IB DIPLOMA

PROGRAMME

54 EXCELLENT
ECONOMICS
ESSAYS
Reference essays for succeeding
in IB DP Economics Paper 1

Highlights
• Model answers to REAL IB Economics exam questions
• Detailed writing guide for acing the 10-mark and
15-mark questions
• Covers all topics in Microeconomics and
Macroeconomics
• Tips and hints to achieving level 7
 54 Excellent Economics Essays

Contents

Microeconomics Essays

Essay Title

1 Resources are relocated in a market via changes in price. Explain how

this is done (10) (May 2015 TZ1 +TZ2 HL)

2 In the market for air travel, explain the concepts of consumer and
producer surplus. (November 2015 TZ0 SL)

3 “The most efficient allocation of resources is achieved at the free market

competitive equilibrium” Discuss this view from society’s perspective. (15)
(November 2015 TZ0 SL)

4 Explain the factors which may affect the cross elasticity of demand
(XED) for different products. (10) (May 2013 TZ2 HL)

5 “The income elasticity of demand has important implications for

producers of primary products, manufactured goods and services”.
Examine this statement. (15) (May 2013 TZ2 HL)

6 The price elasticity of supply (PES) for primary goods tends to be

relatively low and the PES for manufactured products tends to be high.
Explain why is the case. (10) (May 2014 TZ1 SL)

7 The price elasticity of demand (PED) for primary goods tends to be

relatively low and the PED for manufactured products tends to be high.
Explain why is the case. (10) (May 2013 TZ1 SL)

8 Discuss the consequences of a government imposing a price floor on an

agricultural product which may possibly occur (15) (May 2014 TZ1 SL)

9 “Providing a subsidy on the production of rice would have different

consequences for producers, consumers and government”. Discuss this
statement. (15) (May 2014 TZ1 HL)

10 “The incidence of an indirect tax depends on the price elasticity of

demand and the price elasticity of supply.” Explain how this is possible.
(10) (May 2016 TZ1 HL).

11 A price ceiling was imposed on the market for rented accommodation

and a price floor on the market for agricultural products. Explain why a
government may do so. (10) (May 2013 TZ2 SL)

12 “The consumption of merit goods, such as healthy food, can lead to

positive externalities of consumption.” Explain why this is the case. (10)
(May 2017 TZ1 SL)

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 54 Excellent Economics Essays

13 “Advertising by the government is the most appropriate way of

increasing consumption of a merit good.” Discuss whether this is true.
(15) (May 2017 TZ1 SL)

14 “Common access resources, such as fishing grounds, might become

depleted in the absence of a price mechanism.” Explain why this is the
case. (10) (May 2013 TZ2 SL)

15 “Carbon taxes represent the most effective government response to the

threat to posed by the use of fossil fuels.” Evaluate this view. (15) (May
2013 TZ2 SL)

16 An indirect tax is imposed on the consumption of cigarettes by the

government. Explain why this is the case. (10) (November 2015 TZ0 SL)

17 To what extent might the use of indirect taxation overcome the problems
of negative externalities of consumption? (15) (May 2013 TZ1 HL)

18 “There should always be direct provision of public goods by the

government.” Discuss whether this is true. (15) (Nov 2016 TZ0 HL)

19 A loss-making firm in perfect competition would shut down in the long

run. Explain why this is the case. (10) (May 2017 TZ1 +TZ2 HL)

20 Explain the differences between decreasing returns to scale and the law
of diminishing returns. (10) (May 2013 TZ2 HL)

21 Compare and contrast the market structure of monopoly with that of

perfect competition. Use diagrams to support your answer. (15) (May
2013 TZ2 HL)

22 A perfectly competitive firm can make economic (abnormal) profit only

in the short run. Using diagrams, explain why this is true. (May 2014
TZ1 HL)

23 There are some conditions necessary for firms in oligopolistic markets to

engage in price discrimination. Explain what these are. (10) (May 2016
TZ2 HL)

24 Should producers in oligopolistic markets should compete or collude?

Discuss. (15) (May 2016 TZ2 HL)

25 Prices tend to be stable in oligopolistic markets. Explain what this is the

case. (10) (May 2015 TZ1 HL)

26 The government has the tools to response to abuse of monopoly.

Explain two possible responses. (10) (May 2015 TZ2 HL)

27 “Monopolies have inefficiencies but may be considered desirable”.

Evaluate this view. (15) (May 2015 TZ2 HL)

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 54 Excellent Economics Essays

28 “A firm in monopolistic competition will make normal profit in the long

run.” Explain why this is the case. (10) (November 2015 TZ0)

Macroeconomics Essays

Essay Title

29 The income, output and expenditure methods are used to measure real
gross domestic product (GDP). Explain how this works. (10) (May 2014
TZ2 SL)

30 Real GDP per capita is a method of measuring the living standards of a

country’s population. Discuss its usefulness. (15) (May 2014 TZ2 SL)

31 Explain why an economy may be in equilibrium at any level of real output

with the use of the Keynesian AD/AS diagram. (10) (May 2016 TZ1 HL)

32 Explain the possible impact of a rise in government spending on

economic growth by using the concept of the Keynesian multiplier. (10)
(May 2015 TZ2 HL)

33 In contrast to the monetarist/new classical model, an economy can

remain stuck in a deflationary (recessionary) gap according to the
Keynesian model. Discuss why this is the case. (15) (May 2013 TZ2 HL)

34 Explain what the meaning of natural rate of unemployment is. (10)

(May 2015 TZ1 HL)

35 “There is no tradeoff between inflation and unemployment.” Discuss this

view. (15) (May 2015 TZ1 HL)

36 Distinguish between the following types of unemployment: structural

and demand-deficient unemployment. (10) (November 2015 TZ0 HL)

37 Explain cost-push and demand-pull inflation using two AD/AS

diagrams. (10) (May 2014 TZ1 HL)

38 A high rate of inflation may negatively affect both a country’s export

competitiveness and the level of capital investment by firms. Explain why
this is the case. (10) (May 2017 TZ1 HL)

39 Deflation is a more serious problem than inflation for the economy of a

country. Discuss this view. (15) (May 2013 TZ1 SL)

40 Explain why the economy will always return to the full employment level
of output following a recession with the use of the monetarist/new
classical model. (10) (November 2015 TZ0 HL)

41 “An increase in aggregate demand will always be inflationary.” Evaluate

this view. (15) (November 2015 TZ0 HL)

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 54 Excellent Economics Essays

42 Explain how the Gini coefficient is derived and interpreted with the use
of a Lorenz curve. (10) (May 2014 TZ1 SL)

43 Evaluate policies set by the government that could be used to promote a

more equal distribution of income. (15) (May 2014 TZ1 SL)

44 “The market system may not result in an equitable distribution of

income.” Explain why this is the case. (10) (May 2013 TZ1 HL)

45 Evaluate policies imposed by the government to promote equity in terms

of their effects on efficiency in the allocation of resources. (15) (May
2013 TZ1 HL)

46 “The benefits of economic growth will always outweigh the costs.”

Evaluate this view. (15) (May 2014 TZ1 HL)

47 An increase in the level of taxation can influence the level of aggregate

demand in an economy. Explain how this is possible. (10) (May 2016
TZ1 HL)

48 Evaluate the effectiveness of fiscal policy that can be used to promote

economic activity during a recession. (15) (May 2016 TZ1 HL)

49 Evaluate the effectiveness of interventionist supply side policies that is

used to achieve economic growth. (15) (May 2016 TZ1 SL)

50 Explain how an increase in interest rates may influence the level of

aggregate demand in an economy. (10) (May 2016 TZ2 SL)

51 Evaluate the effectiveness of monetary policy which may be used when

an economy is in deep recession. (15) (May 2016 TZ2 SL)

52 Giving examples, explain the impact of automatic stabilizers on an

economy. (10) (May 2016 TZ2 HL)

53 The problem of unemployment can be reduced through the use of

supply-side policies. Discuss this view. (15) (November 2014 TZ0 HL)

54 “The use of monetary policy is always the best way to reduce inflation.”
Discuss this statement. (15) (May 2017 TZ1 HL)

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 54 Excellent Economics Essays

IBDP Economics Paper 1

In the IB DP Economics Paper 1 exam, students are required to do two sets of

questions; one each for microeconomics and macroeconomics in 1.5 hours. Each
set of questions are separated into two parts: part (a) and part (b). The marks
allocated to each part are 10 marks and 15 marks respectively. A guide to
answering both questions is outlined below.

Part (a) 10-mark question

This question is test of knowledge and understanding which is why the vast
majority of questions start or includes the command word “Explain”. Many
students fail to do well in this question as they only state or describe the subject
content without fully explaining the underlying concepts.

According to the IB, the definition of the command word “Explain” is “Give a
detailed account including reasons or causes”. Explaining requires breaking down
the underlying processes at work and show how it fits all together with one
component affecting the next. It is useful to imagine the economic processes as a
car engine and you are a mechanic required to break down each component and
show how it works.

The answer to the following question will be used to outline different parts of the
Part (a) 10-mark question.

Explain why the consumption of merit goods, such as healthy food, can lead to
positive externalities of consumption. (May 2017 TZ1 SL)

As soon as students see this question, they should be able to identify that it is
related to the big topic of market failure and one of the eight market failures
covered in IB Economics: positive externalities of consumption. Since the
questions mentions healthy food, an appropriate example should be given and the
students should know exactly which diagram to draw.
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 54 Excellent Economics Essays

The question asks students to “Explain why”. The word “why” is to provide
reasons and conjunctions such as “because” should be used. Having this mind will
ensure that the student is answering the question directly.

Essay Structure

1) Defining the key words

Defining the keywords is a very good way for students to set the scene and develop
the next stage of the answer. They keywords are economic terms which are
important to answering the question. In the question above, the terms “merit
goods” and “positive externalities of consumption”.

Sample Answer

A- Merit goods are as goods and services considered to be desirable by consumers

but are underprovided when relied on the market for provision. The consumption of
merit goods generates positive externalities which are benefits imposed on unrelated
third party as a result of its consuming such goods.

It is important to define the terms accurately. For example, many students define
positive externalities as simply “benefits to other people” which is not accurate
enough as it is a benefit to “unrelated third parties”. Defining the key terms
accurately is very important as it is the first impression the examiner has to
whether this will be a high quality answer. An excellent set of definitions would
not simply define the terms separately, and would try to link the definitions
together so to enhance the context of the answer. In the written sample above,
whilst the definitions of merit goods and positive consumption externality could
have been provided separately, the author has linked the two concepts together
by stating that merit goods lead to positive consumption externalities.

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 54 Excellent Economics Essays

2) Drawing a diagram

Models are expressed and studied extensively in Economics. In IB DP economics,

the vast majority of these models are expressed graphically and the candidate
should be able to explain the mechanisms of the economic theory using diagrams.

A good diagram needs the following

1) Clearly labeled axis with units

2) Correct demand, supply and other lines
3) Clearly labeled equilibrium price, quantity or any other important values.
4) A title is not necessary but is sometimes useful to show the examiner
what the student is trying to represent.

In the diagram above, I have used acronyms for labels such as MPC and MSC which
is fine as long as I have stated the terms in full in my answer. Whilst it would have
been fine to use P1Q1 to denote the allocative equilibrium, note that I have made
the examiner’s job much easier by labeling them Popt and Qopt to denote the
optimum price and quantity.

3) Analysis and Explanation.

This part of the essay is where the question is directly addressed. It requires using
the student to explain the underlying economic theory using the diagram as an aid.
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 54 Excellent Economics Essays

The mechanism of how it fits together should be clearly discussed together with
causes and effects. Appropriate real life examples should be used to enhance the
level of authenticity to the answer. Useful keywords to use in this section are
“because”, “therefore” and “lead to”.

Sample Answer

B- Avocados is regarded as a kind of “super food” due to the antioxidants it provides

through consumption which makes people more healthy and energetic in general.
The graph above represents the market for avocados where it is assumed the
marginal private cost (MPC) equals the marginal social cost (MSC). When left to
market forces, only Qe amounts of avocados are consumed as people only take into
account of the marginal private benefits accrued to them. This includes a healthier
and more energetic body which will allow them to be more productive in the work
place and may allow them to earn levels of higher income in the long run. As
microeconomic theory assumes people to be self-interested, people do not take into
account the positive externalities created via the consumption of avocados.

C- Regardless of whether such externalities are being taken into account the
consumption of merit goods will benefit unaccounted third parties. The consumption
of healthy foods such as avocados will likely lead to higher levels of worker
productivity which in turn will increase the profitability of their companies. This in
turn may lead to a more vibrant and productive economy. Such companies are
considered unaccounted third parties as they did not have to pay to enjoy any of the
benefits.

D- In light of such external benefits, society would prefer consumers to operate along
the marginal social benefit (MSB) curve where Qopt quantities of avocados are
demanded at the equilibrium. At Qopt, other parties will still benefit from the merit
goods indirectly but such benefits are no longer considered positive externalities
since consumers now account for them in their decision-making. Qopt is the allocative
efficient quantity where there is no welfare loss. Should consumers consume at Qe,
MSB is still greater than MSC which means that there are welfare gains yet to be
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 54 Excellent Economics Essays

enjoyed. This is a regarded as a deadweight loss to society and represented by the

shaded area.

In paragraph B and C, the example of avocados is used as the question explicitly

mentions healthy foods. The avocado market is depicted diagrammatically and the
question is addressed directly via making the distinction between private and
external benefits. The significance of unaccounted third parties and the benefits
enjoyed are clearly highlighted as they are a critical feature of positive
consumption externalities. Notice that the words “Regardless” and “In light of”
were used at the start of paragraph C and D to contextualise my answer and drive
the argument forward.

Notice that the question uses the word “may” and an astute student could
demonstrate deeper understanding by addressing scenarios where would not
lead to positive externalities of consumption. This was the approach adopted in
paragraph D where the social optimum was discussed.

There is a temptation for students to simply describe the diagram without

answering the question directly. Remember that the diagram is only a tool to help
you answer the question. Another common error is to associate the impact of the
economic phenomena to the diagram. For example, when income rises, many
students will write the following:

Increasing income will lead to a rightward shift to the demand curve.

This is a colloquial or even inaccurate way of answer because what is happening

in the real world (increasing income) is separate from the model (the demand
curve). The real world phenomenon should not be used to explain the model. A
more formal answer would be:

Increasing income will lead to an increase in quantity demanded at each and every
price level. Graphically, this is shown by a rightward shift in the demand curve.

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 54 Excellent Economics Essays

4) Conclusion

The conclusion should be a very brief summary of your answer and to highlight
the key points. One or two sentences should suffice.

Sample Answer

D- The consumption of merit goods can lead to positive externalities of consumption

as external benefits are generated in the consumption process e.g. eating avocados
make healthier workers. Such benefits are positive consumption externalities as they
are not taken into accounted by consumers in their decision-making and benefiting
parties did not have to pay for them.

Part (b) 15-mark question

Similar to the 10 mark question, the 15 mark question is found in part b of Paper
1 and students are required to do two such questions; one for microeconomics
and macroeconomics respectively.

The 15-mark question is much more sophisticated than the 10 mark question as
it often requires the student to exercise evaluating skills and make well reasoned
and argued judgments. The following are some of the most common command
words found in 15 mark questions as described by the IB.

Command Terms

Evaluation- Make an appraisal by weighing up the strengths and limitations.

Discuss- Offer a considered and balanced review that includes a range of

arguments, factors or hypotheses. Opinions or conclusions should be presented
clearly and supported by appropriate evidence.

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 54 Excellent Economics Essays

Examine- Consider an argument or concept in a way that uncovers the

assumptions and interrelationships of the issue.

Compare and Contrast- Give an account of the similarities and differences between
two (or more) items or situations, referring to both (all) of them throughout.

The common skill underlying the command terms above is “contextualization”. To

contexutalise is to acknowledge the actual situation and make judgments based
on those situations rather than generically. Many students fall in the trap of
simply putting forward the advantages and disadvantages of the issue as a way of
exercising evaluative skills. Doing so is just a form of “listing” and lacks the sense
of sophistication needed for a higher level answer.

For example, when asked to discuss the effectiveness of using advertising to

increase the consumption of merit goods, many students may say it is effective
because it is persuasive or ineffective because it is expensive. They would make
a list for both sides and wrap up with a conclusion without providing the reasons
why the position was adopted.

To contextualise is to put forward the conditions to when it may be effective or

ineffective. For example, whether advertising is effective will depend on whether
on the affordability of the merit good. If under consumption is due to affordability,
then advertising will be ineffective regardless of its persuasiveness. The channels
of advertising are equally important. If the target audience are teenagers,
advertising on social media channels may be more effective than more traditional
print advertising. Indeed, advertising may be expensive but if the government is
very wealthy e.g. Hong Kong, then they would not have a problem in funding the
advertising.

The following are some phrases which allow students to demonstrate evaluation
and contextualisation.

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 54 Excellent Economics Essays

1) The long run and short run impacts are different. In the long run...in the short
run...
2) Whether xyz happens DEPENDS on ABC
3) It is important to note that...
4) This begs to the question whether...
5) The key question to answer is....
6) On balance, whether abc is this depends.
7) The effectiveness of this policy...

The essay structure for a 15-mark question is similar to a 10 mark question but it
is important to address the question early on in the essay. Many students spend a
lot of time defining terms, drawing and explaining the diagrams without clearly
addressing the question. Everything should be done with a purpose and the
examiner should feel that the student is answering the question directly instead
of regurgitating content and have examiners to second guess their intentions.

Since the 15 mark question is always found in part b to the paper 1 question and
phrased as a follow on question from part (a), students do not need to necessarily
repeat content or diagrams already covered in part (a). They can simply refer to it
in part b of the question. However, if adjustments are made to the diagram e.g.
adding an extra curve, then the diagram should be redrawn for clarity.

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 54 Excellent Economics Essays

Essay 1
Resources are relocated in a market via changes in price. Explain how this is
done (10) (May 2015 TZ1 +TZ2 HL)

The condition of scarcity means that choices in the allocation of resources have to
be made. More specifically, the allocation of resources is a choice of what and how
to produce; the latter which involves a choice about of which and how much of the
underlying resources will be directed to the production of the chosen goods and
services. In a competitive market structure, a change in price; caused by the
changing dynamics of demand and supply, reallocates resources via the two
functions it serves.

Market for oil

Price serves a signaling function as changes in price signals to buyers and sellers
of whether to enter or leave the market. In the diagram above, the supply of oil has
decreased due to a supply shock in the form of a warfare in a politically unstable
regions such as the Middle East. As a result, supply of oil decreased as reflected
by a leftward shift in the supply curve from S1 to S2. At the existing price level P1,
there is excess demand of Q1–Q2 where Q1 is the quantity demanded and Q2 is the
quantity supplied. As a result of the supply shock, resource allocation for the
production of oil has temporarily decreased to where Q2 amounts of oil is being
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 54 Excellent Economics Essays

produced despite the price remaining at P1. Observing the excess demand and the
capacity for prices to be increased, some suppliers will raise the price up to P3
where the market clears. This simultaneously sends contrasting signal to the
suppliers to enter the market and increase the quantity supplied from Q2 to Q3 and
for consumers to buy less and decrease the quantity demanded (Q1 to Q3). When
considering the situation from the original equilibrium e1, a higher price has
reallocated resources away from the production of oil as only Q3 is being produced
as opposed to Q1. Less machinery, human capital and other inputs used to make
the oil is being employed.

The incentive function of price is the reason why an increase in price will send a
signal to suppliers to enter the market and for consumers to leave the market. As
well as reflecting the relative degree of scarcity, price serves as an indicator of the
potential gains to be made. In the example of above, a higher price P3 incentivises
suppliers to increase quantity supplied from Q2 to Q3 as more revenue and profit
can be gained by getting more for each unit sold ceteris paribus.

The above example mainly shows how prices reallocate resources from a scarcity
perspective as only supply is being affected but it can also reallocate resources
from a desirability perspective. For example, a change in taste or increase in
income will lead to the increase in demand for a good or service and hence lead to
an increase in price. The signaling and incentive functions operate in a similar
way which leads to an increase in quantity supplied as compared to the original
equilibrium.

In a competitive market structure, allocation of resources is determined by price.

Via the signaling and incentive function, changes in price reflect different levels of
scarcity and desirability and hence reallocates resources in a way which balances
the forces of demand and supply.

