SERANGOON JUNIOR COLLEGE
JC2 H2 ECONOMICS PRELIMINARY EXAMINATION 10
PAPER 2
1
Assess the usefulness of price elasticity of demand, income elasticity of demand and
price elasticity of supply to a government in formulating microeconomic policies. [25]
ANSWER OUTLINE
Intro

Aim of microeconomic policies: To achieve efficiency in resource allocation and equity in
income distribution.

Overview of uses of different elasticities concepts in formulating microeconomic policies:
(i) Ensure economic efficiency: e.g. PED can be used to measure how much taxes and
subsidies should be imposed in order to reallocate resources to achieve social
efficiency OR encourage/discourage consumption/production
(ii) Income effects on different groups within the society (producers or consumers of
different goods/services) as well as impact on price stability.
(a)
Explain concepts of PED, YED and PES concepts
(i)
PED concept
- Price elasticity of demand is the degree of responsiveness of quantity demanded
of a good to a change in the price of the good itself, ceteris paribus.
- The sign of price elasticity of demand is negative.
- For goods whereby PED value is less than one: Demand for a good is said to be
price inelastic when a change in the price of a good leads to a less than
proportionate change in quantity demanded for the good, ceteris paribus.
- For goods whereby PED value is more than one: Demand for a good is said to be
price elastic when a change in the price of a good leads to a more than
proportionate change in quantity demanded for the good, ceteris paribus.
(ii)
YED concept
- Income elasticity of demand (Ey) measures the degree of responsiveness of
demand to changes in the income of consumers, ceteris paribus.
- A good that has positive income elasticity of demand is one in which the demand
for the good rises when the income rises and falls when income falls, ceteris
paribus. Such goods are known as normal goods.
- For goods whereby demand is income inelastic (0 < Ey < 1): This is where a
change in consumers’ income leads to a less than proportionate change in the
demand for the good, ceteris paribus. An example of good with income inelastic
demand is necessities.
- For goods whereby demand is income elastic (Ey > 1): This is where a change in
consumers’ income leads to a more than proportionate change in the demand for
the good, ceteris paribus. An example of this would be luxury goods. Luxuries are
items we can manage to do without during periods of below average income and
falling consumer confidence. When incomes are rising strongly and consumers
have the confidence to go ahead with “big-ticket” items, the demand for luxury
goods will rise.more than proportionately.
- A good that has negative income elasticity of demand is one in which the demand
for the good falls when the income rises and rises when income falls, ceteris
paribus. Such goods are known as inferior goods.
(iii)
PES concept
- Price elasticity of supply is the degree of responsiveness of quantity supplied of a
good to a change in the price of the good itself, ceteris paribus.
- Supply curves are upward sloping. Thus the sign of price elasticity of supply is
positive.
- For goods whereby supply is price inelastic (0 < Es < 1): When the supply of a
good is price inelastic, a change in the price of the good will cause a less than
proportionate change in the quantity supplied of the good, ceteris paribus.
- For goods whereby supply is price elastic (1 < Es < ): When the supply of a
good is price elastic, a change in the price of the good will cause a more than
proportionate change in the quantity supplied of the good, ceteris paribus.
(b) Assess the usefulness of PED, YED, XED and PES concepts
(1) Knowledge of PED and PES concepts in implementing price controls (explain either
case of price ceiling or price floor)
The market forces of demand and supply determine the equilibrium price and output
produced. In some cases, the equilibrium price may be too high or too low or it may
fluctuate widely such that it leads to undesirable effects on the economy. E.g. loss of
consumer welfare when prices are too high
As such, the government may intervene in the market by imposing price controls (i.e.
ignore market prices totally) or manipulate prices (increase or reduce the price of the
good).
Price ceiling

Objectives of price ceiling: To keep the prices of some goods, like essential
foodstuff, at affordable levels, prevent suppliers from exploiting consumers by
charging exorbitant prices in times of shortage or restrict or discourage production
of the good, thereby freeing some resources for other uses.
 A price ceiling is a legally established maximum price. When a price ceiling is
imposed, firms are only permitted to sell at or below this upper limit. A price ceiling
is effective only if it is set below the equilibrium price. If a price ceiling is set above
the equilibrium price, then there will be no effect on price or quantity traded.
 There is a shortage of Q2Q1 at the price ceiling imposed as the quantity demanded
is 0Q2 but the quantity supplied is only 0Q1. This shortage will persist because the
market is prevented from readjusting itself. The relative size of the shortage
depends on the price elasticities of demand and supply. The more price elastic
the demand and supply, the greater is the resultant shortage.
Price
S
E
P
Pc
Price
ceiling
D
0
Q1
Q
Q2
Fig 2: Price Ceiling Quantity

The shortage of the good may lead to black markets. In the black market, goods
are sold illegally at prices that are above the ceiling price. It exists because
unsatisfied buyers are willing to pay higher prices to get the good. Also, profits can
be made by those who buy at the controlled price and later resell them at a higher
price in the black market.

Implications on government policy:
With knowledge of the price elasticity of demand and supply of the goods that the
government may plan to impose a price ceiling on, it can have an estimate of the
extent of the resultant shortage so as to better deal with the problems that may
arise.
(i) Alternative measures to alleviate the shortage:
With a larger extent of shortage in the market, the government needs to be
prepared with clear measures to allocate the amount of goods in the market
more equitably, for example through rationing methods. The government can
distribute sufficient coupons to match the available supply. These coupons
may be distributed equitably among the population according to age, family
income, family size or any other criterion.
(2) Knowledge of PED concepts in implementation of taxes or subsidies (explain one
case will do)
Tax – To discourage consumption of socially undesirable goods
 Analysis of how taxes discourage consumption of socially undesirable goods like
cigarettes:
Imposition of taxes   COP of cigarettes  expected profits  SS 
price of cigarettes  QDD of cigarettes
 Assess usefulness of PED in implementing microeconomic policies like taxes to
improve efficiency in resource allocation:
The use of a tax to discourage consumption of socially undesirable goods will be
more successful the greater the price elasticity of demand. If demand for the good
is price elastic, a small amount of tax per unit would be sufficient to reduce
consumption significantly.
Price
Tax
SS1
SS0
P1
P0
P2
DDe
Fig. 3
DDi
0
Quantity
Q2 Q1Q0
For example, as seen from Figure 1, for a given amount of tax (P1-P2), for goods
whereby demand is relatively price elastic, there will be a significant fall in quantity
demanded from Q0 to Q1.

