Suggested answers for 2018 A-level H2 Economics

CSQ 1: Policies for health improvement

(a) (i) Using the information in extract 1, calculate the value of the price [2]
elasticity of demand for sugar-sweetened beverages (SSBs).

Price elasticity of demand (PED) measures the responsiveness of quantity

demanded for the good to a change in its price, ceteris paribus.

PED = % change in quantity demanded

% change in price
= −24% / 20%
= −1.2

(a) (ii) Explain one possible factor that could lead to this value. [2]

Demand for SSBs is price elastic. SSBs have numerous close substitutes within
the same price range like bottled water. An increase in price of SSBs tends to
lead to a more than proportionate fall in quantity demanded for that good
because consumers can easily switch to other substitutes.

(b) (i) State the economic concept that you would use to measure the [1]
relationship between the change in price of SSBs as sales taxes are
imposed and the resulting change in demand for bottled water.

The concept is cross-price elasticity of demand (XED).

(b) (ii) Explain the value you would expect to get from this measurement. [3]

Cross-price elasticity of demand (XED) measures the responsiveness of

demand for one commodity to a change in the price of another commodity,
ceteris paribus.

XED value will be positive as bottled water and SSBs are substitutes. An
increase in price of SSBs will cause demand for bottled water to increase when
consumers substitute away from SSBs towards the relatively cheaper bottled
water.

The magnitude of XED depends on the degree of substitutability between

bottled water and SSBs. A small value of less than 1 is expected as bottled
water and SSBs vary in tastes and may not be considered very close
substitutes. An increase in price of SSBs, ceteris paribus, would likely cause a
less than proportionate increase in demand for bottled water.
 For reference (but not needed in response):
percentage change in demand for good A
XEDAB =
percentage change in price of good B
∆QA
× 100%
QA
=
∆PB
× 100%
PB
(c) Explain any two economic reasons why producers decide to spend [4]
millions to ‘strengthen brands and differentiate their products’ (Extract
2).

Strengthening brands and differentiating products will make demand for these
goods more price inelastic if consumers view these goods as unique and as
less substitutable with other brands of SSBs. This gives them the ability to
increase prices for their products. An increase in prices would cause quantity
demanded to fall less than proportionately if demand is price inelastic. This will
increase revenue for firms.

Strengthening brands would also cause tastes and preferences of consumers

to change and more consumers would be attracted to buy these advertised
SSBs with stronger brand. Thus, demand for the firms’ products will increase
and revenue earned will increase. If increase in total revenue is more than
increase in advertising cost, profits earned by the firms will increase

(d) Discuss whether consumers could ever make rational decisions [8]
regarding their consumption of sugar-sweetened beverages (SSBs). [8]
[P] Thesis: Consumers could make rational consumption decisions if
they have sufficient information about the true MPB of SSBs.
[E+E] Rational consumers aim to maximise net TPB from their buying decisions
and they do so by comparing MPB and the price of the product (i.e. MPC).
According to the law of diminishing MU, MPB falls with increasing units
consumed. To maximise net TPB, consumers will consume up to the point at
which MPB = price. Because when MPB> price, consumers can increase net
TPB by consuming 1 more unit. But once MPB < price, consuming 1 more unit
will lower net TPB. The highest level of net TPB is thus attained when the
consumers buys the quantity at which MPB=price.
[L] As long as the consumers have knowledge of the true MPB, they will buy a
quantity that can maximise their welfare.

Anti-thesis: [P] Consumers are not able to make rational decisions

regarding consumption of SSBs due to imperfect information about the
MPB of SSBs.
 Price, Costs,
Benefits ($/q)

P MPC

‘Perceived’ MPB

’True’ MPB

Q of
0 q* q SSBs/t

[E] According to extract 2 (last para), consumer demand is influenced by firms’

marketing strategies. E.g. firms may use trim and fit people to act in the
advertisements for SSBs and do not highlight the dangers of excessive sugar
intake, such that consumers do not know that SSBs could cause obesity.
[E] With persuasive advertising efforts by SSBs manufacturers, consumers are
led to perceive the MPB to be higher than it is, hence perceived MPB curve is
higher than the true MPB curve.
[L] Thus, although consumers are consuming up to the point where MPB =
price, they would not be maximising their self-interest since they would have
consumed up to the point where perceived MPB = price at q, rather than true
MPB = price at q*.

Conclusion:

[Stand] Consumers could never make rational decisions regarding their

consumption of sugar-sweetened beverages (SSBs) unless there is
government intervention to improve the flow of information.
[Substantiation]
In a free market economy, firms are profit-motivated and would have no
incentive to inform consumers the true MPB of the product unless they are
compelled by law to do so. In developed countries where education level is high
and many people are likely to be aware of the harmful health effects of SSBs,
consumers are nevertheless influenced by firms’ marketing strategies and led
to make irrational decisions seen in their over-consumption of SSBs.
Extract 2 suggests that consumers in Mexico are rational in choosing to drink
SSBs over tap water. However, if they had full information about SSBs, these
would not be their choice drinks. It would probably be boiled tap water or healthy
but affordable food like vegetables for sources of energy.
On the other hand, if govt could intervene, e.g. via public education about the
harmful effects of SSBs, then consumers will be more able to make a sound
rational decision about the consumption of SSBs.
(e) Discuss whether fiscal intervention is the best government policy to [10]
deal with the problems caused by over-consumption of SSBs.

Introduction:

Over-consumption of SSBs has resulted in health issues like obesity and

diabetes. Fiscal intervention includes taxes on SSBs and subsidies on fruits,
vegetables and other healthy foods. In addition to fiscal intervention,
governments can also subsidise the research development efforts of firms to
come up with alternative formulations for fizzy drinks and education campaigns.

Fiscal intervention can be used to deal with the problems caused by over-
consumption of SSBs.

[P] One method of fiscal intervention is to implement a tax on SSBs (Ext

1).

SS’=MPC’=MPC + tax

SS= MPC = MSC

P* A
‘Perceived’ MPB (DD)
B
’True’ MPB = MSB (assuming no
externalities)
Q/t
0 Q* Q

[E+E] A production tax is a compulsory levy imposed on the production of

goods and services. The producer has a legal responsibility to pay the tax to
the government which is a fixed fee per unit of output produced. Such a tax has
the effect of raising the marginal cost of production for firms.

If a sufficiently high level of tax is imposed, then MPC would rise till MPC’ and
socially optimum level of consumption of SSB will be obtained As that is the
point where DD = new SS. [L] Welfare loss from overconsumption (area A) is
eliminated.

Evaluation:

Such taxes could reduce employment of workers in the SSBs industry (Ext. 3).
As taxes reduce output produced, derived demand for workers would decrease
and unemployment would increase.
However, taxes generate revenue for governments to spend on education
campaigns and other subsidies mentioned below.

[P] Another method of fiscal intervention is to provide subsidies on

healthy foods.

Price
S1 (MPC=MSC)

S2 (MPC’=MPC-
Subsidy unit subsidy)
P1 per unit

P True MPB = MSB

Perceived MPB (D)
Quantity/t
0
Q1 Q2

[E+E] The government can also provide subsidies to firms that produce foods
that are considered healthier options like vegetables (Ext 1). A production
subsidy reduces the marginal cost of production for the firms, causing supply
to increase and shift downwards to S2. The rise in supply results in a fall in the
equilibrium price to P2 and a rise in the equilibrium output to Q2. The subsidy
results in an increase in output of Q2 – Q1. These subsidies may encourage
consumption of vegetables as they are now cheaper. [L] This would address
health issues like obesity.

Evaluation:

Funding the subsidy would cause the government to incur an opportunity

cost, as government funds used for the subsidy could have been spent on other
areas such as public goods. However, the subsidy could be financed through
the tax revenue collected from taxes imposed on SSBs. Since “strong evidence
shows … subsidies are effective in increasing consumption of fruits and
vegetables” (Ext 1), this policy is likely to be very effective. However, such
subsidies will not deal with the root cause of obesity, which is overconsumption
of SSBs.

[P] Besides fiscal intervention, governments can use other policies such
as collaborating in a joint venture with firms to conduct R&D to come up
with alternative formulations for fizzy drinks, and education campaigns.
Governments can also collaborate with firms in a joint venture to come
up with alternative healthier formulations for fizzy drinks.

[E,E] The government can collaborate with private companies to jointly conduct
research and development to come up with healthier formulations with lower
sugar content which are still tasty. These collaborations could be in the form of
co-funding research projects with government grants. This would then reduce
the extent of negative externalities and consumers’ overestimation of the
benefits of drinking SSBs as the newer versions have lower sugar content.
[L] This reduces the overconsumption of SSBs and the associated welfare loss.

[P] Governments can also launch education campaigns.

To solve the problem of consumers’ ignorance due to imperfect information, the

government will have to provide information to educate consumers on the true
marginal private benefits of consuming SSBs. This reduces the extent of
information failure in the market, and encourages consumers to consume less
of the good as they improve their individual decision-making. Thus, public
education changes consumers’ willingness to buy and hence adjust demand to
match the ‘true’ MPB, [L] bringing the market to the socially optimal quantity to
be consumed and resolving the allocative inefficiency problem.

For example, governments carry out national campaigns to encourage

consumers to cut back on consumption of SSBs, often showing statistics or
highlighting the potential harms in the campaign messaging (e.g. highlighting
how SSBs can worsen obesity).

Evaluation:

Often, consumers’ behaviours are based on existing mindsets that may be hard
to change. Hence, the effectiveness of public education campaigns depends
on consumers’ responsiveness, and such an approach would likely have to be
a long-term measure as it takes time to communicate information to consumers
and change their behaviour. This is in contrast to fiscal intervention measures
which take lesser time to discourage consumption and may have an immediate
impact on consumer behavior.

Conclusion:

[Stand] Fiscal intervention is likely to be the best policy in dealing with the
problems caused by over-consumption of SSBs.

