, with the result that water tables were falling and many water
sources were shrinking or drying up altogether. Rapid urbanization is
placing an increasing strain on water sources.”
Reading on bringing clean drinking water to

villages in India
 “Water should be priced accordingly to provide a

sustainable financial model for the proper operation,
maintenance, updating and construction of new facilities for
water and wastewater treatment systems. Concurrently,
poor families should receive targeted subsidies so they
have access to reliable water supply and wastewater
treatment services. The subsidies could start, for example,
when the water bill of a household exceeds 2 per cent of its
income.”
Reading on the real cost of

drinking water
o E.g. Compare 2-3 reasons about why a government might want to intervene in the market for
clean drinking water and come to a reasoned conclusion about which reason holds the most
weight. Explain why.
o Overall judgement in conclusion

 Make a judgement on whether direct provision or free of charge scheme or other
policies is better in the long run or whether the free market should be left alone (market
failure vs government failure) and support your judgement using economics analysis
as far as possible.
53
L1 • Knowledge of relevant sources of market failure and the interventions raised in the 1–8
question
o Market failure; allocative efficiency and income equity; DWL
o Excessive income inequality And/Or Positive consumption externalities
disregarded because of the pursuit of self-interests And/Or Imperfect
information leading to consumers undervaluing clean drinking water
o Direct provision
o Free of charge scheme
 Max 4
o Listing without explanation of how and why throughout
 Max 6
o 1 policy with limitation(s) only and not linked to any source of market failure
o 1 source of market failure only and no policy
 Max 8
o Journalistic style of writing throughout without using any tool of economic
analysis
o Critical errors in analyses of sources of market failure and interventions
throughout
L2 • Uses appropriate tools of analysis and examples to link analyses of direct provision 9–14
policy and/or free of charge scheme to the source(s) of market failure in the
question. That is, explain how and why each of the policy works in achieving the
intended aim of the government using the market failure diagrams. Explain the
limitations or other undesirable effects of the policy.
• Some lapses in terms of scope and rigour and application
 Max 14
o Balanced answer of only 1 policy (either direct provision or free of charge
scheme) addressing 2 relevant sources of market failure
One-sided answer of 2 policies addressing 2 sources of market failure
L3 • Detailed and accurate analysis of 2 sources of market failure and a balanced 15–20
approach to the 2 policies in the question in the context of clean drinking water in
India using economics framework.
o Uses the market failure diagrams to explain how and why both direct
provision and free of charge scheme are able to address underconsumption
and allocative inefficiency from at least 2 sources of market failure in the
market for clean drinking water in India. Explains the pros and cons of both
policies using economic framework.
o Understands the difference between direct provision and free of charge
scheme
o Provides application specific to clean drinking water AND India (some
awareness of characteristics typical of a developing country suffices)
 To secure high-end L3 (18-20)

o Good organisation, fluent, accurate and coherent arguments with real world
application to secure 18-20 marks

54
Evaluation
E1 • Unsupported judgment on the appropriateness of direct provision and/or free of 1

charge scheme
• And/or unsupported suggestions of alternative policies or refinement to mentioned
policies.
E2 • Substantiated judgment and comment on the appropriateness of direct provision 2-3
and/or free of charge scheme
• Substantiated judgment and comment on the appropriateness of alternative
policies or refinement to mentioned policies
E3 • Substantiated judgment, comment on the appropriateness of direct provision AND 4-5
free of charge scheme BASED ON economics analysis/framework
• AND other insightful and perceptive evaluation based on economics
analysis/framework
1. Nearly 50% of the H2 candidates attempted this question. The responses varied in quality. It was
evident from the quality of the responses that candidates were prepared for a question of this nature.
However, due to time constraint, a significant number of students were not able to complete the essay
as well as they could. These candidates are advised to improve their time management skills and to
balance their time well across all 3 essays. Most candidates were able to get at least a L2 and E2 mark
for this question.
2. Almost all the candidates used diagrams to explain the different sources of market failure generated
from the consumption of clean water. Most generally gave accurate diagrammatic representations of
the different sources of market failure. However, there were still a few candidates who misrepresented
the welfare or deadweight loss on their diagrams.
3. There were a significant number of responses that were still unclear of the conceptual difference
between imperfect information and externalities. The focus of imperfect information is about consumers
undervaluing the MPB from consuming clean drinking water and not on externalities. In other words,
the main reason why external benefits are ignored is due to the pursuit of self-interests and not
imperfect information. The focus of imperfect information is on the consumers themselves and how the
lack of perfect information results in consumers not acting in their own best interests, thus the need for
government intervention, while for externalities, the focus is on the third party
4. Diagrams need to be well-labelled and referred to in the textual explanation, otherwise no credit will be
awarded for the diagrams.
5. Candidates paid attention and showed an understanding of the command word “Assess” and discussed
the pros and cons of the above two policies. A conclusion was also provided by most candidates at the
end of their responses. Candidates are advised not to provide a one sentence conclusion but to explain
why they come to that stand.
6. The focus of the question was on analysing and evaluating the two policies the government has been
adopting to correct any two sources of market failure. Quality ranged from those who elaborated on
their answers using economic framework to those who did not.
7. A large majority of responses did not interpret direct provision and the free of charge scheme as
separate policies. Candidates need to address the direct provision policy and the free of charge scheme
as two separately policies. Direct provision is not synonymous with free of charge scheme. Candidates
that failed to interpret it correctly tend to suffer in terms of the scope of analysis.

55
8. A number of responses wrongly attributed the notion of direct provision of clean water to clean water
being a public good, just because public goods are directly provided by the government. Public goods,
like street lighting and national defense, need to be directly provided by the government because the
free market has no incentive to produce these goods because public goods possess the features of
non-excludability and non-rivalry. To achieve the socially optimal level, provision of public goods also
has to be free because public goods are non-rivalrous.
Merit goods (such as clean water, healthcare services), on the other hand, are provided by the free
market because merit goods are private goods – they possess the features of excludability and rivalry.
The government, however, intervenes in the market for merit goods because if left to market forces,
merit goods will be underconsumed and underproduced from society’s point of view. One method of
intervention is through direct government provision. Direct government provision of merit goods,
however, is not the only form of intervention. Other forms of intervention include the use of subsidies
(whereby the private sector is the supplier but the government uses market-oriented policies like indirect
subsidies to reduce the cost of production and in turn increase supply to reduce the price so as to
increase the quantity demanded in the market), rules and regulation (whereby the government uses
laws to govern the behaviour of private suppliers and consumers) and education and campaigns
(whereby the government improves the flow of information dissemination so as to influence the level of
demand). In many cases, direct government provision of merit goods need not be free of charge.
9. Responses that did not use the market failure diagrams to explain how the policies work could not be
awarded Level 3 marks. Policies in such responses were lacking in economic analysis/framework.
10. Direct provision and the free of charge policy do not result in a shift of the demand curve. Both policies
lead to a movement along the demand curve.
11. Candidates need to use the terms “demand” and “quantity demanded” accurately. Likewise, “supply”
and “quantity supplied”.
12. Direct provision is not a subsidy. In the case of direct provision, the government is the supplier of the
good. Subsidies are market oriented policies whereby the private sector is the supplier of the good and
the government implements subsidies to change the behaviour of the private firms (in the case of
indirect subsidies) and to change the behaviour of consumers (in the case of direct subsidies). A
number of candidates mentioned the use of a subsidy to reduce the cost of production but incorrectly
shifted the demand curve. Indirect subsidies shift the supply curve but direct subsidies shift the demand
curve.
A variety of externalities arise from the extraction, storage, distribution, use and the ultimate disposal
of water. For instance, negative externalities can be generated from water extraction activities (which
can lead to lost biodiversity) and improper disposal of waste water (which can lead to reduced
recreation and commercial fishing). Based on the key words provided in the preamble and question,
however, it is clear that the question is focusing on positive externalities arising from the consumption
of clean water. Candidates are advised to read the preamble and the question carefully and to set their
responses in the given context.
13. A large number of candidates were not able to explain the market failure arising from excessive income
inequality accurately and provided very journalistic explanation for the underconsumption of water if left
to the free market. Most answers were brief, saying that poorer consumers in India are unable to
purchase water at a higher price and hence their demand for clean water with excessive income
inequality is lower than without excessive income inequality.
A more rigorous explanation would require a link to be made to the source of market failure due to the
lack of effective demand with excessive income inequality. For example, clean water is a merit good
but will be underconsumed due to excessive income inequality in India since it is a developing country
with a large number of its people living under the poverty line who do not have the ability to purchase
56
clean water. As a result, the effective demand which is based on the willingness and ability to pay will
be lower with excessive income inequality than that without excessive income inequality as consumers
with insufficient dollar votes do not influence the effective demand. Hence, there is underconsumption
of water under the free market. A large number of candidates also failed to explain how the free market
and socially optimal level of consumption of clean water is determined with reference to the diagram.
Question 4
(a) Explain why a government seeks to achieve sustained economic growth, low inflation and
external stability. [10]
(b) Discuss how far potential conflicts in policy objectives play a part in Singapore’s choice of a
mix of policies to achieve macroeconomic goals simultaneously. [15]
Part (a)
Introduction:
• Clarify that sustained economic growth, low inflation and external stability (healthy balance of payments
and exchange rate stability) are all key macroeconomic objectives of a government.
• Attainment of these KPOs is important as it is indicative that the economy is successful and can raise
the standard of living for its citizens.
Main Body/Development:
• Reasons for seeking to achieve sustained economic growth
Higher levels of consumption hence higher standard of living (material and non-material) can
be achieved
 Sustained economic growth is achieved when an economy achieves BOTH actual growth and
potential growth.
 The dilemma of “unlimited wants but scarce resources” becomes less acute with economic growth
as it is the path to material abundance.
 Actual growth is achieved when there is a rise in real national income. Assuming economic growth
outstrips population growth, there will be an increase in real GDP per capita  assuming production
of goods and services are consumed in an economy  an increase in material standard of living
i.e. more goods and services consumed by an average citizen in the country.
 Non-material aspects also rise when income rises. The important amenities of life become
affordable. Higher income can be spent on travel and other leisure activities that help them to relax
and therefore add to the quality of life for an average citizen. In addition, the non-material well-
being is also improved as more choices and options to nutrition and healthcare becomes available
which increases life expectancy.
 Potential economic growth is achieved when the economy is able to expand its productive capacity
i.e. increasing the maximum amount of goods and services that the economy can produce. This
implies that actual growth can continue to increase into the future  job security  increased
material and non-material SOL
Other acceptable points:

