March 2016 v.

42; Q3a

‘If a firm is experiencing diminishing returns and diseconomies of scale, it means that its output
must be decreasing.’

Explain whether this statement is true. [12]

Introduction:

• The term ‘diminishing returns’ – extra output produced by an extra unit of a variable factor, (e.g.
labour) is less than the previous unit of a variable factor.

• The term ‘diseconomies of scale’ – a firm’s average cost has risen above its minimum average
cost.

Explanation:

• The concept of diminishing returns is related to marginal product. In this case, the marginal
product decreases as more units of a variable factor is added to a fixed factor such as land or
capital.

• In the short-run, factors such as land and capital are fixed. Therefore, output can be increased only
by employing more quantities of a variable factor. Initially, as increasing amounts of workers are
employed to a fixed factor, the extra output from each extra unit of labour will rise. However,
because land and capital are fixed, eventually the extra output from each extra unit of labour will
fall, as more workers are employed. Diminishing returns has set in.

• Draw MP and TP curve to show the relationship between MP and total output since question says
with DMR, output must be decreasing. Explain the diagram.

1
• In contrast to diminishing returns which is a short-run concept, diseconomies of scale occurs in
the long-run. Cost per unit (average cost) begins to increase as more output is produced, simply
because the firm has grown beyond its optimal size or scale of plant.

• Explain reasons for diseconomies of scale – poor communication, demotivated employees,

difficulty in coordination, deteriorating industrial relations, complex interdependence of production
processes.

• Explain and draw relevant average cost (AC) diagram – emphasise that when output increases,
AC will fall. However, if output is increased beyond optimum level, AC will rise and there will be
diseconomies of scale. Therefore, diseconomies of scale does not occur when output is
decreasing.

Conclusion:

Based on the explanation above, diminishing returns and diseconomies of scale occur as the firm’s
output is increasing in the short-run and long-run respectively. Therefore, the statement that output
must be falling if a firm is experiencing diminishing returns and diseconomies of scale is incorrect.

2
 Essay Outline M16qp42 Q6b

Some argue that increases in investment cause national income to increase. Others argue that
the reverse is true: an increase in national income brings about investment.

Discuss whether both these seemingly contradictory statements can be true. [13]

INTRODUCTION:

• Define ‘investment’ and ‘national income’.

DISCUSSION:

Explain how increases in investment cause national income to increase. Explanation must
involve multiplier concept and appropriate diagram:

• Refer to lecture notes. Use the arithmetic example provided in the notes to explain the workings of
the multiplier when investment increases.

Explain how an increase in national income encourages investment – explain accelerator

theory:

• Investment varies with the rate of change of national income.

Ii = Y

• If a £1 million rise in national income caused the level of induced investment to be £2 million, the
accelerator coefficient is 2.

• The rise in national income has caused induced investment to double.

• The accelerator coefficient is determined by the capital-output ratio (include explanation from
lecture notes).

• Due to multiplier effect which results in rising national income, firms may increase their investment
further. However, the extent to which investment rises further will depend on the rate at which
national income is rising:
o If national income is rising at an increasing rate → investment will rise.
o If national income increases by the same amount as previously → firm’s investment will be
constant.

o If national income is increasing at a decreasing rate → investment will fall.

o If national income remains unchanged → only replacement investment occurs.

o If national income falls → no investment at all.

3
 EVALUATION:

• First statement is in relation to multiplier theory which explains the effect of the rise in investment
on national income. It is true that a rise in investment can lead to a final increase in national income
that is larger than the initial rise in investment. However, the multiplier theory has its limitations
(explain about 2 – 3 limitations). Therefore, the actual impact of a rise in investment on output is
difficult to say with certainty.

• The second statement relates to the accelerator theory. As national income rises, it may stimulate
further investment. However, the link between changes in national income and investment is
relatively weak. It is more often the case that investment decisions by firms are influenced by other
factors such as interest rates, profitability and government taxes.

• Explain limitations of accelerator theory – e.g.: even if national income is rising at an increasing
rate, investment may not rise if the capital goods industry is unable to increase their stock of
machinery or if firms feel that the current rise in national income is not sustainable into the future.
The second statement thus is only true up to a certain extent.

CONCLUSION:

Both statements, although contradictory, can be true. Nonetheless, in the context of the real world, the
first statement is more likely to be true than the second statement. This is because in the real world,
there are other factors that firms will consider and which carry heavier considerations such as interest
rates and business sentiment before deciding on investment spending. In other words, in the real world,
decisions on investment are not solely determined by changes in national income.

4
 M17qp42 Q4

A politician remarked that the absence of trades unions would necessarily lead to an
improvement in all labour markets. To what extent does economic analysis support this remark?
[25]

Introduction:

• Definition of ‘labour market’.

Discussion:

• Explain the positive effect in the labour market without trade unions.

• Discuss MRP theory in wage determination.

• Workers will receive a wage equal to MRP value. Workers will have incentive to increase
productivity and improve skills, undergo training in order to earn a higher wage.

• Less disruption to the firm as well – incidences of strikes are reduced. Costs will be lower for firms.
Profits will rise.

• Employment levels will also rise.

• Overall improvement in labour market in terms of employment, productivity, wages, efficiency of

firms. Consumers also benefit from less disruption to availability of goods in the market as absence
of trade unions will mean absence of strikes or worker protests.

• Government also benefits in terms of higher tax revenue from both firms and workers.

Evaluation:

• Not necessarily lead to an improvement in labour market. Explain the negative effects in labour
market without trade unions.

• In imperfect labour markets, monopsony firm will pay a wage below MRP.

• Without trade unions, unskilled and low skilled workers will be at a disadvantage. Weak bargaining
power in terms of wages and working conditions. May lead to exploitation.

• Discrimination of workers in terms of age, gender, race.

• Trade unions thus can improve the bargaining power of the lower skilled workers and prevent
exploitation. Trade unions may agree to higher productivity in return for higher wages. This will
benefit firms and the workers.

• However, trade unions can be disruptive and can raise labour costs of firms.

5
 Conclusion:

Absence of trade unions could bring improvements to the labour market. However, the improvements
discussed would only be possible if there are no exploitation of workers and thus benefits all parties
involved. In practice though, absence of trade unions can lead to worsening conditions in the labour
market and may not necessarily bring about the improvements claimed by the politician.

6
 M17qp42 Q5a n 5b

a) How might the employment composition and age structure of a developing country
differ from those of a developed country? [12]

b) Apart from the employment composition and age structure, discuss what changes
are likely to occur in a developing country if it progresses towards developed
status. Consider whether these changes are always beneficial. [13]

Question (a)

Introduction:

• Difference between developing and developed country.

Discussion:

Explanation about employment composition in developing country:

• Main sector is primary / agriculture. Thus main source of employment and income is this sector,
i.e. a large proportion of population employed in this industry.

• Large proportion of population live in rural area which is where primary activities are centred.

• Limited development of other sectors, thus limited alternative job opportunities.

• Not all developing countries’ employment composition is in primary sector. A number of developing
economies such as Bangladesh and Vietnam are gradually making the transition from primary to
manufacturing sector. As a result, employment composition in these two countries are showing a
shift.

Explanation of employment composition in developed country:

• Very small primary sector, largest sector is tertiary or service. Hence job opportunities and
employment concentrated in this sector.

• Majority live in urban areas.

• Government is also able to encourage growth of tertiary sector through incentives such as subsidy,
tax allowances, R&D grants. This encourages more business start-ups and enterprise in tertiary
sector.

• Factor endowments not suited for primary production (comparative disadvantage). Thus, small
proportion of workforce is in primary sector.

• Nonetheless, developed countries do seek to diversify and due to technological development, may
be able to develop comparative advantage in primary sector. If this materialises, then employment
composition may change as more labour may be employed in primary sector.

7
Explanation of age composition in developing country:

• Large proportion of young people. Reasons – high birth rates, high fertility rates, source of labour,
lack of proper govt welfare system, culture factor, religious factor, less incidences of infant
mortality.

• There may be a rising proportion of older people as well. Reason – lower death rates due to
improving access to medical facilities and services, or better quality food being produced.

• Again, must be remembered that age composition is not the same for all developing countries. Age
composition can change over time.

Explanation of age composition in developed country:

• Falling / low birth rates, emphasise quality of life – smaller proportion of younger people.

• Falling / low death rates due to ability to afford medical services as well as the presence of govt
provision of healthcare. This leads to a larger proportion of ageing population.

• Countries such as Singapore and Japan are experiencing an ageing population problem.

• This age composition may not be good for the developed economy in the long-run. However, if
developed countries like Japan and Singapore take steps to raise birth rates or encourage larger
families, then age composition can change with the emergence of a larger young population.

Conclusion:

• Both developing and developed countries have different compositions in terms of employment and
age structure. It must be remembered that these are dynamic in nature, i.e. the composition does
not necessarily remain the same and changes to both types of composition can occur for both
developed and developing country.

8
 FM 2019 Q7

‘Keynesian policies to solve the problem of unemployment will not work because they will
conflict with the attainment of other key macroeconomic aims.’

Assess the accuracy of this statement. [25]

INTRODUCTION:

• Explain ‘Keynesian policies’ → demand-side policies which are fiscal policy and monetary policy
designed to influence level of aggregate demand (AD) in the economy.

• AD refers to the total planned spending on goods and services produced domestically in a given
period and consists of components such as consumption spending (C), investment spending (I),
government spending (G) and net exports (X – M). In equation terms, AD = C + I + G + (X-M).

DISCUSSION:

Explain the underlying assumption of Keynesian theory:

• Keynesian theory is based on the assumption that demand creates supply. Thus, the level of AD
in the economy will determine the level of output and consequently the level of unemployment.

• If AD is weak, output will be low and there will be reduced demand for labour and lay-offs causing
unemployment to be a problem.

• Thus, Keynesian theory argues that government intervention via fiscal and monetary policies is
essential in order to lift AD level so that problem of unemployment can be avoided.

Explain how fiscal and monetary policies solve unemployment:

To solve unemployment, government will implement reflationary fiscal policy and reflationary monetary
policy.

• Reflationary fiscal policy → government reduces tax and raises its spending. As taxes are reduced,
this will increase disposable incomes of households and profits of firms → raise consumer and
business sentiments → C & I rise. The collective increase of C, I & G will raise overall level of AD
in the economy. Firms will have incentive to increase output level and in the process will employ
more labour. As the multiplier effect of rising AD occurs, unemployment will fall. As firms increase
investment spending on capital goods, this will also create more employment in the capital goods
industry leading to higher employment.

• A reflationary monetary policy can be implemented through lowering interest rates or increasing
money supply. A lower interest rate will reduce borrowing costs for households and firms, raising
C & I and thus AD level. The lower interest rate also reduces returns on savings encouraging more
spending to take place. As a result, firms will respond to the higher AD level by increasing output
which in turn would boost labour demand and result in lower unemployment levels. Alternatively,
government through the Central Bank can buy bonds → increase liquidity in banking sector giving
banks the confidence to reduce interest rates and increase lending to firms and households.

9
• The impact of reflationary fiscal and monetary policies on AD and employment can be illustrated
on the diagram below (draw AD-AS diagram showing shift of AD to the right, rise in real GDP which
implies rising employment).

Explain how fiscal and monetary policies to solve unemployment will conflict with the
attainment of other key macroeconomic aims:

As explained, Keynesian policies can resolve unemployment. However, the same policies will likely
create conflict with government’s other objectives:

• Explain how rising employment will cause price level to rise in the economy, resulting in inflationary
pressures and a possible rise in inflation rates above the 2-3% target. Illustrate this conflict between
unemployment and inflation using Phillips Curve – draw the diagram and explain the diagram.

• If inflation rises to an unacceptably high rate, then government will be forced to raise interest rates.
This will now produce the opposite effect as it will reduce spending levels in the economy, resulting
in lower economic growth as real GDP falls. As a result, unemployment is likely to rise once again.
When inflationary pressures rise, workers may demand for higher wages → firms may react by
laying-off workers and unemployment will once again worsen.