[Substantiation]
Taxes on SSBs are likely to be the best policy in reducing consumption of SSB
as “prices of foods and beverages affect purchase and consumption
significantly”. Demand for SSBs is price elastic and therefore an increase in
price would cause a more than proportionate fall in quantity demanded. They
also have the advantage of generating revenue for the government as
compared to funds for R&D and subsidies which require heavy expenditure.

Although fiscal intervention may be the best policy, it should be used with other
measures for maximum impact on consumption of SSBs. This measure ought
to be used together with education campaigns to produce long lasting changes
in consumer behavior patterns. Joint ventures with private companies to
develop alternative formulations are also appropriate policies as while fiscal
intervention (taxes on SSBs) and education campaigns will lower employment
in the SSBs industry significantly, joint ventures for research and development
will not cause an increase in unemployment. One additional advantage of joint
R&D ventures to support the development of healthier drinks is that provision
of beverages with lower sugar content will not require drastic changes in
consumer behavior and yet resolve the problems associated with
overconsumption like obesity. Thus, the government can use a complementary
mix of policies and use retraining to help retrenched workers find work in other
industries. Other alternatives governments can consider include regulations.
CSQ 2: Bangladesh’s quest for inclusive economic growth.

ai) State what happened to the nominal exchange rate of the Taka (Bangladesh’s currency)
between 2000 and 2014. [1]
Taka has depreciated against the US dollar over the period.
aii) Explain whether you would expect the change in the current account balance to lead
to the change in the value of Taka shown. [2]
The current account balance for Bangladesh improved from a deficit in 2000 to a surplus in 2014.
An improvement in the CA balance could have been due to rise in export revenue which would
have led to a rise in demand for Taka and should have cause an appreciation of Taka in terms of
US dollar. Hence the depreciation of Taka against US dollar is not expected.
iii) What can be inferred from the change in the Gini coefficient for Bangladesh? [2]
The Gini coefficient decreased slightly hence this suggest that income has become more equally
distributed among the people in Bangladesh, albeit only slightly.
b) Explain why a new road network in a country should not be classified as a public good.
[3]
It is not a public good because it is both excludable and rival.
Non-excludability occurs when it is not possible to exclude non-payers from consuming the good
once it is produced. For the case of a road network, it is possible to use tolls to exclude non-
payers from consuming it. Non-rivalry occurs when consumption of a good by one user diminish
the amount available to others. For the case of a road network, its use by one vehicle reduces
the amount of road space available for the other vehicles.
c) Explain one possible reason for the difference in value of income elasticity of demand
for electricity in Bangladesh and Australia. [4]
YED for Bangladesh is at 1.91 hence the demand for electricity is income elastic while that of
Australia, YED is at 0.60, and demand for electricity is income inelastic. One possible reason that
electricity is regarded as a necessity in Australia while it is regarded as a luxury in Bangladesh.
This is in turn due to the level of income difference between the two countries. In Bangladesh,
many households live in poverty (extract 4) and can’t afford the installation costs to obtain
electricity (extract 5). Thus, this good is actually a luxury to many of the poor households. When
the income per person rises, many more households can now afford it and this explains the more
than proportionate rise in demand for it. On the other hand, Australia is a developed country with
high income per person. Many households would already have been consuming electricity and
demand will rise less than in proportion to the rise in income per person.
d) Both Bangladesh and Singapore invest in infrastructure projects. Discuss how such
spending may have different impacts on aggregate demand in these two countries. [8]
Investing in infrastructure projects will increase government spending and this will affect both
countries’ AD but differently due to the size of government sector, the size of government debt
and size of multiplier.
Size of government sector as a percentage of GDP may also matter as a small government sector
would result in smaller changes in AD. For Singapore, the government sector may be smaller
than that of Bangladesh, given that external demand takes up a larger percentage of GDP in
Singapore. Thus compared to Bangladesh, the rise in AD will be less of an extent.
How much the rise in AD is also dependent on government debt. Given that Bangladesh’s budget
balance is negative and has been increasing since 2000. If the country needs to finance the
spending by borrowing from the banks, this will cause crowding out effect. As demand for loanable
funds rises, interest rate on loans will increase and crowd out private investment and
consumption. This would limit the rise in AD for Bangladesh. On the other hand, Singapore has
accumulated sufficient reserves to draw upon for spending hence would not experience crowding
out effect. Thus the rise in AD may be higher than Bangladesh.
Size of the multiplier matters as a small multiplier size will lead to smaller changes in AD when
there is an increased in investment. For a small and open economy like Singapore, multiplier size
would be smaller than that of Bangladesh. For a resource-poor country, MPM is high in Singapore
as she is heavily reliant on imports for energy, food and raw materials, the compulsory saving
rates such as CPF mean that MPS is also high. As such, a high MPW would result in smaller
changes in AD.
Answers may also consider that rise in G may be spent on imports instead for SG case, due to
her reliance on imported inputs. This would limit the extent of the rise in AD.
In conclusion, government spending will increase AD in both countries although the increase
seems to be higher for Bangladesh due to the larger size of G as proportion of AD as well as the
larger multiplier size as compared to Singapore. The only limiting factor on its AD would be to
overcome the fiscal deficit that Bangladesh has.
e) Discuss whether supply side policies are the most appropriate policies to achieve
inclusive economic growth in Bangladesh [10]
Intro: According to Extract 4, Bangladesh’s economic growth has been impressive but only 1%
of the population “almost exclusively enjoys the benefits of economic growth”. There is also
unequal access to water, roads and energy as stated in Extract 5. Thus, there is a need to achieve
inclusive growth. Supply side policies include increasing the horizontal AS via a reduction in cost
of production and increasing the vertical AS by increasing productive capacity via increasing the
quantity and improving quality of resources.
Body 1: Supply side policies are appropriate to achieve inclusive growth in Bangladesh
[P] To achieve inclusive growth, more effort can be made in the area of infrastructure and skills
of workers.
[E+E] Bangladesh government can spend more to improve transport network as well as having
adequate water sources. More can be spend on electricity grid network so that rural areas can
have access to electricity. With these improvement, various sectors of the economy can expand
their business and be more productive. The improved infrastructure would attract investments
especially in less developed areas, leading to a rise in AD. The rise in AD would in turn result in
an unplanned fall in inventories, leading to firms increasing their output and hiring more factors of
production like workers. Through the multiplier process, actual growth is achieved, and jobs are
created to reduce demand deficient unemployment. Furthermore, investments would increase the
capital stock in Bangladesh, leading to a rise in productive capacity and potential growth through
a rise in AS. With AD and AS rising from increased investments, sustained economic growth can
be achieved.
Not only will sustained growth be achieved, as people’s income rises due to more economic
activities, this will help to achieve greater income equality. By focusing infrastructure development
in rural areas, the distribution of the benefits of economic growth can be spread to the lower
income rural residents. The government can also direct more retraining programmes to specific
segments of the labour force such as the females who ‘ face greater challenges accessing finance
and information’ as mentioned in Extract 4. This will allow them to move up the value chain and
improve on their earnings. This is because, with relevant knowledge/skills, they will be able to
take up jobs generated by economic growth.
However, such policies will take a long time to take effect and would not be effective to promote
inclusive growth in the short run. There are also a few considerations when it comes to giving
access to electricity in the rural areas as even though the infrastructure is in place, consumption
among the poor may not be realised in the short run while they are still unemployed. It is probably
only in the long run when they are gainfully employed, there is a more sustained consumption of
electricity. As for retraining programme targeted at females, it may be tougher to implement as
there will be a resistance to change mind-set.
Body 2: Besides supply side policies, the Bangladeshi government can adopt exchange
rate policy as well as fiscal policy for achieving inclusive growth.
[P] Exchange rate policy with a depreciating stance can help to achieve growth via net exports
[E+E] Net exports contribute a large portion of Bangladesh’s national income, as according to
Extract 4, “Bangladesh is currently the second largest exporter of ready-made clothing in the
world”. With a fall in the value of the Taka, the price of exports in terms of foreign currency will fall
and demand for exports will rise. At the same time, price of imports in domestic currency will rise,
causing quantity demanded for imports to fall. Given |PED|>1, import expenditure will fall. As net
export value rises, AD will rise and national income will rise via multiplier, leading to actual growth.
Firms especially in the export industries will expand production and hire more labour, allowing
more Bangladeshis to participate in the labour force thus improving their earnings compared to
having no work or odd jobs previously. In particular, workers in the clothing industry would likely
be manual labourers who are of lower income. This would then help to improve income equality.
However, according to extract 4, many businesses in Bangladesh are owned by a minority of rich
families. The boost in exports may then lead to higher profits earned by these business owners,
which does not contribute to making growth more inclusive.
[P] The Bangladeshi government can consider increasing direct tax to make economic growth
more inclusive.
[E+E] Higher direct tax such as personal income tax and corporate tax may be levied on the 1 %
privileged class and their ‘family owned’ businesses respectively in Bangladesh. This would
reduce their disposable income and after tax profits. At the same time, the revenue earned can
be used to subsidise the poor in areas of infrastructure and education, making the growth more
inclusive.
However, the trade off with growth is inevitable as there will be a fall in C and I thus a fall in
national income via multiplier. This will result in lay-off of excess workers and may make the
majority of Bangladeshis worst off without a job. Furthermore, it will be hard to implement as the
elites ‘control vast amounts of wealth and own most of the banks and other financial institutions
in Bangladesh’. This will prove to be politically unfavourable.
OR, answers could consider reducing corporate taxes for SMEs specifically, to encourage growth
via investments. This would also help owners of smaller businesses, who may be of relatively
lower income. (Ext 4 – “create equal opportunities for all, specifically for the small- and medium-
sized enterprises, to compete and participate in business opportunities”)
Conclusion
[Stand]In conclusion, supply side policies may be the most appropriate policies to achieve
inclusive growth because it targets an improvement in productivity and provide them with the
means to participate in economic growth in the long run.
[Substantiation] However, considering the high level of government debt already accumulated
due to the rising budget deficits (table 1), it will be difficult for the government to fund these
policies. Complementing with a rise in direct tax which transfer wealth to the poor may be a better
choice as the funding of supply side projects could come from the higher income households.
Exchange rate policy is probably the least appropriate as it mainly targets export oriented
industries only.
Paper 2 – Essay Questions

Question 1
The average price of tickets for two concerts performed by singer-song writer Ed Sheeran
in November 2017 at the Singapore Indoor Stadium was S$180. Tickets went on sale six
months earlier and both concerts sold out almost immediately. Some tickets were later
being offered for resale at prices well above their face value.
(a) Using supply and demand curves, explain why there is an excess demand for tickets
and why there is a high resale price. [10]
(b) Discuss possible strategies that concert organisers could use to improve the market
outcome for this type of concert for producers and consumers. [15]

Part a

Introduction
Based on demand-supply analysis, when there is excess demand in the market, it means that
price has been fixed below market equilibrium price i.e. at a disequilibrium level.

