H2 Economics

Tampines Junior College

Preliminary Examination
Suggested Answers
Paper 2
Section A
1.

An exceptionally large number of new homes are currently being

built as part of the cooling measures for the housing bubble.
The housing bubble benefits no one and hurts many when it
bursts. This allocation of land would hopefully moderate
housing prices, so that it would remain affordable for most
residents.
Source: Minister Khaw Boon Wan on Housing
Policies, Budget Debate 2013
(a)

Distinguish between public and private goods, and determine if

public housing is a public good.
[10]

(b)

Using concepts of scarcity, opportunity costs and production

possibility curves, discuss if the allocation of land use for public
housing is justified.
[15]

Suggested answer
a) Distinguish between public and private goods, and determine if public
housing is a public good. [10]
1. State Definition

Public Goods
Non-rivalrous
Non-excludable

Private Goods
Rivalrous
Excludable

2. List Examples

Street lighting,
lighthouses, flood-control
dams, public drainage,
public services such as
national defence and
police

Education,
Healthcare,
housing, cars, alcohol

Example of Public housing

3.
Explain Example of Street lighting
characteristics in i. Public
goods
are i. Private
goods
are
non-rivalrous
relation
to
in
rivalrous in consumption
(ie. Quantity available for
example
consumption
(i.e. quantity available for
consumption
diminishes
consumption does not
with more users)
diminish with more users)
consumption of housing
consumption of the
street light by one person
by one person deprive
does not deprive others
others from consuming it.
from consuming it
It does not matter if 1
individual, 10, 100 or 1000
individual
utilizes
the

streetlight
cost of ii. Private
goods
are
providing the good to 100
excludable
in
people is the same as the
consumption
cost of providing the good
(it is possible to exclude a
to 1,000 people
non-payer consuming the
good)
quantity of lighting remains
unchanged regardless of
Individuals will need to
the number of users
pay
the
unit
before
receiving their keys.
(ii) Public
goods
are
non-excludable
in (iii) Housing is considered a
by
the
private
good
consumption.
(it is impossible to exclude government of Singapore
a non-payer consuming since it is both excludable and
rivalrous in consumption.
the good)
Individuals can free-ride
and utilize the streetlight
once it is installed without
need of payment
(iii) Gives rise to issue of
free-ridership
there is no
expression of demand, P=0.
Price mechanism fails, there is
no signal to producers and no
incentive for producers to
produce.
4.
Highlight \ If left to the free market,
problem if left to
there
would
be
nil
the free market
provision
of
public
(private sector)
goods. Hence there is a
missing market for public
goods. The market has
failed
because
no
resources will be allocated
to the production of public
goods like street lights.
Complete market failure
justify a greater extent of
govt intervention

\ If left to the free market,

there
would
be
production/consumption
of private goods.

Public housing is a private good.

Consumption is rivalrous, since a consumers consumption would reduce
amount of flats available for the next consumers.
Furthermore, there are regulations restricting the consumption of public
housing. In Singapore, public housing is only available for married couples or
singles above the age of 35, with combined monthly income below SGD
10,000.
Singapore government intervenes in the market of housing because they perceive
there is market failure in the provision of housing. Housing could foster sense of
belonging to Singapore, and promote racial harmony among its diverse population.
These external benefits suggest that consumption of housing could be viewed as

having positive externality on the economy. Thus, the government would intervene in
this market.
Synthesis
Government tends to intervene in the markets for both public and merit goods since
both these goods provide substantial benefits to the society. In the context of
Singapore, the government has stepped in to provide for these goods directly as can
be seen from its allocation of resources to national defence and public housing.
Level
L3
L2
L1

Descriptors
Elaborated and rigourous explanation detailing the differences
between public and private goods. Good analysis of whether
public housing is a public good.
Comparison made between public and private good. Analyse if
public housing is public good.
Attempt to explain public and private goods with little/no
comparison made. Did not identify if public housing is public
good.

Marks
7-10
5-6
1-4

b) Using concepts of scarcity, opportunity costs and production possibility

curves, discuss if the allocation of land use for public housing is justified. [15]
Dissecting the preamble
An exceptionally large number of new homes are currently being built as part of the
cooling measures for the housing bubble. The housing bubble benefits no one and
hurts many when it bursts. This allocation of land would hopefully moderate housing
prices, so that it would remain affordable for most residents.
Points we can learn from preamble:
1) There is a large increase in supply of public housing in current time period
does
not address current shortage/problem
Supply of public housing tends to be price
inelastic
increase in DD will lead to an increase in prices to a larger extent
worsens housing bubble
2) There is a problem of housing bubble
unsustainable increase in housing prices
detrimental effects on the economy if it was to burst
unemployment, loss of
savings/wealth/assets, recession, worsen investors/consumers confidence [AD-AS
analysis required]
3) There is a need to ensure housing prices remain affordable to most residence
equity/merit good/goods with positive externality
Introduction
Scarcity refers to the situation where there are limited resources which
cannot satisfy unlimited wants. As such, there is a need for choices to be
made.
This gives rise to the concept of opportunity costs, which refers to the
next best alternative forgone. When choices are made, there will be
opportunity costs incurred, since there are alternatives forgone.
Opportunity costs could be represented as implicit and/or explicit costs.
Implicit costs refer to costs which cannot be expressed in monetary terms
such as time wasted. Explicit costs are costs that can represented in
monetary terms such as prices of goods.
In allocating land to be used for construction of public housing, the
government would have necessarily made choices and forgo certain