 Sustained economic growth helps to reduce unemployment by creating jobs. With economic growth,
more goods and services are being demanded and produced which will in turn lead to a greater
derived demand for labour. This is significant because unemployment is a major source of social
problems such as crime and alienation.
 Sustained economic growth means that jobs are continually created and this leads to assurance of
job opportunities and security which lessens the stress level. This will also help to improve the non-
material aspects of SOL.

57
 Sustained economic growth also means an increase in tax receipts for the government and hence
higher ability to provide public and merit goods that add to both material and non-material standard
of living (increased access to healthcare and education, caring for the environment, building of
parks etc.).
 With higher economic growth, the government will also be able to collect more taxes. The
government will be able to spend more on social safety nets like unemployment benefits, healthcare,
in addition to infrastructure and recreational facilities. The people’s material and non-material
standard of living will improve and people’s welfare will be better.
• Reasons for seeking to maintain a low rate of inflation

Ensuring price stability can help facilitate efficiency in resource allocation
 The government aims for an efficient resource allocation by enabling markets to operate effectively
within a stable economic environment. Price stability aids in economic decision making, allowing
agents to make accurate decisions based on expected price movements which can help facilitate
efficiency in resource allocation. When inflation is low, people do not have to spend a substantial
quantity of time and resources in search for mechanisms to defend themselves from the high
inflation (for example, businesses channeling more resources into portfolio management such as
property, stocks and shares). Instead, time and resources are channeled to more productive
investments which lead to better allocation of resources and actual and potential growth.
Ensuring price stability can help promote investment and in turn potential economic growth
 If inflation is low & stable, firms will find it easier to predict changes in cost of production and prices
and in turn profits more accurately which makes long-term planning easier for businessmen. Hence
their willingness to invest will increase and in turn, investment increases. The increase in
investment will lead to an increase in fixed capital formation and hence productive capacity of the
economy. This promotes potential growth because when more capital goods are produced, the
economy’s ability to produce final goods and services in the future will increase.
Ensuring price stability can help promote international competitiveness and improvement in the
BOP
 Price stability also helps improve price competitiveness of exports
 If domestic inflation is lower relative to inflation in other countries, this improves the price
competitiveness of the domestic country’s exports. Foreign countries will buy more of the relatively
cheaper exports hence raising export revenue. In addition, with relatively lower inflation rates
domestically, households will switch away from the relatively more expensive imports and towards
domestically-produced import substitutes and thus, reducing import expenditure, assuming
demand for imports is price elastic. In sum, the balance of trade position for the country will improve,
ceteris paribus; its balance of payments position will improve.
• Reasons for seeking to maintain external stability

External stability entails attaining a healthy balance of payments and exchange rate stability
 Healthy BOP means currency outflows balances with currency inflows over a period of time. If the
healthy BOP is achieved because the country does not have excessive BOT deficit, this implies
that the economy is able to finance their international transactions and therefore need not borrow
to finance the deficit. Hence there will be no incurrence of foreign debt.
 Healthy BOP means that there is no excessive pressure on the exchange rate (since currency
outflows balances with currency inflows). If the country adopts a fixed exchange rate system, this
implies that the government does not need to intervene in the foreign exchange market to prevent
excessive depreciation or appreciation of its currency which are destabilising for the economy.
Excessive depreciation may result in imported inflation or loss of welfare as imports become more
expensive in domestic currency while excessive appreciation means that exports are relatively
more expensive in foreign currency hence eroding export competitiveness.
 When exchange rates are stable, foreign firms are able to predict with greater certainty the
profitability of their investment projects and this increases the level of foreign direct investment.
This in turn improves the balance of payments account on the capital and financial account and
promote actual and potential economic growth in the country.

58
 Stable exchange rate also means that there is less opportunity for attack on the currency by
speculators. There is hence less necessity for the government to hold foreign reserves to intervene
in the exchange rate market and these foreign reserves can be channelled to more productive
alternative use.
Conclusion:
• Successful economy will mean that there is increasing standard of living for the average citizen.

L1 • Unexplained concepts/analyses. 1–4
• Critical errors in concepts/analyses.
L2 • Insufficient scope 5–7

o Only covered maximum of 2 macroeconomic goals
• Some gaps/errors in analyses.
L3 • Complete coverage of at least 3 macroeconomic goals 8 – 10

• Detailed analyses
• Part (a) of the question was well attempted with many candidates scoring in the higher mark range.
Nonetheless there are still some points that students need to take note of.
• The costliest mistake is when candidates misinterpret the question requirement. The question indicated
the need for candidates to “explain why” governments seek to achieve the three goals i.e. the
BENEFITS of achieving the goals. However, there were some candidates who explained in great detail
as to “how” the goals were achieved. This was particularly rampant for “sustained economic growth”
where candidates explained in great detail how a rise in AD and rise in AS (usually with the use of
AD/AS diagram) will lead to sustained growth. The diagrams and the accompanying analysis were all
NOT required for part (a).
• Luckily, these candidates could still score if they went on to explain the increase in SOL as a result of
economic growth, though they have wasted a lot of precious time in the process. However, there were
a worrying handful of candidates who did not link to the benefits of sustained economic growth and did
not gain marks as a result.
• Majority of the candidates understood the need to explain the benefits but the quality of their answers
differed widely.
• To score well, candidates need to improve on depth of economic analysis for each of the 3 goals.
Sustained economic growth:
o Many candidates wrote like this:
“Actual growth means that there is a rise in income. This means that households experience a rise
in purchasing power and hence an increase ability to consume goods and services therefore
improving their material SOL. When income rises, citizens can also spend more on healthcare and
education, therefore increasing non-material SOL as well”.
While this analysis is accurate, it is far too skimpy!
o Better candidates were able to explain clearly that the proxy for measuring material SOL was real
GDP per capita. Assuming population growth is lower than real GDP growth, an average citizen can
consume more goods and services. Alternatively, candidates could have explained how increased
production meant that more labour resources will be employed hence according them a rise in the
ability to consume.
o As for non-material aspects of SOL, candidates could have elaborated on the qualitative aspects of
SOL. E.g. Higher income can be spent on travel and other leisure activities that help them to relax
and therefore add to the quality of life for an average citizen.

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Low inflation:
o One of the most common response was to explain how low inflation will help improve price
competitiveness of exports. A few common concept errors related to this analysis are as follows:
1. “Low inflation means that prices of exports will fall and hence …” – Low inflation means prices
will still rise. The correct phrasing: “If domestic inflation is lower relative to inflation in other
countries, this improves the price competitiveness of the domestic country’s exports”
2. “Due to relatively cheaper exports and relatively more expensive imports, assuming M-L condition
holds …” – M-L condition is only relevant when the change in relative prices is due to changes in
exchange rates.
External stability:
o This posed problems for more candidates than the other 2 goals.
o One common mistake was to explain that external stability meant a country is able to be less
susceptible to external shocks. Many went on to explain this was particularly important for small
open economies because a fall in income of its trading partners will mean a fall in Net X and growth
etc. This is totally off-focus as they were explaining the causes of external instability.
o The focus of the question should be on the benefits of external stability. Candidates will need to
work on improving their understanding in this aspect.
Part (b)
Introduction:
• Conflicts in policy objectives play an important part in Singapore government’s choice of the mix of
policies to achieve economic goals simultaneously.
• However, there are other factors which will also affect SG government’s choice of policy mix.
Main Body/Development:
• Conflicts between macroeconomic policy objectives is an important consideration in the choice
of policy mix in Singapore
Conflict 1:
o Achieving actual economic growth/low unemployment conflicts with price stability
 Explain how expansionary fiscal policy to boost actual growth may result in demand-pull
inflation.
 ↑ G and/or ↓in T (↑ C & I)  ↑ AD hence multiplied increase in real national income via the k
effect  EG is achieved. (Brief multiplier will suffice)
 ↑ production levels  Need to employ more labour resources (derived dd)  Achieve low
unemployment
 However, ↑AD brings the economy closer to Yf  lack of spare capacity  competition for
scarce resources amongst firms  bidding up factor prices  ↑COP that is passed on
to consumers as ↑GPL  DD-pull inflation resulting in conflict between actual EG/low
unemployment and inflation.
(Students are required to explain using diagram)
Implication on choice of policy mix.

o Therefore, SG government tend to adopt expansionary FP with SS-side effects or complement
expansionary DD management policies with SS-side policies to mitigate the potential conflict.
 Explain how the use of FP with SS-side effects or in combination with SS-side policies will
mitigate the conflict
 E.g. Expenditure on infrastructure (or any sound SS-side policy e.g. education and retraining
of workers)  Expand productive capacity  ↑ AS of the economy  Able to achieve higher
actual EG without inflationary pressure.