Body

[P] The price set by the organisers were below the market equilibrium price, leading to ‘excess
demand’.
[E+E]
The supply of Ed Sheeran concert tickets is fixed by the capacity of the Singapore Indoor Stadium.
Quantity supplied cannot be changed even if price changes i.e. supply is perfectly price inelastic.
This is represented by the supply curve S1.
The demand for Ed Sheeran concert tickets is the willingness and ability of consumers to pay a
price for them. Owing to Ed Sheeran’s popularity, many fans will be willing and able to offer higher
prices than the $180 charged by organisers. At the average price of $180, quantity demanded, Q’
(Fig. 1) is much higher than the quantity supplied, Q1. [L] This led to ‘excess demand’, or shortage
of QQ’ tickets.

Fig. 1: Market for Ed Sheeran concert tickets

In the diagram above, consumers are willing to pay up to price P2 per tickets. However, the
organiser had fixed the price at $180. As such, there is unsatisfied demand and this presents an
opportunity for those who managed to buy it at $180 to resell it to those who did not.

[P] Price of the concert ticket is much higher in the resale market (Fig. 2).
[E+E] In the resale market for the concert tickets, price is no longer fixed by concert organisers.
As such, the high resale price is determined by market forces. The shortage of Q”Q’ tickets (Fig.2)
leads to an upward pressure on the ticket prices. Frustrated consumers will be offer higher prices,
causing price to increase in the resale market.

[E+E] Demand for the concert tickets will be very price inelastic i.e. |PED|<1 since fans of the
singer will find little close substitutes to the concert experience. Even if price were to increase,
these fans will find it hard to switch away to other substitutes. At the same time, supply will be
very price inelastic too, as the number of tickets held by resellers will be limited. Even if resellers
want to sell more with a higher price, they cannot increase their quantity supplied by much. As
price increases, since both demand and supply are price inelastic, quantity demanded will fall less
than proportionately, while quantity supplied will increase less than proportionately too. [L] As
such, a very large increase in price to P2 is required for the market to clear i.e. quantity demanded
equates quantity supplied.

Fig. 2: Resale market for Ed Sheeran concert tickets

Part b
Introduction
Producers and consumers seek to maximise their self-interest i.e. maximise profits and net total
benefit respectively. For producers, market outcome is improved when their profits increase. For
consumers, outcome is improved when they pay lower prices, and/or is able to consume larger
quantities, which leads to larger consumer surplus.
Body
[P] One strategy will be for concert organisers to use a bigger stadium, or hold the concert over
more nights instead of just two.
[E+E] With a bigger stadium, or more concerts performed, producers will be more able to supply
concert tickets. This leads to an increase in supply, reflected by a rightward shift of the supply
curve from S1 to S2 (Fig. 3). Consumers benefit with a higher supply. Consumer surplus is defined
as the difference between the total amount that consumers are willing and able to pay for a good
or service as indicated by the demand curve, and the total amount that they actually pay i.e. $180
in this case. If average price charged remains at $180, consumer surplus will increase from Area
A to Area A+B with the higher quantity consumed.

If supply increases to the extent that quantity demanded equates quantity supplied at $180, there
will no longer be a shortage. Fans will thus have no need to buy resale tickets.

[Ev] This strategy is likely to improve the consumers’ outcome significantly. Even if supply
increases by less than the case explained here, consumer surplus will have increased.

[E] Producers will earn higher total revenue, which is given by price x quantity sold. With a higher
quantity Q2 sold instead of Q1, total revenue increases from Area C to Area C + D. Total cost will
also increase because there is a need to pay the singer and other workers and/or venue for one
more night (or pay likely higher rental for a larger venue). However, should total revenue rise more
significantly than total cost, profits earned by producers will still increase, improving their outcome.

Fig. 3: Increased supply of concert tickets

[Ev] However, producers lack perfect information regarding the demand for concert tickets. If SS
increases beyond S2, there will be excess tickets at the price of $180. In such a case, with unsold
tickets, it may be the case the total revenue increases less than what producers predict. If total
revenue rises by less than the increase in total cost, profits earned by producers may fall.

[P] Another strategy would be for the organisers to practise third degree price discrimination.
[E+E] When organisers carry out third degree price discrimination, the same concert ticket is sold
at different prices to different buyers segmented into distinct groups for reasons not associated
with differences in production cost. This helps the producer to earn more revenue, and ceteris
paribus, higher profits.
[E] The organisers sell the tickets to different groups of consumers, e.g. students and work adults.
Demand from students tends to be price elastic because students on average have a lower
income, thus the price of the concert ticket takes up a much larger proportion of their income.
When price changes, it impacts on the student’s ability to buy the tickets more significantly,
causing a more than proportionate change in quantity demanded, ceteris paribus. Conversely,
demand from work adults tends to be price inelastic as the ticket price takes up a small proportion
of their income. Since the price elasticity of demand differs between the types of consumers, the
concert organisers can charge them different prices to increase the total revenue earned from the
same quantity of tickets.

The organisers can lower the price for the student market and sell more. Since demand is price
elastic, the loss of revenue from the fall in price will be less than the revenue gained from the
more than proportionate increase in quantity demanded, ceteris paribus. At the same time, the
organisers can increase the price and sell less in the adult concert-goer market. Since demand is
price inelastic for working adults, the increase in revenue from the increase in price will be more
than the revenue lost from the less than proportionate fall in quantity demanded, ceteris paribus.

[L] Since the cost of running the concert remains the same, the increase in revenue earned from
practising third degree price discrimination will help the organisers earn higher profits.

For consumers, whether they gain or lose will depend on whether they are classified as ‘students’
or not. For students, they pay lower prices, and have a higher chance of buying tickets since more
tickets will be sold to them. This improves their outcome. For working adults, their outcome is
worsened as they now pay more for a lesser quantity of tickets.

[Ev] For this strategy to work, the organisers must be able to prevent resale of the tickets. If
students could sell the tickets to working adults, adults will only buy from the students and not
from the organisers. However, it is fairly easy to prevent resale by making it clear that the ticket
purchased is for students only e.g. type of ticket printed on the ticket itself, different colour ticket
issued. If concert-goers are required to show their student identification cards when entering using
these marked tickets, non-students will not try to purchase them and risk being turned away.

[P] One more strategy that can be employed will be to charge higher prices i.e. above $180.
[E+E] Since $180 is below the market equilibrium price P2 (Fig. 5), leading to ‘excess demand’,
letting the producers charge a higher price will not cause them to lose sales, so long as the price
is not increased above the market equilibrium price.
[E] If producers charge the maximum they can without causing a surplus, i.e. P2, the revenue they
earn will increase from $180 x Q1 (Area C) to P2 x Q2 (Area B + C). [L] Since their cost remains
the same, profits earned by the producers will increase, improving their outcome.
[Ev] The trade-off of such a strategy will be consumer welfare. Consumer surplus falls from Area
A + B to Area A since consumers will be paying a higher price than before. Their outcome is thus
not improved.

Fig. 5: Higher price charged by producers

Conclusion

[Stand] The best strategy for concert organisers would be to charge higher prices.

[Substantiation] Even if organisers lack information on what the highest price they can charge will
be, and charge a price lower than P2, producer outcome will still be improved compared to
charging $180. This is because total revenue earned will definitely increase, while total cost of
holding the concert remains the same, resulting in higher profits. Compared to using a larger
venue, where it is not clear if the increase in total revenue will be higher than the increase in cost,
charging higher prices is a more certain strategy for organisers to improve producer outcome.
This is especially so if the sound quality is much poorer in the larger venues. For such a concert
which focuses on Ed Sheeran’s live singing ability, consumers may not be as willing to pay high
prices for the tickets, and should tickets not sell out, total revenue earned by producers will not
increase as much.

While consumers lose consumer surplus when higher prices are charged, the negative impact on
consumer outcome may not be very significant if one takes into consideration the high prices in
the resale market previously, which those who failed to obtain a ticket had to pay if they wanted
to watch the concert.