• There is also the possibility that the reflationary demand-side policies will cause the country’s
balance of payments position to worsen. As employment rises, income level in the economy will
increase giving households stronger purchasing power leading to rising demand for imported
goods and services. Firms may also import more intermediate goods and raw materials as
production is increased to meet the rising AD. If inflation becomes a problem, export
competitiveness will fall causing a reduction in export revenue. Consequently, the economy’s trade
balance will worsen thereby worsening balance of payments or causing a balance of payments
deficit. The falling export revenue may force exporters to reduce output and lay-off workers, leading
to unemployment problem occurring.

• In addition, the reflationary fiscal policy implemented to boost AD and employment may result in a
widening government budget deficit → government may be forced to borrow externally to finance
spending → raise foreign debt above what government may consider acceptable.

EVALUATION:

• Keynesian policies to resolve unemployment do not conflict with economic growth objective. As
spending level rises, firms will increase output and investment → the Keynesian policies set off a
multiplier effect causing national income to rise (real GDP rises) and thus improves economic
growth. Therefore, the statement’s claim about Keynesian policies to reduce unemployment
causing a conflict with other macroeconomic aims is not entirely accurate or valid.

• It is not necessarily true that demand-side policies cannot resolve unemployment. The demand-
side policies can work as long as the cause of unemployment is due to weak or low AD. This is
likely true during a recession or a severe downturn which is why many countries still rely on fiscal
and monetary policies to stimulate spending and lower unemployment. Demand-side policies
would not work only if the cause of unemployment is structural in nature or if it is caused by supply-
side reasons.

• In addition, although resolving unemployment can potentially lead to conflict with the other
macroeconomic aims of the government, these potential conflicts may not materialise as
governments may use other policies to prevent a conflict. For example, to overcome the conflict
between low unemployment and worsening trade deficit, government can opt to devalue the
currency alongside the use of reflationary fiscal and monetary policies. The devaluation will ensure
that exports remain competitive and reduces the desire of households to import consumer goods.
The conflict can be avoided as long as government has other policies that it can implement to

10
 prevent the non-achievement of other macroeconomic objectives following Tinbergen’s rule of one
policy for one objective.

• Furthermore, some governments may be prepared to accept the conflict if unemployment is the
overriding concern. If the economy is in a deep recession for example, the need to reduce
unemployment may take priority over other macroeconomic objectives and it has been seen in
reality that fiscal and monetary policies have been effective in lowering unemployment in many
countries – both developed and developing. Keynesian policies are essential to lower
unemployment in the short-term.

CONCLUSION:

The statement that Keynesian policies cannot resolve unemployment as it causes conflict is only
partially correct. Demand-side policies have shown to be effective in many countries in reducing
unemployment, particularly in the short-term. Although it can lead to conflict with other macroeconomic
aims, it must be remembered that governments have other policies that can be used to prevent the
conflict from occurring. Thus, governments today continue to rely on Keynesian policies when faced
with the problem of unemployment and Keynesian policies remain an essential aspect of economic
management in the short-run. In order to effectively reduce unemployment over the long-term and to
reduce the potential for conflict, governments should undertake supply-side policies alongside the
Keynesian policies.

11
 S04qp4 Q2b

Discuss whether marginal utility theory is a realistic piece of economic analysis in explaining
consumer demand.
[13]

Introduction:

• Definition of ‘marginal utility’.

Discussion:

• Explain how marginal utility can be used to explain consumer demand.

o Relationship between MU (Law of Diminishing Marginal Utility) and TU.
o Explanation of equi-marginal principle.
o Explanation on how the MU theory leads to the derivation of the demand curve.

• Analyse the problems of the theory in explaining consumer demand.

o Utility cannot be measured in absolute terms.
o Utility is not the same for every individual.
o Utility is different for different types of goods.
o Theory assumes consumers are rational.
o Habit-forming goods do not follow Law of Diminishing Marginal Utility.
o Consumers’ taste and preference are not constant.
o Theory does not explain consumer demand for Veblen goods.

Evaluative conclusion:

Many limitations. The MU theory is able to explain consumer demand up to an extent only. Nonetheless,
it remains an important theory and analysis of consumer demand in economics.

12
 Essay Outline S08qp4; Q4

Large firms necessarily become monopolistic. Monopolies adopt practices that are undesirable.
Therefore, large firms should be regulated by governments.

Discuss whether there is any truth in this argument. [25]

INTRODUCTION:

• Definition of ‘monopoly’.
• Characteristics of a monopoly market structure.

DISCUSSION:

• Explain why large firms may become monopolistic - e.g. due to blocked entry, high start-up costs,
control over key inputs, through mergers & takeovers.

• Explain the undesirable practices that monopolies and large firms may adopt:
o Consumer exploitation - price discrimination, collusion e.g. price fixing
o Predatory pricing against smaller firms with the aim of increasing market share
o Restrict supply to increase profits rather than focusing on improvement and reduction in costs.
o Productive inefficiency & allocative inefficiency.
o X-inefficiency

• Given the possible undesirable practices of large firms and monopolies, government can intervene
in a number of ways to regulate the behaviour of such firms:
o Taxation
o Marginal cost pricing for monopoly firms
o Nationalisation in cases where private monopolies that produce essential services abuse their
market power
o Marginal cost pricing for large firms
o Subsidy to some monopolies so that they are able to produce at an output level that is
allocatively efficient and still earn some above normal profits.
o Legislation e.g. laws prohibiting anti-competitive practices; the UK Competition Policy;
consumer protection laws.

EVALUATION: Are monopolistic and large firms always detrimental?

• Not all large firms become monopolistic and engage in undesirable practices.

• Many large firms are competitive and this benefits consumers in the markets they operate in. In
oligopoly markets for example, dominant firms are competitive and compete aggressively on non-
price basis and product differentiation. This provides a range of high quality goods and services to
consumers (explain example of automobile industry).

13
• There are advantages of large firms as well:
o Ability to exploit economies of scale resulting in low average costs.
o Ability to undertake research and development and technological innovation due to
supernormal profits earned.

CONCLUSION: whether large firms should be regulated by governments:

Given that there is always the possibility that large firms may become monopolistic and adopt
undesirable practices, there should always be some form of regulation for large firms to ensure that
markets remain competitive and that undesirable practices are avoided and minimised. The presence
of government regulation discourages large firms from engaging in undesirable practices and protects
the interests of consumers and smaller firms. However, there are also advantages of large firms and
not all of them necessarily become monopolistic. It is for this reason that any form investigation or
regulation implemented by the government must be on a case-by-case basis. It would be incorrect to
assume that monopolies or large firms are always harmful.

14
 S08qp4

Discuss the effect of an increase in the supply of money on interest rates and national income.

[15]

Introduction:

• Definition of interest rates and national income.

Discussion:

Explain the impact of an increase in the supply of money on the level of interest rates in the
economy:

Interest
MS1 MS2
rate (r)

excess Diagram 1
supply of
money
r1

r2
LP
Money
Q1 Q2

• Money supply initially at MS1, where interest rate is r1, as seen in Diagram 1 above.

• A rise in money supply shifts the supply curve to MS2. There is now excess supply of money at r1.
Households however only want to hold Q1 money at r1.

• The excess money is thus used to buy bonds since at interest r 1 opportunity cost of holding money
is quite high. Demand for bonds rises → price of bonds rises → interest rate begins to fall until it
reaches r2. At this lower interest rate of r2, quantity demanded for money has risen to Q2, reaching
a new equilibrium.

• Therefore, the rise in money supply from MS1 to MS2 has resulted in a fall in interest rate to
r2.

15
Explain the impact of the lower interest rates on the level of investment:

• The lower interest rates → reduces returns from savings and reduces the cost of borrowing for
households and firms.

• The fall in interest rates to r2 → firms expect a higher rate of return on each extra unit of investment
→ firms increase their investment spending.

• The firms’ decision to increase their investment in response to the lower interest rates can be seen
as a downward movement along the MEC curve in Diagram 2 below.

Interest
rate (r)

Diagram 2
r1

r2

MEC
Money
I1 I2

• The MEC curve represents the level of investment in relation to interest rate. At initial interest rate
of r1, investment was I1.

• The fall in interest rate to r2 caused by the rise in money supply now increases investment to I 2.
Firms undertake a larger amount of investment than previously.

Explain the impact of the lower interest rates on spending and national income using the
concept of the multiplier.

• The increase in investment spending by firms will raise the level of national income in the economy.
This process can be explained using the concept of the multiplier.

• Define ‘multiplier’.

• The rise in investment spending represents an injection into the economy. As investment
increases, output of goods and services will also increase, leading to more employment of labour
and therefore raising the level of income in the economy.

• As income levels rise → this will induce further spending by households (consumption spending
increases) and lead to further increases in production, employment and income levels in the
economy.

• However, not all of the extra increase in income is spent → part of the income earned will be saved,
used to pay taxes and used to buy imported goods and services.

• Therefore, every increase in income results in withdrawals from the economy in the form of
savings, taxes and import spending. As incomes continue to rise, all the extra injection will have
leaked away into all three leakages, signalling the end of the multiplier process and the economy
would reach a new equilibrium level of national income. This final increase in national income will
be larger than the initial investment spending undertaken by firms.

16
Explain a numerical example of multiplier using either W-J approach or AE=Y approach (with
diagram). You can use the numerical example from your lecture notes or provide your own
numerical example:

• Diagram 3 below illustrates a numerical example of the multiplier caused by the initial injection of
investment spending by firms.

J, W

Diagram 3
W1

J2
I by $1m
J1

0 8m 10m National Y

+ 2m

• Current equilibrium national income is $8 million. Assume the lower interest rates has caused
investment spending to rise by $1 million. The J function shifts upwards to J 2 by the amount of $1
million.

• Assume the marginal propensity to withdraw (mpw) is 0.5. This means out of every increase in
income, half will go into savings, taxes and spending on imports. From here, the value of the
multiplier (k) given by the formula k = 1/mpw can be determined to be 2 (k = 2).

• This means the injection of $1 million of investment spending will raise national income by $2
million, raising the equilibrium level of national income from $8 million to $10 million.

Evaluation:

• Although the injection of investment into the economy will raise the level of national income once
the multiplier process ends, the extent to which national income will rise by more than the
initial increase in investment spending will depend on the size of withdrawals or leakages
from the economy.

• A larger mpw → the smaller is the multiplier → the overall rise in the final level of national income
will be smaller.

• The extent to which national income will rise also depend on whether the economy is at or below
full employment. If there are idle resources available at the time of the increase in investment
spending, then the multiplier effect of the investment spending will be larger.

Conclusion:

There is a clear link between money supply, interest rates and national income. An increase in money
supply will reduce interest rates, thereby stimulating consumer spending and an increase in investment.
This will then lead to an overall increase in the final level of national income as explained through the
multiplier concept. However, the extent of the rise in national income will depend on the marginal
propensity to withdraw or the size of withdrawals each time a rise in income occurs, as well whether the
economy is at or below full employment.

17
 S10qp41 Q5b

For some years governments of developed countries have been promoting Fair Trade, which
means paying a fair price for primary products bought from African developing countries. Now
the governments in developed countries, anxious to conserve resources, are complaining that
the transport of products around the world increases pollution and should be limited. They
support instead the purchase of goods produced at home. These are often more expensive to
produce. African farmers may be left with products that their local people do not eat.

Discuss whether the old and the new approaches to trade of the developed countries would help
achieve the conservation of resources. [13]

Introduction:

• Explain ‘trade’ and ‘conservation of resources’.

Discussion:

Analyse how the old approach, i.e. paying fair price for primary goods purchased from African
developing nations help achieve conservation of resources:

• Promotes specialisation (comparative advantage) → efficient use of resources → minimises

resource wastage.

• Enables African farmers to earn profit → incentive to invest in better technology and capital
equipment; use better fertilisers; invest in proper irrigation and drainage systems → reduce
environmental damage and allowing some degree of resource conservation.

• However as a fair price results in better profits → may exploit resources and cause environmental
problems and depletion of resources. Resource allocation questionable as overproduction may
occur.