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 54 Excellent Economics Essays

Essay 2
In the market for air travel, explain the concepts of consumer and producer
surplus. (November 2015 TZ0 SL)

Consumer surplus is defined as the extra benefit derived by consumers when the
market price is lower than the maximum price which they are willing and able to
pay. Conversely, producer surplus is defined as the extra benefit derived by
producers when the market price is higher than the level which they are willing
and able to supply.

The diagram above illustrates the market for air tickets and P*Q* is the
equilibrium price and quantity transacted. For all consumers willing to pay higher
than P* i.e. from P* to P1, they are benefiting from extra utility since they are
paying at a price which is lower than what they are willing and able to pay for.
This is the consumer surplus and is illustrated by the area a+b+c i.e. the area below
the demand curve and above P*. For producers who are willing and able to supply
tickets lower than P*, they are benefiting from extra utility since they are getting
paid a higher price than what they are willing and able to sell at. This is the
producer surplus and this is represented by area d+e.

If the market price was set at P1, the consumer surplus is reduced to area a because
only those willing to pay above P1 will be enjoying the lower than expected price.
Those who were willing and able to pay P* to P1 will no longer be able to enjoy the
utility since they cannot afford it any more. Producer surplus increases in this
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 54 Excellent Economics Essays

case since they lose area e due to the decrease in quantity sold but gains area b
due to the increase in price.

From the airline’s perspective, the consumer surplus marked by area a+b+c is
potential extra revenue to be gained since consumers are already willing and able
to buy it at a higher price. This extra revenue can be captured via price
discrimination which is setting different prices for different groups of people for
the same products. Unlike public transport where concessionary tickets are sold
to children and the elderly, this is not commonly done in the airline industry. The
closest equivalent is for budget airlines to set higher prices for better positioned
seats e.g. nearer to the front in for the same class. Assuming that the differences
are slight, then price discrimination has taken place with people who are willing
and able to pay for a better seat paying for it. Assume that these better seats are
priced at P1 and the other seats priced at P*, then the people who are charged P1
will only enjoy a surplus of area a those paying P* area c. Area b is the additional
revenue gained from price discrimination and is no longer regarded as consumer
surplus.

Consumer surplus and producer surplus is maximised in the airline industry when
there is only once price and airline industries will try to maximize their revenue
via price discrimination where multiple prices are being set.

Mr. Lai’s notes: The second last paragraph on price discrimination is not necessarily
needed for a full-mark answer but is included here to demonstrate how the essay can
be developed.

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Essay 3
“The most efficient allocation of resources is achieved at the free market
competitive equilibrium” Discuss this view from society’s perspective. (15)
(November 2015 TZ0 SL)

The competitive market equilibrium is defined as the market equilibrium price

and quantity where the quantity demanded is the same as the quantity supplied.
According to economic theory, this leads to allocative efficiency as defined as the
allocation of resources whereby the utility of one party cannot be improved
without reducing the utility of another. It is also where social surplus/welfare is
maximized.

In microeconomic, the demand curve is also the marginal benefit (MB) curve as
each successive units consumed would give the consumers less utility. For
example, the second burger which one eats would give less utility than the first
one eaten and hence the willingness to pay at a lower price. On the other hand,
the supply curve is also represented by the marginal cost curve since each price
level corresponds to quantity supplied. Intuitively, more profit needs to
incentivize firms to produce more, hence an upward sloping supply curve.

In the diagram above, the intersection of the marginal social benefit (MSB) curve
and the marginal social cost (MSC) curve is the market equilibrium, and Qopt is the
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 54 Excellent Economics Essays

allocatively efficient quantity because all benefits and costs are fully taken into
account of from society’s perspective. Social surplus, which can be referred to the
cumulative area where MSB>MSC is also maximized at the equilibrium where
MSB= MSC. Note that this is not the case in market failure when there are some
costs or benefits that are NOT accounted for, which would lead to the issue of
over/under provision of goods and lead to a welfare loss. For example, when a
factory freely emits fumes with no consideration of the environment, a divergence
would be created between its marginal private cost (MPC) with the MSC resulting
in the welfare loss in the shaded area represented by the cumulative loss resulting
from MSC>MSB. An over production of Qm-Qopt is created. Another example is
merit goods such as education which generates positive externalities such as
increased productivity in the economy. An under consumption of education
results as it generates positive benefits which are not being taken into account of
and a divergence between MSB and marginal private benefit (MPB) is created.

It must be noted that the competitive equilibrium is a static concept and what is
regarded as an efficient allocation in one instance may not be regarded as the most
efficient when other options are being considered. For example, in the diagram
directly above, a negative productive externality exists because the marginal
private cost (MPC) is greater than the marginal social cost (MSC) curve as seen by
the MPC curve lying to the right of the MSC curve. The social optimum point is
Qopt1 but the market quantity is at Qm meaning that there is an over production of
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 54 Excellent Economics Essays

Qm- Qopt1. When a per unit tax equal to the vertical distance between MSC1 and
MPC is implemented, the MPC should shift upwards and coincide with the MSC1
which will eradicate the externality and lead to an efficient allocation. However, a
carbon tax will lead to an even more optimum result. As fossil fuels are taxed
according to the amount of carbon emitted, there is an incentive for the firms to
switch to more carbon efficient fuel. Since the fuel is more environmentally
friendly, the optimum quantity that can be produced increases. This is shown by
a downward shift in MSC1 to MSC2 and the optimum quantity increases to Qopt2.
Whilst Qopt1 is an efficient allocation under a tax on output, Qopt2 is more desirable
if a tax on carbon is introduced.

Furthermore the concept of allocative efficiency only accounts for whether all
costs and benefits have been fully taken into account and whether social surplus
have been fully maximized. It makes no value judgments on whether a good or
service should be provided at all. In the case of demerit goods, in particular for
vice such as hard drugs, even if the third party impacts have been taken into
account of, society may desire for its consumption to be eliminated. It also does
not take into account whether expensive medicine for life threatening diseases
such as cancer should be set at a lower price.

A competitive market where all costs and externalities are fully taken into account
would yield an allocative efficient outcome. However, its static nature means that
it may not be the most efficient allocation if other possibilities are being
considered and its inability to incorporate value judgments does not necessarily
mean that it is the best allocation from society’s perspective.

Mr. Lai’s notes: a tough question that requires a thorough understanding of

competitive markets and efficiency, particularly at SL level.

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Essay 4
Explain the factors which may affect the cross elasticity of demand (XED) for
different products. (10) (May 2013 TZ2 HL)

The cross elasticity of demand (XED) is defined as the responsiveness of the

change in demand for one good A (and hence a shifting demand curve) to a change
in the price of another good B. It is expressed mathematically by the following
equation.

XED = % change in Quantity in Good A / % change in Price of Good B

The nature of the goods will determine whether the XED between the two is
positive and negative. For substitute goods which means that they can be used for
the same purpose and could be in place of one another in varying degrees, the
value of the XED between two goods will be positive.

Diagram 1 Diagram 2

Coke and Pepsi are regarded as substitutes because they have similar taste and
colour. In diagram 1, when the market price of Coke increases from P1 to P2, the
quantity demanded for Coke will decrease from Q1 to Q2 as less will be consumed
according the law of demand. As a result, people will replace their consumption
of Coke with Pepsi as shown in Diagram 2 where demand for Pepsi has increased
at each and every price level from D1 to D2. An increase in the price of Coke will
lead to an increase in the demand of Pepsi which results in a positive XED as both

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the numerator and denominator in the XED formula are both positive. The greater
the substitutability between the two goods, the more positive the XED will be.
Coke and Pepsi have an XED value of 0.7 which is regarded as a strong substitute.

On the other hand, if the two goods are complementary goods meaning the use of
one good interrelated with the use of another, the goods will have a negative XED
value.

Diagram 3 Diagram 4
Tennis balls and tennis rackets are regarded as complementary good because they
are used together in the game of tennis. In diagram 3, when the market price of
tennis rackets decreases from P1 to P2, the quantity demanded for tennis rackets
will increase from Q1 to Q2 as more will be consumed according the law of demand.
As a result, people’s demand for tennis balls will increase at each and every price
level as shown by the rightward shift in the demand curve from D1 to D2. A
decrease in the price of tennis rackets will lead to an increase in the demand for
tennis balls which results in a negative XED as the numerator and denominator in
the XED equation have different signs. The more complementary the two goods
are, the more negative the value of XED will be. One may think that the XED for
tennis rackets and balls will be very high since they are used together in the game
of tennis. This may not be necessarily true because although both goods are used
in the game of tennis, tennis balls can be used/played without the racket and
hence a change in the price of tennis rackets may have limited impact on the
demand for tennis balls.

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The nature of the goods affects whether the XED between two goods are negative
(complementary goods) or positive (substitute goods). The more negative the
XED value is, the more complementary the two goods are to each to other. The
greater the XED value is, the greater the substitutability between the two goods.

Mr. Lai’s notes: For key words such as “increase”, “decrease” in this case, candidates
are strongly advised to underline to make it easier for the examiner to see. Make
sure steps are explained very clearly in a logical manner. Don’t get confused with
normal and luxury goods which is a very common error.

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Essay 5
“The income elasticity of demand has important implications for producers of
primary products, manufactured goods and services”. Examine this
statement. (15) (May 2013 TZ2 HL)

Income elasticity of demand (YED) is defined as the responsive of the change in

quantity demanded to a change in income. It is mathematically represented by
the following formula:

YED= % change in quantity demanded/ % change in income.

The three types of goods specified have different levels of YED. Primary products
are products extracted from the land and ocean which includes products coming
from agriculture, mining, forestry and fisheries. The YED for primary products is
typically inelastic and valued around 0.2-0.3. This means that quantity demanded
rises less rapidly than the increase in income and exhibit the characteristics of
necessities. In the diagram above, the increase in income from I1 to I2 will only
increase the quantity consumed for primary goods from Q1 to Q2. The reason for
this is because these products are mostly associated for survival and may not be
consumed a lot more if income increases. For example, one may not buy a lot more
rice to eat when income increases since there is a limit to how much of the basic
staple that one wants to consume. This is important for primary producers to
know since they can be aware that when the country undergoes economic growth,
the increase in the amount of income spent on primary goods will not be as great.
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 54 Excellent Economics Essays

However, YED differs for different countries in different economic stages. The
YED for primary goods in developing countries is 0.8, much higher than 0.2 in
developed countries as such goods are considered as luxury goods for the very
poor. This information is important for governments who are interested on the
impact of growing income amongst its people on different industries.

Knowledge of the relatively low YED for primary producers may persuade them
to diversify their businesses to manufactured products. Manufactured goods have
a YED of 1-1.5 and services even higher which means that the proportion of
income spent on such goods increases faster than income. In the diagram directly
above, the increase in income from I1 to I2 will greatly increase the quantity
consumed for primary goods from Q1 to Q2. Many manufactured goods such as
mobile phones, TVs and services such as private education and holiday tours as
regarded as luxury goods. As people’s income increases, they are more likely to
spend more on luxury goods and services to enjoy a higher standard of living. By
diversifying into industries which has a higher YED, this will allow them to
increase their exposure to rising incomes when the economy grows.

Note that there is nothing inherent about primary products which would render
them to have a low YED. Profit maximizing farmers can increase the YED of
primary products by growing exotic fruits and position them as luxury goods. This
is the case in Japan where fruits are sold as gifts for businesses. In an increasingly

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health conscious world, farmers can sell organic vegetables which commands a
premium over non-organic growth vegetables.

In light of the discussion above, the YED is important for letting firms and
governments to know the impact of growing incomes on the demand for their
goods. Given that primary goods are associated for survival, it will have a lower
YED than manufactured goods and tertiary services.

Mr. Lai’s notes: The key word in the question is “importance” and a good answer
would definitely address which stakeholders would be impacted by the changing
YED on different industries.

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Essay 6
The price elasticity of supply (PES) for primary goods tends to be relatively
low and the PES for manufactured products tends to be high. Explain why is
the case. (10) (May 2014 TZ1 SL)

The price elasticity of supply (PES) is defined as the responsiveness of a change in

quantity supplied to a change in price. Due to the different lengths of time needed
for suppliers to respond to time change, the PES for primary commodities usually
have a lower PES than manufactured goods. The former refers to goods derived
directly from natural resources such as agricultural, fishing, forestry and
extractive industries e.g. oil and coal. The latter includes refer to goods which have
been processed from raw materials usually with the use of machineries e.g. cars.

The PES of primary goods is relatively low because it takes more time for
resources to be shifted in and out of the industry. In the agriculture industry, even
if prices of crops increase substantially and farmers are greater incentivize to
increase production, they are unlike to increase crop production significantly as
crops need at least a planting season to grow (and respond to the price increase).
The mobility of resources in the primary sector are also relatively lower than
those in the secondary industry. In many overpopulated less developed countries
such as India, farmers are constrained by the amount of new land that can be used
for cultivation. The amount of new land that is suitable for agriculture is also
shrinking due to environmental degradation such as over farming which depletes
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 54 Excellent Economics Essays

the nutrients in the soil. Given such constraints, the supply of primary goods,
particularly those supplied in less developed countries are less price responsive
to price changes. Hence, even if oil prices rise substantially as demonstrated by
the increase from P1 to P2 in diagram 1, the increase in quantity supplied from Q1
to Q2 is relatively mild. This is also true for other types of primary products such
as oil, natural gas and minerals. Even though these are not “grown”, the high
extraction costs mean that firms do not necessarily respond quickly to price
increases and may wait until prices are sufficiently high, usually due to a severe
shortage in the commodity, to justify further investments to increase production.

On the other hand, the PES of manufactured goods such as mobile phones are
relatively high because mobility of resources are higher and modern production
methods allow production levels to be ramped up or decreases easily. This is
especially true in the present age where advances in technology and the use of
robots have increased the productive capability of a factory within a given space.
The automation of factories means that less human workers need to be employed
and production are not constrained by the difficulty to hire workers or being
affected by the actions of trade unions. Increasing levels of globalization allow
firms to increase their production capabilities by assigning different stages of
production to different locations which are most cost effective e.g. factories in
China. Therefore, when the prices of manufactured goods increases slightly from
P1 to P2, the increase in quantity supplied is comparatively significant.

Primary and manufactured products have different PES mainly because their
differing abilities to respond to price changes. Primary products such as
agricultural products have a lower PES because they need more time and resource
to increase production when prices increase. On the other hand, modern
production methods and technological advances allow increases in manufactured
products to take place easily.

Mr Lai’s notes: the elasticities of primary and manufactured goods are frequently
compared and is a very testable topic.

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Essay 7
The price elasticity of demand (PED) for primary goods tends to be relatively
low and the PED for manufactured products tends to be high. Explain why is
the case. (10) (May 2013 TZ1 SL)

The price elasticity of demand (PED) is defined as the responsiveness of a change

in quantity demanded to a change in price. Due to the different levels of
substitutability, the PED for primary commodities and manufactured products are
different. The former refers to goods derived directly from natural resources such
as agricultural, fishing, forestry and extractive industries e.g. oil and coal. The
latter includes refer to goods which have been processed from raw materials
usually with use of machineries e.g. cars.

Diagram 1 Diagram 2

Primary goods are price inelastic because many of them are regarded as
necessities and have few and no substitutes. For example, oil is used to produce
petroleum which is by far the most common energy source at the equivalent of 19
million barrels a day. It is used to make most products such as plastic, synthetic
fibers and even the lipstick. Hence, even if oil prices rise substantially as
demonstrated by the increase from P1 to P2 in diagram 1, the fall in quantity
demanded from Q2 to Q1 is relatively mild. Consumers of oil such as factories from
the manufacturing industries are compelled to purchase it even if price rises
because it is critical for its production and they cannot find any substitutes.

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On the other hand, manufactured products have a higher price elasticity of

demand because there are many different substitutes and many of them are not
regarded as necessities. In the current internet age where laptops are primary
medium for visual entertainment, television sets are considered to be unnecessary
and there are many substitutes for them given the many different brands
available. Hence, they tend to be a very price elastic where a small increase in
price from P1 to P2 for one type of television as shown in diagram 2 will lead to a
large decrease in the quantity demanded. It is this reason that television makers
frequently conduct price wars with one another as they understand the price
sensitive nature of consumers and would appeal to them economically.

It is important to note that the above claims are generalisations that are largely
true and depends on the assumption of ceteris paribus. Given the technology
advances in the energy industry for example, there are increasing substitutes for
oil such as solar power as an energy source which may make it more price elastic
in the future. Similarly, many television makers incorporate internet surfing
capabilities in their television sets to differentiate against their competitors which
may allow them to be more robust against price competition. Generally speaking
however, the demand for primary and manufactured products are regarded as
price elastic and inelastic due to the differing levels of need and substitutability as
outlined above.

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Essay 8
Discuss the consequences of a government imposing a price floor on an
agricultural product which may possibly occur (15) (May 2014 TZ1 SL)

A price floor is defined as legally set minimum price which producers cannot set
their goods and services lower than. Government imposed a price floors for
agricultural products to support price levels in the hope for primary producers to
earn more revenue and in turn, profit.

A price floor has negative consequences for consumers and mixed results for
producers and workers.

In the diagram above, the equilibrium market price and quantity is Pe and Qe. The
consumer surplus as defined as the benefits enjoyed by consumers from being
able to purchase the agricultural product at a lower price than they are willing and
able to is represented by a + b + c. The consumer surplus which is defined as the
benefits enjoyed by producers from being able to sell the agricultural product at a
higher price than they are willing and able to, is represented by d + e. When the
government sets a price floor at price Pf, the market price rises to Pf and the
quantity transacted falls to Qd which is in accordance to the law of demand.
Consumers are worse off as the consumer surplus is reduced to area a as
consumers are buying less at Qd at a higher price Pf. Producers are better off in
this case from a producer surplus perspective because the area gained from the
higher price they are selling their product at Pf is more than sufficient to cover the
loss in area e as a result of falling quantity sold (Qe to Qd). This is not necessarily
the case should demand be more elastic the price increase may lead to a large fall

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in the quantity bought hence leading to a fall in producer surplus. Note that the
revenue earned (the primary concern from the government’s perspective) has
decreased in this case as PfQd is lower than PeQe. Together with falling quantities
sold, lower revenue earned could possibly mean that fewer workers will be
employed, hence leading to a rise in the rate of unemployment. Society is worse
off as the welfare is reduced by area c + e, which means that society is not
distributing resources in an allocatively efficient manner.

It is important to note that at price Pf, there is excess supply of Qs-Qd as the
quantity supplied is greater than the quantity demanded. In order to ensure that
producer revenues are not affected by the falling quantity sold, the government
may use public funds to buy up the excess supply. An example of this is the
European Union which will buy the excess supply of certain products covered
under the Common Agricultural Policy (CAP). Graphically, this is represented by
D2 which lies on the right of D1. At this point, the price is at Pf and quantity sold is
Qs. Consumers are just as worse off since they are only buying Qd at Pf. Producers
are definitely because revenue has increased from PeQe to PfQs and producer
surplus has increased to b +c + d + e + f. More quantities sold are likely to result
in more employment of workers in the agricultural industry.

However, it is important to note that the government spent Pf x (Qs–Qd) to

purchase the excess supply but the only net gain achieve in welfare is area f.
Hence, society in general is worse off as area c + e + h + i + g is now a welfare loss.
In other words, the government is not generating the full value of social surplus
relative to the money that was spent. The government is likely to be worse off
since purchasing the excess supply will put a burden on its budget resulting in the
sacrifice of other initiatives. Taxpayers are also worse off since the money is not
spent in a way which increases social welfare. Purchasing the excess supply in
developed countries has an indirect negative impact on developing countries
which relies on the agricultural industry for economic growth. This is because
governments may sell the excess supply to these third world countries at very low
prices (also known as dumping), depressing world prices and negatively affecting
the income earned by its citizens.
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 54 Excellent Economics Essays

A price floor definitely makes consumers worse off as they purchase less at a
higher price. Due to the relatively price inelastic nature of demand of agricultural
products, producers earn more revenue and may enjoy more producer surplus.
Workers will be likely to be worse off as less of them will be employed. With
government purchases, consumers, tax payers, government and society will lose
out primarily due to the welfare loss generated. The only clear winner are
producers which should not be surprising price floors were designed to benefit
them in the first place.

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Essay 9
“Providing a subsidy on the production of rice would have different
consequences for producers, consumers and government”. Discuss this
statement. (15) (May 2014 TZ1 HL)

A subsidy is a payment made by the government to firms with the aim of

increasing the production of goods and services. It is often offered to producers
of agricultural products such as rice to provide a level of income support for
them by increasing the effective price that they receive. For example, Thailand’s
government provided USD 2.2 worth of subsidies to rice farmers in 2017 to help
stablise the revenue they are generating.