Implications on government policy:
(i)
If the demand for the good is price inelastic for example due to habit-forming
nature as shown in Figure 1, as in the case of cigarettes and alcohol, a given
amount of taxes will only reduce quantity demanded less than proportionately
from Q0 to Q1. Hence for goods whereby demand is price inelastic, even a
large amount of tax may not reduce the quantity demanded very much. Thus
if demand for a good is price inelastic, it might be necessary to impose a very
high tax in order to reduce consumption to the desired level. Alternatively, to
discourage consumption of such goods, the government may not be able to
rely on the imposition of taxes to reduce the consumption of such national
campaigns can be adopted. It may even be necessary to impose legislation or
ban the sale of the good.
(ii) On top of that, if the demand for the good is price inelastic, the amount of tax
revenue collected will be larger for the government and government can use it
to finance other projects to reduce the consumption of such demerit goods for
e.g. to finance national campaigns to discourage smoking.
(3) Knowledge of YED concepts in implementation of policies:
Knowledge of YED concept will also guide the government in planning their
expenditure on social goods and services. The government would be able to provide
more and better social and community services to meet the increasing demand of the
public.
For example, as the national income of the country increases, people would demand
better recreational amenities, medical care and educational facilities as these are
goods with high positive income elasticity. Therefore, knowledge of income elasticity
enables the government to identify the areas in which it should increase its spending.
(i)
Evaluate the limitations of these concepts
Accuracy and Reliability of the Data
In addition, the data collected for elasticity of demand may not be accurate due to changes
in consumers’ tastes and preferences over time or changes in the types of goods available in
the market (e.g. new products). There could also be difficulty in collecting data or the sample
size taken may be too small to reflect the actual elasticity values. There may be a time-lag
between the collation of the data and the actual implementation of the appropriate measures.
By the time, the measures are implemented, the values may have changed. This may render
these measures ineffective.
Conclusion
The price elasticities of demand and supply will affect the extent in which price and output
will change in a market. And elasticity is also significant in determining some of the effects of
changes in government policy when the state chooses to intervene in the price mechanism.
Levels Marking Scheme
L5 20-25
 The answer is relevant to question and theory is fully explained
 Competent analysis of 3 microeconomic policies with use of all elasticity
concepts but analysis may not be consistently thorough throughout essay
 Detailed discussion of measures that is well-supported by diagrams
 Good evidence of highlighting unstated assumptions that is supported by
analysis
 Good ability to discriminate & form elementary judgements
L4 15-19
 The answer is relevant to question but theory is adequately explained
 Relatively competent analysis of 2 microeconomic policies with use of