New approach:

• May not help to conserve resources because:

o Developed countries may not have comparative advantage in producing primary goods →
inefficient → produce at a higher cost → wastage of resource.
o Land may not be suitable; climate or weather may be unsuitable → more costly to produce →
may outweigh the reduction in transport costs.
o Loss of comparative advantage as resources are transferred towards producing goods that
were previously efficiently produced by African farmers. Redirecting resources away from the
goods in which developed countries have comparative advantage in may result in lower
output, growth and national income.
o African farmers left with surplus → wastage of scarce resources. Farm land abandoned → no
productive use of their resources.
o Domestic firms in developed countries face less competition → importing less from African
countries raises domestic demand → may not have incentive to reduce costs, there will still
be some degree of pollution, some resource wastage due to inefficiency.

• By producing the goods on their own, developed countries can reduce transport costs. There will
also be less pollution and environmental damage → some conservation of resources is possible.

18
• Due to technological development, some developed countries may have been able to develop
substitutes to the goods produced by African farmers → this can turn into comparative advantage
→ production costs are lower; less wastage of resources.

Conclusion:

• The old approach could possibly lead to conservation of resources but may also encourage
overproduction thus not conserving resources. The new approach may seem like a viable
alternative however it may actually lead to more resource wastage. Difficult to say with certainty
as arguments can be made in regard to the inability of both approaches to conserve resources.

19
Analyse whether an increase in the wage rate always leads to an increase in the number of hours
worked by an individual.
[10]

Introduction:

• Definition of wages.

• The relationship between increase in wage rate and number of hours worked can be analysed
through the substitution effect and income effect.

Discussion:

• Explain why an individual is willing to work more hours when an increase in wage rate occurs:

o Opportunity cost of not working increases as wage rate increases.

o Choose work over leisure (substitution effect).

o Substitution effect is stronger than income effect.

o Supply curve slopes upwards.

• Once wage rate rises beyond a certain point:

o Income effect stronger than substitution effect.

o Choose leisure over work (work is an inferior good; leisure is a luxury good).

o A higher income can be obtained from working fewer hours. The individual feels the need to
work less. Opportunity cost of not working has decreased due to the higher wages earned.

o Supply curve bends backwards.

• Draw entire supply curve (upward sloping & backward bending) and explain the diagram. Clearly
label substitution effect and income effect on the diagram.

Conclusion:

A rise in wage rate will lead to a rise in the number of hours worked but only up to a certain point. Once
wages rise further beyond a certain point, the opportunity cost of not working decreases and a target
income can be achieved with fewer working hours. The individual will therefore work less hours. Thus,
an increase in the wage rate does not always lead to a rise in the number of hours worked.

20
A government stated that pay increases in the coming year should be kept to a minimum.
Discuss whether the main determinants of wage rates are factors such as trade unions and the
government rather than market forces.
[15]

Introduction:

• Explanation of ‘market forces as determinant of wage rate’.

Discussion:

Market forces tend to dominate in perfectly competitive labour markets:

• List the assumptions of a perfectly competitive labour market.

• Explain MRP theory & MCL (draw and explain the appropriate diagrams).

• The individual firm is a wage taker and must pay the market wage rate.

On the other hand, government and trade unions will have an influence on wage rate
determination in imperfect labour markets.

• Explain how trade unions influence the wage received in a monopsony market (draw and explain
the appropriate diagram).

• Explain what factors determine the success of trade unions – e.g. membership; ability to organise
strikes; practice of closed shops.

• However, this may lead to unemployment for some trade union members.

• Globalisation may also undermine the ability of trade unions to obtain wage increases above the
equilibrium wage rate.

• Government intervention can be in the form of imposing minimum wage to protect low skilled or
unskilled workers or those workers who are not members of trade unions.

• However, there will be some loss of unemployment. The extent of unemployment will depend on
the price elasticity of demand and price elasticity of supply of labour (draw and explain the
appropriate diagrams).

• In many economies today, and in particular mixed economies, the government is the major
employer of labour, thus having monopsony power and is able to determine public sector pay. This
puts the government into conflict with trade unions if the government pays wages below market
wage rate.

21
 Conclusion:

Market forces will be the main determinant of wages in a competitive labour market. On the other hand,
if the labour market is imperfect, such as the case of a monopsonist who is able to pay a wage that is
below market wage rate, then it is likely that trade unions and government will be able to influence the
wage received by workers. However, the effectiveness of governments and trade unions in obtaining a
wage above equilibrium may be offset by some loss of unemployment and external factors like
globalisation.

22
 S11qp41 Q7

The main way a developing country could become a developed country is for
government policy to concentrate on the protection of domestic industry and
investment in infrastructure. Do you agree that this is the best policy? [25]

INTRODUCTION:

• Definitions of ‘developed country’ and ‘developing country’.

DISCUSSION:

Explain the range of criteria which distinguish developed countries from developing countries:
• Economic structure
• Rural-urban migration
• Human capital
• Physical capital
• Population
• HDI value
• Health & mortality
** Explain about 4, clearly showing the difference between developed and developing
countries using examples.

Examine how investment in infrastructure will help a developing country to become developed:
• Spending by government creates job opportunities → income rises → reduces income
inequality and poverty.
• Infrastructure in rural areas → e.g. irrigation, electricity, water, roads → increase
productivity of farmers → higher GDP and employment and income → will help reduce
rate of rural-urban migration.
• Better infrastructure → creates conducive business environment → encourage
investment by domestic firms and inflow of foreign investment. E.g. transport costs are
lowered → employment, output and incomes rise.

Examine how protection of domestic industry enables a developing country to be developed:

• Development of infant industries & comparative advantage
• Better use of resources (efficient resource allocation)
• Prevention of dumping
• Increased demand for domestic goods → domestic firms can earn profit → can invest in
better capital goods and research and development.
• Reduce balance of payments deficit and external debt
** Refer to AS Topic 4 notes under ‘International Trade’.

23
 EVALUATION:

Examine the problems of both strategies:

• Protection may breed inefficiency; result in retaliation by developed countries.
• Spending on infrastructure is expensive and may require external financing; government
may not have the necessary knowledge to build infrastructure.
• Money allocated for infrastructure may be waster due to corruption.

Given the possible problems, government can consider other strategies such as:
• Encouraging multinational companies to invest (benefits of MNCs)
• Developing human capital → education, healthcare facilities
• Population control measures
• Participation in international trade

** Explain about 3 of the strategies.

CONCLUSION:

There are a range of criteria that can be used to distinguish between developed and
developing countries. For a developing country to become developed, it is of course crucial
that the country invests in critical infrastructure and to protect domestic firms, although
government must be aware of how long-term protection may lead to other problems which
may harm the country’s ability to grow. However, despite the importance of these two policies,
no particular strategy or two strategies alone can bring about the desired level of development.
It is just as important therefore that other strategies be considered as well, as all of the
strategies collectively can contribute to the enhancement of economic development in a
country in short-run and long-run.

24
 S11qp42 Q5

In imperfect competition, labour markets can lead to worker exploitation in terms of the wage
rates they receive compared with the wage rates in perfect competition.

Discuss this opinion. [25]

Introduction:

• Explain ‘labour market’, ‘demand for labour as derived demand’, ‘supply of labour’.

• Distinguish between perfect competition and imperfect competition.

Discussion:

Describe the assumptions of a perfectly competitive labour market:

• All firms and all workers are wage takers.
• There is freedom of entry and no restrictions on the movement of labour.
• Perfect knowledge – workers know what jobs are available and the relevant working conditions;
firms know what labour is available and the level of labour productivity.
• Labour is homogeneous – identical in terms of ability and productivity.
• Workers do not belong to trade unions.
• Labour productivity is measureable.

Explain how wage rates are determined in a perfectly competitive labour market:

• Explain MRPL theory:

o MRPL is the increase in total revenue as a result of hiring one more unit of labour.
o It is downward sloping curve.
o MRPL = MR * MPPL
o The wage received will equal the worker’s MRPL.

25
• Explain the MCL:
o MCL → the extra cost of hiring an extra unit of labour.
o In a perfectly competitive labour market → the firm is a wage taker.
o Therefore, the MCL = the wage paid to the extra worker.
o It is a horizontal line.

Assuming the firm is a profit-maximising firm, the firm will employ workers up to the point where MRPL
= MCL. Refer to diagram below and explain the diagram.

26
Explain how wages are determined in imperfect competition (monopsony market):
• Draw and explain monopsony diagram.

In a monopsonist labour market, the wage rate paid to workers is below what would be paid in a perfectly
competitive labour market. It also has the power to set all other conditions of employment.

However, the comparatively lower wage rate can be corrected to some extent by trade unions and
government regulations.

Explain how trade unions can negotiate for higher wages and prevent worker exploitation:

• The success of trade unions in preventing worker exploitation will depend on the power of the trade
union such as…(include elaboration from lecture notes).

27
Explain how government can also reduce exploitation of workers e.g. through legislation and
minimum wage.

Therefore, based on the discussion so far, perfectly competitive labour markets are unlikely to
lead to worker exploitation, unlike in an imperfect labour market. However, the determination of
wage rates in a perfectly competitive labour market is based on a set of theoretical assumptions
that are not valid in reality.

• Explain some of the limitations of the MRP theory.

Conclusion:

Workers in perfect competition are unlikely to be exploited due to the competitive nature of the market
that the firms are operating in. This assumption however is based on highly theoretical assumptions.
The non-existence of perfect competition in reality means that the realism of the theory is questionable
and as such, there can potentially be cases of worker exploitation, even when markets are competitive.
In contrast, worker exploitation in terms of wage rates received is more likely to occur in imperfect
markets, particularly where the firm has monopsony power. However, in reality, this monopsony power
can be curbed to some degree by the roles of trade unions and government legislation. As a result, it
would not be accurate to assume that workers in imperfect markets will be exploited and paid a wage
rate lower than what is considered fair and appropriate.

28
Discuss whether increases in economic growth are necessarily beneficial to an economy.
[13]

Introduction:

• Definition of ‘economic growth’.

• State the indicator of economic growth, i.e. how economic growth is measured.

• A rise in economic growth is indicated by a rise in the GDP.

• In the short-run → economy moves closer towards its PPC.

• Long-run → PPC shifts outwards.

Discussion:

Explain the benefits of economic growth:

• reduction in poverty
• higher living standards
• increased employment / reduction in unemployment levels
• improved access to healthcare and education
• increased investment
• technological development and innovation
• increased export revenue

However, there are problems associated with economic growth:

• widening income inequality
• rising inflationary pressures
• environmental damage
• depletion of natural resources
• social costs
• increased stress

29
 Evaluation:

Whether economic growth is beneficial may depend on:

• Current rate of economic growth – if current rate of growth is negative or economic growth is
stagnant, then a rise in GDP would be able to deliver the benefits explained above and therefore
improve the overall welfare of the people in the economy. Even so, this does not mean that the
costs associated with economic growth would not occur.

• Ability of government to manage the problems of economic growth, for example effective
implementation of policies to reduce income gap, prevent increases in price level and ensuring
responsible use of natural resources.

• Whether the increase in GDP is spent on things which give direct benefit to society e.g. spending
on infrastructure, research and development, merit goods and public goods.

Conclusion:

Not necessarily beneficial. Difficult to prevent the costs of economic growth from occurring.
Governments must be able to effectively manage the problems of economic growth and ensure that
economic growth can be sustained into the long-term.

30
 S12qp41 Q3b

Discuss whether oligopoly is likely to be the most realistic market structure in a mixed economy.
[13]

Introduction:

• Explain the term ‘oligopoly’.

• Explain the term ‘mixed economy’.

Discussion:

• Describe the characteristics of oligopoly and relate them to a mixed economy.

• Oligopoly occurs when just a few firms between them share a large proportion of the industry.
E.g. where the few firms produce a combined 80% of industry output. The concentration ratio
(percentage of a market controlled by a given number of firms) is usually very high. Note that
alongside the few very large producers, there may also be a large number of very small firms.
This characteristic of oligopoly can be seen in a mixed economy, where due to the presence
of the private sector, there are firms in certain industries who may grow and become
dominant and thus control the output in the industry, with many smaller firms having to
follow the production decisions of the larger and more dominant firms.

• There could be a mixture of price makers and price takers. In an oligopoly market structure,
dominant firms have strong pricing power and thus dictate market selling price to a large
extent. Smaller firms tend to follow the prices set by the dominant firms. This mixture of
price makers and price takers is also evident in a mixed economy in which some firms
owing to their market power are able to influence price while the smaller firms enjoy only
limited influence over price.