Charging a higher price for all concert-goers will also be easier to implement than third degree
price discrimination, since the organisers will not need information on price elasticity of demand
values for the various groups of consumers. Resources are also not needed to check if the ticket
holder is indeed a student or not.
Question 2
Competition among airlines within the air passenger market is high and demand is rising
but many airports at or near capacity. Both variable and fixed costs of production of
airlines continue to change over time. For example, airline jet fuel prices fell by 20.4% over
the year ended 22 July 2016 while the prices of passenger jet aircraft increased by around
1.1% between 2015 and 2016.
Source: International Air Transport Association, accessed 3 August 2016
Using economic analysis, discuss how airlines would likely respond to these changes. [25]

[Introduction]
With changing demand, variable costs as well as fixed costs, airline companies are likely to
change their pricing and output decisions assuming the objective of profit maximization. These
companies will also have to consider their competitors’ possible reactions to their new decisions
since the airline service industry is likely to be operating in an oligopoly market where rival
consciousness is strong. Additionally, airline companies should acknowledge that some of the
conventional profit maximizing strategies might not work given production constraints due to the
lack of capacity in airports.
[Body]
[P] The above changes will lead to rise in MR, decease in MC and rise in AFC.
[E&E] With rising demand for airline services likely due to increased globalization, the marginal
revenue (MR) of airline companies will increase as well. This can be illustrated by an increase in
both the demand (DD) curve from DD to DD’ as well as the MR curve from MR to MR’. Falling
airline jet fuel prices will affect the marginal cost of production (MC) for airline companies. Fuel
costs is a variable costs because the more trips airline companies make, the greater the usage
of fuel. The fall in jet fuel prices result in a fall in marginal cost. This can be illustrated by a fall in
MC curve from MC to MC’. Rising price of passenger jet aircrafts on the other hand will increase
the average fixed costs (AFC). Unlike the price of fuel, the cost of purchasing aircrafts is
considered a fixed cost as it does not vary with the number of trips made. As such, when airline
companies have to purchase more expensive aircrafts when they need to replace or upgrade
existing ones, their average fixed costs (AFC) and thus average total cost (ATC) will increase,
assuming the extent of increase in costs of passenger jet air crafts is larger than the fall in fuel
costs. This can be illustrated by a rise in ATC curve from ATC to ATC’.
[Students can argue that ATC falls assuming the fall in fuel costs outweigh the rise in costs of
passenger jet air crafts]
Diagram 1

[Strategy 1]
[P] One likely response by airlines is to increase price and quantity produced.
[E&E] Initially, the profit maximizing quantity is Q where MC=MR and airline companies are likely
charging their services at price P. With the increased demand for their services, falling marginal
cost as well as rising average total cost, the new profit maximizing quantity is at Q’ where
MC’=MR’ and airline companies should charge at price P’. [L] Theoretically, airline companies
should raise the price of their services from P to P’ and increase the quantity of their services from
Q to Q’, assuming their objective to be profit maximizing.
[Evaluation] Raising the price of their services however may not be a strategic move by airline
companies. This is because operating in an oligopoly market where there are few large firms in
the industry, the firms have high degree of rival consciousness. Moreover, existing firms are
always competing for greater market share. When an airline company raise the price of their
services, other companies may not follow suit in order to attract customers who may switch over
from the relatively more expensive airline company who raised their price. This is particularly
relevant if the services provided are homogenous and there is no strong brand loyalty to the
company. Over time, this airline company will lose its business and loses market share to the
other airline companies. Therefore airline companies will have to think twice before deciding to
raise the price of their services even though theory dictates that they should if they wish to
maximize their profits.
[Strategy 2]
[P] It is possible for airline companies to raise their price however, when airline companies engage
in collusion.
[E&E] This can be in the form of explicit collusion. Airline companies could gather together and
come to an agreement to raise the price of their services together. When every player in the
industry raises their price, companies can be rest assured that they will not lose their business
since consumers cannot switch to other “relatively cheaper” alternatives.
[Evaluation] One argument against this strategy however is the inherent incentive for one player
to “cheat” in this game. For this strategy to work, every company must abide strictly to the rules
of this explicit collusion. If one player does not honour the agreement, every company will not be
able to raise their price lest their customers switch over to the “cheater”. This incentive to cheat
is further motivated by the fact that the agreement is unlikely to be legally binding. In most
countries, explicit collusion is not permitted by law due to anti-competition acts. As such, the
inherent incentive to cheat makes this form of collusion rather unlikely.
[Strategy 3]
[P] Another possibility for airline companies to raise the price of their services is to engage in tacit
collusion.
[E&E] This occurs when the industry leader starts the ball rolling by raising their price first before
other companies follow suit. Large and globally recognized airline companies such as Singapore
Airlines or Qatar Airways can take the lead to raise their prices first, signalling to the other
companies that they too can raise their prices now. [L] When this occur, every company will thus
be able to raise their prices and better maximize their profits.
[Evaluation] For smaller companies however, this strategy is a passive one and therefore they
should adopt other strategies while waiting for the industry leaders to start the price increases.
[Students can focus on just 1 collusion strategy if they do not have enough time in the exam]
[Strategy 4]
[P] Another strategy is to purchase larger aircrafts
[E&E] Raising the quantity of services provided by airlines by buying more aircrafts might not be
feasible because of the capacity constraints in airports. When airports are “at or near full capacity”,
it suggests that traffic flow in major airports are already very heavy and airline companies are
unlikely to increase the number of flights to and fro these airports. To combat this problem, airline
companies can think about purchasing larger aircrafts such as Airbus 380 with bigger capacity to
fit more passengers in one trip instead of increasing the number of trips. With more of such
aircrafts, airline companies can increase the quantity of their services and circumvent the issue
of capacity constraints in airports. Firms are also able to enjoy economies of scale due to the
principle of increased dimensions when they operate aircrafts with larger seating capacity. This
is because it takes the same number of pilots to fly the larger air craft as compared to a relatively
smaller one. [L] Therefore the average costs per unit of service, which can be measured as per
passenger, will likely be lowered. The increase in fuel used is also less than in proportion to the
increase in number of passengers that the aircraft can transport.
[Evaluation] One potential limitation of this strategy is the riskiness of it. When airline companies
purchase these larger air crafts, they incur very high fixed costs as they are likely to be very
expensive. If the demand for their services fall after making the purchases, their profit level will
be affected. However from the preamble it seems like demand for airline services are rising and
therefore this should not be a major issue for most airlines. Having said that, the companies need
to get as much information as possible and weigh the benefits and costs before making the
purchases.
[Strategy 5]
[P] In consideration of the difficulties in raising the price due to strong rival consciousness and the
quantity of services due to capacity constraints at airports, another strategy that profit-maximizing
airline companies can do is to come up with more differentiated services and charge different
prices for them.
[E&E] Even though customers are all flying in the same air craft, the service is not homogeneous.
The flying experience (and the ticket fares) can be differentiated when customers purchase first
class service, business class service or economy class service. Recently, Singapore Airlines and
Cathay Pacific Airlines also launched the premium economy class, which provides differentiated
service from the normal economy class such as greater comfort in the seats at a higher price.
Many airlines such as Air Asia have also started to charge higher price for ‘hot’ seats such as
emergency exit seats that afford greater leg space. Airline companies may not be able to raise
the price of a homogeneous service such as a normal economy seat due to strong rival
consciousness, but they can innovate and come up with more differentiated service to charge
different prices for customers with different types of wants and needs in order to increase total
revenue. One possible differentiation could be offering ‘wifi seats’ where only flyers who
purchased that class of seats are able to access the wifi on-board. This strategy allows airline
companies to slice the pie into more categories and charge different prices for different categories.
For example, airline companies can split current 200 economy class seats to 150 economy class
seats and 50 ‘wifi seats’. They will keep the price of economy class seat at $500 per passenger
but charge $550 for ‘wifi seats’. [L] By doing so, they can extract more revenue from the
consumers without having to raise the price of existing categories (due to strong rival
consciousness) nor increase quantity of services (due to capacity constraints at airports).
[Evaluation] Airline companies are likely going to incur some costs for example installing the wifi
modems on board. While this strategy allows for airline companies to increase total revenue, they
also need to consider the increase in total costs since their objective is to maximize profits.
Therefore, the principle of innovating new differentiation should be incurring the least costs to
command the highest possible price that consumers are willing and able to pay.
Conclusion
[Stand] In conclusion, airline companies are most likely to raise the price of their services and
purchase larger capacity air crafts.
[Substantiation] Even though the rival consciousness among firms in the airline industry is
strong, it seems inevitable that airline companies will likely raise the price of their services due to
rising demand. If an airline company knows that they are the price leader in the industry, they will
go ahead in raising the price of their services from P to P’ since it is the new profit maximizing
price level. Other small airline companies will likely follow after. Even if one airline company does
not raise their price to try and attract more customers, they are unlikely able to cope with the
increased number of flights due to the fixed number of air crafts that it holds and the number of
pilots it employs. At least in the short run, it is more probable that every other airline companies
will raise their prices in order to increase their profits. In the long run however, when airline
companies are able to vary the number of air crafts and pilots, they might be more conservative
in raising their price. Airline companies might also respond by purchasing larger capacity air crafts
even though it may be risky, especially established airline companies with strong brand loyalty
and reputation such as Qatar Airways and Singapore Airlines who are not afraid of sudden
changes in demand for their services. Since they are restricted by the number of flights due to
lack of airport capacities, it makes economic sense to purchase air crafts that can ferry more
passengers per trip. Operating such air crafts can also help the firms reap economies of scale
that would lower their average costs.
Question 3
The proposed Cross Island MRT line would run through the Central Catchment Nature
Reserve. An alternative route going round the reserve’s southern edge would preserve
Singapore’s natural heritage and serve a much larger number of residents. The Land
Transport Authority, LTA says that the alternative route would entail longer travelling time,
higher costs, more land acquisition and possibly bigger engineering challenges.

Source: The Straits Times, accessed 24 May 2017

a. Explain what needs to be considered when a government makes rational spending

decisions about such projects. [10]

b. Discuss whether the government should proceed with the proposed alternative route
for the Cross Island MRT. [15]

Part (a)

Introduction

A government seeks to maximise society’s welfare. When a government makes rational spending
decisions about such projects, it will weigh the marginal social benefits and costs, and a rational
decision is one that maximises net total social benefit. The benefits include the direct benefits to
consumers/households who benefit from using the government project and third party benefits.
The costs include the cost of project and any costs borne by third parties. Other factors which the
government would consider would be budget constraint, alternative perspectives and trade-offs.