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Conflict 2:
o Pursuit of improvement in BOT/ Economic Growth conflicts with inflation
 Depreciation of SGD against foreign currencies to tamper imported inflation may result in
improvement of BOT BUT worsens cost-push inflation
 Depreciation of SGD  ↓ Price of SG exports in foreign currency and ↑ Price of imports in SGD
 ↑Qddx and ↓Qddm. If PEDx+PEDm>1  ↑(X-M)  ↑AD  ↑ RNY
 Moreover, ↑ (X-M)  Improve BOT (in the short run)
 Hence, depreciation of SGD  expansionary effect on economy  ↑Actual Economic Growth
due to rise in AD  ↓ unemployment
 However, when SGD depreciates  Price of imports become relatively more expensive in SGD
 ↑ COP due to ↑ cost of imported raw materials and intermediate goods  ↓ AS due to high
import reliance in Singapore  ↑ M induced cost-push inflation
 Rise in AD also results in DD-pull inflation.
 Students can also address zero appreciation stance instead of depreciation but that entails a
slightly different approach (See Alternative Approach below)
o Implication on choice of policy mix.

 MAS is careful in monitoring its adoption of the gradually, modestly appreciating SGD
against foreign currencies.
 Appreciation  reduce inflationary pressure however will affect price competitiveness of X
 Need to maintain competitiveness of exports through combining use of other policies e.g.
increasing labour productivity through use of SSP  improve quality of exports
Conflict 3:
o Achieving potential EG conflicts with structural unemployment
 When government employ SS-side policies eg. PIC/PSG to encourage adoption of tech/K
equipment in production  ↑AG (thru ↑AS)  ↑structural unemployment since automation
replaces low-skilled labour  retrenched labour do not possess relevant skills to be employed
in other industries.
 Same applies to SS-side policies eg. R&D/innovation to source for new areas of CA/growth.
o Implication on choice of policy mix

 Use of SSP to drive increased productivity/R&D & innovation will need to be coupled with other
forms of SSP that increases labour mobility e.g. skills training
 Increase in occupational mobility  Ability to move into other industries  able to reduce
structural unemployment together with improvement in potential EG
• COUNTER ARGUMENT: Other factors play a critical role in the choice of policy mix in Singapore
• The combination of policies is not merely adopted to mitigate the potential conflicts. There are others
factors influencing this particular policy mix.
1. Economic priority/Root cause of problem
 It is the state of economy that worsens the conflicts between actual EG and dd-pull inflation
since the lack of spare capacity in an economy that is approaching Yf, is the main reason that
led to the competition for scarce resources. During severe economic recession, there will not be
excessive inflationary pressures when pursuing expansionary FP since there is usually sufficient
slack in capacity (where the economy is operating on or nearer to the horizontal portion of AS
curve)
 However, even during a recession, SG govt adopts exp FP with SS-side implications. This
primarily targets at potential EG rather than the trade-off per se, since sustained EG can only
be achieved when there is potential EG.
OR
 During a severe economic downturn, the SG government may even allow SGD to depreciate
and allow some degree of cost-push inflation. However, the depreciation of SGD may not be
sufficient on its own to increase X revenue (since YED > 1 for SG Xs) and stem ↓ EG or ↑ UNm.
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Hence the SG will need to use ER policy together with expansionary EFP (to drive EG) or with
jobs credit scheme to stem ↑ in UNm.
 Hence conflicts are not the main consideration in choice of policy mix.
2. Nature/Characteristics of the Singapore economy

 Size of multiplier
 The primary purpose of combining expansionary FP with SS-side policies is due to the
nature of the SG economy rather than to mitigate policy conflicts.
 K is small in SG. K = 1/MPW. Since SG has a high MPS (due to CPF contributions and
Asian thrift culture) and MPM (due to the lack of resources).
 ↑ AD  more than proportionate ↑ RNY but the high marginal propensity to withdraw results
in a faster rate of withdrawals from the circular flow.
 Hence a large amount of government expenditure needs to be injected into the economy to
increase ↑ RNY to the desired level. The opportunity of the use of government funds will
have significant. Hence there is a need to ensure that the ↑G also leads to ↑ productive
capacity.
 Openness of the Singapore economy e.g. Impossible trinity, reliance on exports &/or imports
 X constitutes a large proportion of GDP/AD
 The more open an economy is, the larger the X as a % of GDP, hence the larger the ↓AD
caused by ↓Net X (ceteris paribus)
 However, depreciation of SGD is not a viable option as it will result in imported cost-push
inflation due to Singapore’s import reliance.
 Zero appreciation stance alone is insufficient and therefore needs to be combined with
expansionary FP to mitigate the fall in AD.
OR
 Due to open economy trilemma (Students need to explain ) SG needs to forgo use of MP
centred on interest rate as a policy tool.
 Hence, unable to use monetary policy centred on interest rates in combination with
exchange rate policy  Adopt other mix of polices instead
 Labour constraints e.g. small population, ageing population

 Lack of labour resources results in inflationary pressures
 Need to use supply-side policy to boost labour productivity together with process innovation.
 Does not stem from conflicts between potential growth and structural unemployment.
3. Time period
 Expansionary FP has significant time lags i.e. recognition lag and implementation lag that
worsens the trade-off with dd-pull inflation since the existence of long time lags could mean that
the expansionary effect on AD only materialises when the economy has almost recovered from
a recession.
 To mitigate the effects of time lag, SG government adopts exp FP with SS-side effects so that
there is also an increase in productive capacity which can mitigate the extent of dd-pull inflation.
Alternative approach
• SG adopts gradual modest appreciation stance because of the nature of the SG economy (small and
open)
• Appreciation of SGD  ↑AS and ↓AD  Trade-off between inflation and BOT/EG
• HOWEVER, in the long run (TIME PERIOD), use of gradual modest appreciation results in low rate of
inflation
o If SG’s inflation rate is lower than competitors  improve that allows improves price
competitiveness of exports  Rise in DD of exports  Improve X revenue and hence BOT
o Moreover, ↑ Net X  ↑AD  no conflict in the long run.

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• In addition, the SG government can also supplement the appreciation stance together with
contractionary FP to dampen inflation in the short run as appreciation of SGD only wards off imported
cost-push inflation but does not address internal sources of inflation.
Conclusion:
• Agree that conflicts in policy objectives do play an important role in government’s decision of policy mix.
• However, other factors can sometimes outweigh the importance of these conflicts in influencing macro
policy decisions e.g. The severity of economic issues facing an economy
• Hence, which factor is more important in affecting policy decisions really depends on the
macroeconomic challenges facing the Singapore economy and the extent to which the conflicts can be
managed.

L1 • Some knowledge of reasons that affect the choice of policy mix. 1–4
L2 • Somewhat descriptive explanation of the reasons that affect the choice of policy 5–7
mix.
• There will be an attempt for balance but answer will not be very well-developed.
L3 • Good coverage of question requirement. 8 – 10
o Addressed BOTH potential conflict in influencing policy mix AND other factors
influencing policy mix.
• Detailed analyses
o Uses appropriate analysis to explain the reasons
o Set within Singapore context
Evaluation
E1 • Unsupported judgment 1
• Unexplained evaluative statements
E2 • Some attempt at an evaluative appraisal of the most important reasons. 2-3
E3 • Uses analysis to support an evaluative appraisal of which reasons are the most 4-5
important.
• The crux of the question requires candidates to analyse how the use of a particular policy can potentially
result in a conflict between macroeconomic goals. As a result of the conflict, this necessitates the choice
of policy mix i.e. the use of the particular policy in combination with other policies to achieve
macroeconomic goals simultaneously.
• Many candidates were able to explain the main forms of conflict between macroeconomic goals. The
more common ones being:
o Increase economic growth/Low unemployment vs Inflation (due to use of DD-mgt policies).
o Reduce imported cost-push inflation vs worsening BOT/decrease EG (due to appreciation stance)
o Increase potential EG vs structural unemployment (due to use of SS-side policy that encourages
use of capital goods in favour of labour)
• However, answers differed in quality from this point forth. Better candidates were able to address
whether these conflicts were an important factor in the consideration of policy mix in Singapore. The
best responses were those who went on to explain how other factors also play an important role in
influencing choice of policy mix.
Unfortunately, most candidates faltered in this aspect – while they were able to identify and explain the
other factors involved e.g. nature of Singapore economy, time lags etc, they failed to link to how these
factors influenced the policy mix. Weak responses typically just explained the conflicts and other factors
without even linking to how they influenced the choice of policy mix.