• There is price rigidity / price stability. Despite changes in underlying costs of production, firms
are often observed to maintain prices at a constant level (Explain kinked demand curve). There is
no incentive for firms to engage in a price war. In a mixed economy, it is not uncommon to find
relatively stable prices in some markets. Governments may implement price stability policies which
must be followed by the firms in that particular industry. Therefore, prices may remain stable for a
period of time. The difference here however is prices are stable due to government intervention,
while in oligopoly market structure prices are stable due to the absence of a price war.

• Firms may produce identical (e.g. metals, chemicals, crude oil, sugar) or differentiated goods
(cars, soft drinks, electrical appliances). Consumers thus enjoy a variety of similar goods and have
the freedom to buy from any firm. In a mixed economy, there are both identical products and
differentiated products that are sold. Consumers are free to buy the goods from their preferred
supplier as long as they are willing and able to pay the price of it. In a mixed economy, firms are
free to decide on production methods to minimise cost and maximise profits. This is also observed
in oligopoly, where firms will constantly assess their production processes in order to lower their
cost by selecting the most efficient method of production.

31
• In a mixed economy, firms are driven by profit motive and thus compete for consumers and
market share. This drives firms to compete on price and non-price basis. In oligopoly markets,
firms compete aggressively on a non-price basis and strive to provide a variety of goods to
consumers and engage in product differentiation. This also gives firms opportunity to build brand
loyalty which further increases their market power. Examples of non-price competition are
advertising, branding. promotional offers. E.g. ‘buy two and get one free’ or free gifts and
competitions and design differences. Annual changes may be no more than cosmetic. Careful
marketing can promote psychological belief among consumers that what they currently have is
already obsolete.

• There are barriers to entry. These entry barriers are similar to those under monopoly (page 74).
This makes it difficult for new entrants to enter the market. In a mixed economy, there are very
competitive markets caused by low entry barriers but there are also markets where there are high
barriers to entry, resulting in the dominance of a few firms.

• The dominant firms of an oligopoly industry may attempt to engage in collusion by either fixing
prices or restricting output. This is considered illegal as consumers are exploited by being forced
to pay higher prices. In a mixed economy, there are also problems of abuse of market power
and consumer exploitation. Firms can become large and dominant and due to the profit motive
may engage in unethical behaviour or abuse their power.

• Firms are interdependent (mutually dependent). Because there are only a few firms under
oligopoly, no firm can afford to ignore the actions and reactions of other firms in the industry.

o If a firm changes the price or the amount of its advertising, the sales of its rivals will be affected.
The rivals may then respond by changing their price or advertising.

o Each dominant firm recognises that its own price and output decisions will affect its rivals and
therefore it expects its rivals to respond. The firm thus carefully considers its rivals’ possible
reactions and as a result, consistently re-evaluates its own decisions.

o In a mixed economy, due to profit motive, consumer sovereignty and competition, there are
firms who would monitor one another closely and copy successful strategies to avoid losing
their market share.

• Oligopoly firms, due to the intense non-price competition factor, engage in research and
development. The above normal profits enjoyed by dominant firms results in huge amounts of
money being invested in the latest technology and continuous research and development to
improve the quality of their goods and services in order to retain or achieve brand loyalty which
would make demand for their goods inelastic or more inelastic, thus increasing their profitability. In
a mixed economy, there is incentive for firms to undertake research and development (in terms of
product or production methods). This has led to rapid technological development and a range of
product and process innovations which has in turn contributed to higher levels of economic growth.

Evaluation:

The features of oligopoly discussed above and the extent to which it fits into the operation of a mixed
economy would seem to make it the most realistic market structure. However, some of the features of
oligopoly are also prevalent in other types of market structures, such as monopolistic competition and
monopoly.

Monopolistic competition – there is non-price competition, brand loyalty, market power, some of the
firms are price makers and firms are driven by the profit incentive. Therefore, monopolistic competition
could also be a realistic market structure in a mixed economy. However, due to the existence of so
many firms caused by the absence of entry barriers, collusion is unlikely to occur and firms in

32
monopolistic competition may compete on price basis as well. Ability of firms in this market structure to
innovate and undertake research and development is also limited and may require some form of
assistance from the government in the forms of grants or subsidy (govt intervention is a feature of a
mixed economy).

Monopoly – the monopolist is a price maker, there are barriers to entry and the monopolist may abuse
its market power by preventing its suppliers from providing key raw materials or inputs to potential
competitors. A monopoly firm may still engage in product differentiation as this will allow it to enjoy long-
term profits. The monopolist earning supernormal profits could spend huge sums of money on research
and development as well. Any abuse of market power by monopolist will likely result in government
intervention and thus government tend to monitor behaviour of monopolist closely.

Conclusion:

The nature of a mixed economy means that firms are driven by profit motive and the pressure of
competition. This can be seen clearly in the oligopoly market structure. However, some of these same
oligopolistic features can also be found in other market structures such as monopolistic competition and
monopoly. Therefore, it is quite unlikely oligopoly is the most realistic market structure, although it may
be one of the more common types of market structure in a mixed economy.

33
 S13qp41 Q7

(a) A newspaper reported that ‘unemployment had risen for the third consecutive month.’ What
might be the cause of a rise in unemployment?
[12]

Introduction:

• Define ‘unemployment’.

Explain a range of the possible causes of unemployment, using examples where possible:

• Structural unemployment

• Cyclical unemployment

• Frictional unemployment

• Seasonal unemployment

• Disequilibrium unemployment → caused by real wage rising above equilibrium level → discuss
demand-deficient unemployment, growth in labour supply without matching increase in labour
demand (wages sticky downwards). Support explanation using the relevant diagram.

• Equilibrium unemployment → demand and supply for labour do not match at microeconomic level
→ discuss frictional, structural and seasonal unemployment.

• An increase in the rate of inflation → export demand and domestic demand decline.

Examiner’s comment:
• Some responses did not refer to the type of unemployment by specific title but
they did provide reasonable explanation of factors which could cause job loss.
• For example, an increase in the rate of inflation which might reduce the demand
for exports or the introduction of new technology substituting for labour.
• Any valid explanation of a possible cause of unemployment was recognised and
rewarded.
• Supporting diagrams and examples were provided and marks were gained
accordingly.

Conclusion:

• Various factors that contribute to unemployment.

34
 S13qp41 Q7

(b) Discuss whether achieving a fall in the level of unemployment should be the main
macroeconomic aim of a government.
[13]

INTRODUCTION:

• Definition of ‘unemployment’.

• Outline the macroeconomic aims of the government:

o Apart from achieving a lower level of unemployment, a government has other aims as well
such as achieving economic growth, a low and stable inflation, a favourable balance of
payments position, a stable exchange rate and sustainable growth & development.

DISCUSSION:

Explain why reducing unemployment level should be the main aim of the government:

• Avoidance of the negative effects of unemployment → explain the negative effects of

unemployment if unemployment is not reduced. If unemployment remains high, there will loss of
output, lower national income and economic growth, increased pressure on government fiscal
position and social effects (refer to lecture notes for elaboration).

• Reducing unemployment brings positive effects to the economy:

o Reduces poverty; raises living standards.
o Higher investment as lower unemployment leads to higher incomes which stimulate spending.
o A boost to technological advancement. A higher employment level causes incomes to rise in
the economy and thus increases demand and spending. Firms will have incentive to
undertake technological development to improve production processes and to produce better
quality goods and services.

Explain the potential problems that might occur if achieving a fall in the level of unemployment
becomes the main aim of the government:

• Reducing unemployment level causes potential conflicts with other macroeconomic aims of the
government.

• A lower unemployment level will cause inflationary pressures to rise, thus conflicting with the price
stability objective:
[explain how – link lower unemployment to rising incomes & spending thus creating demand-
pull pressures; rising spending and growth leads to higher output of goods produced → firms
increase demand for resources and raw materials (cost-push pressures)].

• Use Phillips Curve to illustrate the trade-off between lower unemployment and rising inflation.

35
• In addition, a lower unemployment will also cause balance of payments to worsen:
(explain how – rising incomes due to lower unemployment will increase demand for imported
consumer goods; the reflationary policies implemented to reduce unemployment will stimulate
economic growth → firms import more raw materials and capital equipment).
Rising inflationary pressures caused by lower unemployment will also reduce international
competitiveness of exported goods and services.

• Thus, the aims of a low inflation and acceptable balance of payments cannot be achieved if
government focuses on achieving a lower unemployment level.

EVALUATION:

Given the advantages of reducing unemployment and also the possible problems that may emerge
such as rising inflationary pressures and worsening balance of payments, whether the government
should prioritise achieving a lower unemployment level will depend on the economic conditions of
the country, that is, the position of the economy on its trade cycle.

If the economy is in a recession or deflation where aggregate demand level is very low, then lowering
unemployment level should be the main aim of the government. This will be crucial as a fall in
unemployment will raise confidence level in the economy, leading to demand for goods and services
and thus the production of these goods and services. Not only will living standards and welfare improve,
but there will be less problems such as business failures and bankruptcy.

However, if the economy is currently experiencing a boom in economic activity where there are
rising inflationary pressures, then reducing the level of unemployment should not be the main aim
of the government, more so if the government is attempting to drive unemployment below the natural
rate. In this situation, the government should instead make low inflation and improving balance
of payments as its main priority.

CONCLUSION:

There are many advantages of prioritising a lower unemployment level but there are also drawbacks to
the economy when this lower level of unemployment is achieved. Therefore, there must be careful
consideration whether it is necessary to reduce unemployment level. If the economy is in a recession
or trough, then it most certain that reducing unemployment should be the main macroeconomic aim of
the government. Reducing unemployment however should not be the main macroeconomic aim if the
economy is experiencing strong growth as it is likely that during this period inflation and balance of
payments will be the main challenges confronting the economy.

36
 S13qp42 Q2b

Discuss how a government might achieve a more equal distribution of income.

[13]

Introduction:

• Explain the term ‘distribution of income’ → refers to how income is distributed across an
economy, revealing the percentage of households or individuals at various income or
wage levels.

• Explain what ‘achieving a more equal distribution of income’ means → government aims
to reduce income gap or income inequality between high and low income earners in the
economy.

Discussion:

Explain the various ways a government can achieve a more equal distribution of
income:

• Progressive tax system.

• Transfer payments – explain means tested and universal benefits (refer AS Topic 3 & A2
Topic 3).

• Subsidy to firms and workers to undergo training – aim is to improve skills of workers
enabling them to earn higher incomes.

• Subsidy for education.

• Minimum wage.

• Negative income tax.

• Tax credit.

• Provision of services (A2 Topic 3).

Evaluation:

• Explain the limitations of the policies to achieve a more equal distribution of income –
focus should be on the effectiveness of the policies to achieve a more equal distribution
of income.

• Ultimately, effectiveness of the policies depends on the extent to which government

is able to manage the problems of the respective policies and the ability of the
government to monitor and implement the policies so that the intended outcome is
achieved.

37
 Conclusion:

Many policies available to the government to achieve better income equality. Achieving a more
equal distribution of income cannot be done through the implementation of only one or two
policies. Instead, a combination of policies should be used by the government. However, each
policy has its limitations and the effectiveness of the policies therefore will depend on whether
the government can reduce or overcome the limitations and the extent to which the
government can ensure proper implementation and monitoring of the policies.

38
 May/June 2013; Paper 43

Question 3(b)

Discuss why wage rates might be different in practice than those in a perfectly competitive
labour market.
[13]

Introduction:
• Define ‘wage rates’, ‘labour market’.

Discussion:

• Explain how wages are determined in a perfectly competitive labour market – MRP theory (MRP
= MPP x price per unit of output)
o MFC = AFC
o MRP is downward sloping
o Diagram: page 96 of notes

• Explain the assumptions in a perfectly competitive labour market:

o Workers are homogeneous
o Firms have no buying power
o Productivity is measureable
o There is perfect knowledge

• In practice however, labour market is imperfect.

o Explain why the theoretical assumptions are not valid in practice.
o There are also wage differentials due to differences in labour productivity (MPL) between
occupations and between industries, between males & females, between public sector &
private sector.
o Immobility of labour – geographical immobility, occupational immobility.