In the diagram above, the per unit subsidy of Pp- Pc was given to rice producers
which increased the supply of rice at each and every price level from S to S-
Subsidy. Producers gain because the price received increased from P* to Pp, and
Q* to Q1 resulting in revenue increasing from P*Q* to PpQ1. The producer surplus
also increased from d+h to b+c+d+h as a result. Consumers also gain because they
can buy more rice Q1 at a lower price Pc as compared to P* and Q* respectively.
This also corresponds to the rise in consumer surplus from a+b to a+b+d+e+f.

Note that the relative producer gains as determined by the producers’ share of the
subsidy enjoyed to the consumer gains depends on the relative PED to the PES.
The diagram above conveys that the producers’ share of the subsidy enjoyed Q1 x
(P*-Pp) is more than the consumer gain as expressed by Q1 x (Pc-P*). This is
because the PES is more responsive than the PED which means that suppliers are

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more willing to respond or increase quantity supplied as a result of the price

increase. In other words, firms are more willing and able to take advantage of the
subsidy and respond accordingly. Given that rice production typically has a
relatively lower PES, this situation would probably take place in more developed
countries e.g. France, where the availability of more advanced agricultural
technology would allow industrialised farmers to scale production relatively
easily and more readily respond to price increases.

The government gains or loses depending on the aim of the government. If the
government intends to increase the revenue of the of producers, they are
successful in doing so for at least the short run. However, providing subsidies
financially burdensome to the government and they can only provide it prolonged
periods of time if they have enough financial resources. It is also important to note
that the government does not generate the full value of the subsidy from a welfare
perspective. The size of the subsidy can be represented by area b+c+d+e+f+g but
the increase in social welfare as determined by the increase in consumption and
producer surplus is only b+c+d+e+f, rendering g as a welfare loss. The
government needs to weigh up whether the gain to both consumers and producers
is worthwhile to justify the loss to society.

When a subsidy is implemented, consumers and producers gain as it increases

the quantities of rice traded and leads to a higher price for producers and lower
price for consumers. The government gains if its sole aim is to help producers
but whether it may be able to do so depends on its ability to finance the subsidy
over the long term, not to mention the welfare losses that occur as a result.

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Essay 10
“The incidence of an indirect tax depends on the price elasticity of demand
and the price elasticity of supply.” Explain how this is possible. (10) (May
2016 TZ1 HL).

Incidence of tax is defined as the division of tax burden between consumers and
producers when an indirect tax has been implemented. The tax under
consideration is an indirect tax as defined as a payment paid to the government
by a firm but the whole or a part of the tax is passed on to the consumer as part of
the price of a good or service.

The incidence of tax depends on the relative price elasticity of demand (PED) to
the price elasticity of supply (PES). PED and PES is defined as the responsiveness
of the quantity demanded and quantity supplied to a change in price respectively.

In the diagram above, the government implemented a per unit tax of (Pc- Pp) which
shifted the supply curve upwards from S to S + tax. The market price increased to
Pc and consumers’ share of the tax burden is represented by area a + b. The
effective price received by producers decreased to Pp and their share of the tax
burden is shown by area c + d. The tax revenue generated is given by Q1 x (Pc- Pp)
and represented by a +b + c+ d. Note that the consumer burden is greater than the
producer burden as the PED is relatively more inelastic than the PES as conveyed
by its steeper slope. By being less price responsive, consumers are more unwilling
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 54 Excellent Economics Essays

to reduce their consumption compared to producers in reducing supply as a result

of the price changes. This usually refers to goods such as cigarettes which are
addictive in nature and render consumer demand to be less responsive to changes
in price. Note that a relatively more inelastic PED is the same as saying a relatively
more elastic PES. Referring to the same diagram above, it can be argued that
producers bear less of the burden because they are more willing to supply less as
a result of the drop in effective price received from P* to Pp. In order words, so
long as supply is relatively more inelastic to demand, which is very likely in this
case given the elastic PED, then the consumers will bear less of the burden.

The incidence of tax reverses when the PED becomes relatively more elastic than
the PES. The consumer burden a+b is less than the producer burden c+d. By being
more price responsive, consumers are more willing to reduce their consumption
compared to producers in reducing supply as a result of the price changes. This
usually refers to unbranded goods such as which have many substitutes e.g. bottle
water. When prices increase, consumers immediately switch consumption to
similar substitutes and hence they do not have to bear as much of the burden. Note
that a relatively more elastic PED for an economic situation is the same as stating
a relatively more inelastic PES. A steeper demand curve is also the same as saying
shallower supply curve. Referring to the same diagram above, it can be argued that
producers bear more of the burden because they are less willing to supply less
goods when the effective price received decreases from P* to Pp.

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The incidence of tax depends on the relative PED and PES to one another. When
PED and PES are equal, the burden will be shared equally between the both of
them.

Mr. Lai’s notes: a very good question that tests students’ understanding of tax
incidence and elasticity at the same time. Make sure you know the subject well.

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Essay 11
A price ceiling was imposed on the market for rented accommodation and a
price floor on the market for agricultural products. Explain why a
government may do so. (10) (May 2013 TZ2 SL)

A price ceiling is a legal maximum price for a good or service which firms are not
allowed to set above it and a price floor is a legal minimum price for a good or
service which firms are not allowed to set below. Price ceilings are usually set
below the market equilibrium as shown by Pc and vice versa for price floors as
shown by Pf in the diagram below.

The main reason why price ceilings are set is to make certain goods considered as
necessities more affordable. Accommodation is considered as a necessity and
controls on the rents on rental housing are implemented by some governments to
make it more affordable to low income earners. An example of this are the Public
Rental Housing (PRH) in Hong Kong where the maximum rent for an average sized
apartment is set at around HKD 2000 which only 20% of market rent. Apart from
making it more affordable, the governments may impose rent controls to enhance
income equality and allow the distribution of resources to be more equitable.
Housing is a typically forms one of the most significant components of expenditure
and rising real estate price affects poor people disproportionately more. By
applying rental controls, it puts a cap on the amount which poor people have to
spend on housing and hence increases the amount of disposable income which can

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be allocated to other expenditure. It will therefore lessen social grievances and

allow for smaller differences between different social classes.

Price floors are implemented on agricultural products by governments to provide

income support for farmers. It is set above the market equilibrium such as Pf in
the diagram above. Prices of agricultural products are often unstable since they
are subject to unplanned change in supply caused by unusually good or bad or bad
harvests and hence a price floor puts a minimum to how low prices can go.
Secondly, due to increase of the global production of primary goods, prices of
agricultural goods have decreased and the price floor is implemented to keep
prices from falling too late and hopefully maintain revenue levels. Finally, there
has been a significant reduction in the bargaining farmers when it comes to their
negotiations with sizeable supermarket chains and multinational companies at
both the national and global level. Setting the price floor is in effect to enhance the
bargaining of the farmers and prevent prices from going too low.

Governments set price ceilings on the market for rented accommodation make
housing more affordable and a price floor on the market for agricultural products
to provide income support. However, the government may only be able to help
portion of targeted audience with such policies. By setting a price ceiling below
the equilibrium, there is excess demand for rental housing as the quantity
demanded Qd is greater than the quantity supplied Qs and some of the poor people
will need to wait for a prolonged period of time before getting affordable
accommodation. On the other hand, there is excess supply for agricultural goods
as quantity supplied Qs is greater than the quantity demanded Qd by setting a price
floor above the equilibrium. Unless there is government intervention, there is no
guarantee that farmers will receive a higher revenue despite higher guaranteed
price due to a fall in quantity sold.

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Essay 12
“The consumption of merit goods, such as healthy food, can lead to positive
externalities of consumption.” Explain why this is the case. (10) (May 2017
TZ1 SL)

Merit goods are goods and services considered to be desirable by consumers but
are underprovided when relied on the market for provision. The consumption of
merit goods generates positive externalities which are benefits imposed on
unrelated third party as a result of its consuming such goods.

Avocados is regarded as a kind of “super food” due to the antioxidants it provides

through consumption which makes people healthier and more energetic in
general. The graph above represents the market for avocados where it is assumed
the marginal private cost (MPC) equals the marginal social cost (MSC). When left
to market forces, only Qe amounts of avocados are consumed as people only take
into account of the marginal private benefits accrued to them. This includes a
healthier and more energetic body which will allow them to be more productive
in the work place and may allow them to earn levels of higher income in the long
run. As microeconomic theory assumes people to be self-interested, people do not
take into account the positive externalities created via the consumption of
avocados.

Regardless of whether such externalities are being taken into account the
consumption of merit goods will benefit unaccounted third parties. The
consumption of healthy foods such as avocados will likely lead to higher levels of
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 54 Excellent Economics Essays

worker productivity which in turn will increase the profitability of their

companies. This may lead to a more vibrant and productive economy. Such
companies are considered unaccounted third parties as they did not have to pay
to enjoy any of the benefits.

In light of such external benefits, society would prefer consumers to take into
account of all these external benefits in their decision making. Graphically, the
marginal private benefit (MPB) would coincide with the marginal social benefit
(MSB) curve where Qopt quantities of avocados are demanded at the equilibrium.
At Qopt, other parties will still benefit from the merit goods indirectly but such
benefits are no longer considered positive externalities since consumers now
account for them in their decision-making. Qopt is the allocative efficient quantity
where there is no welfare loss. Should consumers consume at Qe, MSB is still
greater than MSC which means that there are welfare gains yet to be enjoyed. This
is regarded as a deadweight loss to society and represented by the shaded area.

The consumption of merit goods can lead to positive externalities of consumption

as external benefits are generated in the consumption process e.g. eating avocados
make healthier workers. Such benefits are positive consumption externalities as
they are not taken into accounted by consumers in their decision-making and
benefiting parties did not have to pay for them.

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Essay 13
“Advertising by the government is the most appropriate way of increasing
consumption of a merit good.” Discuss whether this is true. (15) (May 2017
TZ1 SL)

Merit goods are goods and services considered to be desirable by consumers but
are underprovided when relied on the market for provision. Governments at
times have attempted to increase the consumption of merit goods using
advertising in print, on TV and via the internet to overcome the market failure
which exists for merit goods.

The above diagram shows the market for vaccination treatment (VT) which
people undergo to be protected against flu viruses. For the purposes of discussion,
it is assumed the marginal private cost (MPC) equals the marginal social cost
(MSC).

Left to market forces, microeconomic theory assumes that people will only take
their own private benefits into account as reflected in the marginal private benefit
(MPB) curve where only Qe quantities of VT are consumed. These private benefits
may include their own health and well-being. Market failure has taken place
because the social optimum quantities of VT to be consumed is actually Qopt as
reflected by the intersection between the marginal benefit (MSB) curve and
marginal social cost (MSC) curve. Qe is less than Qopt because there is no incentive
for people to take external benefits attributed to unrelated third parties e.g. more
profitable companies due to healthier workers, into account. The deadweight loss
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 54 Excellent Economics Essays

to society which describes the net marginal benefits that could be gained is
represented by the shaded area.

Advertising can be used to encourage society to undergo more VT by adopting

persuasive techniques that appeals to both the factually and emotionally minded.
Ideally the increase in consumption will be sufficient to remove the externality
and Qopt is consumed. Advertising has been effectively used in Hong Kong in the
past as it makes people more well informed of the problems about flu related
diseases and benefits of undergoing VT.

However, the effectiveness of advertising to increasing the consumption of a merit

good depends on a number of existing factors. First, the merit goods must be
affordable or else advertising would not be effective regardless of how persuasive
it may be. VT are considered to be very expensive to people living in developing
countries such as India. Rather than using advertising only to increase the
demand for VT, producer subsidies are given to firms to increase the supply of VT
at a lower price. This is especially effective given that poor people are very price
elastic and will be much willing to get VT if prices were lower.

Second, it depends on whether the advertising is convincing enough to persuade

people to change their behaviour. There is no guarantee that the advertisement
would be seen and the people would necessarily change their consumption
behavior. In order to enhance the effectiveness, the government may to need to
lengthen the advertising campaign and pay for more TV spots or billboards. This
may be very costly to the government in the long run, especially if there are many
initiatives to promote.

Advertising is one of the ways to promote the consumption of merit goods but may
not necessarily be the most effective as it does not directly address the
affordability issue and is highly dependent on the quality of the campaign. Its
effectiveness would be greatly enhanced when combined with other measures
such as the provision of subsidies.

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Essay 14
“Common access resources, such as fishing grounds, might become depleted
in the absence of a price mechanism.” Explain why this is the case. (10) (May
2013 TZ2 SL)

Common access resources are resources where no party has property rights over,
no market price and are available to anybody to use without having to pay. They
are rivalrous but non-excludable in nature. An example would be a fishing pond
which no one owns and is accessible to all.

The price mechanism is the system where the forces of demand supply determine
the prices of scarce goods and services which in turn serves the rationing,
signaling and incentive functions to inform consumers and producers of their
decision making. The absence of such a mechanism would mean that common
access resources such as fishing pond would become depleted as the functions of
price mechanism do not come into play to allocate scarce resources.

Price serves a signaling function as changes in price signals to buyers and sellers
of whether to enter or leave the market. In the diagram above, the equilibrium
price of the good is P*Q* and there is no incentive for any parties to deviate from
this price and quantity supplied. For example, if the market price was lowered to
P1 there is excess demand of Qd–Qs. In order to clear the market, the price will
increase to P* which simultaneously sends contrasting signal to the suppliers to
enter the market and increase the quantity supplied from Qs to Q* and for
consumers to buy less and decrease the quantity demanded (Qd to Q*). The

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incentive function comes into play here as suppliers are encouraged to make more
profit by supplying more and consumers to consume less as the good is getting
more expensive. Through the price mechanism, the good is “rationed” (rationing
function) as the excess demand in P1 has prompted price to be increased to P* to
allow the market to clear.

The absence of a price mechanism for common access resources means that the
forces of demand and supplied are not reflected because there is no price to signal,
incentivize and ration. In the case of the fishing pond, people will capture all the
fish and deplete the resource as there is no incentive or barriers for them not to
do so. Note that the absence of the price mechanism is a result of the lack of
property rights. As the resource is non-excludable, there is no one to take and
enforce ownership of the pond and charge consumers accordingly. The fact that
the good is rivalrous; meaning that one’s consumption of the good will reduce the
ability of another to consume, implies that the fishing pond will be depleted over
time as the price mechanism is not in place to ration its use.

The price mechanism allocates resources via the signaling, incentive and rationing
function it provides. Common access resources are depleted due to the lack of
property rights in place which means that the resource is available to use without
any cost. Due to the rivalrous nature of the common access resources such as
fishing ponds, they will be depleted over time.

Mr. Lai’s notes: a rather tough question which requires a good understanding of the
price mechanism and how its absence leads to market failure for common access
resources.

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Essay 15
“Carbon taxes represent the most effective government response to the threat
to d posed by the use of fossil fuels.” Evaluate this view. (15) (May 2013 TZ2
SL)

Carbon taxes is a per unit tax on the carbon emissions of fossil fuels. It is one of
the responses to address the threat of sustainability which can be defined as
damages to the environment which would compromise the ability of future
generations to meet their own needs. Different possible fuels emit different
quantities of carbon and the carbon tax takes this into account by taxing the
amount on the basis of how much carbon the fuel emits. The greater the carbon
emitted, the higher the tax paid.

A carbon tax is effective as there is an incentive for the firms to switch to more
carbon efficient fuel since fossil fuels are taxed according to the amount of carbon
emitted. In the diagram above, it is assumed that the marginal social benefit (MSB)
is equal to the marginal private benefit (MPB). An externality exists because the
marginal private cost (MPC) is greater than the marginal social cost (MSC) curve
as seen by the MPC curve lying to the right of the MSC curve. The social optimum
point is Qopt1 but the market quantity is at Qm meaning that there is an over
production of Qm-Qopt1. With a carbon tax, since the fuel is more environmentally
friendly, the optimum quantity that can be produced increases. This is shown by
a downward shift in MSC1 to MSC2 and the optimum quantity increases to Qopt2.
Carbon taxes are only effective to the extent that it is the main offending
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 54 Excellent Economics Essays

pollutants. Fossil fuels also emit other chemicals such as methane and nitrogen
which can be damaging to the environment and a tax which fail to acknowledge
these other pollutants may render less effective than a tax on output.

Having said that, carbon taxes are known to be more effective than per unit taxes
on output When a per unit tax equal to the vertical distance between MSC1 and
MPC is implemented, the MPC should shift upwards and coincide with the MSC1
which will eradicate the externality. Its equilibrium quantity Qopt1 is smaller than
Qm. While this is effective on paper, the effectiveness of this policy depends on the
extent which the government can measure the externality accurately and
implement a precise amount tax which will eradicate the externality. Both are
almost impossible to do especially the former, it is very difficult to gauge the
amount of third-party impacts.

Furthermore, there are instances where the pollutants result from neighboring
regions which the local government has no jurisdiction over. From the
perspective of the offending regions, the air in the local area becomes a common
access resource where no party has property rights over. This means that there is
no market price and are available to anybody to use without having to pay. An
example is Hong Kong where a lot of pollution is blamed on the factory emissions
from the Pearl Delta region which is blown over by the southern winds. This issue
may call for international cooperation and may not be something a tax on carbon
could simply overcome.

Regulations can also be used to reduce the emission of carbon through legislation.
However, it does not afford the flexibility to producers to respond in a way to
optimise their outcomes under the new constraints i.e. taxes, permits. For
example, a firm which cannot technically reduce pollution may end up going out
of business as they do not have the choice to internalizing the externality via
paying higher taxes.

Carbon taxes are superior to taxes on output which generate the externalities
because the former provides an incentive for producers to switch to the less
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 54 Excellent Economics Essays

polluting resources as well as reducing output whereas taxes on output only does
the latter. It is also considered to be more effective than regulations by economists
because of relatively higher flexibility. However, carbon taxes will only be so much
more effective than taxes on output if carbon is the main pollutant and little of
other chemicals are emitted. It will also depend on whether the carbon taxes can
be imposed which may not be case if the polluting factories are in beyond the legal
jurisdiction of the authorities.

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Essay 16
An indirect tax is imposed on the consumption of cigarettes by the
government. Explain why this is the case. (10) (November 2015 TZ0 SL)

An indirect tax is a payment paid to the government by a firm but the whole or a
part of the tax is passed on to the consumer as part of the price of a good or service.
A government imposes an indirect tax to reduce the consumption of cigarettes; a
demerit good and raise revenue from it.

A demerit good is a good that generates negative consumption externality or costs

on unrelated third parties when consumed. In the case of smoking, smokers are
not taking into the third party impacts of smoking such as the bad smell emitted
to people passing by, rubbish created by stubs thrown on the street and the health
effects on second hand smoking. In the diagram above, it is assumed that the
marginal social cost (MSC1) is equal to the marginal social benefit (MPC1) which
means that all costs have been fully taken into account by the consumers. The
marginal private benefit is greater than the marginal social benefit as shown by
the MPB curve lying to the right side of MSB, which means that consumers are
consuming more cigarettes than what society deem as optimal as they are not
taking into account the third party effects explained earlier. At Q1 levels of
smoking, MSC is greater than MSB negative welfare losses of e are generated.

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In order to overcome this problem, the government may set an indirect tax on
cigarettes. If the government had perfect information, it would set the per unit tax
at P2-P3. This would lead to an increase in the cost of production for cigarette
producers, hence reducing the supply of cigarettes at each and every price level.
This is shown by the leftward shift from MSC1 to MSC2 where Qopt level of smoking
is consumed. At this level, all the costs of cigarette consumption have been fully
taken into account and the quantity consumed is allocatively efficient.

When the government charges the tax, it receives tax revenues equal to the area
of (P2-P3) x Qopt. Although governments rarely state that it charges tax on
cigarettes to raise revenue, this is a good source of government revenue which can
be used for other parts of the economy.

Mr. Lai’s notes: Some students as whether it is allocative efficient outcome since P2
is higher than the original P3. Since allocative efficiency is only concerned about the
quantity perspective, the answer is yes, the price at P2 is still an allocatively efficient
outcome.

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Essay 17
To what extent might the use of indirect taxation overcome the problems of
negative externalities of consumption? (15) (May 2013 TZ1 HL)

Negative externalities of consumption refer to the external costs imposed by

consumers when they consume goods and services which has a negative impact
on unaccounted third parties.