L3
12-14





L2
L1
10-11
1-9








elasticity concepts but analysis may not be consistently thorough
throughout essay
Detailed discussion of measures that is well-supported by diagrams
Good evidence of highlighting unstated assumptions, but not supported
by analysis
Some ability to discriminate & form elementary judgements
The answer has more relevance to question but theory is not fully
explained.
Relatively competent analysis of 1 microeconomic policy with use of
elasticity concepts
Some use of diagrams in explanation
Some evidence of highlighting unstated assumptions, but not supported
by analysis
Limited ability to discriminate & form elementary judgements
Accurate but undeveloped explanation of facts related to question and
theory.
Logical explanation not clear
No use of diagrams to illustrate explanations
Not much evidence of highlighting unstated assumptions
Poor understanding of question requirements
Mere regurgitation of lesson notes on 3 concepts of elasticity
Glaring conceptual flaws is evident
Barriers to entry is the only factor influencing a firm’s pricing strategy and it would
always lead to inefficiency. Discuss.
[25]
2
Introduction:
Barriers to entry are obstacles that prevent new rival firms from entering the industry and
eroding the incumbent’s profits. They may be either natural or created. They form the basis
of monopoly power. The barriers can be classified as economic and institutional barriers.
Besides influencing a firm’s pricing strategy, barriers of entry also have an impact on
efficiency.
Body:
In an industry with high barriers to entry, the firm would have some market power. As a
result, there would be an imperfect market structure, for example a monopoly. In this case,
the firm’s profit-maximising pricing strategy can be illustrated below.
Price, Revenue, Cost
MC
AC
P1
G
H
F
MR
0
DD = AR
Q1
Quantity
The firm’s profit-maximising output is 0Q1 where MC=MR and MC is rising. At output 0Q1,
the equilibrium price is 0P1. At output 0Q1, the total revenue is 0P1GQ1 and the total cost is
0HFQ1. Hence, the firm makes a supernormal profit of HP1GF. In this case, the firm’s pricing
strategy is to charge a price of 0P1, so as to make supernormal profits. In the long run, the
firm could continue to charge the same price as it would be able to make supernormal profits
due to the presence of high barriers to entry that deter new firms from entering the industry.
Price
Price, revenue, cost MC
S
S1
P
P1
0
Quantity
E
P
C
E1
0
Q1 Q
D
AC
P=MR=AR=DD
P1=MR1=AR1=DD1
Quantity
For example, in a perfectly competitive industry where there is no barrier to entry, a firm
does not set its own price and follows the market price instead. Suppose the market price is
0P. The firm’s profit is maximised when output is 0Q units where MC=MR and MC is rising.
At this equilibrium output, total revenue is given by the area 0PEQ. Total cost is the area
0CDQ. Here, total revenue exceeds total cost by EPCD. The area EPCD thus represents
supernormal profit.
When the firms are making supernormal profit, new firms would also be attracted to enter the
industry. As there are no barriers to entry, new firms can enter the industry with ease. As a
result, the market supply increases, leading to a fall in the market price of the good. Hence,
as the AR falls, the supernormal profit earned by the firms will fall until all the firms are
producing at the minimum long run average cost curve and earning normal profit. This is the
equilibrium point E1.
When all firms make normal profit, there is no more incentive for new firms to enter the
industry. The number of firms stabilises. Price charged by the firms also stabilises as firms
are producing at the profit-maximising level of output where MC=MR and AR=AC.
In an oligopoly, the mutual interdependence among firms influences a firm’s pricing strategy.
By this, we mean that each firm is aware that demand for its good depends not only on its
own actions, but also those of its rivals. Here we assume that there is no collusion among
the firms, i.e. firms compete with one another. In addition, the rivals will follow price cuts but
not price increases initiated by a firm.
If one firm reduces its price, the others will react by cutting their prices too. Thus, if the firm
reduces its price, there will be a less than proportionate increase in quantity demanded for
its goods. Hence, its total revenue will fall. Conversely, if the same oligopoly firm raises its
price, its rivals will not follow suit. Thus there will be a more than proportionate decrease in
quantity demanded of its good. Hence, its total revenue will fall. So, each firm must consider
the reactions of its rivals when formulating its pricing strategy.
When there is the threat of another firm replacing the incumbent through the invention of
new products or new production techniques, i.e. ‘creative destruction’ which is a term coined
by Joseph Schumpeter, the existing firm could adopt limit pricing. In this pricing strategy, the
incumbent might choose to set a price that does not maximise short-run profits. This price
may well be below the firm’s short-run profit-maximising price, but the incumbent does so to
deter new firms, which may be discouraged by the prospects of making losses, from entering
the industry.
Besides having an important role in shaping a firm’s pricing strategy, barriers to entry also
have an impact on efficiency. Economic efficiency in the allocation of scarce resources is
achieved if it is not possible to change the existing resource allocation to make someone
better off without making someone else worse off. Essentially, it means that resources
must be allocated such that the right type and right amount of goods and services are
produced at the lowest possible cost. That is, the production of goods and services are both
allocatively and productively efficient.
The monopolist, by virtue of having a high degree of market control, can restrict his output
and charge a higher price for his product than the perfectly competitive industry.
Price, Revenue, Cost
MC
A
B
Pm
Ec
Pc
Em
0
AR
MR
Q m Qc
Quantity
Given his profit-maximising motive, the monopolist will produce where MC=MR. At this
output, 0Qm, the price charged by the firm is higher than his marginal cost of production (P>MC).
It means that society values the last unit of good more than the alternative goods forgone (i.e.
opportunity cost). This means that not enough of the good is being produced. This represents
a misallocation of resources or allocative inefficiency and society’s welfare is not maximised.
Society’s welfare can thus be improved by allocating more resources to produce this good
up to quantity 0Qc where P=MC. Hence, allocative efficiency is attained in a perfectly
competitive industry in which there are no barriers to entry.
The dominant firm may incur higher costs of production due to X-inefficiency, a term coined by
Professor Harvey Libenstein. With high barriers to entry, there is no competitive pressure on
profits. Thus, cost control can become lax. There may be overstaffing and less effort to keep
technology up-to-date, hence resulting in higher average cost of production than it would
otherwise be. In this case, the firm would be producing at a point above its LRAC curve. Hence,
productive inefficiency arises.
There is a lack of incentive for the dominant firm, e.g. monopolist, to innovate and undertake
research and development. This is because of the complacency brought about by the
absence of competition as the monopolist is protected by high barriers to entry. In such a
case, consumers may be faced with a limited variety of goods and hence less choice for the
consumers.
A firm is said to be productively efficient if it produces at the lowest average cost possible for
a given level of output. As long as the firm aims to maximise profits, it would have the
incentive to adopt the least-cost method of production so as to keep unit cost the lowest at
that equilibrium output level. Hence, it would produce at a point on its LRAC curve. In this
light, even if there barriers to entry, the firm could still be productively efficient.
A monopolist has the incentive to invest in large-scale research and development (R&D)
programmes for his product. This is because firstly, he is likely to have the funds due to his
ability to earn supernormal profits in the long run, which is a result of the high barriers of
entry that prevent the erosion of profits. Secondly, there is always the threat of another firm
replacing the monopoly through the invention of new products or new production techniques,
i.e. creative destruction.
Conclusion:
There are different factors that influence a firm’s pricing strategy, of which barriers to entry is
only one of them. The firm should also consider its rivals’ reaction before implementing any
pricing strategy. Additionally, barriers to entry may not always lead to inefficiency. While
allocative inefficiency may be inevitable in an industry with barriers to entry, a more holistic
assessment of efficiency is needed before it can be concluded that barriers to entry lead to
inefficiency.
Marking scheme:
L5
20-25


