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PAPER 1: EXTENDED RESPONSE QUESTIONS

MICROECONOMICS
Resource Allocation
QUESTION 1
Explain the importance of price in allocating scarce resources.(10)
(a) definition of scarce resources
price is determined by supply and demand
price acts as a signal to producers and consumers
price acts as an incentive to producers to reallocate resources
Examiners should be aware that candidates may take a different approach, which if
appropriate should be rewarded.
Evaluate the possible consequences of implementing maximum and minimum price controls.
(15) (Total 25 marks)
(b) definition of maximum price
definition of minimum price
diagrammatic analysis of both maximum and minimum prices
discussion of price controls as forms of government intervention
discussion of the problems associated with the shortages that develop due to
the setting of maximum prices:
queues
waiting lists
rationing
black markets
discussion of the problems associated with the surpluses that develop due to the
setting of minimum prices:
producers can ignore price controls and cut their prices
firms can become productively inefficient
firms are discouraged from producing alternative goods which can be produced
more efficiently but which may have a lower free-market price.
signalling role of prices is distorted and there is a misallocation of resources.
discussion of who suffers from price controls
Up to a maximum of [7 marks] if only maximum or only minimum price controls are
considered.
Examiners should be aware that candidates may take a different approach, which if
appropriate should be rewarded.
QUESTION 2

Briefly outline the various methods of price control open to governments. (10)
(a)

Possible points for discussion:


maximum (ceiling prices)
minimum (floor prices)

subsidies/indirect taxes
price support schemes
buffer stocks
minimum wages.
Two methods, well covered, with relevant examples, would be sufficient to
reach the highest mark band. Candidates who confuse methods of price control
with methods for controlling inflation should be limited to Band 2 and below.
Evaluate the effectiveness of using price controls to reduce poverty.(15) (Total 25 marks)
(b) Possible points for discussion:
definition of poverty, perhaps involving absolute and relative poverty
the ability to provide relatively cheap necessity goods
the ability to provide merit goods
the ability to provide cheaper accommodation
the ability to ensure reasonable wage levels
the cost to the government of implementing price controls
parallel and black markets
any reasonable answer
The best candidates will relate their discussion to the reduction of poverty.
Candidates who evaluate controlling inflation and the reduction of poverty
should be limtted to Band 2 and below.
QUESTION 3
Explain the concepts of maximum and minimum price controls. (10)
(a) Responses should explain what maximum prices are, i.e. price ceilings set by the government
or some other agency. The price is not allowed to rise above this level, although it is
allowed to fall below it. Better responses will give examples of when this may be
appropriate, e.g. for rent controls or for basic goods to keep low for the lower wage
earners. The best responses will also include a diagram.
Responses should explain what minimum prices are, i.e. price floors set by the
government or some other agency. The price is not allowed to fall below this level,
although it is allowed to rise above it. Better responses will give examples of when this
may be appropriate, e.g. for wages or to protect producers incomes. The best
responses will also include a diagram.
Candidates who only deal with one of the concepts should be limited to a maximum
of [5 marks].
Evaluate the idea that government intervention in the form of price ceilings and price floors is
well intentioned, but often leads to undesirable side effects. (15) (Total 25 marks)
[10 marks]

(b)

This part of the question asks the candidate to assess the effects of the imposition of
maximum/minimum prices. It is best approached by taking examples and then
evaluating their success in terms of achieving the desired outcome. Candidates might
refer to several of the examples in each section but it is equally acceptable to have a
well developed discussion on one example only in each section.
Examples and areas for discussion might include:
Minimum prices
setting minimum prices to protect producers incomes. The aim is usually to provide
stability and to give a guaranteed minimum return to important producers.

However, the effect is often to create a glut of the product, which the government
will then have to buy and possibly store.
protecting wages leads to an excess supply of labour
firms with surpluses on their hands may try to evade the price controls and cut their
prices
black markets may evolve to clear the surpluses
high prices may cushion inefficiency
high prices may discourage firms from producing alternative goods that they could
produce more efficiently.
the above may be explained and then the candidate may go on to explain how the
glut might be used as a buffer stock in future times when production is short.
Maximum prices
setting a maximum price below the equilibrium price in a market will lead to excess
demand. For example setting rent below the equilibrium rent in a market will lead
to an excess demand for rented accommodation.
the government may have to instigate rationing
black markets may develop
maximum prices reduce the quantity of an already scarce commodity.
queues may develop
Examiners should be aware that candidates may take a different approach, which if
appropriate should be fully rewarded.
Candidates who only deal with one of the concepts should be limited to a maximum
of [8 marks].
QUESTION 4
Explain how a buffer stock system might be used to stabilize agricultural prices.(10)
(a) Reasons for the creation of a buffer stock scheme could include:
buffer stock schemes are intended to provide a stable framework of prices to benefit
both producers and consumers
buffer stock schemes are generally used in the case of commodities where the price
is very volatile
because many developing countries are dependent on the export of commodities,
they are therefore very vulnerable to such volatility
To explain how the scheme would work:
a graph should be drawn to illustrate the maximum and minimum range of prices
set by the scheme
should also note what might occur to cause the price to move out of the acceptable
range and then explain what an organisation would have to do to bring it back
a buffer stock manager and suitable resources would have to be established
[12 marks]

Discuss the view that intervention in agricultural markets causes more problems than it
solves.(15) (Total 25 marks)
(b) Possible areas for discussion include:
the high costs of storing the goods
the necessity of holding large amounts of financial reserves
the difficulty of choosing an appropriate price range which can be sustained
the possibility of cheating by individual members who might seek to sell a larger
amount by reducing the price

the growing availability of synthetic substitutes for many commodities causing


downward pressure on prices
the increasing supply of many commodities as a result of improved technologies
causing downward pressure on prices
[13 marks]