• Explain that in practice, trade unions, government and monopsonists have an influence on wage
rates:
o Explain how monopsonist influences wage rates – provide relevant diagram.
o Explain how trade unions influence wage rates – provide relevant diagram.
o Explain how government influences wage rates.

Conclusion:
Different in practice as a perfectly competitive labour market does not exist. The assumptions of
perfectly competitive labour market are not valid when applied to reality. Government, trade unions and
monopsonist exist in practice and can heavily influence the wage rates in a labour market.

39
 S14qp42 Q5

It was reported in 2012 that consumers should not be encouraged to save more and reduce their
debts. Increased saving would result in a Keynesian ‘paradox of thrift’ which would not help
economic growth. Instead consumers should spend money on new purchases.

a) Explain and comment on what is meant by the ‘paradox of thrift’. [12]

Introduction:

• Define ‘paradox of thrift’ (the gist of the theory).

Explanation:

• Describe the theory of paradox of thrift and its subsequent effect on economic growth.

• Include the relevant diagram and explain how the rise in W will cause national income to fall,
leading to a fall in savings to the initial level.

Comment on the theory:

Explain why it may not occur (relate explanation to the limitation of the theory):

• Falling demand will cause prices to fall → demand may rise stimulating growth & employment.

• Higher savings results in a lower interest rate → encourage borrowing; banks may also be willing
to lend.

• Investment spending may rise due to higher demand and lower interest rate.

• Although a fall in demand may occur as people save more, however this could be offset by the rise
in exports earnings.

Conclusion:

• Recap.

40
 S16qp41 Q3b

Suppose the price of one of the good falls. Use indifference curve analysis to discuss whether
consumers would always buy more of the good when its price falls. [13]

Introduction:

• Define ‘indifference curve’.

Discussion:

• The consumer’s ability to consume one or more goods will depend on his income, price of the good
and his overall preference.

• Explain that the consumer will be in equilibrium at the point where budget line (constrained by
income and prices of both goods) is tangent to the highest indifference curve (his preference given
his income and the current prices of both goods).

• Draw and explain diagram to illustrate optimum consumption point (equilibrium).

• In general, a fall in the price of one of the good will cause a rise in the quantity demanded for it –
draw and explain diagram.

41
 Evaluation:

However, the consumer may not always buy more of the good when its price falls. It will depend on
whether the good is a normal good or an inferior good or a Giffen good, and the resulting substitution
effect and income effect of a price change.

• If Good X is a normal good or an inferior good, and the price of it falls – quantity demanded will
rise as the price of Good X falls.

• Assume Good X is a normal good – Draw and explain diagram – in this case, quantity demanded
will rise as price of Good X falls (substitution effect & income effect are positive).

• Assume Good X is an inferior good – Draw and explain diagram – in this case, quantity demanded
will rise as price of Good X falls (substitution effect outweighs income effect).

42
• However, if Good X is Giffen good, and the price of it falls – quantity demanded falls as price falls.
o Draw and explain diagram – in this case, quantity demanded falls as income effect outweighs
substitution effect).

Conclusion:

A fall in the price of the good should cause quantity demanded to rise, that is, the consumer will buy
more of the good. However, as indifference analysis has shown, it is not always the case that the
consumer will buy more when the price falls. This holds true only if the good is a normal good or an
inferior good. If however the good is a Giffen good, then the quantity consumed will fall when the price
falls.

43
 S16qp43 Q5a

It was reported that India’s policymakers seem to be fighting a losing battle with inflation. Some
economists linked the persistent rise in prices to the pace of economic growth.

Consider whether economic growth will always cause inflation. [12]

Introduction:

• Definition of ‘inflation’ and ‘economic growth’.

Discussion:

• Explain how economic growth can cause inflation – explanation must cover demand-pull inflation
and cost-push inflation supported with relevant diagrams, and explanation of the diagrams.

• Extent to which economic growth worsens inflation depends on the position of the economy, that
is, whether it is close to full employment.

Evaluation:

• Whether economic growth always causes inflation:

• Not necessarily. Inflation can also be caused by a weak exchange rate which increases the costs
of importing raw materials and capital equipment. It may also be caused by government policies
such as introduction of minimum wage.

Conclusion:

Economic growth can cause inflation to occur. However, it may not be the only reason inflation occurs,
as inflation can also be caused by other factors such as weak exchange rate and government policies.

44
 S17qp43 Q7b

Distinguish between monetary policy and fiscal policy. Discuss whether fiscal policy may be
used to influence the standard of living in a country.
[13]

Introduction:

• Definition of monetary policy and fiscal policy.

Discussion:

Explain the difference between both:

• Fiscal policy – involves changes to government spending and taxation. Related to govt’s budget
plans. State the three budget outcomes. For example, to increase aggregate demand, government
can plan for a budget deficit through a reduction in tax rates and a rise in government spending.
Lower taxes will raise disposable incomes of households and therefore boost consumption
spending, while with lower business tax, firms will be encouraged to increase investment spending.
As the various components of AD increases, there will be an overall increase in AD level.

• Fiscal policy can be used to target specific groups or areas in the economy. However, it is not
flexible as it can only be implemented once a year. Has long implementation lag.

• Monetary policy – involves changes to interest rates, money supply or exchange rate. Used by
government to influence decisions regarding borrowing, saving and spending, including
investment. For example, to increase aggregate demand, interest rate can be lowered. This
reduces borrowing costs and can encourage a rise in consumption and investment spending,
thereby raising AD level in the economy.

• Monetary policy affects all types of spending and is flexible (can be implemented multiple times in
a year). Has short implementation lag.

Analyse how fiscal policy can be used to influence living standard:

• Define ‘living standards’.

• Government can reduce taxes – reduce income tax; business tax and indirect tax.

o Reducing income tax and indirect tax will increase spending power of consumers leading to
better satisfaction of wants. Higher disposable income also means a better ability to save.

o Reducing business tax will increase profits of firms encouraging innovation and investment –
quality of goods improves; quantity of goods produced rises; production costs are lowered;
prices of goods will fall - raise living standards of consumers.

• Government increases its spending:

o Infrastructure development – improve competitiveness of the country and business sector →

improved efficiency, lower production costs. Utilities such as water and electricity – improve
access to important necessities; telecommunications, transport → better efficiency,

45
 productivity, innovation → living standards rise; irrigation and basic infrastructure in rural
areas.

o Merit goods – improvement in access to education and health – healthier workforce, better
skilled workforce → higher incomes. More people can afford education and health.

o Training programmes to increase skills of the unemployed and employed → higher

productivity → higher wages.

o Subsidy for export sector and for R&D – exported goods more competitive → higher export
revenue → increased output, employment and incomes. R&D subsidy encourages innovation
→ better quality goods at lower prices.
o Unemployment benefits – reduces income inequality → increase living standards of the poor.

• A rise in government spending thus creates employment opportunities, encourages innovation,

raises productivity → as economic growth occurs, incomes will rise and so will living standards.

Evaluation:

• Higher G and lower tax will produce reflationary effects on the economy → as AD rises, there will
be demand-pull inflation → living standards may not improve.

• Government may not have sufficient funds to carry out its spending → may borrow leading to debt.
Instead, by increasing tax, government can use the tax revenue to fund its spending on merit goods
which can improve living standards. However, the higher tax will reduce disposable incomes of
consumers → reduce ability to buy goods and services → less wants satisfied and thus living
standards will fall.

• Living standards is qualitative → difficult to ascertain exactly how fiscal policy can improve living
standards.

• Lowering tax does not guarantee spending → economic activity may not expand by much.

Conclusion:

• Fiscal policy can be used to lift living standards. However, the improvement may only occur in the
long-run and effectiveness of fiscal policy in improving living standards is difficult to measure.

46
 Essay Outline

In some economies in 2001 there was a decline in the number of people travelling by
air. Unemployment increased as many people lost their jobs in hotels, airline
companies and tourist related industries. Similar jobs in other industries were
advertised at reduced wage rates.

Explain the different types of unemployment and consider which type the above
unemployment might be.
[12]

Introduction:

• Definition of unemployment.

Body of discussion:

Explain the different types of unemployment:

• Cyclical unemployment (can link to disequilibrium unemployment – refer to lecture notes).

• Frictional unemployment

• Structural unemployment

• Seasonal unemployment

• Regional unemployment

**You must explain at least 4 types of unemployment and support with relevant
diagrams**.

Consider which type the example of unemployment mentioned in the question might
be:

Difficult to say with certainty the particular type of unemployment. It will depend on the
assumptions that are made about the changes described:

• The decline in the number of people travelling by air could be due to falling economic
growth and incomes, suggesting these economies were transitioning into recession or
downturn. The falling incomes reduces demand for air travel as air travel can be viewed
as unnecessary and a luxury or normal good. This subsequently reduced sales and profits
of airline companies resulting in unemployment. As spending slows, this also affected
hotels and other related industries mentioned such tourism. Wages fell due to the fall in
demand for labour. In this context, it can be argued that unemployment is cyclical

47
 unemployment. This however is likely to be temporary as unemployment will likely fall
once these economies recover from the recession or downturn.

• Seasonal unemployment is also a possibility. The fall in the number of people

travelling by air could be a repeat occurrence coinciding with specific times of the year,
for example the decline in air travel after Christmas. This would suggest that the
unemployment occurring in the airline, tourism and hotel industries is temporary, occurring
only during certain times of the year. It could also be temporary and due to factors such
as increased anxiety and fear of flying. Once conditions recover, there should be an
increase in the number of people flying, with related industries experiencing higher
demand once again and therefore reducing seasonal unemployment.

• The example could also reflect long-term factor, suggesting that structural
unemployment is a possibility. This would be a possibility if the number of people
travelling by air decreases over the long-term (long-term decline in the demand for air
travel). This will result in a continuous fall in profits of airline companies, hotels and tourist-
related industries, leading to reduced output and investment spending and possible
contraction of the related industries, including the airline industry.

Conclusion:

There are many different types of unemployment (state the types of unemployment that you
have explained). In regard to which type of unemployment the example refers to, it will depend
on the particular factors causing the decline in air travel and thus, difficult to say with certainty
the particular type of unemployment.

48
 W09qp42 Q7

The economy of South Africa is growing faster than its potential growth rate. The Governor of
the central bank of South Africa said ‘This is why we have inflation. We need to deal with inflation
as it does not lead to job creation. Interest rates are the only tool available to control inflation’.

Do you agree with the Governor’s opinion on inflation? [25]

Introduction:

• Definition and measurement of inflation.

Discussion:

Analyse whether inflation in South Africa is necessarily due to demand-pull pressures:

• Rapid economic growth indicates rising demand for goods and services. As AD is rising and firms
are producing even more goods and services, this will pull up price levels in the economy leading
to inflation. This is known as demand-pull inflation. Apart from the rise in consumption spending,
demand-pull inflation also occurs during rapid growth due to increased investment spending by
firms. As the economy edges closer to full employment, inflationary pressures will begin to rise as
well. In South Africa’s case, there is rapid increase in inflation rate as well.

• Nonetheless, it cannot always be assumed that growth leads only to demand-pull inflation. Periods
of rapid growth can also produce cost-push pressures. Due to rising output, there will be high
usage of limited resources leading to possible shortages of such resources. Consequently, firms’
production costs will begin to rise forcing them to raise their prices. A weakening currency could
also lead to higher cost-push pressures. AN economy that relies extensively on imports of capital
goods and raw materials will experience cost-push inflation since a weaker exchange rate raises
the costs of importing raw materials and capital goods.

• In addition, during times of growth, inflation could have been caused by a rise in money supply. A
rise in money supply in excess of the rise in output will only lead to rising prices of goods and
services, triggering a money supply inflation.

• Therefore, the Governor’s statement that inflation is due to South Africa’s economy growing faster
than its potential growth rate may not be very accurate as the inflation could be caused by other
factors. Demand-pull inflationary pressures suggested by the Governor is only one possibility.