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• Candidates should also understand that they have to be more selective in choosing which aspect of
economic analysis they need to elaborate (and not simply spam everything). E.g. When explaining how
the use of expansionary fiscal policy can help achieve actual growth/low unemployment at the expense
of higher inflation rates, the focus should be on the conflicts as highlighted in the question.
However, there were many candidates who instead focused on explaining the multiplier process in
great detail while (the more important concept of) the conflict was only mentioned in one sentence.
Another example of indiscriminate spamming – when explaining use of exchange rate policy, some
candidates explained at length how the MAS will demand for SG using foreign reserves to appreciate
SGD or vice-versa supply SGD to buy foreign currencies to depreciate SGD. Some candidates even
drew the DD/SS diagram of the forex market.
These economic analyses while accurate were not the main requirements of the question and
candidates end up wasting precious time and forgo answering the question.
• Some candidates also misinterpreted the questions and discuss whether use of polices will lead to
conflicts. Most notably, many explained that SS-side policies can increase both AD and AS and hence
does not result in any conflict of goals.
• Lastly, there is an inaccurate understanding of what constitutes a policy mix. Weak responses typically
think that policies are used in isolation i.e. choose to use one policy instead of another. The best
responses were able to identify that policies should be used in optimal combinations to achieve
macroeconomic goals simultaneously.
Question 5
The US Federal Reserve has hiked interest rates seven times since December 2015. Elsewhere,
some Central banks also raised their own interest rates, with some Emerging-market Central Banks
being pressured to do so to go on the defensive. The Fed’s policy decision might be a positive sign
of the US economy but will have a mixed impact on other countries.
Adapted from Bloomberg 16 May 2018
Discuss the extent to which the move by the US to hike its interest rate should be a cause for
concern for itself and for other economies. [25]
Introduction:
Define rate of interest (r/i): Cost of borrowing or the reward for saving or depositing money in a bank
Clarify context: The hiking of r/i by US Federal Reserve (US’s Central Bank) indicates a contractionary
monetary policy stance which generally aims to dampen inflationary pressures.
Clarify ‘cause for concern’: To determine if US’s r/i hike is a cause for concern or not, one should look at
the impact on the key macroeconomic goals to determine if the goals, namely strong & sustained growth,
low unemployment, low inflation and sustainable balance of payments position, have been compromised.
Development:
Part 1: Discuss the extent to which US r/i hike would be a concern for US itself
Thesis: US’s hike in its r/i might be a concern for US itself.
Negative impact of hike in US’s r/i on US itself

A hike in r/i would increase the reward for saving in banks. As such, for a given income, people are more
incentivised to save than to spend  autonomous consumption falls
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A hike in r/i would also increase the cost of borrowing. This discourages purchases of big-ticket items which
require loans. Again autonomous consumption falls.
With higher cost of borrowing, fewer investment projects would fetch an expected rate of return that exceed
the (higher) r/i. Autonomous investment falls.
Furthermore, as US’s r/i rises relative to other countries’ r/i, there will be short term hot money inflow to the
US from the rest of the world as savers from other countries want to enjoy the higher r/i offered in US. This
increases DD for USD in the foreign exchange market, causing USD to appreciate. An appreciation of USD
will raise the price of US’s exports in terms of foreign currency (thus causing a fall in Qd of exports) while
reducing the price of its imports in terms of USD (thus causing a rise in Qd of imports). Assuming Marshal
Lerner condition holds (PEDx + PEDm >1), net export expenditure X-M would fall. This worsens the current
account of US’s BOP, though the inflow of short term capital had improved its financial account.
All in all, a fall in C+I+(X-M) would cause a fall in aggregate demand (AD) for US.
A fall in AD can cause a more than proportionate fall in real national income via the reverse multiplier effect,
thus reducing actual growth.
Briefly explain reverse k effect:

A fall in autonomous expenditure (C, I, X) first causes a fall in AD (from AD1 to AD’). Firms face accumulation
of inventories and respond by cutting production. In turn, they pay out less factor income and retrench
workers. With lower income, induced consumption falls, thus causing another contraction of AD and income
and this process repeats, eventually leading to a more than proportionate fall in RNY from Y1 to Y2. As real
output falls, the fall in derived demand for labour would also increase unemployment levels.
GPL
AS1
P1
P2
AD1
AD2 AD’
Y1 Y2 RNY
A fall in investment would also contribute to slower capital formation, thus lowering potential growth, making
sustained growth more difficult to achieve.
Antithesis: However, US r/i hike might not be a concern for US itself
As suggested by preamble, US might be enjoying strong economic growth (‘positive sign’) which comes
with growing confidence levels. An expectation of rising national income in near future would cause C+I to
keep rising, putting US at risk of overheating if ↑AD>↑AS, as AD fast approaches full capacity (YF) as it
rises from AD1 to AD2. By hiking r/i, AD can fall to AD3, lessening the strain and competition on existing
FOPs, hence general price level falls from P2 to P3. This offsets the rapidly rising AD, dampening inflationary
pressure.

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GPL AS1
P2
P3
P1
AD2
AD3
AD1
Y1 Y3 YF RNY
Optional: You may go on to the ‘secondary’ effects. Over the long term, lower inflation (due to contractionary
MP) relative to other countries might lead to higher global DD for US’s exports which appear relatively
cheaper. Ceteris paribus, the rise in net exports improves BOT and increases AD, leading to actual growth
and lower unemployment. Lower inflation also makes long-term business planning easier, with better
predictability of changes in prices, costs and profits, thus promoting investment. This stimulates economic
growth (both actual and potential).
Synthesis for Part 1: (can be at the end too)
Whether US’s rate hike is a cause for concern depends on the state of the economy going forward. Since
US is forecasted to be booming with excessive AD growth, a hike in r/i can serve US well by dampening
inflation, achieving price stability, an important condition for sustained growth.
Also, the extent of the rate hike, the speed of hike (i.e. whether the rate hike is appropriately calibrated)
plays a part in determining if US should be concerned. For example, if the hike in r/i is too fast and/or too
steep, then it might lead to more adverse effects, causing greater concerns.
Part 2: US hiked interest rate  Discuss whether this would be a cause for concern for OTHER
economies.
Note: At least 2 well-elaborated points are required.
Thesis: US’s interest rate hike would be a cause for concern for other countries i.e. US’s hike in r/i
had caused negative effects on them.
• After US hiked its r/i  US’s C+I fall  US’s RNY might fall  US’s DD for imports falls. For countries
rely on US as export destination, demand for their exports would fall. Hence their export revenue X falls
 their AD falls. Via the multiplier effect, their RNY might fall more than proportionately. The fall in real
output also reduces the derived demand for labor, resulting in higher unemployment. Thus US’s trading
partners would be concerned.
• Evaluate:
o The greater the dependence on the US as an export market, the greater the extent of adverse
impact.
o Countries who are more export-reliant (eg SOEs) would be suffer more, given that their X forms
a larger % of their GDP.