L4
15-19



L3
12-14

L2
10-11

L1
1-9


Good understanding of question requirements with a very clear attempt to
discuss both aspects of the question
Discussion of the role of barriers to entry in influencing pricing strategy and
causing inefficiency is well-supported by rigorous economic analysis (including
diagrams)
Informed conclusion is provided
Provide sufficient analysis in discussing how barriers to entry can influence
pricing strategy and cause inefficiency – e.g. diagram(s) is drawn and explained
For higher band in this level (i.e. 18m and above), students should be able to link
arguments to barriers to entry influencing/not influencing a firm’s pricing strategy
and to barriers to entry leading/not leading to inefficiency
Show some understanding of how barriers to entry can influence a firm’s pricing
strategy and how barriers to entry can lead to inefficiency
Show some understanding of how barriers to entry can influence a firm’s pricing
strategy or how barriers to entry can lead to inefficiency
Mere regurgitation of lesson notes on barriers to entry with weak application to
pricing strategy and inefficiency
Glaring conceptual flaws are evident
3
(a)
Explain how public goods and merit goods cause markets to fail.
[10]
(b)
Consider whether market-based solutions are the best way for the Singapore
government to correct market failure that results from the existence of a
negative externality.
[15]
Part (a)
Introduction:
Market failure refers to a situation where resource allocation concerning what, how, how
much and for whom to produce using the market mechanism fails to achieve efficiency in the
allocation of scarce resources and equity among the various income groups.
Body:
One area in which the market fails to perform adequately is in the provision of public goods.
In fact, the market completely fails to provide any amount of these goods at all. This
complete market failure is explained by the two key characteristics of non-rivalry and nonexcludability in the consumption of public goods.
 A good is non-rival in consumption if one person’s consumption of the good does not
reduce the quantity available to another person. Because of this, once a public good is
provided, the marginal cost of providing the good to an additional user is zero.
 With zero marginal cost, the basic principle of optimal resource allocation calls for
provision of public goods and services at zero price or no charge. However, if the price is
zero, no firm would want to supply the good. Hence, there is market failure.
 A good is non-excludable in consumption if it is difficult to exclude non-payers from
enjoying the good. This gives rise to a free rider problem. Since non-payers can also
enjoy the good, no one would be willing to pay for it. As a result, demand is concealed
and difficult to estimate.
 Because of non-rivalry and non-excludability in consumption, it is not only often
impossible to charge a market price for a public good, it is often undesirable to do so as
well.
 A public good is also indivisible, that is, it cannot be produced or sold easily in small units.
It satisfies collective wants.
 Given all these characteristics, the private producer who is motivated by profits will not
be keen to produce the good at all. Public goods are goods which are valuable socially
but whose provision would not be undertaken by private enterprise.
Another area in which the market fails to perform adequately is in the provision of merit
goods, e.g. education and healthcare such as the H1N1 flu vaccine.
 Marginal private benefit (MPB) is the benefit derived from the consumption of an
additional unit of H1N1 flu vaccine. Marginal private cost (MPC) is the cost of consuming
an additional unit of vaccine. Marginal external benefit (MEB) is the benefit conferred to
third party who is not directly involved in the consumption or production of the vaccine.
 Because of MEB, there is a divergence between MSB and MPB by the full extent of the
MEB.
C
Cost,
benefit
MPC = MSC
MEB
B
A
MSB = MPB + MEB
MPB
0
Qm



Quantity
Qs
Because individuals only consider their own private benefits and costs, the private
equilibrium level of healthcare services consumed occurs at MPB=MPC, i.e. Qm.
When the true benefits and costs of consuming healthcare are taken into account,
the social equilibrium occurs at MSB=MSC, i.e. Qs.
Since Qm is less than Qs, there is underconsumption of healthcare services.
Between Qm and Qs, for every additional unit of healthcare service consumed, it adds
more to social benefit than to social cost. Hence, there is a net benefit that is not
enjoyed by society since only Qm level of healthcare service is consumed. This loss
of net benefit is known as deadweight loss and is denoted by area ABC.
Conclusion:
Market failure arises when provision of public goods and merit goods are left solely to the
private sector. While the latter would underproduce merit goods, there will be no provision of
public goods if resource allocation is left solely to the market forces of demand and supply.
Marking scheme:
L3
7-10

L2
5-6

L1
1-4


Detailed explanation of both types of market failure with good use of
examples.
Some explanation of how public goods and merit goods cause markets to
fail
Poor understanding of market failures is evident
Glaring conceptual flaws are evident
Part (b)
Introduction:
Negative externality is the cost incurred by a third party, who is someone who is not directly
involved in the consumption or production of the good, for which there is no compensation.
Market-based solutions are measures that reduce the consumption or production of the good
by influencing the market forces of demand and supply. These solutions include Pigovian
taxes and tradable pollution permits.
Body:
Assume the case of traffic congestion. The private benefit is the ease and comfort and
convenience of travelling in private transport. The private cost is the cost incurred by the
private motorist, e.g. cost of car and petrol, maintenance costs etc. The external cost is cost
to the third party who is not directly involved in the production or consumption of the good.
This may be medical costs incurred by the other road users such as pedestrians who
breathe in the polluted air and the loss of output suffered by firms due to traffic congestion.
Assume that the marginal private benefit is also the true benefit or marginal social benefit.
MSC = MPC + MEC
Cost,
benefit
A
E1
MEC
MPC
E
MPB=MSB
0
Number of car journeys
Qs
Qm
The MPC curve shows the additional cost incurred by the private motorists in the
consumption of cars. Marginal social cost is the sum of marginal private cost and marginal
external cost. In the case of goods with negative externalities, the total opportunity cost to
society is greater than the private cost. Thus MSC is greater than MPC and the MSC curve
is above the MPC curve.
The market equilibrium is determined by private benefit and cost considerations only or
demand and supply. Hence, the private equilibrium number of car journeys occurs at 0Qm
where MPB is equal to MPC. The social optimum level of output is attained by taking into
account all costs and benefits of the good to the society. Hence, it is the level of output
where the cost of consuming the last unit of output (MSC) is equal to the benefit derived
from that unit consumed (MSB). This gives us an output of 0Qs.
Thus, the equilibrium output as determined by the price mechanism is greater than the social
optimum level of output bringing about an over-consumption of cars by QmQs.
The above illustrates a situation in which there is a negative externality in consumption. A
similar analysis could be applied to a situation in which a negative externality in production
exists.
The government could impose a tax, which is known as a Pigovian tax, on consumption of
cars equal to the marginal external cost. A tax on consumption of cars, such as road taxes,
has the same effect as an increase in the price of a car journey. The tax shifts the marginal
private cost curve vertically upwards by the full amount of the tax.
Cost,
benefit
MSC = MPC + Tax
E1
Tax =
MEC
MPC
E
MPB = MSB
0
Qs
Qm
Number of car journeys
If the tax is calculated to reflect accurately the marginal external cost the firm inflicts on a
third party, the car user is then said to internalise the external cost. The resulting higher cost
now induces him to reduce consumption to an amount equal to OQs, which is the socially
optimum output level where MSB=MSC. The welfare loss arising from overconsumption is
thus eliminated.
Tradable pollution permits are rights to firms to buy or sell pollution in artificially created
markets. Firms can thus bid for a permit that allows them to create a fixed amount of
pollution. The government can gradually reduce the number of pollution permits available so
that total pollution emissions can be controlled. Tradable permits have been tried in several
countries, including Singapore where an auction mechanism has been introduced for the
trading of ozone-depleting substances.
In due course, when the government reduces the number of pollution limits, the total amount
of pollution allowed can be reduced. This will make the permits more valuable, and thus
more advantageous to firms that can reduce pollution levels at the lowest marginal costs.
Many economists favour the market-based solution to correct externalities because they still
allow the market to operate. Hence, consumer sovereignty is protected. They are also fair
because they force the responsible parties to take on board the full social costs of their
actions. In particular for taxes, by taxing firms for polluting, producers may be encouraged to
find cleaner ways of producing a good. The tax thus acts as an incentive over the long run to
reduce pollution: the more a firm can reduce pollution, the more taxes it can save.
In the case of pollution permits, it is difficult to ascertain the permitted level of production. If
they are based on current production levels, there may be no advantage for firms that have
already taken steps to control their pollution emissions. For taxes, the damage from pollution
is extremely difficult to assess. It is also difficult to apportion blame. An overestimation or
underestimation of the size of the external cost would lead to over-taxing or under-taxing.
This means that a less than or more than social optimum level of output is consumed. As a
result, government failure would arise.
There are stipulated bus lanes at certain times of the day. This is done to ensure that the
passengers of buses can get to their destinations on time. This would increase the
attractiveness of using public transport and hence reduce the demand for private cars during
peak hours since both modes of transportation are seen as substitutes. Furthermore,
industries sited near urban areas are required to use fuel with lower sulphur content.
Rules and regulation are simple and clear to understand and are often relatively easy to
administer. Inspectors or the police can conduct spot checks to see that the law is being
obeyed.
However, if a firm is required by law to maintain pollution at a certain level, there would be
no incentive for the firm to reduce the pollution below the stated level. With a tax on the
pollutant, however, the more the firm reduces the effluent, the less tax it would pay. Thus,
with a system of taxes there is a continuing incentive to reduce pollution.
Conclusion:
Market-based solutions and other measures are adopted by the Singapore government to
correct market failure that results from the existence of a negative externality. There appears
to be no one best way to correct this market failure. As a matter of fact, both market-based
solutions and rules and regulation for example complement each other in correcting the
market failure that results from the existence of a negative externality.
Marking Scheme:
L4
12-15 
L3
9-11