alternatives. Through examining some of the choices forgone, it can shed

lights on whether the choice to allocate land for public housing is justified.
The presence of a housing bubble has garnered concern from the
government. The bubble would cause property prices to rise rapidly, pricing it
out of affordability for Singaporeans and residents. This suggests that there is
a shortage of housing in the market, since scarce commodity would
experience increase in prices. The act of allocating land to public housing
would have meant that there are alternatives forgone.
These choices could be analysed through the use of production possibility
curves [PPC], which illustrates the maximum amount of 2 goods an
economy can produced, assuming that this is within the same time
period, using the same level of technology, the same amount of
resources and that all resources are fully and efficiently used.

Main body
Thesis

the allocation of land to public housing is justified

1) Consider opportunity costs incurred when resources are fully and efficiently
used

Assuming all resources are fully used and Singapore is currently producing
on the PPC at point E.
As government allocates more land to public housing, changing the
production point towards point A on the PPC, the resources remain efficiently
used, however, the change in allocation represents opportunity costs
amount of consumer goods have to be given up in order for Singapore to
produce more public housing.
Since resources are not perfectly substitutable, there will be increasing
opportunity costs incurred
thus the PPC is concave in shape.
From E to A, opportunity costs incurred is at a decreasing rate
allocating
more land to public housings could be justifiable.

Figure 1: Singapores PPC between public housing and consumer goods

Public housing
B

D
A

Consumer goods
4

2) Consider opportunity costs incurred when resources are not fully and
efficiently used
At C, there is underallocation of resources to consumer goods and public
housing.
The economy possess idle resources
allocation of more resources to
public housing will not incur opportunity costs.
Allocating resources towards to public housing allows economy to engage
resources more efficiently
production shifts to B
There is pareto improvement in the economy
the increase in public
housing is not at the expense of consumer goods from C to B
Allocation of land towards public housing is justified.
3) Consider opportunity costs incurred when qualilties/quantities of factor
inputs or state of technology is improved
Point D which lies outside the PPC is not attainable due to scarcity,
Singapore does not possess sufficient resources to attain production at D.
However, improvement in technology could allow Singapore to attain
production at D if the PPC shifts out
improvement in productive
capacity of the economy
Similarly, this could be achieved if there are improvement in factor
quality/quantity of resources
These could be the result of
i) land reclamation
increases factor quantity of land
ii) improvement in construction techonology
able to build more public
housing in given period of time
iii) increase in labour force
more construction workers available
iv) through trade
better quality of resources
cement/steel
able to
build higher structures
Thus, allocating more land towards public housing could be justified.
4) Cooling measures for housing bubble
Singapore has been experiencing a housing bubble
phenomenon whereby
the prices of public housing have been driven sharply, partly due to
speculations.
there is scarce amount of housing available for the
consumers.
Allocation of land of land towards public housing would increase the supply of
public housing. There is an increase in quantity of factor inputs for public
housing.
As supply increases from S1 to S2 in figure 2, a surplus would be generated
at P1. This exerts a downward pressure on price. Quantity demanded would
increase and quantity supplied would decrease as price falls. This continues
till the market clears with a higher output at Q2 and a lower price at P2.
The lower price would contribute to affordable prices of public housing and
address the shortage experienced.
allocation of land is justified.
Evaluation: However, as the supply of housing tends to be price inelastic,
since housing requires time for construction, any further increase in demand
will only lead to higher increase in price. This would also mean that the
increase in supply of public housing would not address the housing bubble in
current time period adequately
the moderation of prices may not be
significant.
While there is a need to allocate more land for public housing, this may not be
effective in moderating the prices
allocation of land may not be justified,
considering time period.

Figure 2: Market for public housing

Price of public housing
S1

P1

S2

surplus

P2
D1
Q1

Q2

Quantity of public housing

5) Public housing is considered to be a merit good by Singapore government

Public housings are a form of asset investment for Singaporeans, which can
be utilized as retirement collaterals
retirement funds in future.
This leads to underestimation of true benefits in the consumption of public
housing from the governments POV.
The consumption is currently set at Qpte where effective demand for public
housing intersects supply of public housing.
The government sets desired demand higher and therefore Qsoc is derived
from the intersection of desired demand and supply.
Since Qsoc is greater than Qpte, there is underconsumption of public
housing in the eyes of govt.
insufficient housing produced
housing is in scarce amount
This leads to development of welfare loss as indicated by shaded region in
Figure 3, thus the market fails.
To address this market failure, the allocation of land to public housing is
justified as government do indeed provide merit goods. In Singapore,
government has provided for other merit goods such as education and
healthcare.
Since land is scarce in Singapore, there is a need for government to
intervene to ensure the best allocation of resources
maximize the
welfare/benefits the economy can enjoy from the use of land
The allocation of land to public housing would lend to increase in
consumption of public housing and therefore correct the market failure.