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• Moreover, assuming free capital mobility, US’s interest rate hike would cause hot money outflows from
their country to the US. The financial account of BOP for these countries worsens.
More people would sell their domestic currency in favour of USD to purchase US’s short-term financial
assets. SS of their domestic currency rises. Thus their currency depreciates against USD.
• Due to depreciation, imports from the US become more expensive in home currency. For countries that
rely heavily on US for imported FOPs (eg developing countries, emerging markets), their import
expenditure rises (PEDm<1) and cost of production rises. Industries cut back on output at each price
level, causing the country’s SRAS to fall from AS1 to AS2. As such GPL rises from P1 to P2 and real
output falls from Y1 to Y2. The import-induced inflation, fall in actual growth and employment would
pose concerns for these governments.
GPL
P2
P1
AS2
AS1 AD1
Y2 Y1 RNY
• In view of these adverse impacts, there had been reports of countries being pressurized to raise their
own interest rates to ‘defend’ themselves. Indeed, in recent years, emerging economies like Indonesia,
India, Turkey and Mexico hiked their own r/i. While such a policy decision by their governments might
mitigate the impacts explained above, the contraction of AD put them at risk of falling economic growth
and higher unemployment, depending on the current state of the economy.
• Evaluate:
o The extent of impact depends on availability of foreign exchange reserves in the economy. If
forex reserves are insufficient, the government might eventually resort to hike their own r/i to
stem hot money outflows to prevent ER problems.
o Obviously, the extent of impact depends on the degree of import reliance.
• For countries like Singapore which are interest rate-takers, Singapore’s r/i would rise in tandem with
US’s, due to our government’s choice of maintaining control over exchange rate and having free capital
mobility. With this increase in r/i, Singapore’s AD contracts, real NY might fall, unemployment might
rise.
• Evaluate:
o The impact may not be undesirable if Sg was initially facing demand-pull inflation. Should AD
growth be excessive, a fall in AD here might alleviate over-heating.
• Optional: A depreciation might possibly trigger a wave of speculative attacks, causing further
depreciation. This necessitates the country’s government to respond by drawing on its foreign reserves
in order to prevent excessive depreciation that will aggravate imported inflation. And should the
depreciation persist, the government might deplete its foreign exchange reserves over time.
• Optional: Since US’s rate hike would dampen its inflation, assuming that its inflation rate is lower relative
to other countries, US’s exports would appear relatively more price competitive. As global consumers
switch in favour US’s goods, other countries producing substitutes to US’s goods would face a fall in
quantity demanded for their exports. Assuming PED>1 (availability of substitutes), these economies
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would suffer falling export revenue (↓X). In addition, within these economies, their own people might
switch away from the relatively more expensive domestically-produced import substitutes to buy more
US goods instead. Demand for imports rises, causing a rise in import expenditure (M↑).
Together the ↓X and ↑M worsens their current account of BOP. The fall in X would also contribute to
fall in AD, resulting in falling actual growth and loss of jobs.
Anti-thesis: US’s r/i hike might not be cause concerns to other countries
• As analysed earlier, US’s r/i hike attracted inflows of hot money, causing USD to appreciate against
foreign currency. In US, price of imports become cheaper in USD, and this leads to a rise in Qd of
imports. This means that other countries who exports to US will enjoy higher export revenue (X↑).
Ceteris paribus, these economies experience a rise in AD and via their RNY increases more than
proportionately via the k effect. Since derived demand for labor rises, unemployment falls too. BOT
improves too.
• Also USD appreciation would cause their export prices to be more expensive in terms of foreign
currency. In the global market, consumers might switch away from US-made goods and demand
more of the relatively cheaper substitutes produced by other economies. Hence these economies
would enjoy a rise in export revenue (X↑), adding on to the benefits above.
• It is also possible that within these economies, their people might switch towards relatively cheaper
domestically-produced import substitutes. Hence demand for domestic goods rises. Cd rises  AD
rises, actual growth can result.
• Evaluate:
o As mentioned, USD appreciation could cause other economies to enjoy a rise in net
exports. But recall that a fall in US’s actual growth or inflation rate (due to hike in r/i) would
cause the opposite effect. The net outcome is uncertain, and it really depends on which
effect is stronger.
• Furthermore, recall that other economies would face currency depreciation against the USD due to
hot money outflows in response to US’s r/i hike. For such countries, exports become cheaper in
terms of USD, while imports from US are more expensive in home currency. Assuming Marshal-
Lerner condition (PEDx + PEDm >1) holds, net exports (X-M) rise. BOT of such countries improve.
A rise in net exports also expands their AD, contributing to actual growth and lower unemployment.
• Evaluate:
o The overall impact really depends on degree of export & import reliance of the country.
The positive impact on RNY due to the rise in AD might be mitigated by the fall in SRAS, if
countries suffer from imported inflation, a possible effect of depreciation.
Conclusion:
• In synthesis, US’s rate hike might or might not be a cause for concern for itself and others.
• For discussion of US’s hike of r/i on itself, it boils down to whether the US government can successfully
lower its inflation rate. The Fed should proceed with its r/i hikes with caution, due to the trade-off with
actual growth and low unemployment.
• For other economies, the impact on them depends on factors such as the nature of the economy- its
openness to trade and capital flows, its degree of reliance on US for trade etc. The inherent state and
stability of the economy might play a part too, in terms of the efficacy of its government in managing its
financial system (eg to prevent speculative currency attacks), its availability of FX reserves, its level of
debt, its ability to tackle rising inflation etc.
• Generally, US’s rate hike is likely to affect many countries significantly, given US’s important global
status and that many countries trade with the US. Moreover, with greater interconnectedness between
countries, all countries would inevitably feel the impact from one another. As such, US’s economic
performance as a result of its rate hike is important to determine if the world benefits or not.
• Governments of other economies should adopt policies to avert any potential negative impact. For
instance, if they are affected from a fall in X from the USA, perhaps countries should look into
diversifying their trade partners to reduce their dependence on the US market. Also, if they have to
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resort to increasing their own interest rate which would lower their growth rate, then their governments
should adopt other mitigating measures. Governments might wish to focus more on supply-side
measures to help promote sustained growth.
• All in all, US’s rate hike is intended to help ensure low and stable inflation, which in turn promotes
sustained economic growth for US over time. Hence assuming that the Fed manages the interest rate
hikes well, an improvement in US’s economic performance is likely to benefit other economies in the
long run.
L1 - Listing of effects 1-8

- Several glaring conceptual errors
- Descriptive answer that lacks the use of economic framework/concepts
- One-sided answer
L2 - Answer displays economic analysis  use of appropriate econ framework/concepts in 9-14
analysis: AD-AS diagram, multiplier
- Answer attempts at a balanced discussion for at least one part (on US and/or on other
countries)
- Under-developed analysis. Gaps evident. Lapses in clarity.
- Answer displays some scope but insufficient. Eg:
attempt to discuss ‘concerns’ with macro yardsticks but not enough scope
insufficient development with respect to ‘external’ effects of US’s r/i hike
L3 - Balanced answer for both parts 15-20
- Answer clearly structured, and coherently and thoroughly developed
- Excellent use of appropriate economic framework/concepts in analysis
- Sufficient scope in analysis: Linked clearly to a wide range of macroeconomic goals to discuss
‘concerns’ (Scope- should cover all 4 macro goals)
- Able to relate to examples
Evaluation
E1 - Unexplained and unsubstantiated statement 1
- Substantiated judgement on whether or not US hike in interest rates is a cause for concern 2–3
E2
for both parts
- Able to uncover some assumptions
E3 - Excellent synthesis and insightful comments addressing both parts 4–5
- Able to uncover assumptions where appropriate to execute sound judgement
• It was pleasing that most candidates were able to identify the trade-off between low inflation and actual
growth/low unemployment arising from an increase in rate of r/i.
• However, few were able to appreciate that the success of US’s r/i hike policy hinged upon the US
Federal Reserve ability to forecast future economic performance of the US accurately. An interest rate
hike was implemented by the Fed on the basis that the US economy was expected to grow in a robust
manner. As such, an interest rate hike will moderate any demand-pull inflation arising from the growth,
and the negative effects of falling real NY and increasing unemployment will be minimal in such a
situation. However, if the Fed was incorrect in its prediction, the contractionary MP will cause significant
fall in real NY and increase in unemployment. Therein lies a key challenge of policy-making, the ability
to make good forecasts of the economy.
• Many candidates failed to cover the effects of a US r/i hike on the 4 KEIs of US and other economies,
instead narrowly focusing only on real NY and unemployment.
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• Candidates are reminded that with the command word ‘discuss’, they are expected to provide a
balanced analysis. A few scripts only covered the benefit of lowering inflation due to the r/i hike, without
considering the possible trade-offs.
• Quite a number of candidates failed to explain the external effects of an increase in US r/i, focusing
only on fall in C & I. On the other hand, a small number committed the bigger mistake of omitting the
decrease in C & I, only explaining the external effect of US$ appreciating. For a question focusing on
r/i policy, both internal and external effects are required, with the internal effects being the most
important one to focus on.
• For the part on external effects, while the effect of hot money flows on the financial account of BOP
was often correctly identified, quite a number of candidates fail to further develop their analysis on
exchange rates, net exports, AD, BOT and so on.
• Quite a number of candidates cannot distinguish short term hot money flows and long term FDI flows.
Short-term hot money moves to economies with higher interest rates to enjoy the higher rewards of
savings. However, long-term FDI does not flow into economies with higher interest rates. FDI refers to
funds brought into a country for the purpose of investments, that is, the purchase of capital goods.
• Some candidates wrote that a hike in r/i discourages foreign direct investment. Some went on to say
that US firms would relocate to other economies due to lower r/i there. However, a country’s r/i doesn’t
really affect foreign investment. Some answers ended up with low scores because they expounded on
the macroeconomic effects of FDI.
• Candidates must be able to discern immediate/direct effects from the longer term/secondary effects.
For example, immediate/direct effects of an increase in US r/i on other economies include a fall in other
economies’ X (due to fall in US real NY), depreciation of other countries’ currency (due to hot money
outflow). Longer term/secondary effects are for example, other economies’ loss of X-competitiveness
due to US’ ability to achieve low, stable inflation targets over the long term (due to contractionary MP)
• A number of candidates have the incorrect idea that developed countries are typically healthy and
operate at/near full employment while developing countries typically operate in the Keynesian range
with significant spare capacity. Both developed and developing countries can experience recessions
as well as over-heated situations depending on specific circumstances and macroeconomic policies
adopted. While it is true that developed countries have higher GDP/capita relative to developing
countries, it is incorrect to further generalise that developed economies are always healthy and at full
employment while developing economies are not.
• For some answers, the Marshal Lerner condition is wrongly applied. For example, in analysing effects
on X and M due to relative inflation rates. Do note that candidates should only use the MLC when
explaining effects of a currency appreciation or depreciation.
• For the analysis of US’s rate hike on other economies, some candidates wrote that other economies
raised their own r/i in defence, and then explained wholly the contractionary AD effects of their own
hike in r/i. However, such an approach lacks relevance somewhat because the impact of how US’s hike
in r/i on these countries was still not addressed.