Take the case of cigarettes for example as illustrated by the diagram above, the
marginal private benefit (MPB) lies to the right side of the marginal social cost
(MSB) curve meaning that consumers are consuming more cigarettes than what
society deems optimal. When smoking, consumers are ignoring the external costs
(a “negative benefit”) imposed such as the bad smell emitted to the surroundings
and the health costs that are induced from second hand smoking. Assuming that
the marginal private costs (MPC1) are equal to the marginal social costs (MSC1),
the equilibrium output is Qm and the vertical distance between MPB and MSB is
the per unit external cost. The shaded area is the deadweight loss which depicts
the cumulative net loss as a result of the overconsumption Qm-Qopt. In order to
reduce the quantity consumed to Qopt where MSC equals MSB and all costs are
benefits are fully taken into account, the government may set an indirect tax equal
to the per unit external cost. As taxation effectively leads to an increase in the cost

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of production, MSC will decrease at each and every price level and MSC1 will shift
to the left to MSC2 where Qopt will be achieved and the externality is internalised.

In theory, indirect taxation is an effective market-based method of overcoming the

market failure as the externality is internalised and the negative costs of cigarette
consumption are taken into account by producers and consumers (parties to the
transaction). However, there are a number of practical considerations which may
limit its effectiveness. First, for the indirect tax to achieve Qopt consumption
precisely, the government must be able to measure the value of the external cost
accurately which is near impossible as it is difficult to attach a monetary value to
some of the costs e.g. uncomfortable feeling from the bad smell and to identify all
the third parties affected. Furthermore, goods such as cigarettes are addictive in
nature and consumers may not be very responsive to an increase in price i.e. low
price elasticity of demand (PED) in the long run. Therefore, in order for Qopt to be
achieved, the government may need to set a very high tax before the optimal level
of consumption is achieved. Whether the government can do so depends on its
political clout and the social sentiment at the time. In Hong Kong, there have been
calls in 2017 to increase cigarette taxation by 100% (which would shift the MSC1
significantly to the left) but the magnitude of the increase is very difficult given
politically sensitive climate at the time.

For this reason, a more sustainable solution in the long run is to combine taxation
with advertising on the ill effects of the externality. In 2012, the Australian
government passed legislation where all cigarettes have to be packed in logo free,
drab dark brown packaging and very graphic pictures of lung cancer and other
dire consequences of smoking are shown. The demand for cigarettes will decrease
and the MPB will shift to the left nearer to the MSB. Combined with a politically
achievable level of taxation, Qopt can be achieved.

It is therefore only to a certain extent that indirect taxation can overcome the
negative externality of consumption of smoking by increasing price which would
lead to a decrease in the quantity demanded. The effectiveness of indirect taxation
depends on the government’s ability to identity all third party costs in a
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 54 Excellent Economics Essays

quantifiable way and implement a sufficiently large tax for the optimum quantity
to be achieved. In the long run, a more sustainable solution would be to combine
taxation with other tools such as advertising which seeks to decrease the demand
as well as the supply of cigarettes at the same time.

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Essay 18
“There should always be direct provision of public goods by the
government.” Discuss whether this is true. (15) (Nov 2016 TZ0 HL)

Public goods refer to goods and services which are non-rivalrous and non-
excludable. Left to the market, these goods will not be provided because
entrepreneurs are unable to charge consumers for the goods consumed even if
they own the property rights. For example, it is not possible for firms to charge
people for the use of streetlights since the people are free to walk on the streets
and the lights will light up the path they are walking on regardless whether they
pay for it or now. Other forms of public goods include public pavements and
national defense. Left to the market, the market failure of missing markets would
occur meaning that consumers would not be able to consume important goods and
services such as the ones listed above. This is as opposed to private goods which
are both rivalrous and excludable which allow firms to earn profit from it e.g. food.

The most common way of overcoming the market is for the government to provide
it directly which is why nearly all of the public goods in society are directly
provided by the government which are financed from government reserves and
taxation. Given that many of these are large infrastructure projects e.g. roads, it
may impose heavy financial burden and opportunity cost on the government,
especially when there are competing projects in the pipeline. One of the most
contentious items on the US government budget is the USD 600 billion military
budget where a lot of it is spent on overseas missions where the money could be
used to provide other services such as healthcare. Furthermore, it is very difficult
to measure the benefits of the provision and hence there may be challenges to
gauging the amount of public goods to be provided.

In light of these reasons, one may also argue whether the government should
always be the one to provide the public good. If the nature of the good can be made
to be more excludable, then there will be more opportunities for private firms to
provide the good, hence sparing the government from the financial burden. For
example, roads and tunnels can be made excludable by using booths where
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 54 Excellent Economics Essays

passing vehicles have to pay tolls to use it. Since private providers make decisions
based on profits, there will be an incentive for firms to provide the service in an
efficient manner and be more responsive to market changes. Having said that,
there are areas such as public defense which may be too politically sensitive for
private firms to be providing it. Military contractors such as Lockheed Martin can
provide the equipment but the “service” component; provision of soldiers and
security would have to be provided by the government. It is interesting to note
that although governments are generally politically motivated, democratic
governments are in a way incentivized to provide defense efficiently as they are
motivated to maximize the amount of political goodwill.

The nature of public goods and the problems of free rider and missing markets
mean that it is often left to the government to provide it. However, if the good can
be changed to become more excludable, hence allowing firms to exercise their
property rights, then the government may not always have to be the provider and
reduce the financial burden of doing so.

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Essay 19
A loss-making firm in perfect competition would shut down in the long run.
Explain why this is the case. (10) (May 2017 TZ1 +TZ2 HL)

Perfect competition is a market structure which has many suppliers and

consumers, perfect information, no barriers to entry and exist and homogeneous
goods and services. These characteristics strips market power from all firms and
makes them price takers. An example of this is the egg market in Hong Kong where
firms basically sell the same kind of unbranded types of eggs.

Firms decide whether to operate in the industry depending on the level of

economic profit that it makes. In the diagram above, the firm is operating at the
profit maximizing quantity Q1 where marginal revenue (MR) = marginal cost (MC).
At this level, the revenue earned is P1Q1 which is less than the total cost of P2Q1.
Hence, the firm is making an economic loss of Q1x(P2-P1). Different from
accounting profit/loss, economic profit/loss includes implicit cost such as the
opportunity cost of running the business. Hence, the economic loss means that the
revenue gained is insufficient to make it worthwhile for the firm to stay in the
industry. The firm will therefore leave the industry in the long run where all
factors of production and costs are flexible.

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In the short run, which refers to the period where at least one factors of
production or cost is fixed, the firm still needs to pay for its fixed cost and it will
continue operating so long as the revenue can contribute to covering some of such
costs. An example is paying rent on the premise which cannot be terminated due
to the terms of the tenancy agreement. At Q1 levels of production, the firm faces
fixed cost of Q1 x (P2-P3) which the firm would need to pay should the firm choose
to shut down immediately (short run). However, the firm can bear a smaller loss
of Q1x(P2-P1) if it continues operations which is why the firm will only shut down
in the long run when these fixed costs such as rent no longer applies. Note that P4
is known as the shut down price which is the price level where if it is any lower,
the firm will shut down in the short run as the revenue cannot even contribute to
the fixed cost and it would minimize loss by shutting down immediately.

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Essay 20
Explain the differences between decreasing returns to scale and the law of
diminishing returns. (10) (May 2013 TZ2 HL)

The law of diminishing returns states that as more unit of a variable input such as
labour is added to the production process whilst all other inputs are kept constant
(short-run), the marginal product will increase at first but will eventually come to
a point where it will decrease. On the other hand, decreasing returns to scale the
state when the increase in input results in the less than proportionate increase in
output. This is a long-run concept.

Diagram 1 Diagram 2

Consider a farm that grows corn. When labourers are employed, the marginal
product as defined as the output attributed to the extra unit of input employed e.g.
labour would increase because the workers can share the work and make use of
more effective production methods. The marginal product will keep on increasing
until it reaches a stage where it will eventually decrease as could be seen in the
diagram above when the number of labourers exceeds Q1. The reason is because
other factors such as the size of the land or the number of large machineries is
fixed in the short run and the increasing number of labour will “overload” the use
of these fixed factors. For example, the farm may become overcrowded and
workers may get in the way of one another or there are not enough tractors for

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workers to use. The marginal product will continue decreasing unless the scale of
the farm would increase in the long run.

Decreasing returns to scale is a long run concept which takes place due to the
diseconomies of scale that sets in when the scale of the companies grows beyond
a certain point. Diseconomies of scale refer to problems such as inefficient
communication and the cumbersome bureaucracy would set in when the
company becomes too big. This concept is usually represented by the long run
average cost starting to increase as could be seen when the company produces
more than Q2 in diagram 2 above. Referring to the previous example, when the
scale of the farm begins to get too big, the owner may have trouble getting his
messages across to the workers efficiently or strategic changes to crop-growing
may be difficult to due to the bureaucracy involved.

The law of diminishing returns is a short run concept that assumes at least one
input factor is fixed and marginal product decreases at a certain point due to
problems such as overcrowding. On the other hand, decreasing returns to scale is
a long run concept which where total product increases at a decreasing rate even
if all inputs are flexible due to economies of scale setting in.

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Essay 21
Compare and contrast the market structure of monopoly with that of perfect
competition. Use diagrams to support your answer. (15) (May 2013 TZ2 HL)

Perfect competition is a market structure which has many suppliers and

consumers, perfect information, no barriers to entry and exist and homogeneous
goods and services. These characteristics strips market power from all firms and
makes them price takers. An example of this is the egg market in Hong Kong where
firms basically sell the same kind of unbranded types of eggs. On the other hand,
the monopoly market structure has only one producer, higher barriers of entry
and exit, imperfect information and has the ability to set price.

Diagram 1 Diagram 2

Monopolies can make abnormal profits in the long run whereas firms in the
perfect competition market structure can only do so in the short run. In diagram
1, the monopoly faces a downward sloping demand curve to reflect its price
setting powers and produces at Qm where marginal profit (MR)= marginal cost
(MC) to maximize profits. As a result, it is able to make supernormal profits of Qm
x (P1-P2) which means that it is able to make a profit over and above what it needs
to stay in the industry. This can make supernormal profits in the long run as there
are high barriers of entry of exist, perhaps in the form of advanced technology e.g.
rocket technology, which makes it hard for aspiring entrants to enter the industry.
On the other hand, firms in perfect competition market structure can only earn
abnormal profits in the short run. In diagram 2, the firm is making supernormal
profit of Q1 x (P1-P2) when price is P1. However, this is not sustainable because

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aspiring entrants will be attracted to the supernormal profits available and will
enter the industry. Supply will increase and the price will decrease to P2 where
Price (P)=Average Revenue (AR)= Marginal Revenue (MR)=MC= Average Cost
(AC) and only normal profits are earned. The firm is only making just enough to
stay in the industry.

Diagram 3 Diagram 4

The different profits made have different efficiency implications for the two
market structures. The marginal benefit (MB) curve can be treated as the demand
curve as each successive units consumed would give the consumers less utility.
For example, the second ice cream which one eats would give less utility than the
first one eaten and hence the willingness to pay a lower price. The marginal cost
(MC) also coincides with the supply curve as Price (P) = MC in perfect competition
market structure and the corresponding quantity produced is also where MR=MC
since AR=MR resulting from a perfectly elastic demand curve. From a welfare
perspective, the monopoly market structure is not allocatively efficient as it only
generates consumer and producer surplus equal to the area of a + b as it produces
less at Qm compared to Qpc under perfect competition (diagram 3). In the perfect
competition market structure, the quantity produced maximizes the social surplus
available since it is operating where MB = MC as shown area of a+b+c+d in
diagram 4. Note that firms operating in the perfect competition market structure
would also be able to achieve productive efficiency as it is producing at a quantity
where average cost is at its lowest.

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The monopoly has the advantage of being able to enjoy dynamic efficiency. Given
that the monopoly makes abnormal profits, it can invest some of those profits to
innovation and produce goods and services which that are of superior quality that
the current offering. Furthermore, innovation may yield progress in technology
where the long run average cost curve can be reduced at each and every quantity
level. This means that even if productive efficiency is not achieved, it may be able
to produce the product at a lower average cost than firms in perfect competition.

The main difference in the two market structures is perfection competition

market structure can only make normal profits in the long run and monopoly can
make supernormal profits. The former market structure produces goods and
services in an allocatively and productively efficient manner but monopolies can
generate dynamic efficiency with the supernormal profits that they earn.

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Essay 22
A perfectly competitive firm can make economic (abnormal) profit only in the
short run. Using diagrams, explain why this is true. (May 2014 TZ1 HL)

Perfect competition is a market structure which has many suppliers and

consumers, perfect information, no barriers to entry and exist and homogeneous
goods and services. These characteristics strips market power from all firms and
makes them price takers. An example of this is the vegetable market in Hong Kong
where firms basically sell the same kind of unbranded types of vegetables.
Abnormal profits refer to the amount of profit made by firm which exceeds the
amount it needs to be willing to stay in the industry.

Diagram 1: Individual Firm Diagram 2: Industry

Firms decide whether to operate in the industry depending on the level of

economic profit that it makes. At P1 in the diagram above, the firm is operating at
the profit maximizing quantity Q1 where marginal revenue (MR) = marginal cost
(MC). At Q1, the revenue earned is P1Q1 which is more than the total cost of P3Q1.
Hence, the firm is making an abnormal profit of Q1 x (P2-P1). However, this is not
sustainable because aspiring entrants will be attracted to the supernormal profits
available which they know of because of perfect information. Hence, they will
enter the industry and will be able to do so easily as there are no barriers to entry,
hence increasing supply in the process. This is shown by the rightward shift in the
industry supply curve in diagram 2 which leads to a fall in market prices from P1
to P2. Given that individual firms are price takers, the firm in diagram 1 will fall to
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 54 Excellent Economics Essays

P1 where Price (P)=Average Revenue (AR)= Marginal Revenue (MR)=MC=

Average Cost (AC) and only normal profits are earned. The firm are only making
just enough to stay in the industry.

Firms in perfect competition industry can only make abnormal profits in short run
because the assumptions of perfect information and absence of barriers of entry
and exit allow aspiring firms to enter the industry and dilute the abnormal profits
being made by pushing the market price down to a level where only normal profits
are being made.

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Essay 23
There are some conditions necessary for firms in oligopolistic markets to
engage in price discrimination. Explain what these are. (10) (May 2016 TZ2
HL)

An oligopoly is a market structure where a small number of firms exert

disproportionate market power over the industry. The oligopoly market structure
has higher barriers to entry, products produced may be homogenous or
differentiated and there is mutual interdependence between firms. Price
discrimination is the practice by firms to charge a different price to different
consumers for the same products.

The price discriminating firms should have some market power or some ability to
set prices. In Hong Kong, the bus industry is controlled by a small number of bus
companies, each of which has control over the ticket prices for the different routes
that they control.

For third degree price discrimination to take place, there should be customers
with different price elasticity of demand (PED) for the product. PED is the
responsiveness of quantity demanded to a change in price. The firm then charges
a higher price for the consumer group with the higher PED and the lower price to
the group with the lower PED. An example of this is the city subway where adults
are charged more because of their higher income and students and children are
charged less because of their lower economic power. As shown in the diagram
below, consumers groups with different price elasticities have been separated into
two separate markets; adults (market 1) who faces a relatively inelastic demand
curve and children and students (market 2) who faces a relatively more elastic
demand curve. The two marginal revenue (MR) curves are summed horizontally
and the total MR curve is seen in diagram 3. Given that the firm profit maximizes,
the subway company will supply Q3 amount of subway services which will be
shared amongst the 2 markets. This is done by equating the MC of the combined
market with the respective MR curves in both markets, generating Q1 in market 1
and Q2 in market 2. Note that the resulting price P1 for adults is higher than P2 in
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 54 Excellent Economics Essays

for children and students meaning that different prices have been charged
successfully for different consumer types. Differing PED is a necessary condition
for price discrimination, as the absence would simply result in the same price
being charged.

Note that the above price discrimination could only take place if safeguards for
reselling are successfully applied against reselling between the different groups.
For example, cinemas charge students less for their tickets compared to those sold
to adults and salespeople will check the students for their student ID cards to
ensure no were no adults who will take advantage and impersonate as students.
For oligopolies, the effectiveness of the price discrimination will be further
enhanced if they could coordinate their pricing strategies such that will not be
undercutting each other and hence lowering overall profit. For example, if one
cinema sets a lower price for adults compared to another cinema chain, then there
is a temptation to engage in a price war which may render all prices to be lowered
to the same as for students.

Oligopolies can only engage in price discrimination if the firms have some market
power, markets can be separated and different PED exist in the market.

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Essay 24
Should producers in oligopolistic markets should compete or collude?
Discuss. (15) (May 2016 TZ2 HL)

An oligopoly is a market structure where a small number of firms exert

disproportionate market power over the industry. The oligopoly market structure
has higher barriers to entry, products produced may be homogenous or
differentiated and there is mutual interdependence between firms. To compete
refers to engaging in price competition and to collude is to fix prices in the hope
of gaining more profit.

Firm 1 and firm 2 operates in an oligopolistic industry where the firms can decide
to set prices “high” or low. The following table shows four possible combinations
of pricing strategies and their corresponding profit outcomes (called ‘payoffs’) for
the two firms.

Firm 1
Low Price High Price

5 2

Low Price
Firm 2 5 10
10 8

High Price
2 8

The table above illustrates the conflicting objectives that both firms have in
deciding whether to compete or collude. Both firms are aware that they would
collectively be better off if they collude and set a high price as both of them would
benefit and attain a payoff of 8 as opposed to 5 if they set a low price. However,
this is not a sustainable strategy pair because both firms have an incentive to
compete by setting a low price and attain a payoff of 10. Should that happen, the

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other firm would get a payoff of 2 and would maximize their payoff by setting a
low price as well, resulting in a payoff of just 5 for both of them.

Hence, even though it is in the best interest for the firms to collude and fix high
prices, the lack of trust may prevent them from doing so. For example, the Hong
Kong newspapers Apply Daily and Eastern Daily were engaged in fierce price
competition in the early 1990s which was so financially burdensome that they
decided to raise prices together. However, the collusion only lasted for one year
as Apple Daily decided to capture market share by cutting prices which led to
Eastern Daily following suit. In addition, a successful collusion also depends on a
number of other factors. For example, the number of firms in the industry has to
be low and all firms need to participate in the pollution. This is to allow for easier
coordination and to prevent any firms from undercutting the colluding firms with
respect to price. Barriers of entry should be should be high as the abnormal
profits, as defined by the excess profit made by firms to stay in the industry, will
attract potential entrants to the industry and drive profits down for the existing
price fixing firms.

Given the difficulty in maintaining collusion and the fact that price competition is
financially detrimental in the long term, many oligopolies would prefer to engage
in non-price competition. This may include providing a superior quality product
and building a distinct brand. An example of this is Apple and Samsung who both
dominate the mobile market with very distinct marketing, branding and product
offerings. Doing so allow them to be more robust against any predatory pricing by
their competitors. This may however not be a viable alternative for oligopolies
producing primary products where the products are essentially the same and little
can be done to differentiate themselves against their competitors. An example of
this is for the oil industry where the OPEC the largest oil cartel, a legally approved
formal collusion, in the world fixes the price by imposing a production quota for
each of its 13 member countries. Due to the lack of product differentiation,
member states are vulnerable when some of it members decide to sell more than
its quota. This is not to mention that collusion is illegal in many places such as the
UK as it limits competition and works against the interest of the consumers.
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 54 Excellent Economics Essays

It would be in the best interest for producers in oligopolistic markets to collude

and fix prices as they can earn abnormal profit. However, many conditions such
as trust, small number of firms need to be in place for price fixing to be successful;
the absence of which will perhaps tempt firms to deviate from the agreement and
compete.

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Essay 25
Prices tend to be stable in oligopolistic markets. Explain what this is the case.
(10) (May 2015 TZ1 HL)

An oligopoly is a market structure where a small number of firms exert

disproportionate market power over the industry. The oligopoly market structure
has higher barriers to entry, products produced may be homogenous or
differentiated and there is mutual interdependence between firms. Prices tend to
be stable in oligopolistic markets regardless whether they are collusive or non-
collusive in nature.

Non-colluding firms in an oligopoly market structure do not fixed prices together

to gain higher profits, but yet experience stable prices.