L2
7-8



L1
1-6



Detailed explanation of how negative externality causes market failure
and competent discussion of at least one market-based solution and one
non-market-based solution to correct said market failure are evident
Analysis shows good application to the Singapore context
Some detailed explanation of how negative externality causes market
failure and good discussion of at least one market-based solution and
one non-market-based solution to correct said market failure are evident
Examples relevant to Singapore are evident
Analysis is not consistently rigorous
Some explanation of how negative externality causes market failure and
some discussion of solutions to correct said market failure are evident
Examples pertaining to Singapore are largely not evident
Explanation of negative externality and solutions to correct market failure
is smattering
Glaring conceptual errors are evident.
4
Labour productivity in Singapore has fallen by 3.9% in 2009.
(a)
Analyse the possible macroeconomic outcomes of falling labour productivity.
[10]
(b)
Discuss the view that supply-side policies are more effective than demandmanagement policies to achieve full employment in an economy.
[15]
PART A
Answer Outline
INTRO
 Explanation of labour productivity:
Labour productivity is the ability to create goods and services from a given amount of
output and is typically measured as output per unit of labour input. The main drivers of
labour productivity are skills, innovation and investment.

Provide an overview of macroeconomic objectives / Provide a link between falling labour
productivity with that of macroeconomic objectives:
The main macroeconomic objectives that a government have are sustained economic
growth, price stability, low unemployment & healthy BOP. With falling labour productivity,
there is an adverse impact on the macroeconomic outcomes for an economy.
BODY
Assuming firms employ the same number of workers, if labour productivity falls  each
worker producing less  AC of production  AS
General
price level
AS1
AS0
AD
P1
P0
0

Y1 Y0 Yf1
Yf0
National output
With the above AS, this will lead to a shortage of goods and services at original
price P0 whereby output demanded exceeds output supplied. There will be an
upward pressure on prices within the economy. Consumers will respond to the higher
prices by decreasing the output demanded. Firms will respond to higher prices by
increasing output supplied. This process of adjustment will continue until a new
equilibrium is reached at a higher general price level. Hence, leading to a rise in
inflation from P0 to P1 and a fall in NY from Y0 to Y1 leading to a fall in actual growth.
Full employment level of the economy will also fall from Yf 0 to Yf1 due to the fall in
labour productivity.
↓in labour productivity  ↓ in efficiency in producing goods and services  ceteris
paribus, this leads to a ↑in unit labour costs  ↓SS  ↑ prices of goods → ↓ quantity
demanded of goods → ↓ revenue and expected profits → ↓production by firms → ↓
demand for factors of production like labour  firms retrench workers
→↑unemployment
With a fall in labour productivity  rise in unit labour costs → ↑ prices of goods
including price of exports  Assume PEDx>1  more than proportionate fall in
QDDx  TRx. On the other hand, imports are relatively cheaper due to ↑in
domestic inflation in Singapore  ↑in DDm  ↑TEm. Hence, worsening of current
account
With worsening current account, a fall in labour productivity would lead to a
deterioration of a country’s balance of payments.
CONCLUSION
For economies like Singapore which only has a small pool of labour as the main resource,
labour productivity is an area that needs to be monitored closely at all times. This is because
a fall in labour productivity can have significant adverse impact on the macroeconomic
objectives of Singapore.
Level Marks Descriptors
L3
7 -10 Clear and thorough explanation of how falling productivity can lead to
impact on 3 macroeconomic outcomes. Reference to AD/AS diagram is
clearly made and explained.
A considered introduction or conclusion is also observed.
L2
5-6
Clear explanation of how falling labour productivity can lead to impact on 2
macroeconomic outcomes (e.g. rise in inflation and fall in economic growth)
Diagram may not be clearly explained or impact on 3rd macroeconomic
outcome is not clearly explained. Some gaps in analysis.
L1
1-4
Smattering of points with vague understanding of how a fall in labour
productivity affects macroeconomic outcomes. Conceptual error/s evident.
PART B
INTRO
 Unemployment is a main concern from the society’s point of view. This is in view of the
many costs it brings like output loss to the economy and revenue loss to the government.
 There are many policies that governments can use to achieve full-employment, namely
demand-management policies like fiscal and exchange rate policies, as well as supplyside policies. Usually a mixture of policies is needed because different policies are
targeted at specific types of unemployment.
BODY