QUESTION 5
Explain how, in a market economy, the price mechanism assists in the allocation of
resources.(15)
(a) Possible areas for discussion
what is meant by the terms
market economy
price mechanism
resource allocation
demand and supply analysis to explain how the price mechanism allocates
resources
explanation of
the rationing function
the incentive function
the signalling function
Note: appropriate credit should be given to students who compare the price
mechanism with command and mixed economies.
Critically evaluate how the price mechanism deals with the problem of non-renewable
resources.(10) (Total 25 marks)
(b) Possible areas for discussion
what is meant by non-renewable resources
the use of properly labelled diagrams to
explain how the price of non-renewable resources is determined by the
interaction of supply and demand
explain that as population and income increase demand will shift rightwards
explain that as the stocks of non-renewable resources decline the supply
curve of these goods will shift to the left
explain how the price for these products will increase
a discussion of the role of income and price elasticity of demand in determining
the extent of the price increase
the incentive to develop substitutes
a discussion of the rationing/conserving effect of the increases in prices
a discussion of how the burden of conservation is passed on to the least
able to pay
a discussion of how present prices might reflect the value of these resources
for present generations but not for future generations
problem of depletion where its impossible to find substitutes e.g. water
limits of pricing in general when seeking to assess environmental worth or
value, e.g. concepts like the commons
Note: appropriate credit should be given to any other relevant points.
[10 marks]

QUESTION 6
What are the main characteristics of a free market economy and a centrally planned
economy?
(a)

Centrally-planned economy
all decisions about what to produce, how to produce and for whom to produce are
made by central planners
state ownership of factors of production
responses may note what is absent in a CPE such as profits, incentives,
competition, role of prices in allocating resources
motive for production is social welfare, rather than profit
Free-market economy
all decisions about what to produce, how to produce and for whom to produce are
made according to the price mechanism
no government intervention
profit motive provides incentives
private ownership of factors of production
responses may note the existence of market failure
Responses may certainly be awarded full marks even if not all points are covered.
There is no obligation to discuss disadvantages of each system.
[10 marks]

Evaluate the possible consequences that may be encountered when an economy makes a
transition from central planning towards a free market.
(b) Responses are likely to discuss the following:
On the negative side
inflation, as a result of shortages which occur because choices are being made by
consumers, rather than the government.
unemployment, as a result of privatization and increased competition. Increased
competition arises as a markets open up to trade and FDI.
income inequality, through the introduction of market forces.
growth of parallel markets, resulting from shortages.
possibility of budget deficit and trade deficit.
On the positive side
greater efficiency
wider competition
increased trade and FDI.
Responses should make use of examples, possibly noting differences between Asian
transition economies, Eastern European transition economies and developing country
transition economies.
[15 marks]

Elasticity
1. Carefully explain what it is that price, income and cross elasticities of demand are meant to
measure. (10)
(a)

Good answers should contain accurate definitions and formulae. Candidates


must address at least 2 of the 3 types of elasticity for band 2 or above, and
all 3 for band 3 or above.

Discuss the practical importance of the concept of price elasticity of demand for
(i)
business organisations,
(ii) the government. (15) (Total 25 marks)
(b) Possible areas for discussion include some of the following:
(i)
For business organisations
relationship between PED and sales revenue
PED and sales revenue in different market situations, e.g. perfect
competition, monopoly, discriminating monopoly, oligopoly
importance of PED for agricultural business organisations
(ii) For the government
PED, expenditure taxes and government tax revenue
importance of PED in relation to government subsidies
PED and the effectiveness of tariffs
PED and the effectiveness of devaluation (the Marshall/Lerner condition)
2. What are the various factors that determine the value of (i) price elasticity of demand and
(ii) income elasticity of demand? (12)
(a)

PED determined by the availability of substitutes / degree of necessity /


proportion of income accounted for by the good / habit / the time period etc.
YED tends to be relatively high in the case of services and manufactured
goods and low in the case of primary commodities. YED and normal/inferior
goods.

Assess the importance of price elasticity and income elasticity of demand for business
decision-making. (13) (Total 25 marks)
(b) Possible areas for discussion include:
PED relationship between price increases/decreases and total revenue,
hence profits
YED relationships between higher/lower income levels, necessity/luxury,
boom/recession, and total revenue, hence profits.
Reward good use of relevant examples. Provided some reference is made to both types of
elasticity, an unbalanced answer thoroughly dealing with one type can reach the higher bands.

3. Explain the factors which influence price elasticity of supply. Illustrate your answer with
reference to the market for a commodity or raw material.(13)
(a) Candidates should define price elasticity of supply. Some factors which influence the PES of
commodities are:
the number of producers and barriers to entry into the industry e.g. oligopolistic oil
industry
the relationship between producers, e.g. cartels, commodity agreements etc.
the availability of producer substitutes
the time period (distinction between very short, short and long run)
storage of stocks - possible with minerals but not with foodstuffs
elasticity of supply of factor inputs - factor endowments, lead times etc.
N.B. Candidates who explain the factors which influence PES without any reference to
a commodity or raw material should be restricted to a maximum of [6 marks].
Candidates who confuse PED with PES should be limited to a maximum of [4 marks],
providing there is something of relevance.
Discuss the importance of price elasticity of supply and price elasticity of demand for
producers of primary commodities in less developed countries. (12)(Total 25 marks)
(b) This part of the question asks the candidate to apply the knowledge provided in
response to (a) using the problems of LDCs as commodity producers.
Reference to real world examples should be rewarded.
Candidates might be expected to consider the effects of degrees of inelasticity of
supply and demand on:
export revenues and the external balance
the exchange rate
fluctuating effects on local employment and investment
Reward any other reasonable argument or example.
N.B. Particular credit should be given to those candidates who are able to relate the
importance of PED and PES to primary commodity producers in LDCs, rather than
just discussing the importance of the concepts in general terms.
Also give credit to those candidates who widen their answer by examining the
importance of PED and PES for the economy at large for LDCs, e.g. in relation to the
terms of trade, balance of payments, depreciation, government revenues etc.