In the diagram below, the non-colluding firm produces Q1 quantities of goods

which is also the level where profit is maximized since marginal revenue (MR)=
marginal cost (MC). The resulting price level P1 is stable because the firm faces a
kinked demand curve and there is no reward for changing prices. If the firm
increases prices, it faces an elastic demand curve because consumers will switch
to substitutes and hence a price increase will be met with a relative large decrease
in quantity demanded hence leading to a drop in revenue. On the other hand, a
price decrease will be met with a relatively small increase in quantity because
other firms will follow suit and decreases prices at the same time rendering little
price advantage for the firm. As a result, the firm will maintain its price level at P1.

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Colluding firms have an incentive to fix prices at a high level to achieve higher
profits.
Firm 1
Low Price High Price

5 2
Low Price
5 10
Firm 2 10 8
High Price
2 8
In the payoff diagram above, the firms have a choice of setting a “High Price” or
“Low Price”, the decisions of which will affect the payoff of the other firm. Game
Theory tells us that the equilibrium strategy pair is to set a low price for both firms
since there is a temptation for the firms to deviate and set a low price for other
combinations. For example, if both firms set a high price, they get a payoff of 8
respectively. However, should Firm 1 deviate and set a “Low Price” it gets a pay
off of 10 where as Firm 2 suffers and gets a payoff of 2. Hence, firm will try and
minimize its own damage by also setting a low price and both firms receive a
payoff of 2. This is actually not optimal since both can actually achieve a payoff of
8 by colluding and fixing prices together. Game Theory conveys that this is not
sustainable since firms always have an incentive to cheat. Having said that,
oligopolistic firms have an incentive to collude over the long term and maintain
high prices in a stable manner because they understand the repercussions of
cheating once. They may find it not worthwhile to sacrifice long-term benefits i.e.
earning a payoff of 8 for unsustainable short-term benefits i.e. earning payoff of
10. An example of this is OPEC, the oil cartel in the Middle East where member
countries agree to keep prices at a stable level.

Prices tend to be stable in oligopolistic markets regardless of whether firms

collude or not because they are interdependent in nature. As illustrated above,
since firms are detrimentally affected by the actions of other firms should they
attempt to act in an aggressive manner e.g. lower prices, they are better off
maintaining stable prices.

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Essay 26
The government has the tools to response to abuse of monopoly. Explain two
possible responses. (10) (May 2015 TZ2 HL)

Monopoly power refers to the power of monopolies or colluding oligopolies to set

prices and such firms may abuse their power to do so by setting very high prices
to achieve higher levels of profits. This is allocatively inefficient from an economic
perspective since firms earn supernormal profit and are being paid more than
they are willing to stay in the industry. This is represented by the area Qm x (P1-
P2) in diagram 1 below. The output of Qm is also inefficient compared to the
allocatively efficient output of Qpc where price (P) equals the marginal cost (MC)
as less is being produced and the welfare loss of area c + d is generated as the
marginal benefit is still greater than the marginal cost.

Diagram 1

Diagram 2
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The government can set legislation in the form of anti-monopoly laws to prevent
firms from merging together to become monopolies. Legislation can also be used
to forbid monopoly-like practices such as price fixing amongst oligopolistic firms
and encourage more competition between them. During the 1990s, Microsoft was
the dominant technology company and they were accused of anti-competitive
behavior as they bundled their Internet browser, Internet Explorer when they sell
together with their popular Windows operating system. The US courts deemed
this to be illegal and Microsoft was fined for their actions. By allow there to be
more competition, the opportunities for monopolies to set high prices and exploit
consumers will be reduced in fear of being undercut.

The government can also introduce more competition through trade

liberalization. Many countries deliberately set trade barriers to protect their own
industries or allow them to grow sufficiently large to compete internationally.
This is known as the infant industry argument. However many of these firms, once
they grow into monopolies would be tempted to exploit its monopoly powers in
the hope of maximizing profit. STDM was the largest casino in Macau for much of
the 20th century and operated in essence like a monopoly. When 3 further licenses
were given in 2002 which later became 6, there was a lot more competition and
the quality of services improved at lower prices. Furthermore, it created a lot of
synergies which led to Macau being the biggest casino city in the world and
generates more than 3 times the gaming revenues than that of Las Vegas.

The abuse of monopoly power can be overcome by removing the monopoly

powers which firms have. This can be done through legislation and introducing
more competition and force it to become more allocatively efficient.

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Essay 27
“Monopolies have inefficiencies but may be considered desirable”. Evaluate
this view. (15) (May 2015 TZ2 HL)

The monopoly market structure monopoly market structure has only one
producer, higher barriers of entry and exit, imperfect information and it has the
ability to set price.

Diagram 1

Diagram 2

Monopolies can make abnormal profits in the long run which means that they are
making a level of profit which is more than they need to remain in the industry. In
diagram 1, the monopoly faces a downward sloping demand curve to reflect its
price setting powers and produces at Qm where marginal revenue (MR) = marginal
cost (MC) to maximize profits. As a result, it is able to make supernormal profits
of Qm(P1-P2). This is deem allocatively inefficient because when the demand curve
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 54 Excellent Economics Essays

is considered as the marginal benefit curve, the firm is operating at a level where
marginal benefit is still greater than marginal cost and gains can still be made by
producing more. This is reflected in diagram 2 where at Qm, the firm is only
achieving a+b levels of social welfare and is not enjoying c+d which it can make by
producing Qpc amounts. As could be seen, it is neither productively efficient
because it is not producing at the lowest possible average cost.

However, monopoly has the advantage of being able to enjoy dynamic efficiency.
Given that the monopoly makes abnormal profits, it can invest some of those
profits to innovation and produce goods and services which that are of superior
quality that the current offering. This is the argument for why many
pharmaceuticals such as GSK have to earn high level of profits so that they can
develop new drugs. Furthermore, innovation may yield progress in technology
where the long run average cost curve can be reduced at each and every quantity
level. This means that even if productive efficiency is not achieved, it may be able
to produce the product at a lower average cost than firms in perfect competition.

Furthermore, monopolies may face more competition than it is typically believed,

especially for internet companies and are always kept on their toes as there may
be new platforms which may challenge their predominant status. For example,
although Facebook is the biggest social media company globally, its status has
been threatened by the photo sharing application Snapchat and video company
Tik Tok. Hence, such monopolies are encouraged to continue to innovate to fend
off the competition. The resulting price and quantity supplied to the market may
be even lower than the price and quantity achieved under perfect competition.

Along the same argument, there are some industries which are natural
monopolies. These are industries such as utilities which calls for a large
investment in fixed assets and has low variable costs. In order for it to fully enjoy
the cost savings from the economies of scale, the firm must be allowed to produce
at high quantities which is not possible if competition is introduced. This is one of
the reasons why Hong Kong Island only has one electric company; Hong Kong

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Light and the government prevents it from exploiting consumers by legally

requiring the company to apply to the government should it want to raise prices.

Monopolies suffer from the problem of allocative and productive inefficiency.

However, it enjoys dynamic efficiency when it reinvests the profits earned into
developing new production and more efficient production methods which allows
prices to fall and quantity to grow in the long term. This is particularly the case for
natural monopolies which needs to product large quantities before it could fully
enjoy the economies of scale.

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Essay 28
“A firm in monopolistic competition will make normal profit in the long run.”
Explain why this is the case. (10) (November 2015 TZ0)

A monopolistic competition is a market structure where there is a large number

of firms, no product differentiation, perfect information but different from the
perfect competition structure, there is product differentiation. Such product
differentiation may be in the form of physical differences, quality and the product
image/branding. An example of this is branded bottled water where branding
allow a certain degree of product differentiation for an otherwise identical
product i.e. water tastes and look the same.

Monopolistic competition will only make normal profits in the long run because
economic profit or losses will be bided away by firms entering and leaving the
market respectively. In diagram 1, the firm faces an elastic demand curve as it has
some market power and is able to set prices. The firm is operating at the profit
maximizing quantity Qm where marginal revenue (MR) = marginal cost (MC) and
is able to make supernormal profits of Qm(P1 x P2). Supernormal profits implies
that the firms are not only making a monetary profit but they are being paid more
than it is needed for them to be willing to stay in the industry. Given the
assumption of perfect information, aspiring entrants will be attracted to the
supernormal profits being made and will enter the industry with ease as there are
no barriers of entry (or exit). This is perhaps reflected from the fact that bottled
water does not require high technology to create and entrepreneurs can gather
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 54 Excellent Economics Essays

the factors of production to produce them in a short period of time. At the industry
level, as shown in diagram 2, the supply of bottled water increases from S1 to S2
leading to a fall in the market price from P1 to P2. At the firm level in diagram 3,
this is shown by a downward shift in the average revenue (AR) and MR curve until
the AR curve is tangential to the average cost (AC) curve. This is significant
because revenue is equal cost and the firm is only making normal profit in the long
run.

Should the firm be making an economic loss, this will only be sustained in the
short run firms will no longer find it worthwhile to operate in the industry.
Supply will be reduced and the price will increase until the AR curve is tangential
to the AC curve where normal profit is being made. At this price level (P2), the
firms are only making just enough to allow them to be indifferent to staying and
leaving the industry. It is a long run equilibrium because firms will not enter or
leave the industry at this point.

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MACROECONOMICS

Essay 29
The income, output and expenditure methods are used to measure real gross
domestic product (GDP). Explain how this works. (10) (May 2014 TZ2 SL)

Real GDP is defined as the market value of all final goods and services produced in
a country over a period of time, usually a year and takes into account the effects of
inflation. The three methods can be used interchangeably to calculate real GDP
within an economy.

The diagram above is the circular flow of income and it clearly shows that the
three methods derive the same GDP value regardless of the economy being open
or closed. The reason is because whatever is produced (output approach) will be
bought through the product markets (expenditure approach) in one way or the
other using income earned (income approach) through the resource markets from
different factors of production.

The expenditure approach measures the total amount of money used to purchase
final goods and services in a country (usually within a year). Final goods and
services (defined as goods and services available for final use) is only included to
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 54 Excellent Economics Essays

avoid the issue of double counting as the inclusion of the value intermediate goods
and services would already be embedded in the value final goods and services. An
example is an iPhone (final good) and its parts e.g. screen, casing (intermediate
good). The expenditure approach has five components. Consumption (C) is the
sum of all household spending on domestically produced goods and services.
Investment (I) is the spending by firms on capital goods e.g. equipment, and
construction which usually enhances the productivity of the economy in the
future. Government spending (G) includes any spending of the government on an
economy such as education and healthcare which may sometimes be referred as
“public investment”. Net Exports (NX) is the difference between exports (X) and
imports (M) which are goods and services sold to and bought from other countries
respectively. The relationship can be expressed in the following equation GDP=
C+I+G+(X-M). Import is a negative value since money is flowing out of the
economy and is treated as “leakage” in the circular flow of income.

The income approach sums up all the returns from the factors of production
within a country over a time period (usually a year). Wages are the returns from
labour, rent from land, interest from capital and profits from entrepreneurship.
The sum of all factor incomes generates the value of national income. Note that
national income is not the same as GDP and adjustments involving depreciation,
indirect taxes as well as the origin of income earned (domestically or abroad)
would be needed to derive the GDP.

The output approach measures the value of final good and service produced in the
economy over a particular period of time; “final” to avoid the problem of double
counting as outlined above. In most countries, industry associations publishes
data on individual industries e.g. agriculture, manufacturing, transport, banking,
which would be collated and published by the country’s census or statistics
department. An example of this would be Hong Kong Banking Report that is
published by KPMG annually. This approach allows for the performance of each
industry to be examined and comparisons to be made across different sectors.

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The three methods outlined are different ways of measuring the GDP or more
generally, the economic activity of an economy. Note that all values are rebased
to the base year to account for the impact of inflation and to come up with a “real
GDP” figure.

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Essay 30
Real GDP per capita is a method of measuring the living standards of a
country’s population. Discuss its usefulness. (15) (May 2014 TZ2 SL)

Real GDP/ Capita is defined as the market value of final goods and services
produced in a country over a period of time (usually a year) per person and
accounts for the impact of inflation. There are many different definitions for
standard of living but it could be generally defined as the level of wealth, comfort,
material goods and necessities available to a group of people within a country.

Real GDP/capita is often quoted indicator of standard of living as it reflects the

average income (using the income method to calculate GDP) of people within a
country. The relationship between income and material wellbeing is obvious. A
higher income means a higher ability to purchase goods and services which will
enhance the material well being of a country. An example of this is China where
the open door policy in 1980 increased the wealth of many people, especially
those living on the coastal regions which initially allowed them to have much
better access to basic needs such as food and clothes and more luxurious products
such as cars and houses later on. Real GDP/Capita is an even better reflection of
standard of living as it takes into account of inflation and allows comparisons to
be made across time.

However, real GDP/capita has often been criticised as a poor indicator of standard
of living as it only measures the materialistic wellbeing of people. It only measures
standard of living in terms of monetary value. Many people argue that this is
insufficient as standard of living also includes many other factors such as state of
the environment, access to quality of healthcare and education, political
governance and “happiness” which cannot necessarily be measured in terms of
money. In other words, it is entirely possible for a country where people have a
real GDP/Capita but yet does not enjoy a high standard of living. For example,
despite ranked for having one of the highest GDP per capita in China, residents in
Beijing have suffered from poor air quality from the neighboring industrial
pollution and smog such that residents will feel nauseous when they are outdoors
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 54 Excellent Economics Essays

for 20 minutes. One measure which attempts to account for the standard of living
more broadly is the Human Development Index (HDI) which also measures life
expectancy, access to education and knowledge in addition to material well being.

Furthermore, real GDP/capita is only an indicator of average income and a high

real GDP/capita may disguise the fact that the majority of nation’s wealth is
concentrated on the hands of a minority group of people. Hong Kong has one of
the highest GDP/capita in the world but is ranked 9th globally for in terms of
income inequality with a Gini coefficient of 0.53. Over 200,000 people live in
subdivided flats or cage homes with less than 20 square feet of personal space
which seriously impedes on their standard of living. It is interesting to note that
these people are not necessarily poor i.e. low real GDP/capita, but are forced to do
so because the cost of living in Hong Kong is so high. Finally, despite accounting
for inflation real GDP does not account for the purchasing power of money across
countries which makes it possible for a country with a lower real GDP/capita to
buy more goods and services than another country with a higher real GDP/capita.
The deficiency of GDP/capita begs the question why it is still widely quoted as one
of the key indicators of standards of living. Indeed, even the HDI uses Gross
National Income (GNI) per capita as a proxy for standard of living in its
measurement. The reason is because real GDP statistics and demographic data is
widely available and significant resources are generally dedicated to its
compilation and calculation by governments and industry associations due to its
status as being one of the most important economic statistic. It is quantifiable and
easy to calculate which allow economists to make comparisons across countries
and time easily and efficiently. Therefore, although real GDP/Capita may not
encompass the full breadth of how living standards are being defined it is my
judgment that its ease of calculation and access to data still makes it a very useful
indicator/ proxy for the standard of living.

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Essay 31
Explain why an economy may be in equilibrium at any level of real output with
the use of the Keynesian AD/AS diagram. (10) (May 2016 TZ1 HL)

Macroeconomic equilibrium is defined as the state where the aggregate demand

equals to the aggregate supply in an economy. Simply put, it is also the state where
the total demand for goods and services in an economy is catered by the real
output of the economy to the exact amount. According to the Keynesian
perspective, there are three equilibrium states of the economy.

In the diagram above, the equilibrium can take place at any point the aggregate
demand (AD) curve intersects the aggregate supply (AS) curve. When AD is at
AD2, the equilibrium output is equal to the potential output Yp where there is full
employment bar those who are in structural, seasonal or frictional
unemployment. Prices are at a moderate P2 and there is neither over cooling or
overheating of the economy.

Suppose that the AD is at AD1 and it intersects the horizontal part of the AS curve
where unemployment and a recessionary gap exists. The equilibrium output is
Ye1 and unlike the classical/monetarist model, this is a sustainable equilibrium
because prices are assumed to be sticky downwards. Even when there is
unemployment, wages have not necessarily come down because external
influences such as trade unions are in place or workers are protected by contracts
which makes immediate salary adjustments difficult.

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When AD is at AD2, the economy is experiencing an inflationary gap since the level
of output Ye2 is greater than the potential output YP. Aggregate demand is strong
and unemployment has fallen below its natural rate as the economy nears its
maximum productive capacity. The equilibrium is sustained at this level of real
output by the economy paying a higher wage level than at the natural rate. An
example of this is China during the period from 2000 to 2005 where substantial
foreign direct investment led to a high demand for Chinese workers resulting in
high pay.

In the Keynesian AD/AS framework, the macroeconomic equilibrium can be in

equilibrium at any level of real output because wages do not have to adjust so
that the economy must be where the output equals its potential.

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Essay 32
Explain the possible impact of a rise in government spending on economic
growth by using the concept of the Keynesian multiplier. (10) (May 2015 TZ2
HL)

The Keynesian multiplier refers to the ripple effect created when increase in
spending by one of the components of aggregate demand (AD) would lead to
subsequent increases in aggregate demand, though each successive increases
would be smaller than the previous due to leakages in the economy. Should the
change in aggregate demand be positive, it would lead to economic growth as
defined by the increase in real GDP.

Aggregate demand is defined as the total demand for final goods and services in
an economy at a given time. It is the summation of consumption (C), Investments
(I), Government Spending (G), Exports (X) minus Imports (M) and commonly
expressed by the following equation.

AD = C + G + I + (X-M)

The government may try to stimulate economic growth by increasing government

spending in the economy which may take the form of infrastructure spending such
as roads and railway and spending on education and medical care. An example of
this is China where USD 112 billion will be spent on high-speed rail in 2018 in an

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effort to increase fixed investments and stimulate long-term economic growth. As

shown in diagram A, this is the autonomous spending or spending which is
brought about by an external stimulus (the government) and will increase the
economic output from Y1 to Y2 in the absence of a multiplier. However, the
multiplier is likely to be positive since the USD 112 billion in real GDP will produce
a further chain of spending otherwise known as induced spending. For example,
the USD 112 billion autonomous spending will be spent on businesses to pay for
materials, capital equipment, labour who the owners of such factors of production
will use it for their own consumption spending. As consumption increases, this
will lead to further consumption and will continue to increase the GDP beyond the
USD 112 billion initially spent on the economy.

The size of the induced spending (Y3-Y2) depends on the marginal propensity to
consume (MPC) which refers to the proportion of the income spent on
consumption. This is regarded as an injection in the circular flow of income as
money is being put in to the system. On the other hand, the proportion which is
not spent is saved which is why savings are regarded as leakages and each
successive round of consumption will become smaller. Assuming that the MPC
stays constant in each round, the multiplier (the multiple which the autonomous
spending is multiplied by) is

Multiplier = 1/(1-MPC)

China is known for its high savings rate and so assuming an MPC of 0.5, the
multiplier would be 1/(1-0.5) = 2 and the increase in economic growth by the USD
115 billion investment would be USD 230 billion.

As a determinant of AD, an increase in government spending would directly lead

to economic growth (assuming that supply is not perfectly inelastic) and its initial
impact is magnified by the multiplier.

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Essay 33
In contrast to the monetarist/new classical model, an economy can remain
stuck in a deflationary (recessionary) gap according to the Keynesian model.
Discuss why this is the case. (15) (May 2013 TZ2 HL)

The monetarist/classical model refers to theoretical model put forward by

economist such as Milton Friedman who believes in the price mechanism in
coordinating economic activities and holds the view that the economy is a
harmonious system where the forces of aggregate demand (AD) and aggregate
supply (AS) that tends the economy to full employment. On the other hand, the
Keynesian model questions the classical/monetarist view that the economy will
reach full employment automatically and in the instance a recessionary gap
(output level less than its potential output) is created due to the lack of aggregate
demand it is possible for economies to be stuck in the recessionary gap in the long
run.

Diagram 1 Diagram 2

In diagram 1, the economy is currently operating at its potential output Yp where

full employment of resources takes place. Following a fall in aggregate demand,
perhaps due to a fall in consumer confidence, AD decrease to AD2 where the price
level falls to Pl2 and output to Ym. Given that the price of goods and services has
fallen, firms will seek to maintain their profitability by reducing the wages of its

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workers. Cost of production will decrease and the short run aggregate supply
(SRAS) will increase and shift outwards to SRAS2 where Yp levels of output are
produced. The critical component of this model is that wages and prices are fully
flexible; a point which Keynesians disagrees with. Keynesians believe that “wages
are stick downwards” due to various labour market rigidities that are in place. For
example, workers have contracts which means that wages cannot be reduced
immediately until the contract period has been served out. Trade unions may fight
against wage cuts and hold strikes if the firm persists. For these reasons, the
economy may not be able to revert to its productive potential Yp in the long run.
Keynesians further believe that product prices will not fall easily even in a
recessionary gap as they do not want to see their profits further eroded in addition
to the rigidity of wages.