Analyse how inflation leads to unemployment and consider other negative effects as well:

• Inflation raises the costs of investing for firms and creates uncertainty. This may deter foreign firms
from investing in the economy resulting in fewer employment opportunities. In addition, since
inflation causes the real value of money to decline, domestic firms may opt to reduce their
investments or invest abroad in order to earn higher real profits. Workers may also demand for
higher wages during times of inflation and firms may be forced to lay-off workers due to higher
costs.

• Given the above, it is thus important for the South African government to control inflation. A low
and stable inflation retains the real value of money and injects confidence into the economy.
Workers are also unlikely to demand for wage increases.

49
• However, unemployment is not the only negative consequence of inflation. Inflation can also
negatively harm the economy in terms of:
o higher living costs and lower living standards.
o falling economic growth.
o worsening balance of payments.
o functions of money
o exporter sector

• Governor’s statement about inflation not creating jobs could possibly be correct however it is
unlikely to be the only consequence of inflation.

Analyse whether interest rate is the only tool to control inflation:

• Explain how raising interest rates will reduce AD and thus demand-pull pressures. However,
raising interest rates may actually worsen cost-push pressures as it increases the debt servicing
cost of firms. It may also not be effective if consumer and business sentiments are still high.

• There are other policies that can be used. Discuss deflationary fiscal policy with a comment on the
limitations. Discuss supply-side policies (no need too detailed – focus on how one supply-side
policy can reduce inflationary pressures, and provide a comment about the limitations).

Conclusion:

It is possible that inflation in South Africa is due to rising AD, however, it is only a possibility as there
may be other contributing factors towards inflation. Inflation is not just harmful in terms of failure to
create jobs but it also causes damage in other aspects such as cost of living, economic growth and
balance of payments. While interest rate is the most commonly used policy to control inflation, it is by
no means the only policy available. Government can opt to implement fiscal and supply-side policies
too. The effective reduction in inflation in short-run and long-run is dependent on the use of all policies.

50
 W10qp42 Q3a

Explain what is meant by internal economies of scale, and analyse the link between economies
of scale and a firm’s long-run average cost curve (LRAC).
[12]

Introduction:

• Explain ‘economies of scale’ → cost advantages derived from increasing its scale of production →
as output expands, the cost per unit decreases.

• Explain ‘internal economies of scale’ → the cost advantages that a firm obtains as a result of its
internal expansion.

• Identify the types of internal economies of scale:

o financial economies of scale
o marketing economies of scale
o technical economies of scale – specialisation & division of labour; increased dimensions;
indivisibilities
o managerial economies of scale
o purchasing economies of scale

Explanation & Discussion:

• Select any four internal economies of scale and describe them in detail.

• As the firm continues to expand and generates internal economies of scale → it moves from one
SRAC curve to a new, lower SRAC curve another.

• Explain an example:

o In the short-run, the firm has only one factory → it has one SRAC curve, that is, SRAC1.

o In the long-run, the firm is able to build more factories → each successive factory that is built
allows the firm to produce on a new, lower SRAC curve. The firm moves from SRAC 1 to
SRAC2 to SRAC3.

o From this succession of SRAC curves, the firm’s LRAC curve can be derived.

o The tangency points of each new lower SRAC curve form the downward sloping part of the
LRAC curve. The firm experiences economies of scale.

51
 Conclusion:

Internal economies of scale occurs due to a firm expanding internally. As it expands, it will operate on
a new and lower SRAC curve and will experience a reduction in costs per unit of output. From the set
of successive SRAC curves, its LRAC curve can then be derived. The economies of scale generated is
represented by the downward sloping section of the LRAC curve.

52
 W11qp41 Q7a

It is reported that some countries are concerned about the expected increase in the proportion
of older people beyond working age and also about the rise in the number of immigrants.

Explain how these expected changes might have an impact on the private and public
expenditure in such countries. [12]

Introduction:

• Explain ‘private expenditure’ and ‘public expenditure’.

Discussion:

Explain impact on private expenditure:

• Assuming immigrants are able to obtain employment → income for spending → private expenditure
will rise. However, the extent of the rise in expenditure will depend on the proportion of income that
is saved and that is sent home to families. As such, private expenditure may fall.

• Those who are above working age → income will fall. Expenditure will depend on ability to save
while working and extent of wealth → private expenditure may or may not rise.

Impact on public expenditure:

• Immigrants who work will contribute to tax revenue. With higher tax revenue → can fund
government spending → govt may increase its spending.

• Immigrants who are unable to find work may rely on welfare payments → government spending
rises.

• With the inflow of immigrants → population likely to grow → increased demand for housing,
infrastructure, merit goods & public goods → government spending likely to increase.

• Those above working age → require increased provision of health care → government spending
may rise.

• If a large number of those above working age were previously employed in the public sector →
government spending on pensions will be substantial.

• However, the rise in government spending on health care may mean a reduction in spending on
other areas of the economy. Overall, there might not be much of a change in public expenditure.

• Public expenditure likely to rise and may put pressure on government to finance any increase in
spending. However, the possible increase in tax revenue from increased immigrants may aid
government in its expenditure.

Conclusion:

• Difficult to ascertain the exact impact of increased immigration and proportion of those above
working age on private and public expenditure.

53
 W12qp43 Q7

The table below shows figures for GDP for two countries in 2000 and 2010.

GDP 2000 GDP 2010

Country
$US billions $US billions
USA 9825 13271
India 469 929

Discuss whether the above figures are sufficient to conclude that the standard of living in the
USA is higher than the standard of living in India.
[25]

Introduction:

• Definition of ‘GDP’ and ‘standard of living’.

Discussion:

Explain that the figures in the table could possibly mean that living standard is higher in USA
than in India:

GDP measures output of goods and services produced → thus a larger GDP figure indicates more
goods have been produced and therefore available to everyone in the economy. As a result, more
wants and needs can be satisfied. Therefore, it can be assumed that people living in the USA enjoy a
higher standard of living compared to those living in India.

However, the figures in the table do not definitely lead to the conclusion that living standards
in the USA is better than in India:

• The figures in the table have not been adjusted to reflect population changes and changes in price
levels in both countries.

• Reasons:

o There could have been a rise in population at the same time as the rise in GDP figures. Thus,
although more goods are produced, these goods must be shared amongst a larger population
than previously. The GDP figures should be adjusted to reflect GDP per person.

o Price level could have risen at the same time as the rise in GDP occurred. Therefore, the
larger GDP figures could have simply been due to a higher price level while actual output
produced has remained unchanged. In addition, removing the effects of price changes is a
more accurate representation of an individual’s purchasing power, and therefore the person’s
ability to buy goods and services to satisfy its wants and needs.

• Therefore, the GDP figures in the table must be adjusted to real GDP per capita.

** explanation of the above must be APPLIED TO THE QUESTION and THE FIGURES GIVEN IN
THE TABLE.

54
• In addition to relying on GDP alone to determine whether living standards have improved is
insufficient due to the various limitations of GDP:

o does not consider non-marketed items (jobs done yourself, which is in the measure of
economic welfare (MEW))

o does not consider the underground economy

o does not consider the effect of externalities

o does not reflect the distribution of income

o does not consider whether the rise in production has been at the expense of leisure time and
well-being.

** discussion of the above limitations must be APPLIED TO THE QUESTION and THE FIGURES
GIVEN IN THE TABLE.

** a general explanation of the limitations (even if it is detailed) but not applied to the figures of
USA and India would not gain the candidate a very good mark.

Given these limitations of GDP, alternative measures such as Human Development Index
(HDI), measure of economic welfare (MEW) can be used.

• Explain that HDI considers real GDP per capita, but goes further to also measure education and
lifespan. Therefore, HDI gives a better indication about living standards in a country compared to
GDP.

• MEW.

Evaluation of HDI and MEW:

• Although both indicators are more reliable as an indicator of living standards, there are a number
of limitations:
o HDI limitations.
o MEW limitation.

Conclusion:

GDP is popularly used as a measure of living standards as data on GDP is easily obtained and is
calculated by many countries. As a result, it is often cited as an indication of whether living standards
have declined or improved. At a glance, the figures would suggest that the USA’s living standards are
higher than India’s. However, GDP has various limitations and as such, to effectively conclude whether
living standards in the US is indeed higher than India’s, alternative indicators such as the HDI and MEW
should also be considered.

55
 Essay Outline W13qp41 Q2b

Discuss the possible choices a firm might face when deciding what business objective it should
have. [13]

Introduction:

• Definition of a ‘firm’.

• State the various objectives of the firm that you will be discussing – profit-maxmisation, sales
revenue maximisation, sales (growth) maximisation, satisficing, loss minimisation, ethical
objectives.

Discussion:

Select four objectives – one of them should be profit-maximisation as it is assumed to be the

traditional objective of firms.

Profit-maximsation objective:
• Firms produce up to the point where MR = MC. When output is at the point where MR = MC, profit
margin would be zero and total profit is the greatest possible.

• Shareholders are the most important to the firm.

• Draw and explain profit-maximisation diagram.

• Explain the limitations / criticisms of this theory:

o Firms do not have perfect information.
o Firms unlikely to be able to determine position of demand and MR curves.
o Costs and revenue may change due to factors beyond the firm’s control.
o Not all firms aim to maximise profits.

Sales revenue maximisation:

• The firm aims to maximise total revenue, thus will produce up to the point where MR = 0. When
MR = 0, this means sale of the additional unit of the good no longer raises total revenue. Therefore,
total revenue is the highest possible.

• Draw and explain sales revenue maximisation diagram.

• Explain why firms may choose to pursue this objective – refer to lecture notes.

Sales (growth) maximisation:

• Firm produces up to the breakeven point where TR = TC. Aims to sell as much as possible without
incurring a loss. The firm will charge lower prices for their goods.

• Under this objective, the firm is aiming at growing its market share in order to become more
dominant in the industry it operates in.

• Draw and explain relevant diagram.

• The firm can choose to produce beyond TR = TC only if it can use cross-subsidisation to cover the
loss. Explain cross-subsidisation – refer to lecture notes.

56
Satisficing:
• The firm aims to make a reasonable profit for its shareholders, at the same time aiming to satisfy
the needs of its stakeholders.
• Give examples of stakeholders → refer to lecture notes.
• Draw and explain satisficing diagram.

Loss minimisation:
• Minimise loss in the short-run caused by external shock.
• The firm at the same time will develop strategy to remain in operation.
• The firm must be able to cover its variable costs.

** refer to lecture notes for more information. **

Ethical objective:
• The firm focuses on corporate social responsibility.
• Explain example of Body Shop.
• This objective is mainly due to consumers who are increasingly educated and thus demand for
more responsible business practices.

** refer to lecture notes for more information. **

Evaluation:

The decision will depend on whether the firm is a new entrant or an existing firm that intends to increase
its dominance in the industry it is operating in, or whether shareholders or employees is its priority.

It will also depend on the size of the firm and the influence of its stakeholders. If for example the firm is
a relatively small firm aiming to grow in size so that it becomes difficult for new firms to enter the industry,
then the firm will choose sales revenue maximisation. Conversely, if the firm is aiming to satisfy its
shareholders, then it will pursue the traditional profit-maximisation objective.

The decision also depends on the structure of the industry that the firm is operating in. In this context,
the selection of the objective depends on the intensity of competition, that is, how competitive the
industry is, the presence of dominant firms for example the number of existing dominant firms and the
extent of the market power of the dominant firms.

In addition, a firm may also change its objective. If the firm is a new firm, it may wish to pursue growth
maximisation strategy and switch to profit-maximisation once it has firmly established its presence in
the market. If the firm initially focused on profit-maximisation, it may then change its objective to
satisficing due to increased pressures from stakeholders.

Conclusion:
There are a range of possible choices available to the firm in deciding which business objective it wants
to pursue. The decision of the firm will depend on the various influencing factors outlined above.

57
 W13qp42 Q5b

Discuss whether the use of fiscal policy is the only effective means of stimulating economic
growth.
[13]

Introduction:

• Explain ‘fiscal policy’.

• State the appropriate fiscal policy stance that will stimulate economic growth.

Discussion:

• Explain, using relevant diagram, how the implementation of this particular fiscal policy will raise
spending in the form of C, I & G → raising AD. As AD rises, firms will increase output of goods and
services leading to higher real GDP. As income rises due to higher employment caused by the
higher real GDP, this will stimulate further spending leading to even higher output levels and higher
economic growth. Movement upward along the AS curve occurs. The economy will operate closer
to its full capacity.