70
Question 6
(a) Explain the potential challenges that might arise when a country loses competitiveness in an
increasingly globalized world. [10]
(b) Discuss whether protectionism is the most appropriate measure to manage the challenges
when a country loses its competitiveness. [15]
Part (a)
Suggested approach to the question:

Identify clearly the relevant aspects of “competitiveness” framed within the context of globalisation which is
characterized by freer trade, capital and labour flows. From these aspects of “competitiveness”, a clear link
to the adverse effects on the macroeconomic objectives need to be made and analysed.
Introduction
- Clarify the meaning of “competitiveness”
• Trade competitiveness – the ability of a country to sell goods and services competitively in a foreign
country. Such external competitiveness can be determined by
o Cost competitiveness: this is primarily determined by differences in unit labour costs and
is reflected by producer prices
o Non price competitiveness: this involves product quality, design, reliability and
performance, choice, after-sales services, marketing, branding and the availability and cost
of replacement parts
• Investment competitiveness – the ability to attract FDI which funds I in an economy. This in turn is
dependent on the expected rate of return (expected profitability) on investment projects as
perceived by the potential investor. This rate of return, in turn, will be influenced by factors such as
o macroeconomic and political stability of the country
o size of the domestic market
o availability of talented and skilled labour,
o existence of good physical infrastructure and
o low tax rates
• Labour (talent) competitiveness – the ability to attract, grow and retain talent.
o Attract: the openness of a country to outside talent
o Grow: how well a country develops people, for example, through a good education system
that offers lifelong learning.
o Retain: quality of life is one of its main components
- Clarify the “challenges” that may arise when a country loses competitiveness
• adverse impact on the macroeconomic goals of a country
o slowdown or negative economic growth (actual), limited potential growth which will impact
SOL over time
o rise in unemployment
o external instability  worsening of the BOP position; weakened exchange rate
Body:
1. Loss of trade competitiveness (Aspect of Trade Flows)
- A country may lose its price competitiveness in the goods it exports because of
o a loss in its comparative advantage (CA)
 According to the theory of comparative advantage, a country is said to have a
comparative advantage over another country in producing a product when the
opportunity cost of producing that product is lower. As long as there are differences
in the opportunity costs of producing specific goods among them, countries will
71
benefit from specializing and exporting products in which they incur a lower
opportunity costs, and importing products in which they produce them at a higher
opportunity costs.
 However, countries may lose their CA over time when they become inefficient and
incur higher costs in production.
o Possible reasons for loss of CA and hence competitiveness of a country’s exports
 depletion of non-renewable resources
 emergence of competing economies who are better able to produce the goods at
a lower opportunity cost due to relatively more abundant relevant FOP.
 higher relative inflation rate which could have been brought about by higher unit
labor cost when wages rise faster than increase in productivity
- The higher costs would be passed on in the form of higher prices of their goods  reduces the
price competitiveness of exports  foreign consumers buy less of the dearer exports as they switch
to cheaper substitutes from other trading partners  assuming PEDx > 1  more than
proportionate fall in quantity demanded for exports  fall in export revenue.
- Consumers of the exporting country may also switch to the relatively cheaper import substitutes as
the domestically produced good loses its price competitiveness  domestic consumers purchase
more of the cheaper imports  rise in import expenditure
- With a fall in X revenue and rise in M expenditure  fall in net X revenue and hence a worsening
of the country’s balance of trade.
2. A country may experience a loss in business competitiveness in terms of a loss of FDI. (Aspect
of Capital Flows)
- This could arise because of:
 fall in labour productivity leading to rise in unit labour cost  rise in firm’s unit COP
 poor industrial relations leading to work stoppages and disruptions in work
processes
 excessive burdensome rules and regulations regarding business start-ups,
expansion of businesses and employment of workers
 uncompetitive corporate tax rates
 weak infrastructural support
- The above would generate poorer expected profit potential from investments in the country  deter
inward FDI flows and may lead to more FDI outflows as well  net FDI outflows occur as a result.
3. A country may experience a loss in labour competitiveness (Aspect of Labour Flows)
- Unit labour cost can be considered as an indicator describing competitiveness
- In order to maintain a high level of competitiveness, labour costs should not rise faster than labour
productivity. If labour costs grow faster than productivity, this increases unit labour costs and hence
unit COP for the firm  cost competitiveness of an economy will suffer ceteris paribus.
- A loss in labour competitiveness could also arise because of a “brain drain”, defined as the outward
migration of highly educated and skilled workers. In turn, a brain drain might be due to many factors
that include:
o Push factors
 Political instability in the home country
 absence of research facilities
 discrimination
 poor working conditions
o Pull factors
 Better quality of life in foreign countries
 higher paying jobs
 superior economic outlook in foreign country
-

72
4. Challenges arising from loss in competitiveness

SR effects
- A fall in AD can cause a more than proportionate fall in real national income via the reverse
multiplier effect, thus reducing actual growth.
- As net X and I are components of AD, a fall in net X and I, ceteris paribus, will bring about a fall in
the level of AD (from AD0 to AD1). The fall in AD can cause a more than proportionate fall in real
national income (from Y0 to Y1) via the reverse multiplier effect (briefly elaborate) thus reducing
actual growth. The economy has moved further away from the full employment output (Yf0) level.
(illustrate using an AD-AS diagram – see Fig 1 below).
- As real output falls, firms hire less factors of production  fall in derived demand for labour  this
would also increase unemployment levels (cyclical / demand deficient unemployment).
- The loss in CA in exporting industries and the outflow of I can also bring about structural
unemployment. The retrenched workers from the affected industries may not have the
appropriate skills to be re-employed in high value-added industries in the country  results in a
mismatch between job opportunities and skills offered (occupational immobility) by the unemployed
in the SR.
- The fall in net X revenue and net FDI outflow worsen both the current and capital and financial
accounts respectively  worsens the country’s overall BOP position.
Other possible effects:
- Assuming all goods produced are consumed and holding population size relatively unchanged, a
fall in real national income results in a fall in real per capita income in the economy  which means
less income will be earned by the average household  reduces their ability to purchase and
consume goods and services  fall in material SOL of its citizens.
- Export oriented industries in the economy that continue to enjoy a CA will experience increase in
demand for their goods and services  increase in demand for labour in these industries  wages
of workers employed in these industries increase. Industries that have lost their CA, on the other
hand, lag behind  firms in such industries experience a fall in the demand for their goods and
services  they will in turn reduce the demand for workers  workers who remained employed in
these industries to experience a fall in / slower wage growth  increase in wage and income
inequality  inequitable outcomes that can lead to social tensions
LR effects
- While a fall in investment contributes to slower capital formation in the economy, a “brain drain”
slows the creation of innovative ideas, and thereafter the advancement of technology. This could
create a secondary effect where investors might also lose confidence in the economy. There is a
fall in both quantity and quality of resources.
- The fall in the quantity and quality of resources has the effect of limiting the growth in the country’s
productive capacity (ie the maximum amount of goods and services that the country can produce
when all its resources are fully and efficiently utilized). This causes the AS curve to shift to the left
from AS0 to AS1 with the full employment output level falling from Yf0 to Yf1. Potential growth is
lowered, making sustained growth more difficult to achieve, thus impacting future SOL.

73
AS1 AS0
GPL
P2
P0
P1
AD1 AD0
Real NY
0 Yf0
Y2 Y1 Y0 Yf1
- A worsening of the country’s BOP position, if persistent, could lead to a downward pressure on
country’s exchange rate  depreciation of the country’s exchange rate  may fuel imported
inflation and deter potential FDI due to uncertainty in profitability of returns from investment (Note
that this is a secondary effect arising from the worsening BOP position).
Conclusion
L1 - Lack of economic framework in explanation 1– 4

- Irrelevancies in explanation.
- Substantial and glaring conceptual errors.
- Listing of points.
- Considers only 1 challenge posed by 1 aspect of loss in competitiveness
L2 - Evidence of use of economic analysis in the explanation of 5-7

• at least 2 challenges posed by 2 aspects of loss in competitiveness, OR
• 1 challenge posed by 3 aspects of loss in competitiveness
- Lapses in analysis evident.
- Lacks depth in analysis
L3 - A well-developed answer with 3 challenges posed by 3 aspects of loss in 8 - 10

competitiveness
• Max 8: only 2 aspects of loss in competitiveness are covered
- Presence of clear economic analysis (with diagrams) and appropriate
categorisation of the possible challenges posed by loss of competitiveness.
- Many of the candidates interpreted the loss in competitiveness solely as a loss in comparative
advantage. This resulted in essays that lacked scope. While a loss in comparative advantage can be
characterized as a loss in trade competitiveness, there are the two other facets of competitiveness that
can be explored.