Supply-side policies ensure that our workers are constantly equipped with the
necessary skills for the knowledge-based economy so as to raise labour productivity.
This will in turn increase efficiency and reduce cost of production AS  GPL
6 years compulsory education to ensure that we have a ready pool of
workforce with basic literacy skills so as to raise labour productivity. This will in turn
increase efficiency and reduce cost of production  AS  GPL
Through education, training and retraining, this can ensure an increase in
labour productivity & employability of workers such that they acquire new skills that are
relevant to a rapidly changing economy, thus reducing structural unemployment.
Evaluation:
1. Takes long time to produce results because time is needed to train workers. Firms may
not want to spend workers for training as there will be loss of output during
training. Workers face difficulties in learning new skills especially the elderly.
Analysis of expansionary fiscal policy:
 G on final gds/svcs such as building infrastructure, spending on education and
healthcare  In Spore, G is done through speeding up spending in projects such as
public housing and lift upgrading. In addition, they also give payments (eg: Workfare
Income Supplement Scheme) to increase disposable income so as to C  AD

Government can also  taxes to AD. By  personal income tax like in Singapore 
Yd  C  AD. Also, corporate income tax   post-tax profits  more funds
for investment  I  AD

The AD  shortage of goods and services  incentive for firms to increase
production   demand for factors of production like labour  multiple national
output, NY and employment, thus reducing cyclical unemployment.
Evaluation:
1. Effectiveness depends on size of K. Spore’s K is small due to high MPW arising from
high MPS and MPM.
 The high MPS arises from compulsory savings through CPF contribution. In addition,
households save another proportion for precautionary and other purposes.
 The high MPM is due to Spore’s limited resources. Hence, we import virtually all final
gds/svcs and raw materials.
 Hence, expansionary FP is ineffective to stimulate growth and employment because
with small K, the final NY is limited. Therefore, govt may have to spend even more or
reduce tax further in order to achieve the desired outcome.
Analysis of exchange rate policy:
 Government may allow the currency to depreciate. When domestic currency depreciates,
o P exports in foreign currency. If DDx is price elastic  more than proportionate 
quantity demanded of exports  TRx
o At the same time, there is an P imports in domestic currency. If DDm is price elastic
 more than proportionate  quantity demanded of imports  TEm
o Consequently, there is TRx and TEm   net exports  AD
o As long as Marshall-Lerner condition is met (sum of PEDx and PEDm > 1),
depreciation would lead to  net exports  AD

The AD  shortage of goods and services  P  incentive for firms to increase
production   demand for factors of production like labour  multiple national output,
NY and employment
Evaluation:
1. This policy of AD to promote employment is certainly effective for trade-reliant
economies like Singapore.
Conclusion
During stable periods of economic growth, most countries like Singapore which is reliant on
its labour pool to sustain economic growth and achieve full employment would definitely
engage in supply-side policies. This is especially so in view of the increasing
interconnectedness of the global economy with globalisation.
Level Marks Descriptors
L4
12-15  Detailed explanation and evaluation in terms of effectiveness and
desirability of at least 3 policies (SR and LR) with the use of AD/AS
framework, adopted by a government to achieve full employment.
 Evaluation is thorough and based on sound economic analysis.
 Clear response to question requirements to compare the effectiveness
of supply-side and demand-management policies to achieve full
employment
L3
9-11  Adequate explanation and evaluation in terms of effectiveness and
desirability of at least 3 policies (SR and LR) with the use of AD/AS
framework, adopted by a government to achieve full employment.
 Evaluation is largely thorough and based on sound economic analysis.
 Some response to question requirements to compare the effectiveness
of supply-side and demand-management policies to achieve full
employment.
L2
7-8
 Some explanation and evaluation in terms of effectiveness and
desirability of at least 2 policies with the use of AD/AS framework,
adopted by a government to achieve full employment. Some conceptual
errors or gaps in analysis.
 Evaluation may not be consistent for all policies discussed.
L1
1-6
 For an answer that shows some superficial knowledge of the economic
policies adopted by a government to achieve full employment.
Conceptual error/s evident.
 Little or no evaluation of the policies mentioned.
5
(a)
Explain why governments should be concerned about a fall in real GDP. [10]
(b)
To achieve high and sustained growth, low inflation is an essential condition.
Hence, its attainment should be the main aim of government economic policy.
Discuss.
[15]
Part (a)
Introduction