Theory of Firm
1. Using suitable diagrams, explain why there is likely to be an absence of long-run
economic profits in perfect competition. (12)
(a)

The explanation might include the following:


definitions of perfect competition (including its assumptions),
economic profit and the long-run
absence of barriers to entry as the principal feature in the elimination
of long-run economic profits
short-run economic profit is possible within this model, while long-run
economic profit is not
description of the process by which long-run profits are eliminated
correctly used and labelled diagrams, incorporated into the
response.
If no appropriate diagrams, no more than five marks should be awarded

To what extent might consumers benefit from increased competition between firms?
(13)
(b) Issues that could be raised include:
factors that influence competition (e.g. barriers to entry, number and
size of firms etc.)
model of perfect competition and its outcome
productive efficiency
allocative efficiency
lower prices and higher output
consumer sovereignty
general benefits from increased competition
lower prices
lower production costs
a more diverse range of products
improvements in quality
greater responsiveness to consumers
potential for greater innovation and technical change
Note: Appropriate credit should be given to students who elaborate on the limits of
competition, e.g. distribution of income, pollution etc. Recognise the value of the
candidates critical awareness
2. Monopoly price is higher and output smaller than is socially ideal. The public is the
victim. (J.K. Galbraith, 1974)
Explain the economic reasoning behind the statement that monopoly price is higher
and output smaller than is socially ideal. (12)
(a) Monopoly price and output
Relevant points might include:
definition of monopoly
explanation of socially ideal, perhaps in terms of different aspects of efficiency
monopoly equilibrium diagram
explanation of monopoly equilibrium
equilibrium in perfect competition
comparisons between perfect competition and monopoly.
Do you agree that the public is always the victim of monopoly? Justify your answer.
(13)(Total 25 marks)
(b)

Victim of monopoly.
Areas of discussion could include:
higher prices and consumer surplus
redistributive effects of monopoly pricing
impact on choice and quality
importance of productive and allocative efficiency
possibility of economies of scale and lower prices
impact of dynamic efficiency under monopoly
importance of research and development
importance of abnormal profits, level of certainty and investment
natural monopolies and public utilities
domestic monopolies versus international monopolies in areas of

national importance
dynamic efficiency under monopoly.
3. Under what conditions is price discrimination possible and profitable? (12)
(a)

Relevant points might include:


definition of price discrimination
existence of an imperfect market
splitting and separation of market (e.g. according to geography, time
and customer type)
differing price elasticities of demand
costs of segmentation less than likely benefits Candidates who use the three market
discriminating monopoly equilibrium diagram to answer this question should be
highly rewarded
[12 marks]

Who gains and who loses from price discrimination? Illustrate your answer with examples.
(13)
(b) Possible areas for discussion:
effects on consumers, e.g. in captive markets/non-captive markets
effect on consumer surplus/producer surplus
redistributive effects
effect on profits
possibility of consumers and producers gaining if a loss-making firm is
turned into a profitable one
links with natural monopoly Reward candidates highly who respond in a technical
manner, e.g. in terms of changes in consumer/producer surplus.
[13 marks]

4. Explain the differences between monopolistic competition and oligopoly as market


structures. (10)
(a) large number of firms (m.c) versus a few dominant firms (oligopoly)
differentiated product (m.c) versus differentiated or standardized (oligopoly)
low barriers to entry (m.c) versus high barriers to entry (oligopoly)
interdependence of firms in oligopoly
comparison of the demand curves
Examiners should be aware that candidates may take a different approach, which if
appropriate should be rewarded.
Discuss the differences between a collusive and a non-collusive oligopoly. (15) (Total 25
Marks)
Collusive Oligopoly
formal (cartel) or informal agreement (tacit collusion) among producers to limit
competition between themselves
they act as if they were a monopoly
discussion of the consequences of the firms acting as a monopoly
impact on consumers
members may compete against each other using non-price competition

regulations to prevent collusion


Non-Collusive Oligopoly
no agreement exists between producers
existence of non-price competition with the possibility of price wars
the kinked demand curve as one model to describe oligopoly behaviour
game theory
contestability of markets prevents firms from exploiting monopoly power
It would be possible to earn full marks on this question without using diagrams,
however use of appropriate diagrams should be rewarded.
Discussion (in part (b)) of only a collusive or only a non-collusive oligopoly should be
awarded up to a maximum of [7 marks].
Examiners should be aware that candidates may take a different approach, which if
appropriate should be rewarded.
[15 marks]

5. How does a monopoly maintain supernormal (or abnormal) profit in the long run?
(12)
(a)

The aim of the question is to have candidates show their understanding of monopoly as
a market structure. The most essential part of any answer must be that barriers to entry
prevent abnormal profit being reduced by competition. Good candidates will develop
this point by considering patents, trademarks, product differentiation, cost advantage,
etc. For the highest marks expect candidates to identify abnormal profit through a
diagram, properly explained.

Is monopoly always undesirable?(13) (Total 25 marks)


(b)

The question is meant to draw attention to arguments for and against monopoly.
The arguments for monopoly are:
natural monopoly, and the associated ideas of economies of scale and minimum
efficient scale
the research and development argument, which may be fine in some monopoly
markets. This can be linked to innovation and cost saving.
The arguments against monopoly are:
allocative and productive inefficiency
higher price and lower output
For the highest marks candidates should include diagrams, properly explained.

6. Discuss and evaluate the proposition that perfect competition is a more efficient market
structure than monopoly. (Total 25 marks)
This question requires a candidate to give an accurate definition of both market structures and how
the concept of efficiency applies to each.
Accurate definitions of allocative and technical (productive) efficiency should also be
expected with better candidates referring to diagrams.
Arguments which support the proposition are:
lower price
allocative and productive efficiency
output is maximised

price equals marginal cost


Arguments which do not support the proposition are:
economies of scale/natural monopoly
research and development
positive effects of price discrimination
7. What does an economist mean by efficiency in the operation of a firm? (10)
(a) This calls for basic definitions and requires students to identify and explain two key types of
efficiency.
(i)
Allocative efficiency occurs where marginal social cost = marginal social
benefit;
where P = MC.
(ii) Productive (technical) efficiency occurs
when firms produce at the lowest cost per unit.
at the minimum of the average cost curve.
Students may introduce/explain concept of Pareto efficiency but this is not
necessary for full marks. Diagrams should be rewarded.
(b)

Discuss whether the achievement of efficiency is possible and desirable. (15)


(Total 25 marks)
Students should distinguish between different types of market structure.
In perfect competition, in the short run, a firm will be allocatively efficient but not
necessarily productively efficient.
In the long run, a firm in perfect competition will be productively and allocatively
efficient.
In all the other market structures, neither allocative nor productive efficiency will
be achieved.
Diagrams are very useful in illustrating these points.
Allocative efficiency is desirable because welfare is maximised; the economy produces
the goods and services most valued by society.
Productive efficiency is desirable because it means that products are being produced at
the lowest cost possible; this represents the most efficient allocation of resources.
However, efficiency may not be desirable because:
firms which are efficient (i.e. those in perfect competition) may not be able to
afford investment in research and development because they cannot earn abnormal
profits in the long run.
such firms do not offer the variety of products because the products are not
differentiated.
although not efficient, a monopolist may produce more than any single firm in
perfect competition as a result of economies of scale.
Candidates who write that the whole idea of efficiency is problematic to economists
should be rewarded, especially if they substantiate it.