74
One, business competitiveness, defined loosely as the attractiveness of a country to foreign investment.
And two, competitiveness for labour, defined loosely as the ability of a country to attract and retain
labour (especially skilled and talented workers). This interpretation, one that encompasses trade
competitiveness, business competitiveness and competitiveness of labour, is also well-scoped to
address the phrase “globalized world” in the question stem, which likewise points to increased trade,
capital and labour flows.
Hence candidates that cherry picked phrases in the question and recalled learnt content did less well
as compared to others who interpreted the question carefully and anchored their entire analysis of
“competitiveness” based on the flows related to globalization.
- Building on this (narrow) interpretation of a loss in competiveness, many candidates explained the
theory of comparative advantage to significant detail, often providing theoretical explanations of how 1
unit of cloth can be exchanged for 1 unit of another good and how the exchange ratio should be fair.
This was not needed. The question asked how a loss in competitiveness created challenges, hence,
more emphasis should be placed on the link between a loss in competitiveness and the potential
challenges.
This would include explaining the process of how unemployment (both structural and cyclical) would
emerge, how growth would be slowed via the reverse multiplier process or how slowed capital
accumulation from the lack of FDI or skilled labour would harm an economy’s potential growth in the
long run.
- Other candidates could see that the challenges are macroeconomic in nature. However, many placed
significant emphasis on the consequences of failing to achieve these macroeconomic goals. This meant
that they explained how welfare payments would increase with unemployment, or how without growth,
merit goods cannot be funded. Some candidates even explained how a BOP deficit would cause a
depreciation, and then followed up with a significant and unnecessarily long emphasis on the adverse
consequences of a depreciation.
Again, this was not what the question emphasized. The question asked how a loss in competitiveness
creates challenges, and hence, more emphasis should be placed on the process of how these
challenges would emerge, rather than their consequences (i.e a secondary effect). If the question had
wanted candidates to explain the consequences of failing to achieve particular macro goals, it would
have been phrased in a way very similar to Essay Question 4(a).
Part (b)
Suggested approach to the question:
Start with an analysis then followed by an evaluation of how protectionism could help to restore or mitigate
the loss of competitiveness for a country and how this could allow the government to address the challenges
identified in part (a). A reference to a specific type of protectionist measure like tariffs is expected.
Follow-up with a separate analytical discussion on the use of alternative policy measures, before concluding
with a reasoned judgement. This is to address the question requirement of “most appropriate”.
The appropriateness of the measures is assessed based on the criterion of effectiveness, desirability and
feasibility.
Introduction
- The adverse consequences arising from a loss in competitiveness have been used by governments to
justify the use of protectionist measures.
- Define protectionism
• refers to actions undertaken by governments to shelter the domestic industries from foreign
competition.
• These actions can be categorized into tariff vs non-tariff barriers to trade.
75
Body
Thesis: Protectionism is an appropriate measure in addressing the challenges arising from the loss
in competitiveness
- Explain how protectionism via trade barriers such as import tariffs can help address some of
these challenges
• Import tariff restrictions are custom duties or taxes imposed on imports of goods or services by
the government
• Objective: to address the loss in trade competitiveness (in particular, price competitiveness)
and worsening of the BOP position
o Through import tariff restrictions, a temporary protection (SR) is provided  this allows
workers in the sunset industries (especially if it employs a significant proportion of the
labour force) to adjust to new conditions in the economy.
Price
S
A
Pe
B C
Pw + Tariff World Price + Tariff
E H J F
Pw World Price
D
Q
Q1 Q2 Qe Q3 Q4
o Explain how tariff works using a tariff diagram

 The import tariff raises the price of imports from Pw to Pw+tariff.
 This increase in price decreases quantity demanded of imports from Q4Q1 to
Q3Q2
 Concurrently, the increase in import prices causes an increase in quantity of
domestically produced substitutes from Q1 to Q2
 Due to the fall in quantity demanded of imports from Q4Q1 to Q3Q2, M volume
and expenditure would decrease and hence X-M value would increase
 The increase in X-M value increases AD, which mitigates the worsening of the
BOT and the BOP caused by the loss in trade competitiveness.
• Objective: to address structural unemployment arising from loss in trade competitiveness

 Moreover, there is a rise in domestic production from Q1 to Q2. To produce this
increased level of output, firms hire more factors of production.
 This helps to retain workers in the industry and buy time for workers to retrain.
 As these workers pick up new skills to move into other industries, the extent of
structural unemployment that would have otherwise occurred would decrease.

76
Anti-thesis: Protectionism is not an appropriate measure to manage loss in competitiveness

especially in trade.
- Explain limitations of protectionist measures
• The use of tariff on imports leads to misallocation of scarce resources
o The protected domestic industry can no longer compete with foreign counterparts even in
their domestic markets due to a loss of CA. Wages have risen faster than the growth in
labour productivity  domestic good has been priced out of the market.
o Protectionism merely perpetuates domestic inefficiency as it prolongs the inefficient use of
the economy’s resources and leads to allocative inefficiency.
 Areas EBH and JFC represent deadweight loss to society or efficiency losses.
They arise because tariffs distort incentives to consumers and producers.
 Area EBH represents production distortion loss because resources are diverted
from the relatively more cost-efficient foreign producers to the relatively less cost-
efficient domestic producers.
 Area JFC represents consumption distortion loss because the loss in benefits from
not consuming Q3Q4 as a result of the tariff is greater than the gain in resources
saved in not producing Q3Q4 units of the good.
• More importantly, the use of import tariffs does not address the root causes of the rise in
unemployment. This is especially so in the case of structural unemployment where the root
cause of the rise in such unemployment arises from the loss of CA of the declining industries
 protectionist measures are often misdirected.
• Protectionist measures, if carried out over the long term, tend to lead to a fall in world output
and trade. Especially if it invites retaliation from trading partners. When trading partners impose
protectionist measures in return, this reduces the demand for the country’s exports which leads
a fall in export revenue. This can reduce the initial gain in X-M and hence resulting in a
slowdown in economic growth for the countries involved (elaborate)
• Tariffs on M raises cost of production and leads to import cost push inflation
This is because many other related industries might use these goods as factor inputs. For
example, an import tariff on Chinese steel might will increase cost of production for domestic
U.S car manufacturers. If the raw material or factor input is used in many industries, it will lead
to cost push inflation for the country.
• It is important to note that implementation of protectionist measures to resolve worsening BOP

is at best a short-term measure
o does not necessarily address the root cause of the worsening BOP position.
o In the long run, better to look at the root causes of a worsening BOP position
 if the root cause of the worsening BOP arises from a higher rate of inflation in the
domestic economy due to demand pull pressures  a better remedy is to raise the
productive capacity of the economy through SSP rather than the use of
protectionist measures.
Analyse the use of other measures that may be more appropriate to address the loss in
competitiveness and manage the challenges (2 alternative policies)
• Policies to improve competitiveness of country’s X industry

o Wage policies
 Establish wage guidelines to ensure wage growth does not outstrip productivity
growth  reduce unit COP and hence price competitiveness of X

77
 Evaluation:
o Wage guidelines are non-mandatory and may not be implemented by the
private sector. Need for political will to lend greater push for moral suasion
to take effect.
o Subsidies for upgrading of technological level

 to encourage productivity and innovation activities in the country  helps to lower
unit COP as well as bring about improvement in the quality of exports &/or
introduce new products  this enhances both price and non-price competitiveness
of the country’s X
o Subsidies for retraining of workers as well as sourcing for relevant skills based modular
courses that help equip workers with the relevant skills to support CA industries
 subsidies and sourcing initiatives encourage workers to attend relevant courses 
upgrade and pick up new skills  improve their labour productivity
o workers are more occupationally mobile, reduce labour market rigidities
o increase labour productivity helps to lower unit COP for firms  pass on
lower costs in the form of lower prices  improve price competitiveness
of the country’s exports
 Evaluation:
o Initiatives are only effective if workers are receptive to the idea of life long
skills retraining and upgrading
o Courses must be relevant and trainers qualified to guide workers in their
learning
o Use of subsidies can put a strain on the government’s budget
• Policies to attract FDI and top talent

o Attracting FDI through
 Tax incentives. Offering competitive corporate tax rates to foreign investors can
contribute to the increase in the post-tax profits of firms, thus incentivising them to
locate their operations in the country  helps to increase FDI flows into the
economy. Firms can also plough back part of the increase in post-tax profits to
further investment projects in the country.
 Investment grants and subsidies to attract FDI especially in undertaking R&D
efforts which contribute to innovation in the country
 Ensuring an available pool of skilled labour. By ensuring an environment of lifelong
learning, this allows workers to be re-skilled and equipped with the relevant skills
that will enhance their productivity. If labour productivity is able to increase faster
than wage growth  unit labour cost and hence unit COP can be reduced  this
will contribute to increased profitability of investment projects for firms
 Enhancement of infrastructure to increase productivity of businesses
 Eg: road network, sea-ports and airports allows firms to transport their goods in a
faster, reliable and efficient manner which helps to improve productivity and lower
COP  allows industries in the country to offer competitively priced goods and
services
 Creating a stable political and macroeconomic environment – this reduces the
degree of risk of investment for foreign investors
o Attracting and retaining top talent from abroad
 the top tier marginal income tax rates can be made competitive. By adopting a low
personal income tax regime, this serves to attract top talent to the country as they
are able to retain a larger portion of their earned income.
 Employment policies that favour flexibility
 Efforts to eliminate cultural and language differences that can create barriers
78
 Evaluation:
o Such policies have an impact on the government budget. The government
has to trim its expenditures or find alternative sources of revenue to finance
the shortfall in its revenue from offering tax incentives and lowering of
corporate / personal income tax rates.
o Tax incentives can also be replicated by competitors in attracting high value-
adding growth industries  must go beyond tax incentives in attract FDI, such
as providing a robust legal system as well as a business-friendly administrative
environment.
• Free trade policy to improve “global competitiveness”

o Signing bilateral and multi-lateral FTAs will see a reduction / elimination of trade barriers
(import tariffs) on the country’s exports  this helps to improve export price
competitiveness  increase demand and hence X revenue
o FTAs also allow the country’s industries to obtain imported raw materials from its new
trading partners at lowest cost  costs savings can be translated to lower prices of its
goods including exports  improve country’s export price competitiveness.
o FTAs also facilitate FDI into the country by reducing / eliminating regulations which serves
as BTE for foreign firms.
 Evaluation:
o However, FTAs require the country’s domestic market to be open to foreign
competition just as it seeks access FTA partners’ markets  risk of consumers
switching to import substitutes from trading partners, reducing demand for its
domestically produced goods .
o Its domestic industries must be sufficiently efficient to compete with foreign
competition in order that it can enter into FTAs.
• Explain how the above alternative policy measures have the effect of increasing AD and AS
and hence manage the challenges faced by a country as a result of a loss in competitiveness
o Increase in AD:
All in all, a rise in I+(X-M) would cause a rise in aggregate demand (AD) for the country 
which in turn can bring about a more than proportionate increase in real national income
via the multiplier effect, thus increasing actual growth and employment. The rise in I +(X-
M) could also have a favourable impact on the BOP position as well.
o Increase in AS:
The increase in FDI as well as improvement in quantity and quality of labour allow the
country to expand its productive capacity  potential growth can be achieved which in turn
allow actual growth to continue to increase into the future thus increasing material and non-
material SOL for its citizens.
Conclusion
- Protectionism may be appropriate in the SR but the LR negative consequences will eventually outweigh
the benefits  it is, at best, a temporary measure; it does not address all the challenges arising from
the loss in competitiveness with respect to business and labour.
- Global competitiveness is crucial for any open economy especially for those who are heavily reliant on
X and FDI for its economic performance.
• Supply side policies are important in enhancing the competitiveness of targeted industries which
the government deems to be economic drivers in the future while FTAs serve to further enhance
the competitiveness of an economy by allowing its industries to access world markets with minimal
tariffs and artificial trade barriers.
• As each policy measure has its limitations, a combination of policies is required for a country to be
competitive in the globalised economy.