Figure 3: Underconsumption of Public housing in Singapore

Price of public housing

SS

Desired DD
Effective DD
Qpte

Qsoc

Quantity of
public housing

Ownership of public housing would instil a sense of rootedness for new

residents
Reinforce national identity
reduce brain drain OR retain the foreign
talents SG has attracted to stay on.
Racial quota for HDB flats would reinforce racial harmony amongst residents
Ethnic integration policy
Promotes social cohesion
contributes to social security and diversity.
This gives rise to external benefits of public housing consumption in
Singapore
positive externality in consumption of public housing.
In the consumption of public housing, the consumers would only consider
their private costs and benefits.
Private costs include the price of the property and the associated opportunity
costs of options forgone in the consuming public housings, such as cars,
holidays. Private benefits would include possible revenue from renting of the
rooms and having personal space.
Many consumers tend to disregard the possible external benefits generated
like racial unity/national identity. Thus, the consumption would be set at Qpte,
where MPB = MPC.
As such, there will be social and private benefits curves, such that MSB =
MPB + MEB

Figure 4: Positive externality in the consumption of public housing

Costs/benefits of public housing

MSC = MPC

MSB
MPB
Qpte

Qsoc

Quantity of
public housing

The social optimal level of consumption is set at Qsoc, where MSC = MSB.
There is underconsumption public housing in the market. At Qpte,
MSC>MSB, additional units of public housing produced would add more to
societys benefits than costs.
Welfare loss to society develops from the underallocation of resources to
public housing
public housing is in scarcity.
Allocation of resources to public housing is justified if the total benefits the
society experiences would outweigh the total costs inccurred

Anti-thesis

allocation of land to public housing is not justified

1) High opportunity costs

Land scarcity
Refer to figure 1
as production shifts from A to B, allocation of land to
public housing would incur high opportunity costs, since Singapore has
to give up more units of consumer goods
imperfect substitutability of
resources.
Since land is scarce and a primary factor input, there has to be efficient
allocation of this resource.
Consider allocation of land for commercial purposes
One Marina
Opportunity costs of rental of offices, creation of jobs, attracting FDIs
analyse impact through AD-AS.
Allocation of land to public housing would not generate as much tangible
returns to the country.
HDB makes hundreds of millions of losses with each year
factoring land
costs and construction and govt subsidy
construction of public housing
worsens fiscal position of government in contrast to revenue generating
projects like commercial offices
high opportunity costs incurred for
provision of public housing

2) Provision of other merit goods

Other merit goods could benefit society
R&D
develop new sectors of
growth
lend to export competitiveness
improves resilience to external
shock which is crucial in current economic conditions where recessions are
occurring with higher frequencies.
Consider land allocated for One North
Research facility for development of
biomedical hub
new area identified as key sector of growth
opportunity
costs
chance to develop key sector of growth and improve resilience of
economy
Education
another form of merit goods which can contribute to
improvement in productive capacity of economy. Furthermore, established
education facility could attract better FDI and foreign talents
Consider land allocation for SUTD
4th public university in Singapore
to
increase proportion of graduates in Singapore
improve factor quality of
labour
attract foreign investment
opportunity costs
expansionary
effect on economy
Healthcare
merit goods and key sector of growth
medical tourism
FDI
to start up medical services in SG
good reputation of high quality medical
services in South East Asian region.
Consider land allocation for Khoo Teck Puat hospital
infrastructure
required to cater to increase in population and aging population
establishing more healthcare providers in housing estates. Opportunity
costs of revenue from medical tourism and attracting FDIs
3) Possibility of overcorrection
Information lag
As government does not possess all information
likelihood that there are error in the derivation of Qsoc
may have led to
overallocation of scarce resources to the market of public housing
resulting in further welfare losses and therefore greater inefficiency in the
allocation of resources
government failure results
incurs greater
opportunity costs
Time lag
the construction of many public housing in current time period
may be remedy the shortage experienced.
market of public housing would
likely experience greater increase in demand for public housing and therefore
higher increase in prices before the supply of public of housing could increase
possibility of surplus of public housing in the future
reinforce bursting of
bubble in the future
incurs greater opportunity costs
Implementation lag HDB is a large government body
bureaucratic red
tape which could hinder the administrative process
leads to higher costs of
production, more time required for vetting processes etc.
leads to slower
response to current shortage in the market
problem of housing bubble
would worsen before intervention is applied.
worsens the opportunity
costs incurred.
Synthesis
Government has to employ cost-benefit analysis in order to allocate land use most
efficiently. Furthermore, government has to consider the short and long run
implications of the allocation of land. While Singapore has been active in land
reclamation, this is neither a feasible nor sustainable option.
Evaluative conclusion
Public housing are sold with a lease of 99 years
govt would be able to re-possess
the land and can re-allocate the land for other uses in future
poor planning could
lead to wastage of resources in construction and tearing down of buildings.