8. Explain how profit is determined in perfect competition. (10)

definition of profit/normal profit/abnormal profit/loss


definition of perfect competition
abnormal profit in the short run only
losses in the short run only
normal profit in the short and long run

diagrams to illustrate the above Examiners should be aware that candidates


may take a different approach, which if appropriate should be rewarded.

Whatever the type of market structure, profit maximization will always be the only
goal of firms. Discuss. (15) Total 25 marks
Points for discussion might include:
different market structures
explanation of profit maximization in terms of MC/MR, TC/TR
profit maximization in perfect competition and imperfect competition
profit maximization diagrams
importance of profit maximization in reality
other goals of firms, e.g. sales, volume or output maximization, revenue
maximization, environmental concerns
managerial goals
preservation of dominant market position
collusion, creation of barriers to entry
contestable markets where firms may not profit maximize due to the
threat of competition
Examiners should be aware that candidates may take a different approach,
which if appropriate should be rewarded.
9. In what ways do firms operating in different market structures compete? (10)
in perfect competition competition is on efficiency as firms are price
takers and goods are homogeneous
monopoly single producer, no competition, emphasis on maintaining
barriers to entry
in oligopoly product differentiation, advertising and other forms of
non-price competition; price competition/price wars; exploitation of
large scale production as an entry barrier; collusion
in monopolistic competition non-price competition.
Answers which simply describe each of the market structures should be limited
to Band 2 and below.
Discuss the view that the more competition there is within each industry the better. (15)
(Total 25 marks)
(b) Possible advantages of increased competition:
Lower price
Better quality
Greater efficiency
Greater choice
More innovation
Any reasonable answer.
Possible disadvantages of increased competition:
No incentive to invest
Natural monopolies
Ethical issues
Increased external costs
Worker exploitation
Falling quality from cost-cutting
Merit/public goods

Any reasonable answer.

Market Failure
1. What role do prices play in the allocation of resources in free market economies? (12)
(a) Candidates might include the following:
explanation of resource allocation
definition of a market economy
definition of a market
characteristics of a market economy
price determination
role of prices in resource allocation (signalling, rationing and incentive functions)
demand and supply diagrams to illustrate resource allocation
consumer sovereignty/producer sovereignty.
Evaluate the options available to governments to overcome the failure of markets arising from
the production and consumption of demerit goods. Illustrate your answer with
examples where possible. (13) (Total 25 marks)
(b) High scoring answers should not only explain the options available, but
should also evaluate them in terms of potential strengths and weaknesses.
Issues and areas for discussion might include:
definition of demerit good
explanation of how the market fails in the case of demerit goods
suitable diagram to show overproduction of demerit goods
use of persuasion/negative advertising to shift the demand curve to the left
explanation of taxation on demerit goods shifts supply to the left
evaluation of taxation policy in terms of
a market-based solution
difficulty of assessing the value of negative externalities
inelastic demand for demerit goods
explanation of different forms of regulation e.g. complete ban, spatial and
age restrictions
evaluation of regulation in terms of
a direct means of tackling the problem
interference with market forces
problem of unofficial markets arising in the case of a complete ban
the problems of enforcement.

2. Explain how the existence of positive externalities may cause free markets to misallocate
resources.
(a) Candidates would be expected to discuss the allocation of resources under a
free market, including discussion of some of the following:
free market scissor diagram
assumptions that underpin the theory of competition, particularly profit
maximisation and self-interest
linking the concept of equilibrium quantity to the allocation of resources
required to produce that quantity of a good

consumer sovereignity
Discussion of the impact of externalities on the free market allocation of
resources may include:
definition of positive externalities
examples of positive externalities
social benefits
the effect of including positive externalities on equilibrium quantity and
the allocation of resources required to produce that quantity of the good
meaning of socially optimum
Candidates might include some discussion of the following:
diagrams referring to deadweight loss or welfare triangles
merit goods
the existence of negative externalities
reference to real world examples of externalities
positive externalities and income distribution
Evaluate the options available to governments to overcome the failure of markets to take
account of positive externalities. Refer to real world examples in your answer.
(15)
(Total 25 marks)

(b)

Candidates should be rewarded for the evaluation of options.


An answer that evaluates well several options would be expected to
outscore an answer that described a full range of options without
evaluation. It is acceptable to use historical examples of countries
which have experienced inflation but examples should not go back
more than 25 years.
As a general guide, candidates should be rewarded more for using specific
rather than generalised examples to illustrate their answers.
Possible areas for evaluation are:
use of maximum prices e.g. for rented accommodation
legislation e.g. to wear seat belts
provision of goods/services free at the point of contact e.g. education/health
a mixture of free and market provision
use of subsidies
positive advertising campaigns
tax subsidies
Candidates might also include discussion of some of the following:
problems in identifying social optimality
measurement problems such as valuing intangibles and the issue of time
(current versus future generations)
the influence of cultural perspective on valuing externalities.