Body

[P] A government will need to consider the benefits and costs of such a project including
the positive and negative externalities that could arise from such projects.
[E+E] The benefits of such a project include the private benefit and the external benefit which is
the beneficial impact on a third party not involved in the economic transaction. For example, with
regards to government spending on infrastructure projects such as the construction of an MRT
line, the private benefit of the project will be enjoyed by the workers who directly use the MRT line
in terms of time saved and more pleasant travel experience. The external benefit enjoyed by firms
who employ these workers, who will benefit from increased profits because the rise in workers’
productivity (as a result of employees being in a less stressful state of mind) will lower the unit
cost of production. The costs of such a project include the private cost and the external cost which
is the adverse impact on a third party not involved in the economic transaction. For example, the
private cost of constructing the MRT line includes construction costs borne be the government.
The external cost would be the noise pollution which will be experienced by residents staying near
the construction area who are third parties not involved in using the MRT line.
 Costs, Benefits ($/q)

MSC = MPC + MEC

A
B
MPC
C

MSB = MPB + MEB

MPB

Q /t
0 Q Q*

The positive externality causes the marginal social benefit (MSB) to be greater than the marginal
private benefit (MPB) of using the MRT. The existence of the MEB causes the MSB curve to be
higher than the MPB curve. The negative externality causes the marginal social cost (MSC) to be
greater than the marginal private cost (MPC) of using the MRT line. [L] A government, seeking to
maximise society’s welfare will seek to produce the socially optimal output is at Q*, where MSB =
MSC and society’s welfare is maximised.

Note: The focus of the paragraph is not on explaining market failure, but the cost and benefit that
the government needs to consider in its decision making.

[P] The cost considered by the government in the above explanation is opportunity cost
[E+E] When a choice is made, opportunity cost is incurred. This is because each time a scarce
resource is used to satisfy a want, an alternative want is sacrificed. Opportunity cost is the cost
of using resources for a certain activity, measured in terms of the net benefit that could be derived
from the next best alternative forgone. For example, when a government spends on infrastructure
projects such as the MRT line, it would incur an opportunity cost since the funds could be
channelled to other uses such as skills upgrading programmes which can improve the quality of
labour and increase the productive capacity of the economy and boost potential growth.

[P] A government would also need to consider its constraints when making rational
spending decisions.
[E+E] Governments have limited tax revenue and they may or may not be willing or able to borrow
funds. However, governments have unlimited projects they want to spend on which means each
government has to choose which project to spend on. Therefore, governments face budget
constraints.

Besides a budget constraint, governments also face the constraint of the social and political
acceptability of their chosen method of intervention. [L] Therefore, a government will have to
consider the constraints it is currently experiencing because this will determine the choices
available for them. Based on these choices, the government will decide on the best-ranked choice
that enables it to maximise society’s welfare. This is the one that yields the highest net total social
benefit.

[P] A government will consider the accuracy of information gathered when making rational
spending decisions.
[E+E] It is important to note that the government might face problems in getting accurate
information to make a well-informed decision. For example, if is difficult to assign a monetary
value to items such as negative externality due to loss of natural environment or even the
inconvenience of land acquisition and relocation. [L] Therefore, a government will need to
evaluate the accuracy of the exact benefits and costs in order to make a decision.

Part (b)

Introduction

In order to make a rational decision, the government has to gather information about the costs
and benefits of the constructing the original route for the Cross Island MRT line and the proposed
alternative route. The government would then have to compare the relative costs and benefits of
each option and ensure that the chosen route maximises society’s welfare.

Body

[P] The government will consider the costs arising from each of the two routes.
[E+E] If the government decides to proceed with the original route, the construction of this route
will lead to the destruction of the environment and natural heritage of the Central Catchment
Nature Reserve. This will have an adverse impact on the plants and animals in the nature reserve
which will result in negative externalities as third parties will not be able to enjoy the natural beauty
of the nature reserve, and there will be welfare loss. On the other hand, if the government chooses
to proceed with the alternative route, commuters will have to endure the longer travelling time
which may reduce their productivity and result slower expansion of Singapore’s potential growth.
In addition, this alternative route will lead to more land acquisition which means that owners of
houses and commercial buildings in the vicinity will have to be relocated which means they will
suffer from inconvenience and potential financial costs.

[P] The government will consider the benefits arising from each of the two routes.
[E+E] If the government decides to proceed with the original route across the nature reserve,
commuters will enjoy a shorter travelling time as compared to the case if the government were to
choose the alternative route to build the train line around the nature reserve instead. This will
boost worker productivity which means that more output is produced per unit of labour. This
improvement in the quality of labour results in the expansion of Singapore’s productive capacity
as the economy is now able to produce more goods and services. Also, the rise in workers’
productivity will lower the unit cost of production for firms which is likely to attract more FDI. The
increase in FDI will result in the increase in I component of AD and a multiplied increase in real
GDP resulting in actual growth. Greater FDI will also lead to a rise in the quantity of capital stock
which will enable Singapore to generate more goods and services. This increases the productive
capacity hence increase in AS, illustrated by the rightward shift of the vertical AS curve, resulting
in potential growth. In addition, the shorter commuting time allows commuters to spend more time
with family or more time for leisure activities. This will boost quality of life and improve the non-
material aspect of standard of living.
On the other hand, the alternative route will serve a larger number of residents as mentioned in
the preamble. This means that more people can enjoy the Cross Island line and benefit from
greater convenience and access to transport. As more people have access to the line, there will
be greater equity. This would also lead to improved worker productivity and boost potential
growth.

[EV] The original route will most likely result in more significant improvement in worker productivity
due to time savings, and hence will result in greater economic growth as compared to the
alternative route.

[P] The government will also consider the size of the opportunity cost incurred with the
construction of each route.
[E+E] Both routes require substantial amount of government funds for the construction of the MRT
line. This means that the government will incur opportunity costs in terms of the value of the
alternative foregone such as spending on building a new hospital which allow residents to gain
greater access to healthcare and improve standard of living. However, the original route across
the nature reserve would incur lower costs of construction as compared to the alternative route of
building the train line around the nature reserve. As mentioned in the preamble, building the train
line around the nature reserve would incur higher costs. This means that proceeding with the
alternative route will put a greater strain on the government budget and result in greater
opportunity costs.

[EV] At this point of time, the Singapore government has sufficient reserves to pay for the
additional costs of constructing the alternative route. However, with an ageing population which
will require the government to spend more on areas such as healthcare services, the strain on
government budget is still a significant factor in the decision making, and the government may
prefer not to go with the alternative route.

Conclusion

Stand: It is important for the government to consider the benefits and costs of building either route
and should choose to build the route which results in relatively higher net benefit for society.
Whether the government should proceed with the alternative route also depends on what the
government/society prioritises at her current stage of development.

Substantiation: The government has to consider what it values more. If she values preserving
nature/greenery and providing more residents access to the MRT line, she will proceed with the
alternative route. On the other hand, if she priorities a greater rate of economic growth due to the
shorter travelling time and less worry about fiscal debt, she would stick with the original route. It
can be argued that preserving nature/greenery and providing more residents access to MRT line
would be the priority at this stage of Singapore development. This is because the Singapore
government/society is at the stage where it puts a greater value on sustainable and inclusive
growth rather than just high and sustained economic growth.
Question 4
In April 2016, Singapore’s Finance Minister Mr Heng Swee Keat, announced that in the
fiscal year 2016, total government expenditure is expected to be S$5.0 billion (7.3%) higher
than the previous year.
Source: Singapore Budget 2016, accessed 3 August 2016
Assess whether an increase in government expenditure, such as that announced in the
2016 budget, is likely to have a significant impact on Singapore’s economic performance.
[25]

Introduction
An increase in government expenditure (G) would affect both the aggregate demand (AD) and
aggregate supply (AS) of the Singapore economy. This essay would explore the impact of an
increase in G on Singapore’s economic performance in terms of the four macroeconomic goals –
sustained economic growth, price stability, low unemployment, as well as a healthy balance of
payments.
Body
Thesis: Increase in G has a significant impact on Singapore’s economic performance
[P] An increase in G can lead to actual economic growth and a fall in demand-deficient
unemployment if the economy has excess spare capacity.
[E+E] The rise in G increases the demand for domestically produced goods and services. For
example, if the government expenditure is on transport infrastructure, there would be an increase
in demand for domestic construction services. Thus, an increase in G would lead to an increase
in AD.

Figure 1: Rise in G leading to actual growth and a fall in demand-deficient unemployment

Assuming the presence of spare capacity, the rise in AD, illustrated by a rightward shift of the AD
curve from AD to AD1 in Figure 1, results in an unplanned fall in firms’ inventories as AD exceeds
national output at the current general price level (GPL). This will lead to firms increasing
production and hiring more factors of production, such as labour, as it is a derived demand from
output produced. As a result, households’ income will increase. Part of this income earned by the
workers will be spent on consumption of other domestic consumer goods and services, while
another part of this rise in income is withdrawn as savings, taxes, and import expenditure. As a
result of this induced consumption, AD increases further from AD1 to AD2. This causes another
round of unplanned fall in inventories for the producers of these other domestic consumer goods
and services. They will then increase employment and new incomes will then be created for those
employed in these industries. Their incomes would increase, and part of this rise in income will
again be spent on domestic consumption, while a portion will again be withdrawn as savings,
taxes, and import expenditure. The national income will be higher as output increases further. The
multiplier process would lead to a multiplied increase in real GDP from Y to Y3. As a result, there
will be actual economic growth and a fall in demand-deficient unemployment.
L] Thus an increase in government expenditure is likely to have a significant impact on
Singapore’s economic performance as it can lead to increases in real GDP.
[P] An increase in G can lead to demand-pull inflation if the economy is at or near full employment.
[E+E] An increase in G increases AD, and AD shifts rightwards from AD to AD1, as illustrated in
Figure 2.