In lieu of housing bubble

concern could be centered on ensuring prices of public
housing remain equitable
primary objective of public housing
consumption of
HDB flats even for the low-income
foster Singaporean sense of rootedness.
More importantly
this is an opportunity for the government to demonstrate its
resourcefulness in reducing the bubble before it threatens the economy with
likelihood of recession and poor investment outlook.
Complementing policies
Regulations in housing market to ensure equity and
reduce speculation on housing has been imposed. However, as there are no perfect
policies, there remains a need for govt to implement a basket of policies.
Level
L3

L2

L1

Evaluation
E2
E1

2.

Descriptors
Elaborated and rigourous explanation detailing the pros
and cons of allocating land for public housing with
constant references made to the concepts of scarcity,
opportunity costs and production possibility curves.
Clear explanation as to why the allocation of land use to
public housing is justifiable, with consideration to
alternative land use and other goals of governance.
References to opportunity costs and production
possibility curves are required.
Attempt to explain why provision of public housing is
desirable, with some economic analysis on merit
goods/positive externality. References to opportunity
costs incurred must be addressed.
Descriptors
Reasoned judgement with insights on current economic
development and how decisions made by government
could be affected by long run and short run objectives.
Conclusion with stance made, which lacks economic
analysis.

Marks
9-11

6-8

1-5

Marks
3-4
1-2

Using economic analysis, discuss the effects of an improvement

in technology in the computer tablet industry and its related
markets.
[25]

INTRO
- Improvement in technology affects both demand and supply in the industry. Need to
use demand and supply analysis as well as various elasticity concepts to analyse the
change. Relevant elasticity concepts that can be used here are price elasticity of
demand, price elasticity of supply and cross elasticity of demand.
BODY
1) Demand Factor: There has been a favourable change in tastes and preferences
due to the improvement in technology in the computer tablet industry, causing the
demand for tablets to increase, ceteris paribus.
There has generally been an improvement in technology in the computer tablet
industry where tablets get lighter and more portable. Also, tablets now have a longer
battery life as compared to before. This is important to users because they might not

10

always be able to charge their tablets freely. Furthermore, tablets are now more
sensitive to the touch of the users finger, allowing users to navigate more easily.
Technology has also allowed tablets to become more flexible, allowing the surface to
twist and turn, according to the users requirement. These improvements have
resulted in a favourable change in tastes and preferences for tablets, causing the
demand for tablets to increase and the demand curve shifts to the right, ceteris
paribus.
2) Supply Factor: Improvement in technology has caused the supply for tablets to
increase, ceteris paribus.
Improvement in technology has allowed tablets to be produced more efficiently. This
is because producers have found new ways to produce tablets at a cheaper cost,
maintaining the same level of quality. The improvement in technology has caused the
cost of production of tablets to fall and profit margins for producers to increase. This
raises the supply for tablets and shifts the supply for tablets to the right, ceteris
paribus.
3) Price elasticity of Demand: The demand of tablets is price elastic
- Since there is a shift in supply, the price elasticity of demand would be relevant.
Demand of tablets would be price elastic. Price elasticity of demand is negative and
its magnitude is greater than one. This is because tablets have many other close
substitutes, for example, notebooks. They are close substitutes because they are
both portable and allow users to go online even when they are out. Furthermore,
tablets are luxury goods as users usually do not need them to do work, but usually
use them for leisure purposes. This contributes to the high price elasticity of demand
for tablets.
4) Price elasticity of Supply: The supply of tablets is price elastic
- Since there is a shift in demand, the price elasticity of supply would be relevant.
Supply would tend to be more inelastic in the short-run than in the long-run. This is
because, in the short-run, computer tablet manufacturers can only increase
production by increasing the variable factors of production such as labour. Therefore,
when there is an increase in the price, quantity supplied will only increase by less
than proportionately. However, in the long run, supply of tablets would be more price
elastic. Price elasticity of supply is positive and its magnitude is greater than one.
Firms are able to vary all factors of production. For example, instead of relying just on
an increase in labour, computer tablet manufacturers can set up more factories to
produce more goods.
Furthermore, the price elasticity of supply also depends on the degree of factor
substitution. Much of computer tablet production tends to require low-skilled workers
who do not require much training. Thus, it would be relatively easily for tablet
producers to hire more workers if the price were to increase. Supply of computer
tablets would tend to be price elastic in the medium term and the long term.