3. The basic economic problem is one of scarcity of productive resources. Explain how
resources are allocated between competing uses in a market economy. (10)
(a) Answers may include:
an explanation of the economic problems in terms of consumer wants being greater
than scarce resources.
an outline of the different productive resources/factors of production
a description of the characteristics of a market economy, e.g. Private capital, limited
role of government, consumer sovereignty, etc.

an explanation of the role of the price mechanism in the allocation of resources


through:
the interaction of demand and supply
the signalling function of price
the incentive function of price
the rationing function of price
an explanation of the role of profit in allocating resources
use of correct diagrams, e.g. demand and supply, production possibility frontiers,
etc.
Discuss the view that there is strong justification for government intervention in the market
for health care.(15) (Total 25 marks)
(b) It is important to mark this question with an understanding that candidates
will live in countries, which have a variety of different types of healthcare system and
their answers will reflect this.
For the view that there is strong justification for government intervention in the market
for healthcare answers may include a discussion of:
types of government intervention: state provision, subsidies, compulsory
health insurance, maximum price of healthcare products, regulation of
healthcare providers, e.g. licensing of drugs, care as a merit good
under-provision of healthcare as a merit good market failure
the positive externalities associated with health care, e.g. productive
workforce.
under-provision of healthcare to the less well-off people in society.
the provision of healthcare education and information, e.g. HIV, diet,
contraception, etc.
the importance of government planning in healthcare, e.g. future provision
of health resources
the correct use of MSC/MSB diagrams to illustrate the need for
government
intervention in healthcare.
The arguments against government intervention in healthcare may include
the discussion of:

higher taxation to pay for state provision


the opportunity cost of resources for other areas of government intervention e.g.
education
inefficiency of state provision, e.g. bureaucracy, political decision making, etc.
the problem for government of judging and meeting the socially efficient
level of output for healthcare.
how free markets may lead to a more efficient provision of healthcare
through the interaction of demand and supply (signalling and incentive
functions of price).
For an evaluative approach candidates should consider the advantages and
disadvantages of Government intervention.
Examiners should be aware that candidates may take a different approach,
which if appropriate should be fully rewarded.

4. What role do prices play in the allocation of resources in free market economies?
[12 marks]

(a)

Candidates might include the following:


explanation of resource allocation
definition of a market economy
definition of a market
characteristics of a market economy
price determination
role of prices in resource allocation (signalling, rationing and incentive functions)
demand and supply diagrams to illustrate resource allocation
consumer sovereignty/producer sovereignty.

Evaluate the options available to governments to overcome the failure of markets arising from
the production and consumption of demerit goods. Illustrate your answer with
examples where possible. (13)(Total 25 marks)
(b)

High scoring answers should not only explain the options available, but
should also evaluate them in terms of potential strengths and weaknesses.
Issues and areas for discussion might include:
definition of demerit good
explanation of how the market fails in the case of demerit goods
suitable diagram to show overproduction of demerit goods
use of persuasion/negative advertising to shift the demand curve to the left
explanation of taxation on demerit goods shifts supply to the left
evaluation of taxation policy in terms of
a market-based solution
difficulty of assessing the value of negative externalities
inelastic demand for demerit goods
explanation of different forms of regulation e.g. complete ban, spatial and
age restrictions
evaluation of regulation in terms of
a direct means of tackling the problem
interference with market forces
problem of unofficial markets arising in the case of a complete ban
the problems of enforcement.

5. Carefully distinguish between merit goods and public goods, illustrating your answer with
examples. (12)
(a)

Key features of merit goods are: can be provided through the market but not in
sufficient quantities because of: positive externalities / income distribution
problems / information/foresight problems. Non-excludability and nonrivalry are the key features of public goods (unlikely to be provided through
the market).

To what extent is it desirable that the government should provide merit goods and public
goods? (13) (Total 25 marks)
(b)

Possible areas for discussion include:


government provision of merit goods on grounds of
positive externalities and underprovision at the free market price

income distribution and lack of effective demand


lack of present and future information
danger of private monopoly power arising
market provision of merit goods on grounds of
government failure
general arguments for market provision in terms of competition, profit motive,
costs, prices, efficiency and consumer choice
alternatives to government provision and the free market such as
subsidies, maximum prices etc.
arguments for state provision of public goods in terms of unlikelihood of
market provision / the free-rider problem / optimal resource allocation.
Mark part (b) as a whole.
An unbalanced answer in terms of coverage of both public and merit goods
can still enter the higher mark bands if at least one area is of sufficient
quality.
6. Why do markets sometimes fail to set socially acceptable prices? (12)
(a) Among the factors responses are expected to consider are:
the presence of externalities, especially negative externalities, which lead to
overconsumption at undesirably low prices. Better responses will illustrate this with
a diagram illustrating equilibrium at prices and quantities lower and greater than is
socially desirable.
the difficulty of providing merit goods through free markets: these would be
underconsumed because of higher-than-desirable market price, though not all
societies or people would agree on what should be considered a merit good.
the abuse of monopoly power. Monopoly power gives the firm greater sovereignty
leading to a deadweight loss of output at higher price and lower efficiency. Again,
good responses might be expected to draw a diagram illustrating this.
less important points (because the question is wider than plain market failure) might
include difficulties that markets themselves experience in finding equilibrium or
market-clearing price due to time-lags, supply inelasticities, etc.; the distorting
influence of government intervention through taxes and subsidies, etc.
To what extent can governments overcome this form of market failure? Illustrate your answer with
examples.(13) (Total 25 marks)
(b) To some extent the answer to (b) will depend on what has been written in response to
(a). Bearing in mind this is a Standard Level question, responses might include:
the use of taxes and subsidies to adjust levels of price and output into line with
social costs. Better responses will again illustrate this with a diagram. Examples
might be drawn from goods with consumption externalities such as cigarettes, or
environmental externalities such as petrol.
tradable permits. Explaining this is challenging and examples are relatively rare, so
responses covering this clearly should be well-rewarded.
anti-monopoly/anti-trust legislation to reallocate sovereignty in markets from
producers to consumers. Examples here could be from the airline, oil or telecoms
industries, among many others.
adjustments to the legal framework in which markets operate, such as the
establishment of property rights.