In diagram 2, the Keynesian AS depicts a horizontal section where wages and

prices do not move downwards even when output falls for the reasons previously
discussed. Despite operating at a level below economy’s full potential, point d is a
legitimate equilibrium in the long run. Point d corresponds to the same point in
figure 1 in the monetarist model where prices have remained at Pl1.

In my judgment, the Keynesian model presents a more realistic view of the real
world as economies have indeed been seen stuck in a recessionary gap for
extensive period periods of time. The most notable example is Japan which have
seen low levels of economic growth following the its stock market crash in 1988.
Part of the reason is that there is a culture for firms to employ workers for their
whole life and it is unlikely for wages to be cut.

The Keynesian model argues that an economy can be stuck in the recessionary gap
for long periods of time as prices and wages are not flexible which contrasts with
the classical/monetarist view which argues the opposite.

Mr. Lai’s notes: The concluding paragraph can be taken away if there is not enough
time)

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Essay 34
Explain what the meaning of natural rate of unemployment is. (10) (May
2015 TZ1 HL)

The natural rate of unemployment is the sum of seasonal, structural and frictional
unemployment. In the monetarist framework as shown in the diagram below, the
equilibrium output in the short run is determined by the forces of aggregate
supply and aggregate demand which could be inflationary (where the real output
(Ye is greater than the potential output (Yp), deflationary (where Ye is less than the
Yp) or at the potential GDP where Ye = Yp.

According to the monetarist approach, any unemployment that occurs is “natural”

when real output equates potential GDP because changes in wages (assumed to be
flexible) would restore output to the long run equilibrium. This is because when
Ye = Yp, factor markets such as labour are also in equilibrium meaning no
unemployment should not exist as the wages would be set at a level where the
market is cleared and no worker would be willing and able to work but unable to
find any job. Should there be any unemployment, it must be due to labour
rigidities which are the underlying causes to frictional, seasonal and structural
unemployment and are independent to fluctuations in the business cycle.

Frictional employment takes place when workers are between jobs and are
transitioning because they have been fired, made redundant or simply to find a

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better opportunity. It tends to be short term and is independent of the economic

cycle the economy is in as is inevitable given the changing dynamics of industries.
The frictional unemployment can be made longer or shorter with information.

Seasonal unemployment occurs when the demand for certain goods and services
are seasonal and hence the demand for labor changes likewise. For example, farm
workers would be made redundant during the wintertime but would be rehired
during the harvest time in the summer. This is the same for lifeguards who would
be out of work during the winter months when many pools will be closed due to
the cold weather.

Structural unemployment takes place as a result of the change in the structure of

the economy which results in the change in the demand for particular types of
skills, industries and hence related jobs and workers. A good example of this is
the rapid demise of the textile and other secondary related industries in during
the 1980s in Hong Kong when many factories moved to mainland China following
the country’s open-door policy which offered cheap labour and land for
operations. Such change can also be brought about by improvements in
technology where certain jobs are replaced by robotics such as the workers who
used to work in factory lines.

The natural rate of unemployment is the unemployment which occurs when

employment is at its full capacity given the constraints imposed by frictional,
frictional and structural unemployment.

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Essay 35
“There is no trade off between inflation and unemployment.” Discuss this
view. (15) (May 2015 TZ1 HL)

Inflation is defined as the sustained increase in price levels and unemployment is

the state which workers who are able and willing to work cannot find gain
employment. According to the Phillips curve, there is a negative relationship
between inflation and unemployment where the favourable condition of one e.g.
low unemployment would be achieved at the cost of the other e.g. high inflation.
The reasoning can be explained by diagram A, the AS-AD model and B the Philips
curve below.

Diagram A Diagram B

Assuming an upward sloping short run aggregate supply (SRAS) curve, different
levels of aggregate demand (AD) will yield different levels of income and output.
At AD1 the price level is at Pl1 and the real GDP at Y1. Following an increase in
aggregate demand due to some form of autonomous spending such as increase in
consumption, the AD curve will shift outwards to AD2, hence achieving a higher
price level Pl2 and output Y2. Note that this corresponds to the Phillips curve as a
higher level of output refers to a lower level of unemployment as more labour are
engaged for the production of goods and services. The output at Y1 and Y2 in
diagram 1 corresponds to the unemployment levels u4 and u3 in diagram 2. The
relationship remains the same when the level of aggregate demand increases for
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 54 Excellent Economics Essays

AD3 to AD5. At AD5, a higher level of output corresponds to a low level of

unemployment but a higher level of inflation Pl5 is achieved at the same time.

The increase in AD which increases price level is the case of demand-pull inflation
where general price levels in the economy are caused by increases in aggregate
demand. An example of this is the increase in inflation from 0.12% to 2.65% in
2015 due to stronger investment and consumer spending following a more
confident investment outlook.

However, the negative relationship between inflation and unemployment

depends on a stable SRAS which may not always be the case as cost of productions
are prone to change due to supply shocks or technological improvements.
Consider the diagram 3 and diagram 4 below.

Diagram 3 Diagram 4

At the SRAS1, the price level is at Pl1 and the output is at Y3. Following an increase
in the cost of production, less is being supplied at each and every price level and
the SRAS curve shifts to SRAS2 where the price level is at a higher Pl2 and the
output is at a lower Y2. A lower output corresponds to higher levels of
unemployment u2 as less labour is needed to employed. Given that one Phillips
curve corresponds to one SRAS curve, a leftward shift in the SRAS curve to SRAS2
will lead to a rightward shift in the Phillips curve. This was the case during the

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1973 oil crisis when the prices of oil increased by 40%. Since oil is used in a wide
variety of products from petroleum to plastic, the rise in oil prices greatly
increased the cost of production and led to a decrease in output and subsequently
an increase in unemployment. There was known as stagflation and there was no
tradeoff between inflation and unemployment.

Even in the absence of supply shocks, the SRAS proves to be unstable as well in
the long run according to the classical framework.

Diagram 5 Diagram 6
Suppose that the the aggregate demand increases from AD1 to AD2, the level of real
output increases from Yp to Yinfl in digram 6 and the the level of unemployment
drops from u3 to u1. However, as the price level has increased from Pl1 to Pl2 but
wages have stayed constant, workers will negotiate for higher wages, hence
increase the cost of production and reducing the SRAS from SRAS1 to SRAS2. The
price level increases to Pl3 and the natural rate of output reverts to Yp. From the
perspective of the Phillips curve, operating on a higher SRAS2 shifts the Phillips
outwards to short run Phillips Curve (SRPC2)and the unemployment returns to u3.
Hence, it can be seen that there is also no tradeoff between inflation and
unemployment in the long run when wages are sufficiently flexible. Indeed, there
are instances when wage changes maybe rigid, such as a recession where real
output has decreased but wages are held constant due to labour market rigidities

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such as trade unions and existing contractural terms. An example of this is when
the US was in recession in 2008 but wages stayed relative constant.

The Phillips curve demonstrated that a tradeoff exists between inflation and
unemployment. However, this depends on a stable SRAS curve which may not
necessarily be the case in the presence of supply shocks and flexible wages in the
long run.

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Essay 36
Distinguish between the following types of unemployment: structural and
demand-deficient unemployment. (10) (November 2015 TZ0 HL)

Structural unemployment results from a change in the structure of the economy

(local or national) which leads to a decrease in the demand for workers with
certain skill sets. Together with seasonal and frictional unemployment, it is one
of the types of unemployment that occurs when the economy has reached the rate
of natural unemployment. On the other hand, demand-deficient unemployment
occurs during the economic downturn of the business cycle due to low or declining
aggregate demand. It is therefore also known as cyclical unemployment.

Consider the diagram above, the economy was originally producing at Yp where
the level of demand deficient unemployment is zero. According to the monetarist
perspective, this is regarded as the long term equilibrium as the aggregate
demand curve (AD1) intersects the short run aggregate supply curve (SRAS) at the
point where long run aggregate supply (LRAS) is reached. However, due to falling
aggregate demand which may be a result of falling consumer confidence due to a
dire outlook of the economy as was the case in 2009 in the UK when the world
financial crisis broke out, the economy will produce at less than its potential
output. Graphically, this is shown by a leftward shift in the aggregate demand
curve to AD2 where a lower output Yrec is produced. As less output is produced,

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less workers will be employed leading to a rise in unemployment. The “lack” of

demand (demand-deficient) is responsible for such unemployment.

On the other hand, structural employment is not associated with the business
cycle or the levels of aggregate demand. During the 1980s, many coalmines in the
UK were shutdown due to competition from abroad and the UK economy was
transitioning to a full-fledged service industry. As a result, many regions such as
Nottinghamshire and Yorkshire which had a sizeable coal industry experienced a
substantial rise in structural unemployment which had nothing to do with the
changes in the business cycle. According to the monetarist view, structural
unemployment is a form of labour market rigidity which takes places even when
the economy is at the long run equilibrium (Yp in the diagram above). Hence, it is
part of the “natural rate of unemployment” as it arises naturally from an imperfect
labour market. Given that these imperfections and rigidities are embedded in to
the economy, monetarists consider the natural rate of unemployment (where
output is at Yp) as full employment.

Demand deficient unemployment and structural employment are fundamentally

different concepts as the former is caused by falling aggregate demand as a result
of the downturns in the business cycle whereas the latter is caused by the changes
in the structure of the economy (local or national). Structural unemployment
occurs independent of the state of the business cycle and is one of the forms of
unemployment that constitutes the natural rate of unemployment.

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Essay 37
Explain cost-push and demand-pull inflation using two AD/AS diagrams.
(10) (May 2014 TZ1 HL)

Inflation is defined as a sustained increase in general price levels over a period of

time.

Diagram 1

Cost-push inflation is caused by an increase in cost of production or supply side

shocks. In the diagram 1, the economy is producing at its potential output Yp and
the economy is at its long-term equilibrium. Following an economy-wide increase
in the cost of production, the short run aggregate supply will be reduced as less
could be supplied at each and every price level. This is shown by a leftward shift
in the SRAS curve where the new output is Yrec and price level has increased to Pl2.
An example is the 1973 oil crisis where member states of OPEC initiated an oil
embargo against large industrial nations such as the US and UK. As a result, the
price of oil increased 4 times within 6 months and had serious implications on the
supply side of economies as it is a widely used commodity in the production of
many goods. The combination of rising prices with falling output caused by supply
shocks is known as stagflation.

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Diagram 2

Demand-pull inflation is caused by an increase in aggregate demand (AD) in an

economy which can be brought about by any changes in consumption,
government spending, investment and net exports- the determinants of AD. In
diagram 2, the economy is operating at full employment producing Yp. An increase
in government spending would lead to an increase in AD as shown by a rightward
shift from AD1 to AD2. Output will increase to Yinfl and price levels will increase to
Pl2. An example of this is the rise in net exports as a result of the increase in the
number of tourists coming from Mainland China following the implementation of
the Individual Visit Scheme in 2003.

Cost-push and demand-pull inflation are caused by decreases in the aggregate

supply and increases in the aggregate demand of the economy respectively. Both
types of inflation result in similar negative consequences such as uncertainty and
menus costs which may have long lasting effects on an economy if not controlled
to low levels.

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Essay 38
A high rate of inflation may negatively affect both a country’s export
competitiveness and the level of capital investment by firms. Explain why this
is the case. (10) (May 2017 TZ1 HL)

Inflation is defined as the sustained increase in general price levels. Inflation

would lead to increase in the price of exports which will make it more expensive
for foreign countries to purchase its goods and services. As a result, less will be
imported from the country and hence negatively affecting its export
competitiveness.

Diagram 1

In diagram 1, the economy is operating at its potential Yp. Following an increase

in inflation, exports become more expensive and the demand for its export
decreases. All else being equal, net exports and hence aggregate demand
decreases as a result as shown by a leftward shift from AD1 to AD2 and output falls
to Yrec. Note that a fall in net exports will actually lead to a fall in price levels from
Pl1 to Pl2 ceteris paribus. An example of this is Singapore in 2017 which saw net
exports decrease because of the rise in inflation. According to purchasing power
parity (PPP), inflation should lead to the depreciation of its domestic currency as
the demand for the country’s currency will fall following the decrease in the
demand for its exports. This will make exports cheaper and imports more
expensive until net exports resume to its original levels. When PPP holds, inflation
will not negatively affect the country’s export competitiveness ceteris paribus.
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 54 Excellent Economics Essays

But given that exchange rates may also be affected by a lot of other factors such as
the flexibility of the exchange rate regime, the restoration of the export
competitiveness is not guaranteed.

Inflation negatively affects the level of capital investments by firms primarily

because of the uncertainty it creates. With high inflation, firms are less willing to
invest heavily because it will be more difficult to forecast costs and revenues as
this will be affected by future prices of the input for their products. However, it is
interesting to note that some economists have argued that some inflation is good
for capital investments. Spooked by very stable prices i.e. inflation close to zero,
the head of the Japanese Bank of Japan Haruhiko Kuroda argued that since firms
cannot expect nominal revenues to increase in the coming years via inflation,
firms would seek self preservation by cutting costs and reducing capital
expenditure.

Inflation is generally regarded as having a negative impact on export

competitiveness and capital investment due to the changes in prices and the
uncertainty it creates.

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Essay 39
Deflation is a more serious problem than inflation for the economy of a
country. Discuss this view. (15) (May 2013 TZ1 SL)

Inflation and deflation is defined as the sustained increase and decrease in general
price levels respectively. Inflation is seen as having negative impacts over the
economy because of the negative consequences that it produces on the economy.
It erodes the value of cash over time and impacts workers who are paid fixed
wages as their purchasing power would decrease. Furthermore, it creates
uncertainty as people are not able to predict future changes in purchasing power
(of income, wealth and income as measured in terms of money). Firms would be
reluctant to make large scale investments as they are unable to make accurate
forecasts of the future costs and revenue.

Diagram 1
Compared to inflation however, many argue that deflation poses a more serious
problem. In diagram 1, the economy is currently at full employment and Yp output
has been achieved. Following a decrease in aggregate demand (AD), the AD curve
shifts from AD1 to AD2 and the economy moves to a recessionary gap where Yrec
levels of output is produced and price levels move to Pl2 signaling that deflation
has taken place. The decrease in prices may set up a deflationary spiral which has
more dire consequences than inflation. When prices for a single period fall,
consumers may delay their consumption decision because they may expect prices
to continue to fall. It may also discourage borrowing by consumers and firms as
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 54 Excellent Economics Essays

the real value of debt increases as price level falls and they may not be able to
service the debt. As a result, AD will fall further and the real output will continue
to fall below Yrec. This is the case in Japan since the early 1990s where prices have
been largely stable or falling due to falling aggregate demand owing lack of
consumer confidence and the import of cheap products from countries like China
i.e. “imported” deflation.

However, not all forms of deflation are bad. A growth in the country’s technology
would lead to an outward shift in the countries long run aggregate supply curve
(LRAS) as more can be produced at each and every price level. In diagram 1, this
is seen as an outward shift in LRAS where real output has increased to Ym and
price levels fall to Pl2. This is good deflation as it is associated with economic
expansion, rising incomes and output and increasing employment and growth.
This was the case in the UK and the US during the late 19th century when both
countries became heavily industrialised and they were able to benefit from the
economies of scale by producing products such as steel and ships at a significantly
larger scale with modern production methods e.g. mass production.

Furthermore, it is uncertain that the consequences of deflation would be worse

than hyperinflation, a severe form of inflation where technically refers to a
situation where price levels increase by more than 50% per month. The most
famous example is the hyperinflation which took place in Germany during the
1920s where the price level in 1924 is 100 trillion times higher than that in 1914.
Under such circumstances, the economy is thrown into disarray as money
basically loses its value and can no longer be a unit of account. Workers would
demand higher wages and immediately spend it in fear of the currency further
losing their value and hence fueling a further wage price spiral. Business stop
investing in productive activities and firms will withhold selling their goods
because the cash they receive will not be worth much or they could sell it later at
a higher price. In the most extreme case, the economy will revert to a barter
economy where goods are exchanged directly for one another and hence creating
inconvenience as the double coincidence of wants would need to be satisfied.

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In my judgment, when a choice is made between moderate inflation and moderate

deflation caused by falling demand, the latter would probably present a more
serious problem as it will lead to a fall in real output whereas the former leads to
inconveniences such as uncertainty which could be minimized through policy
control. However, deflation can also be good when it is created by improvements
in the economy's productive capacity and will definitely be more desirable than
when the economy undergoes hyperinflation for reasons discussed above.

Mr. Lai’s notes: Due to the simplicity of the diagrams used, falling prices could also
refer to disinflation (vs. deflation) but it is fine for these purposes. Comparing the
seriousness of stagflation against deflation is also a valid line of argument.

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Essay 40
Explain why the economy will always return to the full employment level of
output following a recession with the use of the monetarist/new classical
model. (10) (November 2015 TZ0 HL)

In the monetarist/new classical framework, full employment of output is defined

as when the economy’s unemployment level is at the natural rate of
unemployment where structural and frictional unemployment are also included.
This framework proposes that following a recession; formally defined as a fall in
GDP for 2 consecutive months but simply the economy is operating less than its
potential output in this framework, the economy will be able to restore itself to
full employment through the assumption of perfectly competitive markets and
flexible wages.

Monetarist/new classical model of economy

Illustrated in the diagram above, the economy’s equilibrium is currently at Pl1Yp

where output is at full employment level. Due to a rise in interest rates, the cost
of money increases and the level of investment falls, triggering a decrease in the
aggregate demand as reflected from the shift from AD1 to AD2. As a result, real
GDP falls from Yp to Yrec and the price level from Pl1 to Pl2. Note that as the
economy is producing below its potential of Yp to Yrec, a recession is created
through the recessionary gap of Yp - Yrec created. Lower aggregate demand implies

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lower demand for the factors of production, including labour which is either
underemployed or simply being made redundant.

Note that as the AD shifts to the left, it leads to a downward movement on the short
run aggregate supply curve (SRAS) which assumes constant wages in the short
run. Given lower prices of Pl2, firms find it difficult to sustain wages at the current
level and would look to maintain profitability by lowering wages. Assuming
flexible wages and the fact that workers are in a position of weakness (higher
levels of unemployment relative to the natural rate), wages would decrease. The
cost of production for the firm would therefore decrease, allowing them to
produce more at each and every price level. Graphically, this is shown by a
rightward shift in the SRAS curve from SRAS1 to SRAS2 and the long run
equilibrium of Yf where potential out is restored.

From the above, it is clear that the assumption of flexible wages drives the process
which allows the economy the restore itself to full employment. This model fits
best in countries where the labour market is flexible and there are few market
rigidities such as minimum wages and trade unions which hinders the labour
markets ability to readjust itself. An example of this would be Hong Kong where
minimum wages are relatively low and labour unions are far less powerful than
their European counterparts.

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Essay 41
“An increase in aggregate demand will always be inflationary.” Evaluate this
view. (15) (November 2015 TZ0 HL)

Aggregate demand (AD) is the total demand for final goods and services in an
economy at a given time. An increase in AD may be inflationary, as defined as a
sustained increase in the general price level, depending which framework one
views the economy through.

According to the monetarist/new classical model, an increase in AD will be

partially inflationary in the short run and purely inflationary in the long run.
Consider the diagram below.

Monetarist/new classical model of economy

The economy is currently operating at the long run equilibrium of price level Pl1
and producing real GDP of Yp, which is the potential output of the economy where
all resources are essentially employed i.e. natural rate of unemployment. Should
AD increase through a rise in government spending, the AD curve will shift from
AD1 to AD2. Note that the impact of the shift in AD is only partially inflationary (so
far). Indeed price level has increased from Pl1 to Pl2 but real GDP has also increase
from Yp to Yinfl in the short run.