11

5) Market Adjustment Process

Pri e

m uter ta lets

S1
S2

P1
P2
D1
Q1

Q2

D2
uantity
tablets

m uter

At the original price, P1, quantity supplied is greater than quantity demanded. There
is a surplus. There would be an downward pressure on price. As price falls, quantity
supplied falls and quantity demanded increases. This causes the surplus to gradually
fall until the market clears and final equilibrium is reached. The equilibrium quantity
has increased to Q2 and the equilibrium price has fallen to P2. As demand and
supply are both price elastic, the % change in Pe is small relative to the % change in
Qe.
6) Relative shifts: The increase in supply is greater than the increase in demand
It has been observed in the real world that prices for tablets have generally been
dropping, therefore it is very likely that the increase in supply is greater than the
increase in demand. This could be because even though there are many innovations
for tablets that are very attractive to users, causing the demand for tablets to
increase, the increase in demand is limited because many of these innovations have
also been applied to notebooks and even desktops and therefore may not be unique
to tablets alone. Furthermore, due to the high level of competition between the
different tablet makers such as Apple and Samsung, producers always resort to
research and development to find new ways of making the costs of making their
tablets lower, so that their products can compete on the international market.
7) Effects of improvement in technology in the tablet market on substitutes
Notebooks are close substitutes to tablets. This means that the cross elasticity of
demand for tablets and notebooks would tend to be positive and high. Since price of
computer tablets falls, Qd for tablets increases
Since tablets and notebooks are
close substitutes
consumers switch from using notebooks to using computer
tablets instead
DD for notebooks will fall by m.t.p
Pe and Qe of notebooks drop
quite significantly
Evaluation: However, with increasing innovation resulting in a greater amount of
product differentiation, it is likely that the cross elasticity of demand between tablets
and notebooks will fall. For example, making it easier and more convenient to play
games on the tablet will reduce the substitutability between tablets and notebooks.
Also, if tablet producers are able to create products which allow users to read without

12

discomfort, tablets may eventually replace books, a function that notebooks are
unlikely to be able to fulfil.
8) Effects of improvement in technology in the tablet market on complements
Internet services are close complements to tablets. This means that the cross
elasticity of demand for tablets and notebooks would tend to be negative and high.
Since price of computer tablets falls, Qd for tablets increases
Since tablets and
internet services are close complements
consumers use more internet services
along with their increased usage of tablets DD for internet services will increase by
m.t.p
Pe and Qe of internet services increase quite significantly
Another complement is that of online video games such as those produced by Zynga.
It is also a close complement of computer tablets. This is because many users prefer
to play these video games on tablets as tablets use touchscreen technology which
allows users to simply touch the screens to play the game instead of having to use a
mouse which may be more inconvenient. Therefore, it is likely that online video
games are a closer complement of computer tablets as compared to notebooks.
Therefore, the demand for online video games will increase by m.t.p
Pe and Qe of
online video games increases quite significantly.
Evaluation: Between internet services and online video games, it is likely that internet
services are a closer complement to tablets than online video games. This is
because almost every user with a tablet would require internet services in order to
use the basic functions of the tablet. On the other hand, not every tablet user plays
video games. Therefore, a fall in the price of tablets would generally cause a greater
increase in demand for internet services as compared to online video games,
resulting in a larger increase in Pe and Qe for internet services.
CONCLUSION
It is highly likely that the trend towards improvement in technology will continue,
resulting in a continued increase in demand and supply for tablets in the industry.
However, the relative extent of shifts in demand and supply may not stay the same.
For example, in the future, there could be ground-breaking innovations for tablets
that could cause demand to increase substantially more than the supply. Or, it is
possible that one of the tablet manufacturers gains a strong dominance, and possibly
even a monopoly over the tablet market. Such a monopoly may reduce the incentive
to engage in further R&D to reduce costs as the competitive element in the industry
no longer exists, and therefore limit increases in supply in the tablet market.

13

Marking Scheme
Level

Descriptors

Level 1

Answers are mostly irrelevant.

Listing of points

6-9

Very little contextualization

Errors and misconceptions shown throughout explanation
Little elaboration on demand and supply factors, mainly listing

Level 2

Must examine the computer tablet market, as well as the market of a complement OR
substitute good
Answer shows adequate knowledge of demand and supply forces and how these affect
equilibrium price and/or equilibrium quantity.
Answer may not be balanced when considering demand and supply factors
Little use or incorrect use of elasticity concepts
Lack of economic analysis and development
Response lacks contextualization
Little analysis of markets

1-5

10 - 11

12 - 14

Level 3

15 18

19 - 21

Must examine the computer tablet market, as well as the market of a complement good
and a substitute.
Answer shows adequate knowledge of demand and supply forces and how these affect
both equilibrium price and equilibrium quantity.
Response considers both demand and supply factors
Some effective use of elasticity concepts
Some economic analysis
Response lacks contextualization
Little analysis of markets
Response must have examined both the computer tablet market and at least either
substitutes or complements
Answer demonstrates good knowledge of demand and supply forces and how these
affect equilibrium price and equilibrium quantity, and shows knowledge of market
equilibrium
Answer considers both demand and supply factors
Good use of elasticity concepts. Students must have considered Eab and Ep OR Es
Good economic analysis
Effective use of diagrams
Good contextualization
Response must have examined both the computer market as well as both substitutes
and complements
Answer demonstrates excellent knowledge of demand and supply forces and how these
affect equilibrium price and equilibrium quantity, and shows knowledge of market
equilibrium
Both demand and supply factors very well-explained
Excellent use of elasticity concepts. Students must have considered Eab and Ep and Es.
Excellent economic analysis

14

E1 (1-2)
E2 (3-4)

Very effective use of diagrams

Very good contextualization
Mainly unexplained judgement.
Judgement based on analysis.