N.B. To reach bands 4 and 5 there must be some evaluation of the arguments and an
analytical approach overall.
[13 marks]

7. Is economic growth compatible with the protection of the environment? Discuss with
reference to sustainable development.
(Total 25 marks)

Areas for discussion could include:


definitions of economic growth/sustainable development
conceptions of development, e.g. industrialisation, urbanisation, social needs etc.
indicators of development (e.g. GDP, GNP, HDI, GPI, GEM etc.)
environmental costs of economic growth
pollution
land degradation
deforestation
ozone depletion
hazardous processes
depletion of non-renewable resources
Effects that different income groups have, through their different consumption
patterns, on the environment
urban against rural dwellers
large landowners versus marginal peasants
consumers from more developed countries compared with more populous
but less affluent consumers from less developed countries
Role of multinational corporations
exporting hazardous practices and materials to less developed countries
(e.g. pollution in the Rio Grande region in Mexico, Bhopal in India, etc.)
Global economy
higher level of debt associated with high levels of environmental
degradation
World Bank and IMF policies, e.g. structural adjustment policies and
Export Oriented Industrialisation encourage the export of natural resources
Global solutions
an awareness of the Earth Summit in Rio and the Kyoto convention
GEF
global concerns
Perspectives on the environment
neo-liberal (e.g. markets in tradeable emissions permits)
difficulties with pricing the future and applying traditional market concepts
to non-renewable resources sustainable development
(e.g. Brundtland Commission definition)
anti-development (e.g. Sachs view that sustainable development is merely
the repackaging of traditional views of economic growth)
[25 marks]

MACROECONOMICS
GDP Growth and Development
1. Briefly explain the various major objectives of macroeconomic policy. (10)
(a)

Candidates should briefly explain the goals of price stability, full employment, satisfactory
balance of payments, economic growth and a more equal/unequal
distribution of income and wealth.
Critically examine the view that the control of inflation should always be the most
important objective of governments. (15)
(b)

Possible areas for discussion include some of the following:


justification of the view in terms of the various ill-effects of inflation
challenging the view in terms of
situations in which inflation may not be a problem
the trade-off between inflation and unemployment
reasons why full employment should be the priority
reasons why economic growth should be the priority
reasons why the balance of payments should be the priority
reasons why income and wealth distribution should be the priority

2. To what extent is GNP per capita an appropriate measurement to use to compare living
standards in different countries?(12)
(a) Possible areas for discussion include:
increases in GNP often associated with improvements in living standards but this is
not necessarily the case; economic growth is not the same as economic
development
GNP alone not a good statistic to use to measure living standards, let alone compare
countries
statistic does not indicate the distribution of income
statistics may not be accurate; degree of accuracy will vary from country to country
different countries have different conventions for calculations
extent of black, hidden, informal economy may differ, leading to varying levels of
underestimation in different countries
work at home/subsistence agriculture not included amounts will vary, leading to
varying levels of underestimation
the type of output/spending not clear some types of spending are more likely to
improve living standards than others
statistics may be converted at official exchange rates which will not necessarily
reflect purchasing power
Discuss other measures which might be used to compare living standards. (13) (Total 25
marks)
The following could be mentioned:

composite indicators such as: Human Development Index, Human Suffering Index,
Physical Quality of Life Index, Index of Sustainable Economic Welfare, Human
Poverty Index
GNP per capita refined to take account of purchasing power parity rates
the need to look at other indicators of living standards: e.g. life expectancy, infant
mortality, literacy rates, access to safe water, daily calorie supply, number of
doctors per 100 people, number of televisions etc.
the desirability of being able to value the more intangible indicators such as
gender equality, political freedom, freedom of speech, civil rights. However,
answers based entirely on non economic indicators and which ignore HDI,
HPI etc. should not score more than [6 marks]
the need to account for the negative aspects of growth such as resource depletion,
externalities
[13 marks]

3. Discuss the main problems involved in measuring the national income of a country. (12)
(a) Problems of measuring the national income
Relevant points might include:
definition of national income
inadequate information, e.g. because of tax evasion and the parallel/hidden
economy
the problem of double-counting
the subsistence/non-money part of the economy
valuation of government services
allowances for market prices/factor cost, property income,
imports/exports
the problem of timing etc.
Why do many economists prefer to use composite indexes, such as the Human Development
Index and the Human Poverty Index, as well as national income figures, to indicate
living standards? (13) (Total 25 marks)
Issues and areas for discussion could include:
definition of living standards
the need to use real GDP (GDP at constant prices) to take inflation into account
the need to use purchasing power parities which compare living costs
the distribution of income
the impact of externalities
production does not equal consumption (the composition of output)
the size of the informal economy
the production of de-merit goods
non-marketing goods
living standards influenced by wealth not just income
tastes and needs may be different in different countries
degree of accuracy of data varies between countries
living standards also influenced by factors such as human rights,
democracy, etc.
composite indexes provide a broader measure of living standards,
e.g. HDI (literacy and health), HPI, GEM (gender empowerment) etc.

Identify the components of aggregate demand and briefly explain two factors which might
determine each of these components.(10)
(a) Answers may include:
a definition of aggregate demand (AD)
a definition of the components of AD: Consumption, Investment, Government
Expenditure, Exports Imports (net Exports), (candidates may use C+I+G+X
which is rewarded in the same way)
an explanation of any two factors that determine:
consumption e.g. real income, consumer confidence, interest rates and
availability
of credit, attitudes to saving, wealth, etc.
investment factors e.g. business expectations, interest rates, level of profit,
available finance (level of savings)
government spending e.g. political priorities (improve public services, defence,)
rate of economic growth, unemployment/inflation, tax revenue
exports minus imports e.g. rate of economic growth, exchange rate changes,
domestic producer efficiency, foreign producer efficiency, changes in the terms
of
trade, protectionism.
It is important to award candidates for showing an understanding of the factors which
affect AD rather than just listing factors. Where candidates just write list factors the
maximum mark should be level 2.
Evaluate the likely impact on an economy of a substantial rise in the level of interest rates.(15)
(Total 25 marks)
(b) Answers may include a discussion of the impact of a rise in interest rates on:
consumption spending
saving rates
investment spending
government spending (government borrowing costs increase)
rate of inflation
level of unemployment
rate of economic growth
balance of payments
current account (imports and exports)
capital account (capital flows)
exchange rates
use of AD/AS analysis to illustrate impact of shifts of:
reducing AD (reducing C, I, etc.)
reducing AS (increasing costs of production)
for an evaluative approach candidates may discuss:
costs and benefits of higher interests rates
the short and long term consequences of higher interest rates
the significance of the impact of higher interest rates on different factors
Examiners should be aware that candidates may take a different approach, which if
appropriate should be fully rewarded.