Define real GDP: GDP refers to the value of final goods and services produced in the
country over a period of time. It is in real terms because the value has been adjusted for
inflation.
Explain the meaning of fall in real GDP:
o fall in real GDP means the country produces less goods and services. It implies a fall
in the level of economic activity.
Body
Governments should be concerned with a fall in real GDP, esp. if it occurs for a prolonged
period of time for a few reasons:
a.
Fall in real GDP will lower the standard of living of the people.
Standard of living refers to the material and non-material welfare of the people. Real
GDP per capita is a very reliable single indicator that reflects the standard of living.
Fall in real GDP means that national income increases. Ceteris paribus, this means that
people’s purchasing power has decreased. Hence, they are not able to buy as much as
before, leading to a fall in their standard of living.
b.
Lower level of economic development
Fall in real GDP → fall in real incomes (personal incomes and profits) → ↓ govt tax
revenues → less funds for expenditure on infrastructure e.g. roads, hospitals, schools →
hinder economic development.
c.
Lowers the level of confidence in the economy
If a country experienced a fall in real GDP for a prolonged period of time, this can erode
consumer and investor confidence. The fall in confidence level due to fall in
expectations of future profits → ↓ investment and capital flight.
d.
Fall in real GDP can lead to social instability. This is due to the fact the fall in real
GDP usually occurs with rise in unemployment. In such a situation, firms usually
retrench workers due to fall in production. The rise in unemployment can contribute to
more petty crimes and also rise in social discontent which can disturb the social stability
of the country.
L3
7 – 10
L2
5–6
L1
1–4
Thorough analysis of the consequences of fall in real GDP through
different aspects. Covers at least 3 aspects.
Adequate analysis of consequences of fall in real GDP. At least one idea
must be carefully explained and elaborated.
Some understanding of the concept of fall in real GDP and its implications.
Very limited explanation throughout the essay.
Part (b)
Introduction
Define and explain meaning of low inflation:
 Low inflation is defined as a period of relative price stability. Inflation is mild.
 Low inflation does not distort the pattern of resource allocation. It is a generally good
sign of the health of an economy.
There are many factors that are essential for sustained economic growth. These include the
quantity and quality of the factors of production, the level of technology, infrastructure,
business environment, social and political stability. Low inflation is one of those conditions
that are needed to ensure a conducive environment for investments and hence economic
growth.
Body
1. Define and explain high and sustained growth
 2 concepts of economic growth – actual and potential.
 Actual growth is the increase in national output actually produced. It is represented
by a movement from a point inside the production possibility curve (PPC) to a point
on the PPC.

To have sustained economic growth, the country must achieve potential growth.
Potential growth refers to the increase in the full-employment level of national output.
Potential growth increases when there is an increase in the productive capacity of the
economy. It can be illustrated by an outward shift of the PPC.
2. Explain how low inflation can contribute to economic growth.
a. Low inflation provides an environment that is conducive for savings and investment.
o Low inflation → real value of savings is protected because of greater certainty
over real interest rate. ↑Savings → more funds for capital formation → more
investments can be undertaken.
o ↑I → ↑AE → ↑NY → ↑induced consumption → further ↑NY.
b. Low inflation contributes to export price competitiveness
o If the country’s inflation rate is lower than in other countries → its exports will be
relatively cheaper → ↑dd for country’s exports → ↑export earnings → ↑AE →
↑NY.
Thus, we can see how low inflation can instill confidence in the economy as well as boost
export price competitiveness, thereby contributing to economic growth.
Whether the attainment of low inflation should be the main aim of govt economic policy
depends on the following, among other things:
1. Severity of the problem
When a country is plagued by hyperinflation, the situation is so chaotic that it can lead to a
collapse of the monetary system as people lose confidence in money as a medium of
exchange and store of value. There is great uncertainty and instability which result in capital
flight and thus reducing the volume of savings, investment and economic growth. In such a
situation of hyperinflation, it is important that the government arrest the problem of inflation
first, restore confidence in the economy and then proceed with other measures to achieve
economic growth.
2. Possible trade-offs
Furthermore, low inflation may not always be the main aim of govt economic policy. Most
governments today have an inflation target. However, its attainment can come at a cost of
slower economic growth. E.g. contractionary monetary policy such as higher interest rates
used to control inflation → ↓C and I → ↓AE → surplus of goods and services → downward
pressure on prices and real national output.
Because of this conflict between low inflation and high growth, at times e.g. when the
problem of slow growth is deemed to be more severe than inflation, it may be necessary to
let go of the low inflation target in order to accelerate the economic growth rate.
Conclusion
It is indisputable that low inflation is an essential condition for economic growth. Govts
should consistently use supply-side policies to increase its productive capacity in order to
ensure that its AS can meet with the rise in AD and hence achieve price stability.
L4
12 – 15
L3
9 – 11
L2
7– 8
L1
1–6
Rigorous analysis of the benefits of low inflation, making clear the links
between low inflation and sustained economic growth.
Good discussion of the statement, e.g. provides rationale or basis for thesis
and anti-thesis. Clarity and maturity of thought are displayed. Reasoned
judgement based on sound economic theory.
Rigorous analysis of the benefits of low inflation, making clear the links
between low inflation and sustained economic growth.
Adequate attempt to discuss the statement, although the substantiation
may not be consistently thorough. Generally good analysis but quality of
evaluation may be just adequate.
The links between low inflation and sustained economic growth are
adequately explained with at least 2 well-explained ideas. However, there
was lack of clarity in discussing the statement. Assertions were made as to
whether low inflation or other goals should be the main aim but with very
limited substantiation.
Some explanation of the benefits of low inflation. Very limited attempt to
discuss the view.
6
While integration into the world economy continues to underpin Singapore’s
economic success, its exposure to the global business cycle is posing considerable
challenges at present.
(a)
Explain how Singapore’s balance of payments might have been affected by
the global business cycle in recent years.
[10]
(b)
Discuss what policy options would best reduce a country’s balance of
payments deficit.
[15]
Part 6(a)
Introduction
Explain briefly, how being small and open, Singapore’s balance of payments have been very
much affected by the global cycle.
The downswing of the cycle usually had an adverse impact on Singapore’s balance of
payments. Conversely, an upswing of the business cycle resulted in an improvement in
Singapore’s balance of payments.
Body
Explain briefly the meaning of balance of payments, and the 2 components of the balance of
payments i.e. the current and capital accounts. With relevant examples, explain the items in
the 2 accounts.
The global recession in recent years have affected S’pore’s BOP in the following ways:
Global recession e.g. in the US that was brought about by the sub-prime crisis → contraction
of world trade, Singapore being no exception.
1.
 foreign incomes +  unemployment  purchasing power   dd for
Singapore’s exports. Since the US is Singapore’s major trading partner, there is a
significant drop in demand for its exports of manufactured goods and services for
both final and intermediate goods   export earnings, worsening current balance.
2.
Global cut-backs in consumer spending due to poor consumer confidence + fallin
stock prices that reduce MNC’s ability to fund investments +  profits, poor business
confidence   FDI into Singapore as MNCs cut back their overseas investment
plans in preparation for worst case scenarios   long-term capital inflow 
worsening capital balance.
3.
Subprime crisis + disruptions in financial systems  tighter credit conditions e.g.
higher interest rates and more stringent regulations on lending and borrowing   in
both exports and investments into Singapore.
4.
Singapore’ BOP has also been affected by the business cycle which was caused by
the higher crude oil and food prices.  prices of crude oil and food  less than
proportionate fall in Qty dd of imports due to its price inelastic demand (oil and food
being essential ingredients and raw materials)   total import expenditure on these
items  worsening current balance.
Mark Scheme
L3
7 - 10
L2
5–6
L1
1–4
Rigorous analysis with clear examples used to explain the changes in BOP.
Explained how each of the 2 accounts (current and capital) is affected.
Explanation of changes in BOP is adequate but not rigorous. Did not bring
out clearly the characteristics of Singapore that explains why its BOP is
sensitive to global business cycle.
Some understanding of the structure of balance of payments with an attempt
to explain how BOP is affected by business cycle.
Part (6b)
Introduction