3.

Microsoft invests billions on Research and Development (R & D)

which has contributed to a stream of innovations that have
transformed business and the homes. To encourage innovation,
intellectual property rights are given to innovators for a period
of exclusivity to earn a reasonable return on their investment.
Source: The Straits Times ASK: NUS ECONOMISTS
16 Nov 2011
(a)

Explain how barriers to entry affect a firms pricing behaviour

and profits earned.
[10]

(b)

To what extent is Microsofts market power justified?

[15]

Part (a)
Introduction:
The key factors that affect the structure of a market are number of firms in the
industry, nature of product, knowledge of the market and the existence of barriers to
entry (BTE). BTE are obstacles that prevent entry by potential competitors into the
market. BTE play a key role in determining firms pricing decisions and profits earned
in the long run.
Development:
1. Consider market structure with no/weak BTE vs market structure with
strong BTE
(a) Market structure with no BTE e.g. Perfect Competition and
Monopolistic Competition
Under perfect competition and monopolistic competition, with no barriers
to entry, firms can enter and leave the industry easily. This gives rise to
many small firms in the industries.

Consider Perfect Competition

In the extreme under perfect competition, where product is

homogenous and with the existence of perfect knowledge together
with no BTE, firms are price takers in the market. Illustrate with the
LR equilibrium adjustment process.
With many buyers and sellers trading a homogeneous product, each
buyer and seller is a price taker. The firm is unable to affect market price
by changing its output. It has no control over the market price because
many other firms are offering the product that is essentially identical. If

15

he charges more than the market price, buyers will go elsewhere. The
firm may sell any quantity it likes but only at the market price.

Assume the PC firms are making supernormal profits in the short run
Figure 1: Adjustment process from supernormal profits to normal profits

The PC firms take the initial market price P determined by the market forces
of DD and SS. Assuming that these existing PC firms are making
supernormal profits, new firms will be attracted to the supernormal profits and
enter the industry. This is made possible as there are no barriers to entry for
the industry. Market supply thus increases resulting in a shift of the market
supply curve to the right from S to S1. Consequently, market price will fall
from P to P1 and there will be a downward shift of the individual firms
demand curve from D to D1 since they are price-takers.
The gradual fall in an individual firms price will continue until price exactly
equals AC at P1 and all supernormal profits are wiped out. Normal profits are
now achieved. At this point, there is no more entry of new firms and long run
equilibrium is attained.
Thus, perfectly competitive firms will take the price set by the market demand
and supply of the industry and sell at the prevailing market price and due to
no BTE, PC firms can only make normal profits in the long run.
Consider Monopolistic Competition

For monopolistic competition, where product is slightly differentiated and

with no BTE, the firms face a fairly elastic demand curve.

Monopolistic competitive firms have some market power and can set
prices but not high prices as with no BTE, competition will be stiff

In the long run, similar to PC firms, firms in monopolistic competitive

markets can only make normal profits due to freedom of entry as any

16

supernormal profits earned in the short run will attract entry of new firms
which compete away the supernormal profits.
(b) Market structure with strong BTE e.g. Monopoly & Oligopoly
With imperfect information, unique product under Monopoly and
differentiated/homogeneous product under Oligopoly, firms under these 2
market structures have market power i.e. it is able to set prices which is
further enhanced by their high barriers to entry.

Examples of barriers to entry are large economies of scale in production,

network effects and government policies

Consider Monopoly

With high BTE, in the extreme, a single firm (pure monopoly) or a

dominant firm exist in the market. With only a single or single dominant
firm in the market => the product is unique or with no close substitutes.
The demand for the product is inelastic

Monopoly will be able charge high prices to earn more and even possible
to earn supernormal profits in the long run as rival firms can be prevented
from entering the market to erode away the profits.

Figure 2: A monopolist is a price setter and given substantial BTE it can earn
supernormal profits even in the long run

Cost,
Revenue,

MC

Pe
B

D
C
E

Qe MR

= AR

ut ut

The profit-maximising condition, where MR = MC and MC cut MR from below,

occurs at point E. The monopolist restricts output at OQe and charges an
equilibrium price at OPe. With high barriers to entry, it can keep its rivals out
and thus able to earn supernormal profits even in the long run.