Inflation
Explain the costs of inflation and the costs of deflation. (10)
(a)

Definitions of both inflation and deflation


Costs of inflation include:
effects on those who rely on fixed-income or are in a weak bargaining position
implications of higher export prices
inflation harms lenders and benefits borrowers
uncertainty
inflation may lead to high nominal interest rates
menu costs
shoe-leather costs
Costs of deflation include:
falling prices may cause consumers to defer spending leading to greater
deflationary pressure
investment spending is discouraged
benefits lenders and harms borrowers.
Examiners should be aware that candidates may take a different approach, which if
appropriate should be rewarded.

Evaluate demand-side policies as a means of reducing inflation. (15) (Total 25


marks)
(b)

definition of demand-side policies: fiscal policy and monetary policy


explanation of how demand-side policies can be used to reduce inflation
discussion of the problems associated with deflationary fiscal policy
e.g. difficulty of fine-tuning, time-lags
discussion of the problems associated with contractionary monetary policy: an
increase in interest rates slows economic growth and negatively affects exports due
to increase in exchange rate.
not effective in reducing cost-push inflation
an evaluation of demand-side policies versus supply-side policies
For a discussion of only one policy up to [7 marks].
For a full discussion of two policies (e.g. Fiscal and Monetary policy) up to [15
marks].
Examiners should be aware that candidates may take a different approach, which if
appropriate should be rewarded.

Describe the main causes of inflation. (10)


(a)

definition of inflation
explanation of the cost-push causes of inflation
rising unit labour costs
rising raw materials costs, e.g. rising oil price
rising capital costs
profiteering by businesses
explanation of the demand-pull causes of inflation
rising consumer demand
expansionary fiscal policy
expansionary monetary policy

correct application of AD and AS diagram to illustrate the causes


of inflation
Examiners should be aware that candidates may take a different approach,
which if appropriate should be rewarded.

If inflation is a major problem faced by governments it must follow that the opposite,
deflation, is desirable. To what extent do you agree with this statement?(15)(Total 25
marks)
(b)

Points for discussion might include:


definition of deflation
distinction between inflation and deflation
the consequences of inflation on:
re-distribution of income e.g. fixed incomes, borrowers and lenders
business investment
economic growth and development
international competitiveness
menu costs
shoe leather costs
beneficial effects of inflation e.g. business profitability
the consequences of deflation on:
economic growth and development
unemployment
impact on borrowers and lenders
business profitability
international competitiveness
beneficial effects of supply-side deflation
Examiners should be aware that candidates may take a different approach,
which if appropriate should be rewarded.

Discuss the possible consequences that might occur when a government attempts to reduce
inflation.(Total 25 marks)

Responses should include a definition of inflation and note that there are several causes.
Better responses will note that the policies used to reduce inflation will depend on the
cause of inflation.
Government attempts to reduce inflation will include deflationary monetary and fiscal
policies as well as supply-side policies.
If solution is deflationary monetary policy (higher interest rates), consequences include
higher loan repayments
lower purchasing power of income
appreciation of currency reducing competitiveness of exports, leading to trade balance
problems
decreased investment, with negative implications for economic growth.
If solution is deflationary fiscal policy (higher taxes and decreased government spending),
consequences include
lower disposable income
less consumption
disincentive effect
fall in spending on health and education and other public/merit goods.
If solution is supply-side policies, consequences include

increased efficiency
reduced trade union power
reduced social security benefits
greater privatization
more competition
increased flexibility in labour markets.
Responses should note that the deflationary polices are likely to lead to increased
unemployment. There might be some reference to the trade-off between inflation and
unemployment and the Phillips curve.

Unemployment
Unemployment remains persistently high in a majority of countries
throughout the world.
Explain the economic problems that high unemployment may cause for a
country.(10)
(a)

The economic problems of high unemployment include:


opportunity cost in terms of output foregone and inefficiency
impact on government finances more expenditure and less tax revenue
individual and social costs
the impact on poverty and income distribution
unequal impact of unemployment in terms of region, urban/rural, gender, race
and age
Any reasonable answer.

Discuss the reasons why governments find the goal of full employment difficult to
achieve.(15)(Total 25 marks)
(b)

In responding to this question, answers could:


an appropriate definition of full employment should be included
candidates need to be familiar with the various types of unemployment,
but need to be aware that frictional, structural unemployment and
seasonal unemployment constitute the natural level of unemployment
and exist beyond the full level of unemployment
problems which occur as a result of trying to reduce demand-deficient
unemployment are inflation and current account issues
appropriate diagrams would be a keynesian AD/AS model showing an
increase in AD and/or a Phillips curve showing the trade-off between
inflation and unemployment
Limitations of using fiscal policy to raise AD e.g. time lags, crowding
out
Some awareness of conflicting opinions of the shape of the LRAS and the
implications of trying to achieve full employment should be highly
rewarded.

What are the consequences of unemployment in an economy?(10)


(a) Candidates may define unemployment. Credit should be given for
examination of the different types of unemployment with brief mention of
causes.
Consequences
A variety of approaches may be taken by candidates and the following may be
considered by them.
lower output and standard of living this may be considered at both the
individual and macro levels. Candidates may use PPC diagrams to illustrate.
personal costs such as self-esteem, health, etc.
social costs, such as disruption to family units, crime, etc.
lost tax revenue for governments and higher expenditure by governments
on welfare payments and the provision of basic support
In discussion, candidates should be rewarded for drawing on theory in their
answer, such as labour market diagrams, AS/AD diagrams, the Phillips curve
and PPC diagrams.
Reward candidates who distinguish between private and public costs in
structuring their answer.
Examine the strategies that may be used to reduce unemployment, referring to more
developed countries and less developed countries in your answer.(15)(Total 25
marks)
(b) Candidates may examine strategies generally, with reference to the situation
found in MDCs and LDCs. Alternately, candidates may choose to discuss the
situation in MDCs and LDCs separately. Either approach is acceptable, with
candidates being rewarded for recognising that the strategies used in MDCs
are not necessarily appropriate for LDCs, and vice versa.
Discussion may include:
the role of aid in creating employment
the role of trade in creating employment
structural adjustment policies designed to align labour skills with the needs
of employers, such as retraining schemes, use of appropriate technology,
government initiated projects designed to employ labour directly or to
provide infrastructure that will create employment in the private sector
labour market reforms designed to remove barriers to the free market for
labour (such as removing minimum wage legislation or the abuse of power
by unions and employer organisations)
policies designed to stimulate the level of aggregate demand, such as the
use of fiscal and monetary policy, or the redistribution of wealth and
income
regional policies
distinction between underemployment and unemployment
less scope for government intervention/welfare systems in LDCs.
Candidates should be rewarded for recognising the problems associated with
the strategies suggested.