• Critique the effectiveness of this particular fiscal policy:

o Consumption may not be sensitive to tax changes → the fall in income tax rates raises
disposable incomes of consumers. However, consumers may decide to save the increase in
disposable income instead of spending it.

o Time lag problem – reductions in income tax rates and business tax rates may not have
immediate impact on raising spending levels and therefore economic growth in the economy
(impact lag). The impact of government spending, e.g. spending on infrastructure to increase
employment, income and growth may occur only in the medium to long-term. As a result, there
may be little effect on economic growth in the immediate (short-run) period.

o Government does not have all the necessary information. For reflationary fiscal policy to
be effective in stimulating economic growth, government must be able to accurately determine
the value of the multiplier. An underestimation of the value of the multiplier will lead to
government increasing its spending or reducing tax rates by too much resulting in rising
inflationary pressures and a worsening balance of payments. Overestimating the value of the
multiplier leads to too little injections and insufficient cuts in tax rates → will not raise AD
sufficiently to stimulate economic growth.

o Crowding out effect. Government may borrow to finance its spending. It will offer higher
interest rates leading to withdrawals from banks as households purchase government bonds.
This may cause banks to react by also raising interest rates thus increasing borrowing costs,
which will deter investment by firms. The rise in government spending is thus offset by the fall
in investment spending. Economic growth may not rise by much. Borrowing from banks will
mean banks have less loanable funds, resulting in a fall in investment spending by firms.

o Clash of macroeconomic objectives. As AD and economic growth rise due to the

reflationary fiscal policy, there will rising inflationary pressures (explain demand-pull inflation)
and a worsening of the current account of the balance of the payments as consumers and
firms increase their importation of consumer and capital goods. Rising inflation may harm
export competitiveness resulting in a fall in export revenue.

58
 Explain other alternative policies available to the government:

• Fiscal policy however is not the only means of raising economic growth. Other policies may also
be adopted to stimulate growth:

o explain reflationary monetary policy.

o explain supply-side policy, e.g. capital goods market (encouraging investment), removal of
trade barriers; education & training that will raise productivity and efficiency of labour.

o comment on the limitations of these two policies:

▪ reflationary monetary policy has a long impact lag (average of 18 months) therefore a
reduction in interest rates will not raise spending immediately. If confidence level is low
in the economy, lowering interest rates may not result in significant increases in
borrowing and spending.
▪ as for supply-side policies, main limitation is that they are long-term policies (long impact
lag) and their outcomes uncertain as the success of it depends on the reaction of firms
to the policies.

Conclusion:

Fiscal policy can stimulate economic growth but is not the only policy option available to the
government. Other policies such as monetary policy and supply-side measures can also be adopted.
However, given that all three policies have their respective limitations, it may be best for the government
to use a combination of these policies in order to effectively stimulate economic growth.

59
 Essay Outline W14qp41 Q2b

Discuss what is likely to happen to the equilibrium price and output if a perfectly competitive
firm were to become a monopolist. [13]

INTRODUCTION:

• An explanation about the difference between perfect competition and monopoly.

DISCUSSION:

Explain equilibrium price and output of a perfectly competitive firm:

• The firm is assumed to be a profit-maximiser, therefore will produce up to output level where MR
= MC.

• In perfect competition, there are a large number of small firms due to the absence of entry barriers.
No firm has influence over the price it can charge and must therefore accept the market price. This
makes the perfectly competitive firm a price taker. Therefore, the price charged at the profit-
maximising output is P = MC.

• Due to it having no influence over market price, the firm must earn normal profit to remain in the
market. This means the firm must be cost efficient. Hence, the firm must operate at minimum
average cost at the profit-maximising level of output.

• Draw and explain relevant diagram.

• From the diagram, it can be seen that the firm in a perfectly competitive market is both allocatively
efficient and productively efficient.

• Due to competition, perfect knowledge and consumer sovereignty, the firm must produce the good
that consumers want in the amount that the market demands as failure to do so will cause the firm
to lose its market share and therefore forced to shut down. As a result, the firm is allocatively
efficient, and for the profit-maximising output, the price is equal to marginal cost.

• If the firm is cost inefficient, it will be forced to raise its price. This will cause the firm to lose its
market share and to shut down given that the goods are homogenous and all of its competitors are
selling the same good at the market price. Consumers show no preference or loyalty due to the
homogeneity of the good sold. There is therefore incentive to be as efficient as possible and to
produce at lowest average cost.

• At the profit-maxmising output, the firm is only earning normal profit where AR = AC.

• Because the firm earns normal profit and consumers pay only the market price for the good, this
means both consumer surplus and producer surplus are maximised.

Explain the change to equilibrium price and output if the perfectly competitive firm becomes a
monopolist:

• The firm is assumed to be a profit-maximiser and will therefore still produce up to the point where
MR = MC. However, unlike in perfect competition, the firm is now a single firm in the market and
will therefore produce less compared to when it was a perfectly competitive firm. Hence, the

60
 equilibrium output in the market is less than the optimal output in perfect competition and there is
excess capacity.

• The firm becomes a price maker from a situation of price taker. Able to influence the price of its
good due to a lack of close substitutes available. Due to the lack of competition the firm is able to
charge a price that exceeds marginal cost of producing the last unit of the good (P > MC). The
price charged is thus higher than the price the firm would have charged in perfect competition.
There is allocative inefficiency.

• The firm will also have less incentive to be cost efficient. Barriers to entry means no competition
for the monopolist. Notice that at the profit-maximising output of MR = MC, the firm is not operating
on the lowest point of its AC curve. There is productive inefficiency.

• Therefore, when the perfectly competitive firm becomes a monopolist, the equilibrium price is
higher and the equilibrium output is lower.

• Draw and explain relevant diagram.

• There is a deadweight loss and an appropriation of consumer surplus, enabling the firm to enjoy
supernormal profits.

• In the long-run, the price is higher and output is lower than if the firm were a perfectly competitive
firm.

EVALUATION:

Is output always lower and price always higher if the perfectly competitive firm were to
become a monopolist?

• Not necessarily.

• Due to ability to achieve economies of scale. Average cost can be kept low and the monopolist
can operate at lowest AC.

• In addition, the fear of government intervention may force the monopolist to produce more and
charge a lower price.

• If government were to intervene, the government can force the firm to adopt marginal cost pricing
and to produce at the optimal level.

CONCLUSION:

A perfectly competitive firm accepts the market price and must produce at minimum cost and at the
optimal level in order to remain in the market. If the firm becomes a monopolist, it can fix its price and
does not need to produce at minimum cost. Therefore, equilibrium price will be higher and output will
be lower. However, this may not occur as a monopolist can achieve economies of scale thus enabling
it to produce more and charge a lower price.

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 W14qp42 Q3

Discuss the similarities and differences between a firm’s likely price and output policy in perfect
competition and oligopoly. [25]

Introduction:

• Explain ‘perfect competition’ and ‘oligopoly’.

• Explain the characteristics of both market structures.

Discussion:

Similarity:

• Both are profit maximisers → produce where MR = MC.

• However, oligopoly firms likely to earn abnormal profit compared to perfect competition firm due to
entry barriers. Firms in PC will likely earn normal profit in the long-run.

• Firms in both markets will calculate cost changes and revenues at various prices. For both firms,
profits will be affected by changes to cost and revenues. Hence, firms in both markets will likely
focus on costs and revenue as well.

Differences:

• Firm in perfect competition is a price taker → adjust output to the point where MR = MC but charge
P = MC. In the short-run will likely earn supernormal profit but in the long-run will only earn normal
profit (explain with relevant diagrams). Dominant firms in oligopoly also produce where MR = MC
but charge P > MC. Enjoy supernormal profits in short-run and long-run.

• No price competition in perfect competition but firms in oligopoly may engage in a price war.

• No product differentiation in perfect competition but firms in oligopoly differentiate their goods
(although they may also sell identical goods).

• Strong interdependence between the product of one firm and the actions of another firm in
oligopoly. Number of firms small enough for each firm to realise that competitors will respond to
anything that the firm does. Therefore, any action or strategy that a firm intends to take must take
into consideration the reaction of its rivals. In perfect competition, there are many small firms →
action of one firm unlikely to affect others.

• Explain price rigidity and kinked demand curve.

• Strong incentive for oligopoly firms to collude to raise price or restrict output. However firm in
perfect competition will not collude as all firms have small market share. Firms will produce as
much as possible at the market price. No incentive to charge a price above market price. Setting
a price below market price will result in loss and possible shut down.

Conclusion:
• There are similarities but firms in each market structure may adopt different pricing policy to
maximise profits due to the different market conditions.

62
 W14qp42 Q4

A huge company with a turnover of $99.3 billion paid its chief executive $10.9 million in 2011. At
the same time it was reported that the company did not pay what was regarded as a living wage
to all its employees.

(a) Use economic analysis to help explain why there can be wide differences in wage rates.

[12]

Introduction:

• Define ‘wages’. In a competitive labour market wages are determined by the demand for and
supply of labour.

Explanation:

Due to interaction of demand and supply of labour:

• If demand exceeds supply → wage rates will rise. Firms willing to pay more.

• If supply exceeds demand → wages will fall. Will pay less for labour.

Due to differences in MRP:

• MRP can differ due to differences in labour productivity and the price of the product sold.

• An improvement in labour productivity could lead to a high wage rate. Higher labour productivity
will shift the MPP curve to the right. Since the MRP is derived from the MPP curve, therefore the
MRP curve will shift to the right. Firms will pay more for workers who are productive. In contrast, a
fall in productivity shifts MPP to the left. MRP will fall as firms will pay less to workers who are less
productive. Therefore, wage rates can differ due to differences in labour productivity.

• The demand for the good. The higher the demand for the good, the higher will be its market
price. Since MRPL = MPP x price, therefore, the rise in price will increase the MRPL and the
MRP curve will shift to the right. For example, if the market price of a car rises from £5000 to
£10000, the MRP will double (because MRP = MP x price). Car manufacturers will then be
prepared to pay more for labour.

Due to differences in skills and specific job requirements:

• Low-skilled or unskilled workers earn much less. Such workers are easily replaced → firms not
willing to pay much. Highly skilled workers contribute more in terms of profitability → firms will pay
more. The gap between poorly skilled and highly skilled workers gets wider each year. Market
demand for skilled labour grows more quickly than for semi-skilled workers resulting in labour
scarcity. This pushes up pay levels. Highly skilled workers are often in inelastic supply and rising
demand forces up the “going wage rate” in an industry.

• If a job requires specific set of skills or qualifications or long periods of training → supply of labour
will be less than demand → wages rise.

63
• Jobs that are dangerous or risky → wages tend to be higher, e.g. miners. In comparison jobs that
provide better working conditions, job securities or relatively good pensions will tend to pay workers
less.

• Footballers and actors who possess talent that very few have → supply of such labour remains
low → wages much higher.

Discrimination:

• Difficult for certain groups to take certain jobs even if they are equipped with the necessary skills
and qualifications → discriminatory practices result in supply of labour in some occupations to
remain low → pushing up the wages in these occupations.

Trade unions:
• Industries with a strong trade union pay more than those with a weak trade union. Unions might
exercise their bargaining power to offset the power of an employer in a particular occupation and
in doing so achieve a mark-up on wages compared to those on offer to non-union members.

Other factors:
• Job location
• Gender
• Public sector and private sector
• Capital-intensive and labour-intensive industries

Conclusion:

• Wages received by each individual will differ based on the discussion above. If the wage
differences are too wide and causes income disparity, there may be a need for the government to
intervene in order to reduce the wage differences.

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(b) Discuss how this analysis could be adapted if a trade union intervened in the process of
wage determination.
[13]

Introduction:

• Explanation of trade unions and collective bargaining.

Discussion:

• Trade unions intervene due to the presence of monopsony or an imperfect labour market.

• A monopsony can result in exploitation as it is the single buyer of labour and can therefore pay a
wage that is less than the worker’s MRPL (draw and briefly explain monopsony diagram).

• Trade union could negotiate for higher wage rates with the firm – draw and explain bilateral
monopoly diagram.