Figure 2: Rise in G leading to demand-pull inflation

When AD rises, profit-motivated firms respond by increasing production. When firms increase
output and operate closer to full capacity or full-employment (Yf), production becomes less
efficient. This is because firms will be forced to use resources that are less and less suitable for
their production. Thus, increasingly larger amounts of labour and other inputs are required per
additional unit of output produced. This causes the unit cost of production to increase (i.e. the AS
curve slopes upwards). This means firms will only produce extra output if it can be sold at higher
prices. Hence, the rise in AD leads to an increase in the GPL. When AD rises further, with the
increased scarcity of resources, the GPL is further pulled upwards with limited increase in national
output. Once Yf is reached, continued increases in AD (e.g. to AD2) will lead to increase in the
GPL only.
[L] Thus an increase in government expenditure is likely to have a significant impact on
Singapore’s economic performance as it can lead to demand-pull inflation.
[P] In Singapore, the increase in G is channelled towards infrastructure development and
education, with the aim to promote long-term economic growth through SS side effects. This can
lead to sustained growth for the economy.
[E+E] As the increase in G is channelled towards infrastructure development, such as the building
of roads and highways. Such government spending on infrastructure results in the increase the
quantity of capital, which leads to an increase in the capital stock, and the productive capacity of
the economy. The increase in G on education, such as the provision of training facilities or
subsides to encourage workers to go for further training and upgrade themselves, helps the
workforce to upgrade and to increase their productivity. For example, in Singapore, the
government provide grants through the Workfare Training Support Scheme for low skilled workers
to upgrade their skills. This would raise the quality of workers as workers would be able to
generate more output per man hour and cause an increase in the productive capacity of the
country, resulting in the increase of AS (vertical). Vertical AS therefore shifts rightwards and the
full employment output level increases from Yf to Yf1. There is therefore potential growth, which
is required for future increases in real national income. The potential growth would also slow down
the rise in GPL, reducing demand-pull inflation in Singapore.
The rise in the productivity of labour also causes a fall in unit cost of production, assuming that
the rise in productivity is greater than rise in wages. The fall in unit cost of production results in
an increase in AS (horizontal). Horizontal AS therefore shifts downwards and GPL falls. There is
a consequent movement along the AD curve, which means that there is a change in planned
aggregate expenditure arising from a change in the GPL. This could be because a fall in the GPL
causes real income to increase, allowing consumers to have greater purchasing power to
consume more goods and services. Hence, consumption rises, causing a rise in real GDP, as
indicated by the downward movement along the AD curve (i.e. real balances effect).
[Alternative explanation] Another reason could be because when GPL falls, assuming no change
in the foreign exchange rate, the price of domestic goods relative to foreign goods fall and
domestic goods become more price competitive than foreign goods. Thus, import expenditure
decreases as households switch to buying the relatively cheaper domestic goods whilst export
revenue increases as foreigners buy more local goods. Hence, net export expenditure increases,
causing a rise in real GDP (i.e. international substitution effect).
Overall, the rise in AS is illustrated by a downward and rightward shift of the entire AS curve from
AS to AS1 as seen in Figure 3. As a result, equilibrium real GDP rises from Y to Y1, indicating
actual growth, and Yf increases from Yf to Yf1, indicating potential growth.
Figure 3: Rise in G leading to sustained economic growth
[L] Thus an increase in government expenditure is likely to have a significant impact on
Singapore’s economic performance as it can lead to sustained economic growth.
[P] Furthermore, since the rise in G in Singapore is channelled towards education and skills
retraining, structural unemployment can also be reduced.
[E+E] Structural unemployment occurs when workers are unable to find jobs that require their
particular skills. This usually arises due to structural changes in the economy and because
workers are occupationally immobile. In the case of Singapore, with technological advancement
and automation, changes in production processes would have caused some workers to be
displaced. They also tend to lack the skills to work in other growth industries, resulting in them
becoming structurally unemployed. The rise in G on education and skills retraining supports
workers in acquiring new skills to work in a new sector, thus increasing their occupational mobility
and reducing structural unemployment. This is seen in Singapore from the SkillsFuture scheme,
where subsidies and grants are provided to encourage workers to go for retraining to acquire new
skills, such as those related to information technology, financial technology, as well as med-tech.
[L] Thus an increase in government expenditure is likely to have a significant impact on
Singapore’s economic performance as it can significantly reduce structural unemployment.
[P] The rise in G on infrastructure development and education and training might also lead to an
improvement in the balance of trade (BOT).
[E+E] The rise in G to develop infrastructure such as roads and highways, as well as airports and
seaports would lead to a rise in productivity in the export sector. This is because the development
of roads and highways allows for better connectivity within the country as areas in the country
become more connected and accessible. The development of airports and seaports would also
allow firms in the export sector to be able to export more goods much more easily. Furthermore,
as explained previously, a rise in G in the area of education and training leads to increase in the
quality of labour as workers become more productive. If the increase in G is on education and
training of labour in the export sectors, workers in these sectors would become more productive,
producing a greater amount of goods per unit labour.
As a result, export revenue would increase. Assuming import expenditure remains unchanged,
the rise in export revenue would lead to a rise in (X-M), indicating an improvement in Singapore’s
BOT. [L] Thus an increase in government expenditure is likely to have a significant impact on
Singapore’s economic performance as it can significantly improve BOT.
Also, the rise in productivity in the export sector increases Singapore’s attractiveness as a
destination for foreign direct investments due to the rise in potential revenue that can be earned,
which also leads to an improvement in Singapore’s BOP.
Anti-thesis: The impact on Singapore’s economic performance may not be significant
[P] In Singapore, the effect of an increase in G on actual growth and unemployment is limited due
to factors such as the size of the multiplier (k) and the size of the government sector as a
proportion of GDP.
[E+E] The size of the multiplier is determined by k = 1/MPW, where MPW refers to the Marginal
Propensity to Withdraw. If MPW is high, withdrawals in every round are larger and less of the
increased income earned by households are injected back into the Singapore economy. MPW is
made up of the Marginal Propensity to Save (MPS), Marginal Propensity to Tax (MPT), and
Marginal Propensity to Import (MPM). The MPS in Singapore is likely to be high due to the
presence of a compulsory savings scheme, the Central Provident Fund, as well as a lack of social
safety nets such as pension benefits. Furthermore, with the lack of natural resources, Singapore
has to import most of its consumer goods and industrial raw materials. Thus, Singapore’s MPM
would likely also be high. As a result, the MPW of Singapore is likely to be high, leading to a low
value of k. With a small multiplier, the impact of an increase in G on actual growth would be
limited, and the fall in demand-deficient unemployment would be marginal as well.
The size of Singapore’s government sector as a percentage of GDP also limits the effect of an
increase in G on actual growth and unemployment. In 2016, government expenditure was only
10.7% of Singapore’s GDP, indicating a small size of the government sector. [L] As such, the
impact of raising G on actual growth and unemployment is not significant.
[P] Also, the effect of an increase in G on sustained growth and structural unemployment may be
limited in the short run.
[E+E] This is because these supply-side effects are usually only seen in the long-term. The
building of infrastructure to increase Singapore’s capital stock and the education and training of
workers to raise the quality of labour requires substantial time to take place. Furthermore, the
effects may also be uncertain, especially in the case of the government spending on education
and training, as it depends largely on individual workers’ willingness to be educated or reskilled.
Conclusion
[Stand] An increase in government expenditure by the Singapore government is likely to have
broad and significant impact on Singapore’s economic performance, but the aspect of the
economy that is impacted is different depending on the nature of the government expenditure.
[Substantiation] As the Singapore economy is operating at or near full employment in 2016,
evident from the low unemployment rate of 3%, any rise in government expenditure focused on
the demand-side is likely to lead to a rise in inflation and hence a worsening of Singapore’s
economic performance in this area, with the impact fairly significant because of the large increase
in G. On the other hand, a rise in government expenditure with a supply-side intent will reduce
inflationary pressures and improve economic growth, improving the country’s economic
performance in these areas.
In 2016, a large proportion of Singapore’s government expenditure was made in the areas of
education (17.43%), health (14.98%), as well as transport (13.76%). As such, it can be seen that
the Singapore government expenditure is undertaken with a supply-side intent to reduce
inflationary pressures and improve economic growth, though the impact will be significant only in
the long run.
Question 5
It was suggested by economists early in 2017 that world interest rates were likely to rise
in the future.
(a) Explain why Singapore chooses exchange rates rather than interest rates as its main
tool of monetary policy. [10]
(b) Discuss whether a rise in world interest rates would be of overall benefit to Singapore’s
economy. [15]

Part (a)
Introduction
● Define monetary policy: Monetary policy is a demand-management policy whereby the
central bank of a country uses interest rates or exchange rates as alternative instruments to
achieve the macroeconomic goals of a country.
● Singapore Context: Singapore is a small and open economy and its characteristics are the
underlying reasons for its choice of tool of monetary policy.
o Small: Limited natural resources, small domestic demand
o Open: Dependent on imported raw materials, external demand is relatively larger

Body
Reasons for choosing exchange rate as its main tool of monetary policy:
[P] Exchange rate based monetary policy is more effective in influencing AD in Singapore.
● [E, E] As an open economy, trade is an important engine of growth for Singapore and thus
a policy such as exchange rate based monetary policy that can influence X, would be
more effective.
● In the event of slowing growth or a recession, the government can use exchange rate
monetary policy to raise the growth rate. MAS can allow the SGD to depreciate through
adjusting the band within which the SGD floats or adopt a policy of zero appreciation. This
would lower export prices in foreign currency and raise import price in SGD. Demand for
exports would rise, resulting in a rise in X revenue. Assuming |PEDm|>1 1, quantity
demanded for imports would fall more than proportionately, resulting in a decrease in M
expenditure. (X-M) increases overall.
● Since export revenue makes up a very large proportion of the total demand in Singapore,
the impact of an increase in (X-M) will result in a significant rise in AD resulting in higher
national income and actual growth.
● In comparison, interest rate policy mainly impacts C and I expenditure which make up a
smaller proportion of total demand in Singapore. The impact on AD would be smaller than
the impact of exchange rate based policy.