79
• Factors that can determine the international competitiveness of a country in the LR would include
having a sound and fair institutional environment, an efficient and extensive infrastructure, support
for enterprise/entrepreneurship and a workforce that is a healthy, well-educated and adept at
absorbing new technologies.

L1 - Mere smattering of points (protectionist measures) without clear economic 1–4
analysis.
- No linkages made between the outcomes of protectionist measures to the
specific problems that the loss of competitiveness poses.
- Presence of conceptual errors.
L2 - Clear linkages are made between protectionist measures adopted and how they 5-7
are effective in managing the challenges brought about by the loss of
competitiveness.
• Explanation of how protectionism addresses dumping will be accepted only if
student has explained that one of the reasons for the loss in its export
competitiveness is a result of unfair trade practices by other countries
- Answer has also considered the limitations of the protectionist measure, but lacks
scope (number of challenges highlighted in answer) and depth (economic
framework)
- Answer provides only 1 alternative measure to the protectionist measure
L3 - Well-balanced answer with discussion of at least 2 alternative measures that 8 - 10
addresses at least 2 challenges posed by the loss of competitiveness
Evaluation
E1 - An unexplained judgement  An unexplained evaluative conclusion/comment 1
E2 - Evaluative assessment of the appropriateness of the policies supported by 2-3

economic analysis but could be more insightful
- Substantiated judgement on appropriateness of protectionist measures and
alternative policies in addressing the challenges arising from loss in
4-5
E3 competitiveness
- Able to provide appropriate assumptions in executing judgement
Examiners’ Comments
- Many of the candidates had learnt protectionism well. This was seen in well drawn, and often well
analyzed tariff diagrams. Candidates must however understand that just because a concept is well-
learnt does not mean it should be replicated in its entirety especially when a question mentions an
associated concept, i.e. protectionism. There were many instances where the explanation provided for
protectionism was not adapted or modified so that it answered the question better.
- This question asked how protectionism helped countries to “manage the challenges”. Despite this,
many candidates did not link the tariff diagram to any macro-economic “challenges”, often stopping
short at quantity references on the diagram. As an illustration, see the explanation below, where often,
the underlined portion were left out.
• The import tariff raises prices from Pw to Pw+tariff. This increase in price decreases quantity
demanded of imports from Q4 to Q3. Concurrently, the increase in import prices causes an increase
in quantity of domestically produced substitutes from Q1 to Q2. Due to the fall in quantity of imports
from Q4Q1 to Q3Q2, M expenditure would decrease and hence X-M value would increase. The
increase in X-M increases AD, which alleviates the worsening of the BOP position caused by the
80
loss in competitiveness. Moreover, there is a rise in domestic production from Q1 to Q2. To produce
this increased level of output, firms hire more factors of production. This helps to retain workers in
the industry and buys time for workers to retrain. As these workers pick up new skills to move into
other industries, the extent of structural unemployment that would have otherwise occurred would
decrease.
- A common mistake when explaining the effect of a tariff is to say that a tariff increases consumption
since tariff raises the price of imported goods and hence consumers switch to consuming more
domestically produced good. While it is correct that domestic consumers would switch to the relatively
cheaper domestically produced goods (assuming they are close substitutes), it is not entirely clear that
overall consumption expenditure (C) rises. What is certain is that M expenditure decreases. Do note
that the C component in AD comprises consumption of both domestically produced and imported
goods.
- This question required the candidates to explicitly discuss alternative policies. This means explicit
paragraphs should be dedicated to alternative policies, and both their benefits and their limitations
should be discussed in detail. The alternative, placing the (often very brief) explanation for alternative
policies in the conclusion, might imply that one did not read the question carefully, beginning the essay
the moment the word “protectionism” was seen.
- Perhaps due to the lack of time, or perhaps (of more serious consequence) due to habit, candidates
sometimes used vague phrases to gloss over their explanations. To illustrate:
• Protectionism can help sunset industries as it buys time for these dying firms. (✘)
• Tariffs raise the level of domestic production from Q1 to Q2. To produce this increased level of
output, firms hire more factors of production. This helps to retain workers in the industry and buys
time for workers to retrain. (✓)
• Protectionism is appropriate in this case, as it would help to generate growth and create jobs. (✘)
• Due to the fall in quantity of imports from Q4Q1 to Q3Q2, M expenditure would decrease and hence
X-M value would increase. Because X-M is a component of AD, the increase in X-M increases AD.
Assuming there is spare capacity in the economy, an increase in AD would increase real national
income more than proportionately by the multiplier effect. In addition, as AD increases, firms require
more factors of production to produce the higher level of output. Given that labour is a derived
demand, the demand for workers will increase, and this would help alleviate cyclical unemployment.
(✓)
- Many candidates often cited that protectionism does not solve the root cause of the loss in
competitiveness. However, in the remaining parts of the essay, what this root cause was, did not
seemed to be explained.
- Some candidates chose policies to treat challenges that have nothing to do with a loss in
competitiveness. These include appreciation of one’s currency to overcome imported inflation from rise
in oil prices, or even job fairs to overcome frictional unemployment. Again, both these challenges have
nothing (or contrived) links to competitiveness. Better policy choices well-linked to the loss of
competitiveness are definitely available.
------ END ------

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Raffles Institution

Nurturing the Thinker, Leader & Pioneer

Year 6 Preliminary Examination 2018

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@RI 2018 9757/Preliminary Examination/Y6/18 [Turn Over

(a) With reference to Table 1,

• Definition of PED: measure of responsiveness of change in Qty demanded of a good to a

@RI 2018 9757/Preliminary Examination/Y6/18 [Turn Over

@RI 2018 9757/Preliminary Examination/Y6/18 [Turn Over

Candidates may write any two of the 3 factors given below.

1. A higher minimum price fixed by the government

2. Demand or supply changes

3. PED or PES values

@RI 2018 9757/Preliminary Examination/Y6/18 [Turn Over

@RI 2018 9757/Preliminary Examination/Y6/18 [Turn Over

@RI 2018 9757/Preliminary Examination/Y6/18 [Turn Over

• Benefits to the Society (in terms of Dynamic efficiency)/Producers/Consumers:

@RI 2018 9757/Preliminary Examination/Y6/18 [Turn Over

@RI 2018 9757/Preliminary Examination/Y6/18 [Turn Over

• Madagascar has a natural comparative advantage in the production of vanilla because it is a

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• Over-specialising in a commodity such as vanilla “correlates with poverty”

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• Over-specialising in the production of vanilla might cause the Madagascan economy to be

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@RI 2018 9757/Preliminary Examination/Y6/18 [Turn Over

@RI 2018 9757/Preliminary Examination/Y6/18 [Turn Over

Market for dairy products in EU

@RI 2018 9757/Preliminary Examination/Y6/18 [Turn Over

@RI 2018 9757/Preliminary Examination/Y6/18 [Turn Over

Knowledge, Application, Understanding, Analysis

L1 • Several glaring conceptual errors and/or lack of economic 1–3

@RI 2018 9757/Preliminary Examination/Y6/18 [Turn Over

@RI 2018 9757/Preliminary Examination/Y6/18 [Turn Over

@RI 2018 9757/Preliminary Examination/Y6/18 [Turn Over

Conclusion and Synthesis:

@RI 2018 9757/Preliminary Examination/Y6/18 [Turn Over

Knowledge, Application, Understanding, Analysis

L1  Smattering of points not directly linked to question 1–3

E1  An unexplained conclusion /judgment or mere repetition of 1

E2  A judgment/conclusion supported by reasons / economic 2

@RI 2018 9757/Preliminary Examination/Y6/18 [Turn Over

@RI 2018 9757/Preliminary Examination/Y6/18 [Turn Over

• Post-Brexit, UK policymakers signed new trade agreements as part of the policy

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Explain how supply-side measures are effective in achieving sustained and

• Improving labour productivity through education, apprenticeship and skills

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• Limitations of signing new Free-Trade Agreements:

@RI 2018 9757/Preliminary Examination/Y6/18 [Turn Over

• Limitations of supply side measures:

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Conclusion and Synthesis:

• Signing new FTAs and implementing supply-side measures are effective in

@RI 2018 9757/Preliminary Examination/Y6/18 [Turn Over

L1  Smattering of points not directly linked to question 1-4

E1  An unexplained judgement/evaluative conclusion/comment 1

E2  A judgment/conclusion supported by reasons / economic 2-3