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However, producing Yinfl is unsustainable as it is operating beyond the economy’s

potential output. Put another way, when prices increase through a shift in AD,
wages are still assumed to be held constant in the short term as represented by an
upward movement along SRAS1. Given that labour resources are scarce, workers
are in a powerful bargaining position and would ask for a wage increase to
compensate for the rise in the general price level. Following an increase in wages,
cost of production increases and less could be produced at each and every price
level. Graphically, this is shown by a leftward shift in the SRAS curve from SRAS1
to SRAS2. Note that the resulting P3 and real GDP produced demonstrate that an
increase in AD is purely inflationary. Whilst prices have further increased to Pl3,
output has returned to the potential output level of Yf. In other words, an increase
in AD has only managed to increase price levels in the long run with no impact on
output at all.

This is viewed differently from the Keynesian perspective which assumes

inflexible wages (“wages are sticky downwards”) and resulting fact that the
economy could operate with unemployment over a sustained period of time. An
increase in AD could be inflationary or not, depending at the unemployment status
at the time.

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In the diagram above, the AS curve is represented by a reverse L shape. Section

one (0rigin-Y2) is where there is unemployment of resources. If AD was to
increase in this section, perhaps through an increase in government spending
which would lead to a shift from AD1 to AD2, this would lead to an increase in real
GDP (Y1 to Y2) without causing any increase in price levels (maintained at Pl1) i.e.
AD increase is not inflationary at all. The underlying intuition is that when
resources such as workers are abundant, firms are able to employ more of them
without paying higher prices. Workers are in a weak bargaining position as they
have no incentive/ability of asking for higher pay. This was the case in Hong Kong
when unemployment was at high levels following the SARS epidemic in 2003.
Attempts by the government to stimulate the economy via tax breaks and other
concessions did not lead to any meaningful increases in wages.

At section 2 (Y2 to Yp), the AS curve is upward sloping meaning that the supply of
workers is becoming scarcer in the market. An increase in AD from AD2 to AD3
can still increase real GDP (Y2 to Y3) but given the relative scarcity of workers in
the market, firms cannot hire more workers without raising wages. Here, an
increase in AD is partially inflationary as an increase in GDP also leads to an
increase in general price levels. This is the case in China in 2006 the economic
growth rate was high and there was great demand for resources. GDP increased
by around 8% that year but wages also increase by an average of 6% across the
country. In section 3 (Yp to Ymax), all resources are used up in the economy and
any further increases in AD will not lead to higher output. Any attempts to do so
such as increase AD4 to AD5 only results in pushing up price levels as people are
essentially bidding against each other for the same resources. Increases in AD are
purely inflationary in this section.

Whether an increase in AD is inflationary or not depends on the state of

unemployment within the economy. If resources are fully utilized i.e. all workers
are employed, both the Keynesian and monetarist/new classical model would
agree that an increase in AD is purely inflationary and supply side measures would
be needed to generate further growth. On the other hand, when unemployment
exists in the economy, the Keynesian puts forward that an increase in AD would

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not be inflationary at all. The monetarist/new classical view admits at best that
the economy is partially inflationary in the short run but totally inflationary in the
long run, given its assumption of flexible wages. Comparing the two, Keynesian
seems to conform more to reality as labour markets are imperfect and
unemployment do exist over a long period of time as can be seen in many
European countries such as Greece, Spain and Italy where unemployment rates
have been in double digits (22%, 18% and 11% respectively now) for many years
after the financial crisis. Inflation rates have been very low, even when the
government has attempted to stimulate the economy through tax deductions,
proving that increases in AD need not to be inflationary.

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Essay 42
Explain how the Gini coefficient is derived and interpreted with the use of a
Lorenz curve. (10) (May 2014 TZ1 SL)

The Lorenz curve is a graphic way of reflecting the degree of income inequality
within an economy. It is used to calculate the Gini coefficient which is a numerical
value that reflects income inequality.

In the graph above, the vertical axis is the cumulative percentage of income and
the horizontal axis is the cumulative percentage of population. The latter is
divided into quintiles and is ranked in order of ascending wealth. For example,
40% refers to the poorest 40% of the population and for country 1, it owns 10%
of the country’s wealth as shown in the vertical axis. The Gini coefficient is the
ratio between the area bound by the country’s Lorenz curve and the diagonal
straight line (which reflects perfect equality) to the total area underneath the
diagonal line. For country 1, this is reflected by the expression A/(A+B+C). Since
the area bound by the curve and the diagonal line must be equal or smaller than
the area under the curve, the value of the Gini-coefficient must between 0 and 1.

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The more convex the Lorenz curve, the greater the inequality. Consider the Lorenz
curve in Country 2, the richest 20% owns 80% of the country’s wealth as opposed
to the same quintile owning 68% in country 1. The Gini coefficient will necessarily
be higher since the area bound by the curve and the diagonal line includes area B
and the coefficient can be expressed as (A+B)/(A+B+C). Should there be extreme
inequality where one person owns the entire country’s wealth, the Gini-coefficient
would be very close to 1.

The Gini-coefficient is derived by dividing the area bound by the Lorenz curve and
the diagonal line to entire area below the diagonal line. The larger the Gini-
coefficient, the greater the income inequality.

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Essay 43
Evaluate policies set by the government that could be used to promote a
more equal distribution of income. (15) (May 2014 TZ1 SL)

The distribution of economy refers to the extent which income is being distributed
to people within a country. Great income inequality leads to social problems such
increasing poverty and interclass conflict and governments may adopt policies to
create a more equal distribution of income.

The most common type of policy is for the government to make transfer payments
to individuals for the purpose of redistributing income away from wealthier
groups and towards other groups. Those who receive the payments are the
vulnerable groups such as sick people, very old people and children of poor
families. Such transfers may include disability pensions and unemployment
benefits which are funded via taxation. There are many types of taxation which
can be implemented such as personal income taxes, a tax on income, corporate
income taxes (taxes on corporations) and wealth taxes (taxes on ownership of
assets such as property). Income tax is the most significant of the three types of
taxation and includes taxes on wages, rental income and interest income.
Assuming that the country has a proportionate or progressive taxation system, the
rich should pay more in absolute terms. Transfers are effective in promoting a
more equal distribution of income but a number of issues occur. First, there is a
question of fairness and even if the rich should pay more tax than the poor, how
much more should they pay. Also, there is also the notion whether equality
actually leads to a fairer distribution since a meritocratic society may argue
against it.

The second method is for the government to subsidize and directly provide the
merit goods. Merit goods refer to goods which are beneficial for consumers and
often produce positive consumption which are underprovided by the market and
under consumed. Examples include education and healthcare. The argument here
is that if left to the market, such goods would be underprovided. Not only would
the government need to provide it, they must ensure that it is affordable to the
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 54 Excellent Economics Essays

lowest income groups. Many developed countries and city states such as Hong
Kong provides free education up to secondary levels and health care for its
citizens. A more distribution of income has occurred as government has made
certain goods available to poor people who would otherwise not be able to afford
it. However, one must also think about the quality of the goods produced and not
for its namesake. The Hong Kong government has a very advanced healthcare
system but the care provided by the state for serious illnesses such as cancer is
considered to be far rudimentary compared to the private sector, and patients
have to wait much longer for life saving procedures compared to the rich. One
may argue that this is natural given that the product is free but one may also argue
to whether the good has been genuinely provided for them and whether all on an
equal setting.

It must be noted that the government intervention to promote a more equal

distribution of income inevitably leads to welfare losses.

In the diagram above, the firm is operating at P1Q1 where the demand and supply
curve are D and S1 respectively. When a per unit subsidy of P3-P1 is imposed, it
will shift allow the supply to increase from S1 to S2. As a result, consumers pay a
lower price and are able to buy more at Q2 as reflected in the increase in consumer
surplus in area b+d+e. This makes the product more affordable which allow a
wider population base to consume the product, hence narrowing the level of
wealth disparity. Producers also gain as their effective price has increase to P3
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 54 Excellent Economics Essays

and are selling more at Q2 which is reflected in the gain in producer surplus in area
a+c which may allow small businesses more capacity to survive the competition.
However, the gains for consumers and producers is less than the amount the
government spent on subsidizing the product Q2(P3-P2) and hence a deadweight
loss of area f is generated. The allocation is deemed allocatively inefficient with a
subsidy.

Transfers, direct provision and subsidies are two policies which promote a more
distribution income. However, the extent they should be used, issues with fairness
and the welfare loss are considerations which the government consider before
using them.

Mr. Lai’s notes: An interesting development is that many leading entrepreneurs are
calling for the provision of a universal basic income where people would be given
some cash to support their basic needs and would lead to more risk taking in the
form of starting businesses and generate wealth to a wider range of people.

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Essay 44
“The market system may not result in an equitable distribution of income.”
Explain why this is the case. (10) (May 2013 TZ1 HL)

The market system allocates resources according to the forces of supply and
demand with price acting as the means to ration, incentivize and to signal.

According the circular flow of income, the amount of goods received by consumers
in an economy depends on their level of income, which in turn depends on
payments they receive by selling their factors of production (land, capital, labour
and entrepreneurship). The amount of money they receive from selling the
factors of production in contingent on the factor prices and the quantity of
resources which they have. The income distribution problem that arises from this
system is that the ownership of the factors of production can be highly unequal.
For example, most people possess the labour skills which they can employ to make
a return in the form of wages. However, some people are either more skillful than
others or possess a skillset which are rewarded more richly in a market based
economy e.g. doctor vs. cleaner. Those who are poor may not be able to buy even
the most basic needs such as food, clothing and shelter. For those who do not have
any skills, they would be unable to earn any wages which would mean they would
not receive any goods and services unless they have other factors of production to
sell, which will be unlikely given their circumstances.

Income inequality is further enhanced by the fact that the highest earning
individuals are often further gifted with other factors of production such as land,
capital and entrepreneurship. Given the wide array of opportunities to invest, the
deployment capital to money managers to directly on stocks and bonds have only
made the rich richer and widened the income distribution gap.

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In the Lorenz curves above, the USA has a Lorenz curve which is closer to the 45
degree line than China meaning that it has a more equal distribution of income
than China. The reason for this is because China has great disparity between
Coastal cities such as Shanghai and Shenzhen compared to the western regions of
Chongqing. Apart from the greater trading activity which takes place along the
coast, it was also because the coastal cities were designated as special economic
zones and were given preferred treatment and much more investment resources
as compared to the rest of China. Hence, people living there are far richer
compared to those living in the inner regions. On the other hand, whilst income
equality also takes place in the US, the geographical disparities are less
pronounced as natural resources are more equally distributed and its longer
history of peace allowed the government to redeploy resources to poorer regions
and grow them.

The market only reflects the forces of demand and supply and there is no
mechanism to address unequal distributions of income. Hence, a market
determined distribution of income in an economy is likely to be very unequal as
the allocation of the factors of production are unequal in the first place and people
in their respective wealth positions become increasingly entrenched.

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Essay 45
Evaluate policies imposed by the government to promote equity in terms of
their effects on efficiency in the allocation of resources. (15) (May 2013 TZ1
HL)

Equity is the concept of how fairly resources are distributed whereas efficiency
refers to the extent which resources are allocated in such a way where there is
minimal wastage. The free market economy allocates resources according to the
forces of demand and supply with prices serving the role of signaling, providing
incentives and rationing. Efficiency is achieved where demand equal supply as it
is also where marginal benefit (MB) equals marginal cost (MC) and no extra utility
can be gained by consuming/producing more. When the market is working
perfectly and there are no externalities, the market is allocating resources
efficiently but there is no guarantee that the market will be allocating resources in
an equitable manner, hence the need for government intervention to reallocate
resources. There are many definitions of equity and the equal distribution of
resources is one way of defining it. For the purposes of this essay, equity would
be discussed in the context of equality.

The government may enhance the equity within society by intervening in a

number of ways such as taxation, increasing expenditure on merit goods and the
provision of subsidies. In the case of providing subsidies, the government would
provide financial subsistence to producers to allow them earn higher levels of
revenue and in turn profit.

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In the diagram above, the firm is operating at P1Q1 where the demand and supply
curve are D and S1 respectively. When a per unit subsidy of P3-P1 is imposed, it
will shift allow the supply to increase from S1 to S2. As a result, consumers pay a
lower price and are able to buy more at Q2 as reflected in the increase in consumer
surplus in area b+d+e. This makes the product more affordable which allow a
wider population base to consume the product, hence narrowing the level of
wealth disparity. Producers also gain as their effective price has increase to P3
and are selling more at Q2 which is reflected in the gain in producer surplus in area
a+c which may allow small businesses more capacity to survive the competition.
However, the gains for consumers and producers is less than the amount the
government spent on subsidizing the product Q2 x (P3-P2) and hence a deadweight
loss of area f is generated. The allocation is deemed allocatively inefficient with a
subsidy. The same case occurs for a tax. Governments may implement an indirect
tax on certain high price items such as spirits and cars to raise tax revenue which
can then be used to provide services for the poor. Assuming that the goods are
merit goods, the tax acts as a wedge as it does not allow social surpluses to be fully
maximized.

Furthermore, the provision of transfer of payments such as unemployment

benefits may deter people from fully employing their efforts for employment. This
might be particularly the case in countries where welfare and tax rates are
particularly high and may act as a disincentive for people to enter the workforce.

However, It must be noted that government policies can serve to promote

efficiency and equality at the same time. The market working by itself is
susceptible to market failure, hence allocative inefficiency and may need
government intervention to rectify the problem. An example of this is public
education. Being a merit good, education generates positive externalities which
are not accounted for by third parties which leads to an under provision of the
service. The government can overcome the under provision by subsidizing
education and increasing the number of people who could take it. The provision
of education serves to improve the productivity of the masses and allow the poor
the climb the social ladder, hence lessening the wealth disparity within the
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 54 Excellent Economics Essays

country. This was the case for Singapore which offered universal free primary
education since the 1960s and played a critical role for helping Singapore achieve
industrialization and become one of the leading countries with the highest
GNP/capita with a relatively low Gini coefficient of 0.46.

From a practical perspective, efficiency is a rather meaningless positive

abstraction if society is not happy with the distribution of resources. Hence,
governments around the world should still adopt policies which promote equality
even if it leads to reductions in efficiency, not to mention the situations in which
the policies can achieve both at the same time as outlined above.

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Essay 46
“The benefits of economic growth will always outweigh the costs.” Evaluate
this view. (15) (May 2014 TZ1 HL)

Economic growth is defined as the increase in real output over a period of time.
Whilst the benefits of economic growth is quite obvious as it is often a paramount
macroeconomic objective aspired by countries, whether is should be achieve
regardless of cost is debated.

Economic growth is desired by countries as it is a key component of economic

development. Rising national income, especially if it is measured on a per capital
basis would lead to higher standards of living as people would be able to afford
more goods and services. This is especially so for developing countries where
rising incomes can lift people out of extreme poverty. Indeed, the rapid double-
digit growth in China from the early 1980s to the mid 2000s has been credited for
lifting more than 800 million people out of poverty. Secondly, economic growth
can stimulate jobs and contribute to lower unemployment rates which in turn help
reduce inequality and social ills such as crime and youth delinquency. Finally,
economic growth can lead to a fiscal dividend where, with higher income, income
tax will increase and raise tax revenues for public good and projects such as
infrastructure and healthcare. Through the multiplier effect, rising incomes can
lead to proportionately higher levels of growth.

Hence, arguments against economic growth are not about whether it ought to be
desired but rather the cost incurred to achieve it. For many developing countries,
economic growth is achieved at the expense of the environment and irreversible
impacts on sustainability. In Brazil, over 700,000 square kilometers of the
Amazonian rainforest have been removed to make space for other industries such
as cattle ranching and to sell its resources through logging and mining. As
resources are finite, the extraction of resources is unsustainable and the
international community is suffering the externalities imposed by Brazil’s actions
through global warming and rising seas levels. Brazil is also feeling the pain as
deforestation has been attributable to the droughts it has been experiencing in the
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 54 Excellent Economics Essays

last couple of years and affecting people’s livelihoods and the quality of human
capital.

Rapid economic growth may also lead to problems of income inequality and social
divisions. Since the 1980s, China has relied on a number of special economic zones
(SEZ) along the coast such as Shanghai and Shenzhen to spearhead national
growth and hopefully allow the wealth and development to dissipate to the rest of
the country. However, this has not happened and it has been estimated that the
inland-coastal wealth disparity has increased more than 3 folds in China since it
opened its markets up.

However, arguing that these developing countries were wrong to pursue growth
due to the heavy costs incurred is an unfair critique made from first-world biases.
Many of these developing countries are suffering from widespread poverty where
child mortality is extremely high and life expectancy to be very low; plagued by
problems such as famine and lack of basic medical care for curable diseases such
as malaria. With survival a key priority, developing countries are forced to adopt
the quickest way to grow economically, and often this is to extract its natural
resources and sell it to other countries for export revenue. It does not have the
luxury to consider more sustainable ways of growth with survival such as a
pressing issue. Hence one would argue that developing are justified in pursuing
growth which may have serious consequences to the environment in the short
run.

For developed countries however, governments can consider means of growth

which are more sustainable in the long run. Economic growth may conflict with
other macroeconomic objectives such as low inflation and policy makers can
consider means of growth which although would imply more moderate growth,
can also put inflation under controllable levels. For example, the US had 10 years
of quantitative easing since the 2008 financial crisis where interest rates were
very low to stimulate economic growth. Seeing inflation rates increasing in 2017,
it embarked on a course of normalization where interest rates were slowly
increased.
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 54 Excellent Economics Essays

Achieving economic growth is one of the most important macroeconomic

objectives of the as it is one of the critical aspects of increasing standards of living.
Developed countries can achieve economic growth whilst trying to minimize its
shortcomings whereas developing countries may achieve it at all cost for the sake
of survival.

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Essay 47
An increase in the level of taxation can influence the level of aggregate
demand in an economy. Explain how this is possible. (10) (May 2016 TZ1 HL)

Aggregate demand is defined as the total demand in an economy and is comprised

of consumption, investment, government spending and net exports. An increase
in taxation would reduce aggregate demand and lead to a fall in the real output of
an economy.

Diagram 1

A increase in taxation can come be in the form of increasing the tax rate on income,
profit or an indirect tax on goods and services such as cigarettes which the burden
are shared by the consumers and producers depending on the tax incidence. Of
all the taxes, an increase in the taxation on income, which includes salary, rent and
other forms of income is the most significant as income tax forms the largest
proportion of the tax collected. In 2017, the Scottish government increased the
tax rate of its highest earners by 1% and would take in an additional GBP 164
million in tax revenue. In diagram 1, this increase would lead to a decrease in
income as people’s disposable income has decrease and could be seen in a
leftward shift in the aggregate demand (AD) from AD1 to AD2. The full extent of
the shift would probably be more than GBP 164 million due to the multiplier effect

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where the decrease in spending by consumers would lead to further decreases in

spending by businesses and other institution since they are making less money
now.

Note that the decrease in aggregate demand may not be permanent as the
government may use the increase in tax revenue to finance public expenditure
such as infrastructure, building and education in which case the aggregate
demand will be shifted back out.

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Essay 48
Evaluate the effectiveness of fiscal policy that can be used to promote
economic activity during a recession. (15) (May 2016 TZ1 HL)

Fiscal policy is the use of government revenue collection and expenditure to

influence the economy. In times of a recession, as defined as two consecutive
quarters of falling GDP, the government can use expansionary policy to stimulate
the economy by increasing aggregate demand (AD). It is able to do so because
government spending, which fiscal policy directly influences is one of the
constituents of aggregate demand together with consumption, investment and net
exports.

In the diagram above, the economy’s level of aggregate demand is at AD1 where
the equilibrium output is Yrec and a recessionary gap takes place as it is producing
at a level below its potential Yp. This was the case in China in 2009 when the
country saw a slowdown in its economy following the global financial crisis. The
Chinese government stimulated the economy directly by implementing
expansionary policy and spent more than RMB 4 trillion on infrastructure and
socially welfare. Graphically, this is represented by a rightward shift in the
aggregate demand curve which would ideally shift back to the position of AD2
where employment thereby the potential output is restored.
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 54 Excellent Economics Essays

Fiscal policy is highly effective in promoting economic activity with direct impact
and guarantees the policymaker that the change in aggregate demand moves in
the desired direction. It is able to impact the economy further through the
multiplier effect where the initial autonomous spending i.e. RMB 4 trillion in
China’s case would lead to further spending in other areas. Furthermore, the
spending is often geared towards investment goods such as infrastructure,
education and health which is able to increase the potential output of the economy
and shift the long run average cost (LRAS) curve outwards to the right.