1
Note: in reality, as Singapore is highly dependent on imports, |PEDm| is likely to be less than 1 which would mean M
expenditure increases. However, given the size of Singapore’s export markets relative to that of her small domestic
market, it is likely that the increase in X is greater than the increase in M, thus a depreciation will likely result in a rise
in (X-M).
[P] Exchange rate based monetary policy is a quick and effective way to curb inflation in
Singapore.
● [E, E] As a small and open economy lacking in natural resources of her own, Singapore
is heavily reliant on imported inputs and imported final goods/services rendering her
susceptible to imported inflation. Inflation in countries from which Singapore imports will
lead to a rise in prices of imported inputs leading to cost-push imported inflation in
Singapore. One quick and effective way to reduce such imported inflation is to allow the
SGD to appreciate. A stronger SGD will offset imported inflation since it will lower the price
of the imported inputs in terms of SGD, reducing unit COP.
● Moreover, a policy stance of an appreciation in the SGD can also lower demand-pull
inflation that is caused by rising export demand. A stronger SGD would increase export
prices in foreign currency and lower import prices in SGD. Demand for exports would fall,
resulting in a fall in X revenue. Assuming |PEDm|>1, quantity demanded for imports would
rise more than proportionately, resulting in an increase in M expenditure. (X-M) decreases
overall, leading to a decrease in AD. If Singapore was operating near full employment
level of output, the fall in AD, which leads to firms cutting back on production and hiring of
factors of production, will lower GPL. This is because with more idle factors of production
in the economy, firms will be able to utilise more suitable and efficient combinations of
factors of production in their production process, reducing unit cost of production
(movement along AS) and allowing firms to accept a lower price. [L]This thus lowers
demand-pull inflation.
● Exchange rate centred monetary policy is thus viewed to be more effective than interest
rate centred policy in controlling inflation given Singapore’s heavy dependence on exports
as a major engine of growth and imports for basic necessities such as food, energy, and
factors of production.

Reasons why interest rate is not chosen by Singapore as the tool for Monetary Policy:
[P] As an international financial centre and by adopting a managed float exchange rate
system, Singapore loses control of her domestic money supply and interest rate.
● [E, E] Singapore is an international financial centre where financial capital is allowed to flow in
and out freely. By adopting a managed float foreign exchange rate system and choosing to
allow free movement of financial capital due to her position as an international financial centre,
Singapore loses control of her domestic money supply and interest rate.
● For example, if MAS decides to raise interest rate to lower demand-pull inflation in Singapore
by raising Singapore’s interest rate, this will lead to an inflow of funds from USA to Singapore.
This inflow of short-term capital will put pressure on the SGD to appreciate against the USD.
Since Singapore is on a managed float exchange rate system, MAS will not allow the
appreciation to rise beyond the upper limit. It will intervene in the forex market and sell SGD.
Once that happens, this will cause Singapore’s domestic money supply to rise (since the
foreigners are buying the SGD to buy financial assets in Singapore which means that the funds
will end up in Singapore’s domestic money supply). The rise in Singapore’s domestic money
supply will lead to downward pressure on Singapore’s interest rate (i.e. some households will
save the excess money, leading to an increase in SS of loanable funds and a downward
pressure in interest rate), thus negating the effects of the original intended contractionary
policy.
[P] Singapore chooses not to use interest rate as the tool for its monetary policy because
Singapore is a price-taker for interest rates, making it difficult to target interest rates.
● [E, E] It will be very difficult if not impossible for MAS to control the interest rate as the small
size of the Singapore economy makes Singapore a mere price taker in the world market for
funds. This means Singapore’s interest rates are very much influenced by the interest rates
of larger economies such as the USA.
● Singapore is an international financial centre where financial capital is allowed to flow in and
out freely. When interest rate in USA rises, ceteris paribus, financial investors will take their
funds out of Singapore and place them in USA where the returns for the financial investment
is relatively higher. This will lower the supply of loanable funds in Singapore, leading to a rise
in interest rates in Singapore. Thus, the interest rate in Singapore tends to move in line with
that of large economies like the USA. In contrast, the foreign exchange rate of the SGD is
relatively controllable through interventions by MAS in the foreign exchange markets.

Part (b)

Introduction:
● Interest rates refer to the cost of borrowing or the returns to savings
● To determine whether a rise in world interest rates would overall benefit Singapore’s economy,
we would have to weigh the costs and benefits to the economy relating to growth, inflation,
unemployment as well as the balance of payments.
Body:

A rise in world interest rates will negatively impact Singapore

[P] A rise in world interest rates will result in negative growth due to the contractionary effect on
other economies and the rise in domestic interest rates in tandem with the world interest rates.
● [E, E] A rise in world interest rates (e.g. US) would mean that the cost of borrowing increases
in US. For firms, there will be units of investment for which the MEI is now lower than the
interest rate, and hence are now unprofitable when previously they were not, resulting in a
decrease in I expenditure. Households may also decrease planned consumption expenditure
financed by loans. In addition, consumers will receive higher returns on their savings which
increases the opportunity cost of consumption. Hence, C expenditure falls. The fall in both C
& I expenditure will cause AD to fall. Assuming that US has spare capacity, this results in a
multiplied fall in the real GDP of US.
● The fall in real GDP in US will result in a fall in the Americans’ purchasing power, and hence
demand for goods and services, including those imports from Singapore will fall (assuming
these goods are normal goods), causing a fall in X revenue of Singapore .
● In addition, since Singapore is a price taker for interest rate (as explained in part a), this means
that interest rates in Singapore would also rise in tandem with world interest rates. This would
reduce C & I expenditure in Singapore as costs of borrowing has increased.
● Hence, the fall in X revenue, C & I expenditure in Singapore will cause a fall in Singapore’s AD
from AD1 to AD2. The fall in AD will create surpluses at the existing general price level with
AD < AS and hence there will be an unplanned rise in firms’ inventories. Firms will reduce
production and hire less factors of production, such as labour. As a result, households’ income
will decrease and this decrease in purchasing power will result in a fall in consumption of other
domestic goods and services, causing a subsequent fall in AD from AD2 to AD3. Hence there
 will be lower national income as output decreases further. [L]The downward multiplier process
would lead to a multiplied fall in real GDP to Y2 and negative economic growth in Singapore.

[Ev] Evaluative Comments:

● As Singapore is a very open economy that is heavily reliant on trade (Exports accounts for
about 173% of GDP in 2017), the fall in X will impact Singapore’s AD to a large extent.
● Moreover, as this is a rise in world interest rates, the growth rates of many of our key trading
partners will all be adversely affected. Hence, the extent of the fall in Singapore’s X will be
significant as demand for Singapore’s exports by many of our key trading partners will fall.
Thus, the fall in world interest rates is likely to lead to significant negative growth in Singapore.
● On the other hand, the size of Singapore’s multiplier is small due to its high MPW. Our MPM
is high given our lack of natural resources while MPS is high due to CPF contributions and the
Asian culture of thrift. This results in a high MPW and hence multiplier is small in Singapore.
Hence, the extent of the fall in real GDP will be dampened since more of the decreased income
is intended as withdrawals from the circular flow of income at every round and less of the
decreased income is ‘injected’ back into the economy (and lead to decreased consumption of
domestically produced goods and services).
● If consumer and business sentiments are very optimistic in Singapore or the other countries
(e.g. due to a booming economy, which might be the reason for an increase in world interest
rates by Central Banks to dampen overheating), the rise in interest rate globally and
domestically may not discourage C and I expenditure significantly in both Singapore and
foreign countries. C and I may be interest rate inelastic. The extent of the fall in Singapore’s
AD and real GDP will be dampened.

[P] The rise in world interest rates may result in demand-deficient unemployment in Singapore.
● [E,E]When output is reduced, there will also be a rise in demand-deficient unemployment as
firms retrench workers to cut production. Increase in unemployment leads to a fall in the income
and purchasing power of the unemployed, thus reducing their ability to consume goods and
services. [L]Their material SOL worsens.

[P] The rise in world interest rates may also result in a deterioration in current account in
Singapore.
● [E,E]The fall in (X-M) also suggests a worsening of the BOT in the current account as the fall
in X revenue implies a decrease in inflows in the current account. Ceteris paribus, this would
worsen Singapore’s balance of payments.

[P] The rise in world interest rates may also result in a slowdown in potential growth in Singapore.
● [E,E]The fall in I may also slow down capital accumulation, resulting in a slower increase in
(vertical) AS, thus potential growth may slow.

On the other hand, a rise in world interest rates may benefit Singapore.

[P] A rise world interest rates may reduce inflationary pressures in Singapore.
● [E, E] Assuming that the Singapore economy is operating near full employment, the fall in AD
will also result in a fall in GPL from P1 to P2, reducing demand pull inflationary pressures. This
is because when output is reduced, the resulting rise in unemployment means that firms are
better able to get the resources that they need, resulting in more efficient factor combinations
and falling unit cost of production. [L]Hence, firms are willing to sell the lower output at lower
prices.

Additional Point (optional as impact is minimal):

[P] A rise in world interest rates may also cause a positive impact on growth via a possible
depreciation in the SGD.
● [E, E] Although Singapore is a price taker for interest rate and Singapore’s domestic interest
rates moves in tandem with foreign interest rates of larger economies like US (i.e. rise in world
interest rates will cause a rise in domestic interest rates), this correlation may not be perfect
(i.e. domestic interest rates may not be totally identical with foreign interest rates). Singapore’s
interest rate is largely determined by foreign interest rates as well as expectations in future
movements of the SGD exchange rate. In recent years, Singapore’s domestic interest rate is
slightly below foreign interest rates such as the US interest rate 2.
● Hence, despite domestic interest rates increasing in tandem with the rise in world interest rates,
it may still be lower than foreign interest rates such as that of the US. This interest rate
differential between countries may still result in hot money outflows from Singapore to other
countries (e.g. US) where interest rate may be slightly higher. This causes an increase in
supply of SGD in the foreign exchange market and the SGD will depreciate. Assuming that the
SGD exchange rate is still within the bands of the managed float exchange rate system and
the MAS does not intervene, the depreciation in SGD will result in a fall in the price of exports
in foreign currency and a rise in the price of imports in domestic currency. Demand for exports
will rise and X revenue will increase, while the quantity demanded for imports will fall and
assuming that |PEDm|>1, M expenditure will decrease. This results in an increase in (X-M)
and AD increases.
● [L]This will have positive impacts on actual growth, demand-deficient unemployment and
current account.