State meaning of BOP deficit and that it can arise from current and/or capital balance.
Explain briefly why huge and persistent BOP deficits can be a cause of concern for the
govt: falling foreign reserves which means less funds for future economic
development
- Increase in external debt which will can lead to lower standard of living for future
generations
- Currency devaluation which can cause inflation, loss of confidence in the country,
capital flight and hence slower economic growth.
Body
1. Devaluation
Devaluation refers to the deliberate attempt by a government to reduce the external value of
its currency.
For example, assume that the US has a balance of payments deficit and its government
decides to devalue its currency to solve the deficit problem.
Devaluation of US$ makes US exports cheaper in foreign currency (SGD) and its imports
more expensive in domestic currency (US$).
If the demand for US exports is price elastic, the fall in export prices in foreign currency will
result in a more than proportionate increase in quantity demanded for exports, ceteris
paribus. Hence, there would be an increase in its export earnings.
At the same time, if the demand for imports is price elastic, the higher import prices will lead
to a more than proportionate fall in quantity demanded for imports, ceteris paribus. Hence,
there would be a fall in import expenditure.
Therefore, net exports would rise, leading to an improvement in the current account balance,
ceteris paribus. Ceteris paribus, there would be a reduction in the US balance of payments
deficit.
-
The Marshall-Lerner condition should be used to determine whether devaluation is
effective in reducing the balance of payments deficit.
Evaluation
Devaluation is an appropriate tool to solve the BOP deficit if:
In managing a country’s exchange rate, its currency may be over-valued i.e. the fixed
price of the currency is higher than what it would have been under a floating exchange
rate system. Over-valuation reduces the country’s export price competitiveness and
hence lowers the demand for the country’s exports. On the other hand, it also
encourages imports due their artificially lower prices.
Hence, the govt should sell the domestic currency in order to lower the value of the
currency to solve the BOP deficit problem.
2. Expenditure-reducing or deflationary policy
The govt can also consider using expenditure-reducing or contractionary demand
management policies such as monetary and/or fiscal policies.

A contractionary fiscal policy involves an increase in taxes and reduction in government
expenditure. An increase in personal income taxes will lead to a fall in disposable
income. This will lead to a fall in consumption expenditure. An increase in corporate
taxes will lead to a fall in post-tax profits which results in a fall in investment expenditure.
The fall in government expenditure, consumption expenditure and investment
expenditure will reduce the level of aggregate demand, resulting in a fall in national
income.
This will induce a fall in demand for imports, hence leading to a fall in total import
expenditure. Ceteris paribus, net exports would fall, leading to an improvement in the
current account balance. Ceteris paribus, this will reduce the balance of payments deficit.
Evaluation:
These contractionary demand management policies would be most appropriate if:
i.
inflation is the cause of the deficit. The higher inflation can be due to rise in AD such as
C and I. Higher relative inflation rates of a country can cause its exports to be relatively
more expensive and imports relatively cheaper than domestically produced goods. Thus,
the country’s current balance worsens. Furthermore, the higher inflation rates can also
lead to capital flight as people lose confidence in the economy. As such, it is import for
the govt to lower inflation rate to solve the problem.
3. Supply-side policies
To reduce the balance of payments deficit, the government can introduce measures to lower
the costs of production and boost the productivity of the factors of production. This can be
done with a higher expenditure on training of labour and research and development.
When the country’s exports become more competitive, its volume of exports will increase. In
addition, its demand for imports will fall, as domestically produced goods are now cheaper
relative to foreign goods. The balance of payments deficit can thus be reduced.
Evaluation
1. Supply-side policies are especially needed if the cause of the BOP deficit is that of loss
of comparative advantage. In this age of globalisation, the emergence of new low-cost
producers has caused a shift in comparative advantage across the world. As such, a
country that experiences a loss of their comparative advantage will suffer a permanent
fall in its export demand. Thus, there is a need for the country to restructure its economy
to find new products to sell and so improve its BOP.
Conclusion
The best policy options would be those that solve the root cause of the problem. That would
be ideal. In reality, there are many factors that could have contributed to the BOP problem.
As such, different policies are needed to counter these sources of the problem.
L4
12 – 15
L3
9 – 11
L2
7–8
L1
1–6
Rigorous analysis and evaluation of at least 3 policies and must address
both current and capital balance problems. Thorough evaluation of all 3
policies with clear understanding of what determines a “best” policy.
Insightful conclusion, preferably with some reference to Singapore.
Rigorous analysis and evaluation of at least 3 policies and must address
both current and capital balance problems. Evaluation is limited to
making statements without clear development of ideas.
But for 10 marks and above, expect thorough evaluation of 1 policy.
Adequate explanation of 2 policies with some evaluation. Both policies
may address only current balance problems. Limited evaluation.
Some explanation of the policies used. May not be clear in terms of
stating which is the best policy.