Government Policies
Explain the difference between demand-side and supply-side economic policies. (10)
(a) explanation of demand-side policies in terms of monetary and fiscal policy
explanation of supply-side policies in terms of particular policies, e.g. tax cuts,
welfare cuts, privatisation, deregulation and an outward shift of the LRAS curve
use of AD/AS diagram to illustrate the difference
Reward references to the KeynesianMonetarist debate.

Higher economic growth can only be achieved through the implementation of


supply-side policies. Discuss. (15) (Total 25 marks)
(b)

Answers may include:


definition of economic growth
illustration of economic growth in terms of an outward shift of the PPC/LRAS
curve
distinction between actual and potential growth
explanation of linkages between supply-side policies and growth
importance of AD
Reward references to the KeynesianMonetarist debate
demand-side policies and the multiplier effect
interdependence of supply-side and demand-side policies
This is potentially a big question for candidates to tackle. Do not expect answers to be
able to cover the greater part of the above. Good candidates should be able to show
how supply-side policies can increase economic growth. They also need to be able to
discuss this in the context of alternative demand side policies.
Examiners should be aware that candidates may take a different approach, which if
appropriate should be fully rewarded.

Explain the relationship between the Lorenz Curve and the Gini Coefficient. (10)
(a) Lorenz Curve
a curve showing the proportion of national income earned by any given percentage
of the population
used to show the degree of inequality of income in a society
the farther from the 45 line is the curve, the greater the degree of inequality
Gini Coefficient
a statistical measure of the degree of income inequality
measures the area between the 45 line and the Lorenz Curve as a proportion
of the entire area under the 45 line
ranges between 0 and 1
a Gini Coefficient of 0 represents complete equality; coefficient of 1 represents
complete inequality
Up to a maximum of [6 marks] if there is no diagram(s).
Up to a maximum of [5 marks] if the relationship between the Lorenz Curve and the
Gini Coefficient is not examined.
Examiners should be aware that candidates may take a different approach, which if
appropriate should be rewarded.

Evaluate the effectiveness of the various methods that governments may use to redistribute
income. (15) (Total 25 marks)
(b) explanation of the different forms of taxation and how they can be
used to redistribute income
discussion of the issues associated with using taxes to redistribute income
explanation of transfer payments made by government
discussion of the issues associated with transfer payments
subsidies
merit and public goods
Up to [15 marks] can be awarded for a full discussion and evaluation of two methods.
Up to [15 marks] can be awarded for a less than full discussion of three or more
methods but evaluation must occur; [recognising the time constraint].
Answers which are effectively a list and are without evaluation can be awarded up to
[6 marks]. A discussion of one method with evaluation can be awarded up to [7
marks].
Different forms of taxation are to be seen as one method. In the same way different
forms of transfer payment, subsidies, merit goods and public goods are to be each seen
as one method.
Examiners should be aware that candidates may take a different approach, which if
appropriate should be rewarded.
Using suitable examples, explain the difference between the multiplier and the
accelerator. (10)
(a) explanation of multiplier
use of numerical examples
explanation of accelerator
use of examples
key differences. E.g. multiplier is autonomous, accelerator is induced
Emphasis will normally be placed on the multiplier. This is acceptable as long as the
candidate displays a basic understanding of the accelerator. Reward candidates who
appreciate the interaction between them, that the multiplier is investment led and the
accelerator is income led.
Examiners should be aware that candidates may take a different approach, which if
appropriate should be rewarded.
Evaluate the proposition that the most effective way to reduce unemployment is through
the use of demand-side policies. (15) (Total 25 marks)
(b) Points for discussion might include:
explanation of demand-side policies
explanation of monetary and fiscal policies
different types of unemployment: equilibrium/disequilibrium and traditional
types
evaluation of the appropriateness of demand-side policies to combat types of
unemployment, e.g. appropriate to cyclical and demand deficient, but not to
seasonal and structural.
AD/AS analysis
problems of demand-side policies
benefits of supply-side policies
drawbacks of supply-side policies

overall evaluation
Examiners should be aware that candidates may take a different approach, which if
appropriate should be rewarded,
Evaluate the effectiveness of demand-side and supply-side policies in the short and long run.
(Total 25 marks)

Responses should distinguish between the short run and the long run in some way.
Responses should explain demand-side and cover both fiscal and monetary policies. Better
answers will use diagrams.
Responses should explain supply-side policies. Better answers will cover both market-based
and interventionist policies, as well as using diagrams.
Better responses may consider the Keynesian/neo-classical debate on the shape of the LRAS
curve.
Responses should attempt to evaluate the different policies and better candidates will realize
that demand-side policies are effective, to an extent, in the short run, although there are costs
because of trade-off. They should also realize that the majority of supply-side policies are
long term and take a fair amount of time to take effect.
Better responses may also identify the situations that arise when supply-side policies are also
demand-side policies and there may be a clash of outcome. For example, lowering interest
rates as a supply-side policy may lead to a shift of AD to the right and inflationary pressures
in the short run.
[25 marks]

The world economy may be subjected to economic shocks, such as a sudden increase
in oil prices and terrorist attacks. With the help of an aggregate
demand/aggregate supply diagram, explain the possible economic effects of
such shocks.(12)
(a)

Possible effects:
shift of the AD curve, and/or the AS Curve, to the left
reduction in output
reduction in employment
lower growth
lower standard of living
on the price level
on the balance of payments
on exchange rates
any reasonable answer

Evaluate the main economic policies that governments might use to minimize these effects.
(13)(Total 25 marks)
(b)

Discussions may include the following:


fiscal policies
monetary policies
trade policies
supply-side policies.