Raffles Junior College JC2 Preliminary Examinations 2007 ECONOMICS Higher 2

Paper 1 Case Study 18 September 2007 2 hour 15 minutes

Additional Materials: Answer Booklet/Paper

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READ THESE INSTRUCTIONS FIRST Write your name, index number and CT class on all the work you hand in. Write in dark blue or black pen on both sides of the paper. You may use a soft pencil for diagrams, graphs or rough working. Do not use staples, paper clips, highlighters, glue or correction fluid. Answer both questions. Start each question on a fresh sheet of paper. At the end of the examination, securely fasten your work to each question separately. The number of marks is given in brackets [ ] at the end of each question or part question. You are advised to spend several minutes per question reading through the data before you begin writing your answers.

This document consists of 8 printed pages.

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D e ve l o pi n g t h e T h i nk e r , L e ad e r & P i o ne e r

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2 Question 1 Answer all questions. Coffee Price Economics Extract 1 Coffee is generally traded in financial instruments known as futures contracts, and this is mainly done through the New York Board of Trade. A futures contract is a standardised contract, to buy or sell a certain underlying instrument at a certain date in the future, at a specified price. The New York Board of Trade is the designated futures market and exclusive global marketplace for Coffee "C" futures contracts. The "C" contract pricing is driven up and down by variables like changing weather conditions in the major producing countries, political turmoil, speculation about production levels, changing transportation costs and other unexpected factors. That word, "unexpected," is key. For example, news of a possible drought or freezing conditions in coffee producing areas would likely reduce global supply and thereby increase prices. Assuming demand stays the same, the decreased supply would drive up prices in order to achieve a market-clearing price. The "C" looks at washed Arabica coffee produced in several Central and South American, Asian and African countries to establish the "basis" for the contract. Coffees judged better are at a premium and naturally those judged inferior are at a discount. Of course, this all primarily relates to green coffee prices. Roasted coffee whether bought directly from a roaster, the grocery store, or in the form of a beverage is a different product that has other factors affecting its ultimate price. Since coffee importers and large brokers primarily sell against replacement price (the price to pay in order to replace coffee sold to end-consumers), similar to how petroleum vendors do, when the "C" goes up, so do coffee prices. These commodity markets can be quite volatile (referring to the magnitude of price movements) which is why you often see fairly significant moves in the price of petrol at the pump, for example. The same thing happens with green coffee when the variables affecting the market price get a little crazy. So, the prices coffee suppliers pay to make coffee available to consumers are greatly affected by the global coffee trade in the same way local petrol prices are affected by the global oil market. Coffee importers tend to price their green coffee based on the going market rate. However as the coffee makes its way through the layers of middlemen, whether green coffee vendors supplying home-roasters or commercial roasters supplying the ready to brew product, the prices generally become more rigidly based. In other words, the coffee that end-consumer purchases doesnt move around in price quite so much as the coffee exchanged at the earlier phases of the coffee delivery mechanism (at the export/import level). The market rate pricing method is naturally more transparent than the steady, rigid pricing. The coffee market can be very volatile even over very short periods of time. However, expecting all coffee consumers to accept dramatic price fluctuations would likely be a very

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3 poor decision on the part of the coffee suppliers particularly because people dont like or accept rapid change all that well. Leaving coffee prices paid by end-consumers to fluctuate would no doubt lead to confusion and annoyance similar to what many people feel when stopping to fill up their vehicle with petrol these days when the petrol price changes are very obvious. Overall, there are many moving parts in the process of getting coffee off from the farm and into your cup. Each part represents a unique and frequently changing price component as well. Even with all the moving parts and middlemen, the value of a fresh cup of coffee can be great often well beyond the 15 or so that someone roasting their own coffee might spend to have a wonderful sensory experience. Chart 1: Coffee C Market Basis Price

Source:Coffee Price Economics by Jonathan Harrier, USA, May 2007

Extract 2 Coffee is not just a drink. Its a global commodity. As one of the worlds most traded productssecond in value only to oilthe coffee industry employs millions of people around the world through its growing, processing and trading. But while the coffee trade is vital to the politics, survival and economies of many developing nations, the industrys pricing and futures are decided in conference rooms and on stock exchange floors in some of the worlds wealthiest cities. The International Coffee Agreements Coffee has been a valuable international trade commodity since the 1800s. Established in 1963, the International Coffee Organization (ICO) has operated under the International Coffee Agreements of 1962, 1968, 1976, 1983, 1994 and 2001. The agreements were negotiated under the authority of the United Nations.

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4 The International Coffee Agreements were the most successful effort to control coffee supply to date. From the 1960s to 1989, they stabilized the market and stalled a decline in prices. The agreements included both importing and exporting countries, limited excess supplies using a quota system, implemented price controls and promoted an increase in coffee consumption. The first agreements helped to strengthen the economies of coffee-producing countries in Africa and Latin America. The success of the International Coffee Agreements was owed in part to the United States, who helped to enforce the quota system in an effort to prevent communism from destabilising poor Latin American countries. But when the U.S. pulled out from the agreement in 1989, serious repercussions ensued. In 1989, the ICO extended the 1983 agreement to allow for more time for negotiation. It also suspended the quota system, plunging coffee prices to about half their previous levels and to record lows by the early 1990s. The ICO was unable to reach a consensus regarding price regulation and coffee prices plummeted.
Source: Independent Lens_BLACK GOLD_ The Economics of Coffee PBS.htm

Tasks (a) (b) What is meant by the term market-clearing price in Extract 1? [2]

(i) With the help of the data provided, examine the nature of coffee price changes for the period 1994 to 2006. [4] (ii) To what extent can economic theory explain such price changes? [8]

(c)