17

Consider Oligopoly

High BTE can also give rise to a few dominant firms existing in the
industry. This gives rise to an oligopoly. In an oligopoly, as each dominant
firm has a significant share of the market, they are mutually
interdependent in their pricing and output decision-making i.e. each firm
has to mindful of the reactions of their rivals to its decision-making. Thus
in pricing decision, they could either act in a non-collusive or collusive
manner.
Prices tend to be rigid in an oligopolistic market as it is assumed that rival
firms will follow a price decrease and not a price increase (acting in a noncollusive manner). That is, if a firm is to decrease its price, it will lead to a
less than proportionate increase in its quantity demanded as the other
firms will follow its price decrease. On the other hand, if the firm increases
its price, it will lead to a more than proportionate fall in its
quantity
demanded as the other firms will not follow its price increase.
Thus oligopolistic firms could practice price leadership (acting in a
collusive manner) where the most dominant firm could lead in for e.g.
raising prices to its profit-maximising and the other firms will tacitly follow
the price increase.
Due to high BTE, oligopolistic firms are able to earn supernormal profits
even in the long run as the high BTE keep out the rival firms from entering
the industry to compete away profits.

Note
Students can consider how monopoly or oligopoly firms could practice limit
pricing or predatory pricing if they have other aims instead of profit-maximising.
Limit pricing prevents firms from coming into the market, whereas firms that use
predatory pricing try to drive competitors out of the market.
Conclusion:
Thus BTE is an important factor affecting a firms pricing decision and in particular to
the type of profits it can possibly earn in the long run.
Part (b)
To what extent is Microsofts market power justified? [15]
Introduction:
Microsoft has high barriers to entry and this enhances its market power i.e. giving it
greater ability to alter the market price of its good. When a firm abuses its market
power it will result in a less than efficient allocation of resources. In this essay, using
the efficiency criteria, we will examine whether Microsofts market power is justified.
Development:
1. Define efficiency
Efficient allocation of resources refers to a situation whereby resources are
allocated in such a way that no one can be made better off without another being
made worse off. That is social efficiency or pareto optimality is achieved.

18

In the narrow sense, efficiency can be defined as economic efficiency which is

achieved when there is both productive and allocative efficiency. In a broad
sense, efficiency also takes into consideration dynamic efficiency, economies of
scale (EOS) and cost-savings, product variety and consumer choice.
2. Consider circumstances where Microsofts market power may not be
justified
(i) Productive and allocative efficiency
Microsoft with substantial market power is a dominant firm in the software market.
It is productively efficient from firms view but productively inefficient from
societys viewpoint and is also allocatively inefficient.
Productive efficiency
A profit-maximising firm is necessarily productively efficient since profit
maximisation requires the firm to minimise its cost for producing that level of
output. In this respect, all firms, regardless of their market structures, are
productively efficient.
However a profit-maximising firm with market power produces at the falling
portion of the LRAC curve. It produces with excess capacity and not fully utilising
the given plant size. Hence from societys viewpoint, it is not considered
productive efficient.
Allocative inefficiency
Allocative efficiency is achieved when resources are allocated in such a way that
the right quantity of every commodity is produced. It is achieved when for each
good produced, its marginal cost of production is equal to its price. That is P =
MC.
However, Microsoft with market power is allocatively inefficient. It produces an
output where P > MC.

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Figure 3: Existence of market power leading to welfare loss arising from allocative
inefficiency

e enue
st
Pri e
a

Pm

Pe

MCm

SSPC
c

d
MR

Qm

Qe

Quantity

To achieve allocative efficiency, production should take place at the point where P =
MC (point c) and the socially efficient level of output is at OQe.
However, given its market power, to maximise its profits, Microsoft restricts output to
Qm, charging price at Pm. At Qm, P > MC i.e. the value consumers place on the last
unit (Pm) exceeds the marginal cost of producing it (MCm). Comparing OQm to OQe, it
is evident that there is underproduction of the good in this case. The welfare loss i.e.
the deadweight loss resulting from this underproduction (or misallocation of
resources) is given by the area acd. From the welfare point of view, more should
have been produced. In other words, Microsoft fails to achieve allocative efficiency.
3. Consider circumstances where Microsofts market power may be justified
(ii) Dynamic Efficiency
Market power enhanced through BTE allows Microsoft to earn supernormal
profits even in the long run. These supernormal profits earned enable the firm to
reinvest it to further improve its products. Given a contestable market, there will
be incentive for Microsoft to further improve to keep out its potential rivals. That
is, Microsoft will be willing to invest in R & D to improve its product which
benefits the consumers.
In this context, the market power given to Microsoft to encourage R & D via BTE
in the form of intellectual property rights is justifiable as such research required
high fixed costs. In addition, this given market power is only short-term in nature
as stated in the preamble that the intellectual property rights are given only for a
period of exclusivity for the firm to earn a reasonable return on its investment.
Consumers can also enjoy greater product variety and choices as firms
undertaken innovation to compete with one another.