• Trade union and monopsonist agree to a higher wage without a reduction in employment. It will
also benefit the monopsonist as employment of future workers will not raise marginal cost of labour
due to the agreed wage rate.

• However, wage and level of employment will depend on the bargaining strength of the trade union.
A demand for higher wage without corresponding improvement in productivity may see the
monopsonist reluctant to pay the higher wage and employ the same number of workers.

• Trade unions could also restrict supply of labour (closed shops).

• If trade unions are unable to negotiate (unsuccessful) → can approach government to step in as
mediator or approach a tribunal.

• Although trade unions can intervene to influence wages, their influence will depend on a number
of factors:
o Number of members
o Demand for the product
o Labour cost as part of total cost
o Profitability of the firm

Conclusion:

Intervention of trade union in wage determination implies that the labour market is imperfect and there
is exploitation of labour. There are various ways in which a trade union could intervene – through direct
negotiation with the firm or if without success, then through a tribunal or with the help of the government.
The overall success will depend on the relative bargaining strength of the trade union and the firm.

65
 W14qp43 Q4b

Does the use of the term ‘imperfect’ mean that there is some failure in the labour market that
should be corrected by government intervention?
[13]

Introduction:

• Definition of ‘labour market’.

Discussion:

There are instances where firms have more power than workers and thus may seek to exploit
this power to its own advantage. This occurs in a monopsony labour market, where the firm is
the major buyer of labour.

• Explain concept of monopsony with relevant diagram.

• Labour market failure may occur if there is labour exploitation in terms of working conditions and
not just in terms of being forced to accept a lower wage.

• There can also be failure in labour market if firms reduce their employment of labour resulting in
workers being laid-off.

Examine how government can correct failure in labour market:

• Minimum wage.

• Assisting in arbitration or conciliation.

Failure in labour market can also be corrected through the role played by trade unions, and not
only through government intervention:

• Definition of ‘trade union’.

• The role of trade union involves collective bargaining.

• Trade unions can negotiate for better wages – include diagram and explanation.

• Nonetheless, ability of trade union to correct labour market failure depends on its power.

• Trade unions may not necessarily correct labour market failure. They may worsen the situation as
wage inflation may result and firms may transfer production to countries where wage levels are
lower.

66
 Evaluation:

Consider whether imperfect could be thought of as synonymous with faulty or failure in the
labour market:

• Not a failure if the monopsonist does not exploit workers and abuse their market power, i.e. the
monopsonist pays a wage equal to MRP instead of ACL.

• Not a failure if low wages are determined by market forces of demand and supply of labour, and
workers receive a wage equal to their MRP value.

• Not a failure if firms do not forcibly lay-off workers.

Conclusion:

The term imperfect could possibly mean there is some failure in the labour market, particularly in the
case of a monopsonist that seeks to drive down wages and provide poor working conditions or forcibly
lay off workers. In this situation, government as well as trade union can step in to correct the
imperfection. However, the term imperfect does not necessarily mean there is failure in labour market,
especially if the firm although paying low wages, is paying a wage equal to the worker’s MRP value and
does not attempt to exploit workers.

67
 W15qp41; Q7

‘People in developed countries suffer from pollution and overcrowding. However, people in
developing countries suffer from malnutrition and poverty.’

Discuss whether it is correct to distinguish between developed and developing countries in this
way and consider how living standards can be compared between the two types of country.

[25]

INTRODUCTION:

• Definition of ‘developed country’ and ‘developing country’.

DISCUSSION (first part – distinguishing developed & developing countries):

• Developed countries do suffer from pollution and overcrowding (explain why). However,
developing countries also face these problems (explain why). The difference here would be the
extent of pollution & overcrowding problems and the effects of both.

• Malnutrition and poverty are a major problem in developing countries (explain why – use examples
to show why malnutrition and poverty (in particular absolute poverty) are major problems in
developing countries – refer to notes and Additional Reading).

• Explain that poverty problems however differ in developed countries – in developed countries main
problem is relative poverty rather than absolute poverty and extremely rare for malnutrition to
occur:

o There are many different reasons why there are poor people in industrialized countries. For
example, there may be stagnating wages, long-term unemployment and rising prices of
essential goods. Other reasons that are more complex may be racism, immigration and an
increasing number of single parent households. If the social safety nets are absent or low,
poverty may become even more widespread.

o Poverty reflects failures in the systems for redistributing resources and opportunities in a fair
and equitable manner. These lead to deep-seated inequalities and thus to the contrast of
excessive wealth concentrated in the hands of a few while others are forced to live restricted
and marginalised lives, even though they are living in a rich economic area

Since developed and developing countries share the same problems of pollution, overcrowding but
differ in terms of poverty and malnutrition, these four criteria alone are insufficient to distinguish between
developed and developing countries. Other criteria must also be considered, such as:
• economic structure
• population size and rate of growth of population
• income levels and income per capita
Select any three or four
• income gap and explain with
• quality of physical and human capital supporting examples.

• economic growth
• technological development

68
 DISCUSSION

(second part of the question – how living standards can be compared between the two types
of country):

• Definition of ‘living standards’.

• Explain influences on living standards:

o income, prices, choice of goods and services available, quality of goods and services
available.

o living standards in a country is influenced by economic growth, employment level and extent
of poverty.

In general, developing countries have lower living standards than developed countries.
There are a number of ways to measure living standards – GDP, HDI and MEW.

• Explain the use of GDP as a measure of living standards:

o Explain how the value of GDP is an indicator of the differences in living standards between
developed and developing countries.

o Explain why GDP is commonly used. Comment that for GDP to be more accurate, it must be
adjusted to consider price level and population, that is, converted to real GDP per capita.

o Briefly comment (not explain) some of the limitations of GDP – just comment briefly on any
2 or 3 limitations given below:
▪ does not reflect income distribution
▪ does not include non-market activities
▪ does not include underground economy
▪ does not consider leisure time and working hours
▪ does not consider externalities such as environmental damage
▪ does not consider the types of goods produced

• Explain HDI as a measure of living standards:

o explain each component of HDI.
o explain the range of values between 0 and 1 and the significance of the HDI values as an
indicator of living standards, that is, must explain how the different HDI values indicate the
differences in living standards between developed and developing countries (e.g.: higher HDI
values of developed countries reflects a higher standard of living).
o A brief comment about one limitation of HDI.

• Explain the use of MEW:

o how it is calculated and the factors that would be added and subtracted.
o explain how these factors that are added and subtracted provide a better idea of living
standards in a developing country and developed country.

69
 o A brief comment about why MEW is not popular as an indicator of living standards – e.g.
difficulty in placing a value on factors that improve or reduce quality of life.

Note: There is no need to discuss in detail the limitations of GDP as the question is not specifically
asking about whether GDP is the best way or is the only way to measure living standards. Instead, the
question is asking how living standards can be compared, that is, the range of indicators that can
be used.

Conclusion:

The criteria mentioned in the question to draw a distinction between developed and developing
economies is not sufficient. Other criteria or features must also be taken into consideration. There are
many influences on the standard of living in developed and developing countries and living standards
can be compared using indicators such as GDP, HDI and MEW. However, each measurement has their
respective limitations and therefore the best possible way to compare living standards between
developed and developing countries is to refer to all three collectively so that a more accurate
comparison can be obtained.

70
 W15qp43 Q7

Economic development and the exploitation of resources can result in structural change and
unemployment in some industries, increased environmental damage, overexploitation of fish
stocks, increased inequalities in the distribution of income and pressure on resources causing
inflation.

Explain what is meant by a developing economy and discuss whether it would be wise to
conclude from the above opinion that developing countries should, therefore, not seek to
become developed.
[25]

Introduction:

• Definition of developing economy.

Discussion:

• Explain the characteristics (4 to 5) of a developing economy, WITH EXAMPLES.

• A comment of how economic development may possibly result in the problems mentioned in the
question.

Evaluation:

• Not all countries will experience all of the problems identified in the statement. Even if the problems
do occur, they are likely to occur at varying degrees in different countries.

• There are in fact many benefits of becoming a developed economy:

o Lower poverty

o Higher employment, economic growth, increased investments.

o Rising incomes

o Better living standards

o Technological advancements

o Lower income inequality

o Better quality human capital

o Government will be in a better position to provide for the unemployed, the low income groups
as well as to spend on the economy’s physical capital such as infrastructure.

o Increased access to global markets which raises export revenue.

• Overall, there is an improvement in the economic welfare of the developed country.

71
 Conclusion:

• While achieving developed status brings problems, there are also many benefits to be gained from
achieving a developed country status. Hence, to say that country should not seek to become
developed is incorrect. The statement is one-sided.

72
Assess how alternative macroeconomic policies might affect the demand for money.
[13]

Introduction:

• Define ‘demand for money’; state the three motives for holding money.

Discussion & evaluation:

• Explain the three motives for holding money.

• Analyse how fiscal and monetary policies will affect the demand for money:

o Assume govt implements reflationary fiscal policy where G rises and T falls:

o Higher G creates more employment opportunities and thus higher incomes → transactions
demand for money will rise; precautionary demand will rise too.

o Lower taxes will increase disposable income leading to higher spending and thus,
transactions demand for money will rise. however, if spending is done through the use of
money substitutes, then transactions demand for money may not necessarily rise or may not
rise as much as expected. Precautionary demand for money would rise too.

o In addition, reflationary fiscal policy will worsen inflation. As price level rises, more money is
required to purchase goods → transactions demand for money will rise.

o Fiscal policy is unlikely to affect speculative demand for money as it does not involve changes
to interest rates. However, if spending levels are high enough and confidence is high, then
individuals may decide to hold less money for speculative purpose and hold more money for
transaction purpose instead. In this context, speculative balances will fall.

o If government were to raise money supply (reflationary monetary policy), this will cause price
of bonds to rise and interest rates to fall. Bond owners would sell bonds to make a capital gain
from the higher price, leading to a rise in speculative balances.

o Lower interest rates reduce borrowing costs and reduce returns from savings, making it less
attractive to save money. This may lead to increased borrowing by firms and consumers.
Spending levels will rise in the economy, indicating a rise in the demand for money for
transactions purpose. However, lower interest rates may encourage the use of money
substitutes such as debit and credit cards. Hence, demand for money for transactions purpose
may not rise. Precautionary demand for money may also rise as spending may be directed
towards more expensive goods and services.

Conclusion:

A reflationary fiscal policy and monetary policy may possibly cause a rise in the demand for money for
transactions and precautionary purposes. Speculative balances may or may not be affected by fiscal
policy while monetary policy will affect speculative balances as speculate balances are interest elastic.
Nonetheless, it is difficult to say with certainty the impact of macroeconomic policies on the demand for
money as different individuals would respond differently to the policies and may be affected in different
ways.

73
 W17qp41 Q2

Discuss whether privatisation and an increase in competition would hinder or help the
achievement of economic efficiency.
[25]

Introduction:

• Define ‘economic efficiency’.

Discussion:

• Explain the concept of economic efficiency, i.e. productive efficiency and allocative efficiency with
relevant diagram(s).

• Explain how privatisation and injection of competition will achieve productive and allocative
efficiency.

• Explain how privatisation and injection of competition may not lead to economic efficiency:

o Can lead to emergence of monopolies (e.g. through mergers, takeovers) and oligopolistic
collusion → no incentive to keep costs down; charge higher price (P > MC). In the case of
monopoly, there will be X-inefficiency.

o Abuse of market power; exploitation of consumers; lack of research and development;

declining quality of goods; declining variety of goods.

o Underproduction of merit goods.

o Overproduction of demerit goods – link to negative production externality.

o Non-provision of public goods.

Evaluation:

• There is the need for the government to intervene. Explain the various forms of government
intervention to achieve economic efficiency.

• Even so, presence of government does not guarantee the achievement of economic efficiency due
to lack of information. However, there will be Pareto improvement and the economy moves closer
to economic efficiency.

Conclusion:

Privatisation and increase in competition can help achieve economic efficiency. However, due to profit-
motive of the firms, in practice, privatisation and increased competition may not lead to economic
efficiency and may instead lead to a number of market failures. Hence, there is a need for government
intervention to achieve efficiency. Although government can intervene in various ways, economic
efficiency will still be difficult to achieve in practice.

74