However, it must be noted that direct government spending can only take place if
the government has sufficient funds to do so. Many countries adopt the fiscal
policy indirectly through tax cuts which would increase the disposable income of
consumers and companies (assuming reductions in income and corporate tax)
and the desired outcome may not be guaranteed. In the case where consumer
confidence is low, such as the Japanese economy in the early 1990s, consumers
would rather save up the extra income instead of spending it. Should the country
choose to pursue expansionary fiscal policy without the funds to do so, it will be
forced to borrow money from the money markets, hiking up interesting rates and
crowd out private investments as firms would find it more costly to fund their
investments. The crowd out effect is disputed by Keynesian economists who
argue that the government stimulus to the economy would improve business
sentiment and encourage investment even if interest rates are higher. Indeed
business confidence is a major boost to investment and many US businesses are
willing to invest in the midst of a healthy economy even when interest rates are
anticipated to rise in 2018.

Although fiscal policies have a direct impact on the economy, its effectiveness is
limited by the time lags for the period after the problem has been identified. A
recession is typically defined as declining GDP for two consecutive periods. Hence,
the government may not be certain whether the economy is entering a minor
correction before going on to further heights or whether it is genuinely heading
towards a recession. Having said that, the modern economies have automatic
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 54 Excellent Economics Essays

stabilisers such as unemployment benefits in place which would help reduce

short-term fluctuations and respond to downturns swiftly. An example is
unemployment benefits where the supposed reduction in consumption as a result
in the lost in income when a person loses his job is dampened as they would
receive unemployment benefits.

Fiscal policy might be more effective if combined with expansionary monetary

policy. The reduction in interest rates does not require funds and unlike fiscal
policy, it allows “fine tuning” of the economy via incremental changes to the
interest rates. It is not surprising to see both fiscal and monetary policy to be often
used hand in hand in stimulating the economy such as the US and China after the
financial crisis in 2009.

Fiscal policy is an effect tool for stimulating the economy if the government can
correctly identify a genuine economic downturn and have the sufficient funds to
do so. If not, the government may crowd out private investments or rely on
reductions in taxation which may have the desired effect should the economic
sentiment be weak.

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Essay 49
Evaluate the effectiveness of interventionist supply side policies that is used
to achieve economic growth. (15) (May 2016 TZ1 SL)

Supply side policies refer to policies geared towards increasing the productivity
of the economy via increasing the quantity and enhancing the quality of the factors
of production. The interventionist approach refers to deliberate attempts by the
government to increase the supply side via spending on areas such as education
and training and research and development.

Training and education would lead to the improvement in quality of labour

resources and would thereby increase labour productivity. Workers become more
employable and the natural rate of unemployment would be reduced via the
reduction in structural unemployment. The government would need to provide
education and retraining directly because education produces a number of
positive externalities which may be underprovided by the market itself as
providers do not take into the account of third-party benefits. In Hong Kong, the
government, through the Education Retraining Bureau (ERB) has been very
successful in retraining older women to become qualified domestic workers to
meet the increasing demand for non-domesticated helpers. In the diagram above,
more productive workers are reflected by an outward shift in the long run
aggregate supply curve (LRAS) meaning that more can be produced at each and

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every price level. The potential output increases from Y1 to Y2 and the price level
drops from P1 to P2 ceteris paribus.

Another example of an interventionist approach on the supply side is the

investment on infrastructure which is a form of physical capital and includes
power, telecommunication and urban transport. For the past 30 years, China has
been investing heavily on its infrastructure, most noticeably the high speed rail
network which has substantially increased mobility of resources e.g. labour
around the country and has proven to be a driving force behind the rapid growth
of the country. Other examples of interventionist supply side policies include
industrial policies which are designed to support growth of the industrial sector
of an economy and investment in research and development in the effort to
improve the quality of capital goods.

It must be noted that interventionist supply side policies to increase economic

growth is much more effective in the long run as the impact takes time to
materialise. For example, infrastructure takes time to build and workers need to
be retrained. Fortunately, many interventionist policies is generated through
government spending and has an impact a direct impact on aggregate demand and
therefore can help to close a recessionary gap. This is the case in China where
there has been concerns that the government has been spending a lot of money on
infrastructure for the sake of maintaining short-term GDP goals rather than for
the sake of enhancing the productive capacity of the economy. Interventionist
policies could contribute to destabilizing the economy by adding to inflationary
pressure should the economy be experiencing inflation.

Being interventionist in nature, many question the government’s ability to make

the right decisions and their interference may result in less efficient outcomes due
to the influence of political pressures and lack of necessary information.
Proponents of market-based policies would argue that the market is better
positioned to increase the productivity of the economy providing that appropriate
incentives are in place and the price mechanism can efficiently reflect to aspiring
entrepreneurs which industries have the highest potential for growth. An
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 54 Excellent Economics Essays

example of this is privatisiation where state owned industries are put in the hands
of private firms who have an incentive to cut costs and produce goods and services
more efficiently. This was the case in the UK during the 1980s where the Thatcher
government privatised a number of state-owned companies such as British
Aerospace and British Airways. Economic growth is generated through higher
profit earned. In addition, market based policies requires much less government
spending than the interventionist approach. Such spending could be used on
better alternative uses elsewhere and often requires substantial amounts of tax
revenues for financial support. This may return to negatively affect the economy
as higher taxes would create disincentives to work, hence lowering economic
growth.

Having said that, it must be noted that interventionist policies presupposes that
the free market economy cannot achieve the increase in potential output by itself,
hence the intervention needed in specific areas. Economic history points to the
successful cases of the Asian tigers; Hong Kong, Taiwan, Singapore and South
Korea which has achieved very high rates of growth through the use of highly
interventionist policies focusing on investment in human capital and industrial
policies. These countries lack any natural resources but yet have been able to
achieve much higher economic growth than countries blessed with more natural
resources e.g. Brazil and countries in Africa.

Interventionist supply side policies are most effective when the government
invests on the infrastructures for an economy to grow upon. In addition to
physical capital such as roads and bridges, this also includes general education,
healthcare, a sound legal system for businesses to operate in. In areas which are
industry specific such as which products to produce, the market may be in a better
position to make those decisions and the government can provide the necessary
market based framework to increase such capabilities through market based
policies such as privatization and deregulation.

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Essay 50
Explain how an increase in interest rates may influence the level of
aggregate demand in an economy. (10) (May 2016 TZ2 SL)

Interest rates is defined as the cost of money to borrow and the central bank
often adjusts the interest rates to influence aggregate demand and in turn the
level of real output. Aggregate demand is defined as the total demand for goods
and services in an economy and comprises of consumption, investment,
government spending and net exports.

The central bank would increase interest rates using open market operations. In
order to reduce the supply of money in an economy, it would sell bonds to the
market in exchange for money. In the diagram above, the supply of money would
decrease from MS1 to MS2 and assuming that the demand of money stays constant,
the price of money i.e. interest rates would increase to IR2. Increasing the interest
rates would make it more expensive for consumers and businesses to borrow
money and would lead to a decrease in aggregate demand (AD) as consumption
and investment are determinants of AD. Furthermore, the increase in interest
rates would lead to more capital inflow as investors from abroad wants to
capitalize on the higher returns. The domestic exchange rate would appreciate
and it would improve the terms of trade as the price of exports would become
more expensive and imports are cheaper. The balance of trade, however, would
deteriorate as the fewer goods and will be exported and the value of imports
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 54 Excellent Economics Essays

would increase. This would lead to a decrease in net exports, hence pushing
aggregate demand further down.

Increasing interest rates are often used to eliminate inflationary gaps in the
economy. During the stock market boom in 2006, the Chinese government
believed that the economy is overheating and increased interest rates (one year
lending rate) by 27 basis points. Represented in the classical/monetarist diagram
of the economy above, the increase in interest rates has led to a decrease in AD to
AD1 which is graphically shown as a leftward shift in the aggregate demand curve.
The general price level decreases and the output level decreases from Yinf to Yp.

Mr. Lai’s notes: Many students forget that interest rates also affect exchange rates
besides consumption and investment which has an impact on the balance of trade.

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Essay 51
Evaluate the effectiveness of monetary policy which may be used when an
economy is in deep recession. (15) (May 2016 TZ2 SL)

Monetary policy refers to the measures carried out by central banks to influence
economic activity through the changes of money supply. It is adopted to stimulate
economic growth when the economy is in a recession, as defined as two
consecutive quarters of declining GDP, though its effectiveness is somewhat
limited in a deep recession, generally defined as a recession lasting more than a
year.

When the economy is an economic recession, the central bank may lower interest
rates to stimulate aggregate demand. It does so through open market operations
where it increases the money supply by buying bonds from the financial markets
and releasing money to the economy. As the supply of money has increased, the
cost of money i.e. interest rates will decrease making it more affordable for
consumers and firms to borrow money for the consumption and investment
activities. Furthermore, a lower interest rate will lead to an outflow of capital as
returns are lower leading to more of the domestic currency being supplied.
Assuming a flexible exchange rate regime, the domestic currency will depreciate
leading to an increase net exports as the value of exports and imports will increase
and decrease respectively. As illustrated in the diagram above, an increase in
consumption and investment will lead to an increase in aggregate demand (both
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 54 Excellent Economics Essays

being determinants of AD) and the AD curve will shift to the right. Theoretically,
the output level will increase from Y1 to Y2 and the economy will be brought out
of a recession ceteris paribus.

The effectiveness of the monetary policy depends on how responsive banks are
willing to lend money to consumers and firms and consumers and firms to borrow
money from banks. In a deep recession, neither may be likely. During a recession,
banks may make the borrowing requirements such as the level of prior income,
length of job history for consumers or the financial profitability of firms more
stringent to ensure that the borrowers can repay the loan during such
economically stringent times. Similarly, levels of consumer confidence will be low
in a deep recession and people would be unwilling to spend even if they can easily
borrow money. An example of this is Hong Kong in 2003 when the SARS epidemic
affected Hong Kong and even when property prices dropped substantially, the
number of transactions was still sparse. Firms are unwilling to invest in a deep
recession because they are unsure whether they can recoup the costs from their
capital investments. This is the case in Brazil where even when the Brazilian
Central Bank cut interest rates for the first time in four years by 0.25% in 2016,
investment continued to be weak and remained 30% below the peak in 2017
when the country emerged from the recession due to President Temer’s
corruption scandal.

Hence, monetary policies may only be effective in the long run when the issues
underlying the low consumer and investment confidence such as an epidemic and
corruption scandals have been resolved. In the short run, the government may
have to resort to more direct intervention in the form of fiscal policy such as
increasing government spending on welfare or giving cash directly to people to
spend. An example of the latter is Macau which has been known to give its citizens
around USD 600- USD 1000 each year since 2008 which has known to enhance a
high degree of consumer confidence. Note that fiscal policy in the form of reducing
taxes may have a limited impact as it consumers and firms may not be incentivized
to spend more such as the case with falling interest rates.

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Essay 52
Giving examples, explain the impact of automatic stabilizers on an economy.
(10) (May 2016 TZ2 HL)

Automatic stabilizers are policies which are put in place which stabilizes the
economy by reducing the short-term fluctuations of the business cycle without
any direct intervention by government authorities. As a result, the economy will
be subject to less shocks and fluctuations.

Progressive income taxes are an example of automatic stabilisers. Such taxes

works by taxing people who earn higher income a higher proportion of income
and vice versa. When the economy enters the upswing of a business cycle where
real GDP and income rises, the government tax revenue automatically increases
as the increased income would be taxed at a higher tax bracket. Disposable
income would be lower than it otherwise would be and hence will put downward
pressure on consumption and lead to a lower than expected aggregate demand
(AD) by virtue of being a determinant of AD. As illustrated in the diagram above,
the economy is currently at Y1 and an upswing in the business cycle should
increase AD from AD1 to AD3, hence achieving an output of Y3. However, due to
the dampening effective of the progressive tax, the increase in AD would only
increases to AD2 with output at Y2

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In a recession however, the level of tax revenue would be lower as income and real
GDP falls and income streams would be taxed at a lower taxed bracket. Disposable
income would be higher than it would otherwise be and consumption would be
enhanced, thereby exerting an upward pressure on aggregate demand. Using the
same diagram above, the downswing of the business cycle should have shifted the
AD curve from AD1 to AD5 but due to the enhancing effect of the progressive tax,
it would only shift to AD4 and output would fall to Y4 instead of Y5. Note that a
proportionate tax would also have the same impact but the moderating effects
would not be as pronounced as the tax rates stays the same at all levels of income.

Unemployment benefits are another type of automatic stabilisers. When the

economy experiences an economy downturn, aggregate demand would decrease
and more people would be made unemployed. With lower income, consumption
would drop and real output would fall from Y1 to Y5 in the diagram above, ceteris
paribus. However, unemployed people are entitled to unemployment benefits
which would compensate for the lost income to a certain extent. Consumption
would not drop as much and output would fall to Y4 instead of Y5. When the
business cycle enters an upswing, people who are previously unemployed will be
likely to find jobs and consumption increases less than it would in the elimination
of the unemployment benefits.

Note that the progressive taxes and unemployment benefits will not be able to
eliminate the inflationary and deflationary gaps by itself but can help to reduce
the severity of those gaps.

Mr. Lai’s notes: Make sure that the impacts of the stabilizer on both an upswing and
downturn are discussed. The concepts of MPT and MPC could also be discussed in
this question.

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Essay 53
The problem of unemployment can be reduced through the use of supply-side
policies. Discuss this view. (15) (November 2014 TZ0 HL)

Unemployment refers to the people who are willing and able to find work but
cannot find any. Supply side policies are policies implemented by the government
to expand the potential capacity of the economy and one of the ways of
overcoming unemployment.

In the diagram above, the economy is operating at its full potential Yp and there is
at full employment as it is operating at its natural rate of unemployment. Whilst
this means that there is no cyclical unemployment, unemployment caused by low
levels of aggregate demand, structural unemployment, seasonal and frictional
unemployment exists. Supply-side policies are most useful in reducing structural
unemployment and it can be categorised between interventionist and market-
based policies. Graphically, this would lead to an outward shift in the LRAS curve
which would increase output to Yp2 and reduce the level of structural
unemployment.

Interventionist policy is very effective in reducing structural unemployment

which causes are specific and can be addressed directly. It presupposes that the
market is not able to achieve the desired results by itself. Following the movement
from a manufacturing based industry to a service based industry and many
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 54 Excellent Economics Essays

factories moved up to China, many women in Hong Kong were made redundant
and struggled to find work in the service economy as they were generally less well
educated. Through the Employees Retraining Board (ERB), the government
provided retraining to such workers and many of them became qualified domestic
helpers which was in great demand given that many families had two working
parents. The government could also invest in areas which they see great potential
for growth and provide the ecosystem for such industries to thrive. In recent
years, technological startups and app development industry has started to build
momentum in Hong Kong but the lack of affordable real estate meant that many
companies found it hard to expand. As a response, the Hong Kong government
recently invested HKD 50 billion into the industry of which HKD 30 billion would
be dedicated to building a science park in the northern part of Hong Kong which
could house more than 2000 startup companies. As a result, this could reduce
structural employment amongst the technology sector

A very powerful way of increasing the capacity of the economy for the government
to be involved in the investment in new technology which may improve
productivity by many folds. In Australia, tax breaks are given for companies which
undergoes research and development and in the US there are schemes which the
government subsidizes R&D efforts to encourage more innovation. It is important
to note that an interventionist approach does not require the government to be
directly involved with the production e.g. investing in the technology unilaterally.
There will be more opportunities for those in the research and development
sector. Apart from not having the necessary knowledge, the reason for this is
because it would be far better off for the private sector to determine which areas
are worth investing and allow them to drive the initiative.

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Market-based supply policies such as labour market reforms are also used to
reduce unemployment. By weakening the power of trade unions, workers are less
likely to be able to secure high wage increases and allow the labour market to
respond to the forces of demand and supply. Wages can fall in times when the
labour demand is weaker, hence reducing the level of unemployment. Similarly,
by reducing the level of unemployment benefits, it would encourage people to
seek employment reduce the time they become unemployed.

Note that supply side policies are not effective in overcoming cyclical
unemployment which is caused by the lack of demand. In the diagram above, the
economy is operating at Yk where this unemployment caused by the lack of
demand (Keynesian perspective). Even if there were policies which successfully
extends the productive capacity of the economy from AS1 to AS2, there real output
would remain at Yk. It is also ineffective in reducing frictional unemployment
which could only be improved through better access to information about the job
market. Supply side policies are long term in nature and are not suited to
overcoming unemployment which require more immediate remedies.

Therefore, supply side policies are only effective in reducing unemployment

which are structural in nature. Should the unemployment be cyclical, frictional or
seasonal in nature, then other solutions are called for. In the real world, a country
is most prone to structural unemployment when the economy transitions from a

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primary –secondary – tertiary dominant economy. In order to ensure that the

transitions are done in a smooth manner where structural unemployment is
minimized, the government ought to ensure that its workers are suitably trained
and its education system is well suited for such changes.

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Essay 54
“The use of monetary policy is always the best way to reduce inflation.” Discuss
this statement. (15) (May 2017 TZ1 HL)

Monetary policy is a demand-side measure which sought to influence economic

activity by influencing the interest rates. One such area is the rate of inflation, as
defined as the sustained increase in general price levels where policy makers have
an incentive to keep it at low sustainable levels to minimize the costs associated
with it such as uncertainty. Whilst monetary policy is generally an effective way
of reducing inflation, it may not be the best measure under all circumstances.

Monetary policy is effective in addressing inflation because of the direct impact it

has on aggregate demand. In the diagram above, the economy is experiencing an
inflationary gap as Y1 is greater than Yopt. The price level of P2 is considered too
high as compared to P2 and the central bank wants to reduce the level of inflation.
By using open market operations, the central bank will increase the level of
interest which will have a direct impact on reducing AD due to its influence on
consumption, investment and net exports; all determinants of AD. As people find
it more expensive to borrow money, consumers and firms will it more costly to
fund their consumption and investment activities. Higher interest rates will lead
to an inflow of capital from countries where returns are lower, leading to an
appreciation of the domestic currency. Whilst the terms of trade would improve
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 54 Excellent Economics Essays

where export and import prices goes up and down respectively, net exports would
decrease as the value of exports and imports would decrease and increase
respectively, hence dampening aggregate demand. Studies have been to the case
in Brazil in the majority of rate increases since 2003.

Monetary policy is effective as it can be implemented more quickly than other

measures such as fiscal policies as it is often determined by central banks which
are independent and free of any political constraints. For this reason, many
countries use monetary policy to achieve inflation targeting, defined as a
commitment by the central bank to attain a rate of inflation which is publicly
announced and enhances the level of decision making certainty as stakeholders
such as consumers and firms can foresee the level of inflation to come. However,
it is important to note that using monetary policy for such purposes comes with
at a high opportunity cost as it cannot be used to achieve other macroeconomic
objectives such as exchange rate stability or the full employment level of real GDP.
This is especially so if the objectives call for opposing measures e.g. low interest
rate may boost real GDP but may lead to higher inflation. An example of this is
China since 2013 when it is committed to sustain high rates of growth and has an
incentive to keep interest rates low but are constantly fearful of rising inflations
rates.

Monetary policy also suffers from time lags as even though the implementation
can be swift, time is needed to recognize whether the level of inflation is exceeding
a certain threshold and any forecasts to predict it can be unreliable. Furthermore,
the effectiveness of monetary policies ultimately relies on people’s ability to
respond to the adjusted cost of money. For example, if consumer confidence is
very high, even higher interest rates may not deter consumers’ willingness to
borrow money, hence making the reduction of inflation rates a more difficult task.
For this reason, it may be more effective to use contractionary fiscal policy via
reduced government spending which has a direct adverse impact on aggregate
demand. As a lot of government spending is geared towards society’s welfare e.g.
infrastructure spending, reducing it in the name of controlling inflation may not
be possible. However, it may be able to reduce the payouts (a type of transfer) for
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 54 Excellent Economics Essays

places which regularly gives its citizens cash payout such as the Wealth partaking
scheme in Macau where citizens were given around USD 1300 in 2017 so that
consumption can be tamed.

In light of the discussion above, although monetary policy is the most common
policy to control inflation used by countries around the world e.g. UK, USA and
Japan, it may not always be the best policy to do so, especially when there are
competing macroeconomic objectives that requires the use of monetary policy
and reduced responses to the adjusted interest rates due to heighted economic
confidence. Its effectiveness can be enhanced by combining it with contractionary
fiscal policy and reductions in transfers.

Mr. Lai’s notes: Explanation of how open market operation works taken out as it is
not key to this essay.

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