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(iii) Economies of Scale (EOS) and cost savings

Large firms such Microsoft also produces on a large scale and reaps EOS.
Software development is characterised by substantial EOS as the fixed costs of
producing software, including applications, is very high. By contrast, its marginal
costs are very low. Thus to be cost-efficient it needs a large consumer base to
sell its products. In addition, to keep out its rival firms, Microsoft will be
incentivised to pass on the cost savings to its consumers.
Figure 4: Price and Output under Perfect Competition and Large Firm which
reaps

Revenue/
Cost
MCpc =
SSpc

Ppc
MCm =
SSm

Pm

MR
O

Qpc Qm

AR
Output

The perfectly competitive industry would produce an output OQpc and charge
a price OPpc as given by the intersection of the PC industrys demand and
supply (SSpc) curves. In a market where a large firm can reap substantial
economies of scale, its marginal cost curve (MCm) lies lower than the MC
curve of the perfectly competitive industry (MCpc). The large firms profit
maximising price and output is at OPm and OQm respectively where
MCm=MR. This illustrates that large firms such Microsoft can actually
produce a larger quantity and charge a lower price as compared to perfectly
competitive industries.
Conclusion:
In conclusion, as long as a market is contestable, firms with market power will usually
plough back profits earned to improve product so as to keep its rival firms out. This is
in particular applicable to industry affected by fast-pace changing technology such as
in this context of the IT/software industry. In addition market power that is
strengthened through short-term BTE such as intellectual property rights and patents
are needed to encourage firms to undertake R & D to benefit the consumers in the
long run. In this aspect, Microsofts market power can be justified.
However, long term absolute market power is often frowned upon as it can lead to
inefficiency and societys welfare is undermined. Thus it is also important that the

21

government put in place anti-trust laws and regulations to prevent the abuse of
market power by firms, but one has to be mindful that intervention by the government
can at times lead to greater welfare losses than without its intervention as
government may not have the necessary information in its decision-making.

Mark Scheme:
Part (a)
Level

Descriptors

Marks

L3

A well-developed and rigorous explanation on how the existence

of BTE can affect a firms pricing behaviour and profits earned.

7-10

L2

An underdeveloped explanation of both (i) no BTE and (ii) high

BTE affecting a firms pricing behaviour and profits earned; lacking
in rigour.

5-6

OR
A well-developed explanation of either (i) no BTE or (ii) high BTE
affecting a firms pricing behaviour and profits earned.
L1

For an answer which shows some knowledge on how the

existence of BTE can affect a firms pricing behaviour and profits
earned. Answer contains errors and inaccuracies.

1-4

Part (b)
Level
L3

Descriptors

Marks

A competent response containing well-developed analysis of whether

market power can be justified showing both scope and depth in the
discussion.

9-11

Discussion to be centred on efficiency criteria in both narrow and broad

sense. Candidates may also include the equity criteria.
High L3 (10 -11m): Insightful analysis based on given context.
Note: No reference to productive efficiency => cap at L3 (max 9m)
L2

An underdeveloped explanation of the negative and positive effects of

market power relating to welfare maximisation.
OR
A well-developed explanation but mainly one-sided view.
OR

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6-8

No reference is made to given context.

Note: No reference to economic efficiency => cap at L2 (max 8m)
L1

For an answer which shows some knowledge of the negative and/or

positive effects of market power. Answer contains errors and inaccuracies.

1-5

E2

Judgement based on analysis

3-4

E1

Mainly unexplained judgements

1-2

Section B
4.

Discuss the significance of the multiplier size, factor endowment

and Marshall-Lerner condition in influencing macroeconomic
policy decisions in Singapore.
[25]

Introduction:
State the characteristics of Singapore economy: Singapore is a small & open
economy, highly dependent on trade.
State examples of macroeconomic policies: Demand-management policies (fiscal
policy, exchange-rate based monetary policy), Supply-side policies (marketoriented, interventionist polices), International policies (e.g. trade policies).
Main Development:
Analysis of how the 3 characteristics influence decisions regarding macroeconomic
policies in Singapore:
i) The multiplier size
Topic sentence: The effectiveness of demand-management policies is dependent
on the size of the multiplier.
Definition: The multiplier indicates the number of times income changes relative to
the initial change in AE.
Formula: Multiplier = 1/(1 MPC), where MPC = Marginal Propensity to Consume on
domestically produced goods & services
Explanation of how a demand-management policy works via k effect:
If the government adopts expansionary fiscal policy, increasing G by $100m, then AD
also increases by $100m (via its affect on G).
Firms will experience a fall in inventories, signalling to the firms to increase
production. Firms will hire more workers to increase output. This results in increase in
employment and income increases. As income increases, spending by the
households will increase. As ones spending becomes anothers income, this
increase in spending will lead to an increase in income of another group of people
because of the increasing demand for the goods and services they produce. The
multiplier effect is triggered off leading to a multiple increase in production, output
and national income from Y1 to Y2. This will boost actual growth and employment.

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