With the aid of a suitable diagram, analyse the impact of the suspension of the quota system in 1989 on the income of coffee growers and the economic welfare of coffee consumers. [6] If you are an economic advisor to the government of a developing coffee-growing country, what measures would you recommend to protect the incomes of farmers as well as to ensure economic growth for the country as a whole? Discuss the effectiveness of such measures in achieving both the policy objectives. [10] Total: [30]

(d)

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Question 2
Extract 1: China and US Trade America's anger at China is clearly growing. In February it filed a complaint to the World Trade Organisation (WTO) against Chinese export subsidies. In late March the Department of Commerce announced tariffs of 10-20% on glossy paper imported from China, to offset the impact of alleged government subsidies. China's trade surplus with America increased to $233 billion last year, accounting for almost 30% of America's total deficit. China's total current account surplus reached an estimated $250 billion, or 9% of GDP, up from only 1% in 2001. The surge in its foreign exchange reserves, to over $1.2 trillion, also suggests that the yuan is undervalued: without those massive purchases of dollars, the currency would have risen. China's large bilateral trade surplus with America largely reflects Asia's changing supply chain. Much of what America buys from China today once came from Japan, South Korea and Taiwan. China now imports components from these countries, assembles them and exports the finished goods to America. Knock out these and America's bilateral deficit with China shrinks by more than half. Furthermore, Chinas import growth collapsed after 2004 when the government started to tighten policy, causing a sharp slowdown in construction, one of the biggest importers of machinery and materials.

Figure 1: Chinas Merchandise Trade Balance, $bn

200 150 100 50 0 1996 1998 2000 2002 2004 2006

Source: Thomson Datastream

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% change 5 4 3 2 1 0 2000

Figure 2: Annual Real GDP growth of USA

2001

2002

2003

2004

2005

Source:http://www.ekonomifakta.se/en/Facts_and_figures/GDP/Economic_growth/Real_term s-of-trade_adjusted_GDP/

Figure 3: Annual Real GDP growth of China

% change 12 10 8 6 4 2 0 2001 2002 2003 2004 2005 Source: www.chinability.com

The devil to measure It is hard to see how China can be blamed for job losses when Americas unemployment rate (4.5%) is close to its lowest for decades. Trade with China may affect the composition of jobs in America, but it has little impact on total employment. It is true that some workers are harmed by trade with China, just as there are some losers from all international trade. But the American economy overall is better off, so in theory there is ample room to compensate any losers.

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7 Trade with China helps, not harms the average American. Thanks to imports from China, prices are lower and real incomes higher. Commentators often refer to the cheap yuan as being an unfair subsidy for Chinese exporters. But it is a moot question who exactly is subsidising whom. Not only do cheap imports subsidise American consumers, but Chinas large purchases of Treasury bonds also hold down American interest rates, thereby subsidising home buyers. Wishful thinking The real cause of the deficit is that Americans spend too much and save too little. This means that the country has to import surplus savings from abroad by running a currentaccount deficit. If a stronger yuan did not cause Americans to save more, it would do little by itself to reduce the trade deficit. Another reason why even a big rise in the yuan would do little to reduce Americas deficit is that there is little overlap between American and Chinese production, so American goods cannot replace Chinese imports. Instead, other countries, such as Indonesia and Vietnam, would probably replace the Chinese. Shifting purchases to higher-cost producers amounts to imposing a tax on American consumers, says Stephen Roach, chief economist of Morgan Stanley.
Source: The Economist, 17 May 2007

Extract 2: Trades victims Low-skilled workers in a rich country, such as America, suffer when trade expands with a poorer country with plenty of much cheaper low-skilled workers, such as China. If labour markets are efficient in the rich country, the displaced workers should find new jobs, but their wages will probably fall. Although the country overall gains handsomely, these people are often worse off. Traditionally, trade-displaced workers have also tended to be older and less educated than typical workers, and to have worked in only one industry. They take longer than average to find another job and, when they find one, are more likely to see their wages fall.
Source: The Economist, 18 Jan 2007

Extract 3: China sets up pollution blacklist China's emissions of carbon dioxide and pollutants have soared on the back of its ongoing economic boom. China has set a target of cutting the emission of pollutants by 10% between 2005 to 2010. However, with China now building about two new fossil fuel power stations every week, Western environmental commentators say it will be all but impossible for it to achieve that reduction.

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8 Earlier this month, a Chinese environment official admitted to British politicians that China was not able "for the time being" to commit to binding agreements to cut carbon emissions.
Source: BBC News, 30 Jul 2007

Tasks (a) (i) With reference to Figure 1, describe the trend in Chinas merchandise trade balance from 2000 to 2006. [2] (ii) Account for the trend identified in a(i). [4] (i) With reference to Figures 2 and 3, compare the economic growth of USA and China between 2001 to 2005. [2] (ii) Assess the impact of Chinas trade on its standard of living during this period. [4] To what extent is trade with China harmful to USA? Evaluate the measures that USA can take to correct the trade imbalance. [8] [10]

(b)

(c) (d)

Total: [30]

Copyright Acknowledgements: Question 1 Extract 1 Question 1 Chart 1 Question 1 Extract 2 Question 2 Extract 1 Question 2 Figure 1 Question 2 Figure 2 Question 2 Figure 3 Question 2 Extract 2 Question 2 Extract 3 Coffee Price Economics by Jonathan Harrier, USA, May 2007 Coffee Price Economics by Jonathan Harrier, USA, May 2007 Independent Lens_BLACK GOLD_ The Economics of Coffee PBS.htm The Economist, 17 May 2007 Thomson Datastream http://www.ekonomifakta.se/en/Facts_and_figures/GDP/Economic_growth/ www.chinability.com The Economist, 18 Jan 2007 BBC News, 30 Jul 2007

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