[Ev] Evaluative comments:

● However, the above effect will likely not be significant

2
Reference: MAS Economics Explorer #3: Monetary Policy and the Economy
 o Since Singapore’s interest rate will move in tandem with foreign interest rates, the interest
rate differential between Singapore and foreign countries will be minimised, thus the extent
of the hot money outflow and exchange rate depreciation will be dampened.
o Moreover, Singapore’s managed float exchange rate system will control the extent of the
depreciation. If the SGD depreciates significantly below the lower limit, MAS will intervene
by buying SGD to push the exchange rate back within the bands. This will also mean that
the depreciation of SGD will not be significant.
o Singapore’s |PEDm|<1 due to Singapore’s lack of natural resources, this will cause M
expenditure to increase instead when SGD depreciates. Again, this will dampen the extent
of the overall increase in (X-M).

Conclusion:

● Stand: The negative impacts are likely to outweigh the positive and Singapore is most likely
to not benefit overall.

Substantiation:
● Whether Singapore is likely to benefit from a rise in world interest rates depends on the nature
of its economy. Being a small and open economy who is highly reliant on trade and is a price
taker in interest rates, Singapore is highly affected by changes in world interest rate and
growth rates of other economies around the world.
● Overall, although there may be some positive impacts due to the possible depreciation from
hot money flows, rising domestic interest rates in Singapore in tandem with world interest
rates (due to our price taker nature in interest rates) would reduce the interest rate differential
and minimise such positive impacts. Moreover, the Singapore economy has spare capacity
and inflation is currently negligible at less than 1%. Thus, the benefits of the rise in world
interest rates in curbing demand-pull inflationary pressure is relatively negligible.
● On the other hand, being highly reliant on trade, the contractionary effect of the rise in world
interest rates on many of Singapore’s major trading partners such as USA will bring about a
more significant adverse impact on Singapore.

● In addition, the extent of the negative impact on Singapore will also depend on factors such
as consumer and investor confidence, size of multiplier (as explained earlier), as well as other
factors affecting other components of AD.
● Though there are potential negative impacts, these may be addressed by appropriate
government policies in response. For example, in the face of negative growth, the government
could use an expansionary fiscal policy (e.g. increase in G expenditure) to expand the
economy thus minimising the negative effects.
● Optimistic consumer and investor confidence will also minimise the negative effects on the
Singapore economy, although this is unlikely in light of global uncertainties caused by the
ongoing US-China trade tensions.
Question 6

"Across the globe, people are wondering why the US, usually the leader in free trade, is
now taking a protectionist stance."
Source: Foreign Policy Journal, February 2017
(a) Describe two different types of protectionist policy measure and explain how each
type would affect trade. [10]
(b) Discuss the extent to which protectionism would be beneficial to an economy. [15]

Part (a)
Introduction:

Protectionism refers to the partial or complete protection of domestic industries from foreign
competition in domestic markets. Governments may adopt protectionist policy measures to
restrict free trade in order to overcome the negative impact that comes from free trade, for
example, to slow down the decline of an industry. Such protection may be achieved by setting up
trade barriers. Two different types of protectionist policy measure, namely, import tariffs and
deliberate devaluation 3, will be explained. (Note: an alternative measure, import quotas, has been
included. Students need to explain only 2 out of the 3 measures)

Body:
[P] Import tariffs can be used as a form of protectionist policy measure to restrict volume
of imports.
[E, E] Import tariffs are taxes that are levied on products when they are imported into the country.
The aim is to restrict imports to protect domestic industries from foreign competition. Imposition
of such tariffs results in higher prices of imported goods relative to prices of domestic goods. This
will encourage consumers to switch away from the relatively more expensive imports to
domestically produced goods, hence protecting domestic industries and jobs.
To analyse the effect of a protective tariff, we will assume that the domestic country is a small
buyer of a particular good, and thus a price taker at the world price. The foreign industry is willing
to supply as large a quantity as the small country wants to buy at the world price, i.e. world supply
curve is horizontal as supply is perfectly price elastic.

3
This refers to the downward revision of the value at which a country’s currency is fixed in terms of foreign
currencies. It is a deliberate action by monetary authorities when a country operates under a fixed exchange rate
system
 Diagram 1: Economic effects of a tariff - price taker country

[E, E] Before the imposition of the tariff, at the world price of Pf, consumption was OD units, of
which OA units is from domestic production source (price taker country producing OA on domestic
SS curve Sd) and remaining quantity supplied of AD is from imports.

However, after the imposition of the tariff, the market price rises by the full amount of the tariff to
Pt since this is a small country that cannot influence world price. At price Pt, domestic production
increases by AB to OB units. Imports are reduced from AD to BC units. From the above, the
imposition of the tariff has raised the price of imports, resulting in a reduction in imports and an
increase in domestic production. This means less exports by its trade partners selling to this
country. [L]Hence overall this results in lower volume of trade.

[P] Import quota can be used as a form of protectionist policy measure to restrict volume
of imports.
[C,E] Import quotas refer to limits on the amount of imports during a given period of time. They
are usually only imposed when the government wishes to reduce imports when tariffs are
ineffective. This is usually due to a price inelastic demand of imports where a rise in price of
imports results in only a less than proportionate fall in quantity demanded of imports. By restricting
the quantity of imports, quotas directly lower imported supply to Q1Q3 (which is equal to Q3Q4),
causing equilibrium price (Pw+q) to be higher than under free trade (Pworld). With the quotas,
domestic firms sell from 0Q1 to 0Q1+Q3Q4 at higher prices of Pw+q. This means less exports of
Q1Q3 (= Q3Q4) by its trade partners to this country. [L] Hence overall this results in lower volume
of trade.
 Diagram 2: Economic effects of an import quota - price taker country

[P] Deliberate devaluation is another form of protectionist policy measure to increase

volume of exports and decrease volume of imports.
[E, E] Devaluation refers to a downward revision of the value of a country’s currency in terms of
foreign currencies. It is a deliberate action by the monetary authorities through selling the local
currency in the foreign exchange market. A devaluation of a country’s exchange rate aims to
make its exports cheaper in foreign currencies and its imports more expensive in the local
currency. This causes foreigners to switch from their home products towards this country’s
exports, while locals would tend to switch their expenditure from relatively more expensive imports
to locally produced goods and services. Hence the volume of exports rises while the volume of
imports falls. Furthermore, the increase in demand for exports by the foreigners leads to increases
in export revenue while the decrease in quantity demanded for imports leads to decreases in
import expenditure if demand for imports is price elastic.

Part (b)

Introduction:
Whether protectionism would be beneficial to an economy depends on its impact on economic
growth, inflation, employment and BOT. The extent of its impact will depend on the nature of the
economy and the time period in which the protectionist policy measures are implemented.

Body:

Thesis: Protectionism would be beneficial to an economy

[P1] Protection helps to increase national income, improve BOT and reduce
unemployment.
[E,E] The use of protectionist policy measures in part (a) lowers import expenditure and increase
the export revenue. From the tariff diagram, it can be observed that with protectionism, amount
of imports is reduced from AD to BC and the production of domestic firms rises by AB. Similarly,
devaluation results in a rise in net exports, assuming demand for imports is price elastic. This is
because the rise in price of imports leads to a more than proportionate fall in quantity demanded
of imports and hence there is a fall in import expenditure. The improvement in net exports results
in improvement trade balance, ceteris paribus.

The impact of these protectionist measures also results in a rise in AD as consumers switch to
consuming more domestically produced goods and services i.e. increase in Cd, assuming that
the tariff is applied across many goods and services, for example, imposition of US tariffs on
China’s steel and aluminium. This would lead to an unplanned fall in inventories for firms. This
would signal firms to increase production and hire more factors of production such as labour.
Households’ income would increase and the higher income would induce consumption of other
goods and services. Other firms would then experience an unplanned fall in inventories and
increase production. Therefore national income increases as output increases further. The initial
increase in AD from AD to AD1 would then lead to a multiplied increase in national income from
Yto Y3 due to the multiplier effect, and hence actual growth, assuming there is spare capacity. As
demand for labour is derived from the demand for output, firms will need to hire more labour.
[L]Demand-deficient unemployment is thus reduced as the economy moves towards full
employment level of national income.

[Ev]The benefits of protection will depend on the nature of the country. If a country like Singapore
imposes tariffs, given the small size of its domestic market, the increase in Cd will not lead to a
significant increase in AD. Hence the extent on its impact on growth will be limited.

[E, E] Protectionism can help to reduce structural unemployment especially in the case of sunset
industries. These are industries that have lost their comparative advantage or are on the decline.
Such restrictions on imports can slow down the decline of the industry and allow for more local
production. This helps to cushion any adverse impact on employment and provides time for labour
to be retrained and re-channelled to other growing industries. This will reduce the incidence of
structural unemployment.

[Ev] In today’s globalised world, specific structural changes leading to unemployment and
vulnerability to the external demand shocks are to be expected and tends to be short-term in
nature. Such protection may unnecessarily slow down the restructuring process, depriving the
thriving industries of valuable resources.

[P2]: Protection helps to develop infant industries which can contribute to economic
growth
[E, E] These are industries that are too small and yet to have gained economies of scale. Without
protection, they will not survive against competition from abroad. Protection from foreign
competition will allow them to expand and become more efficient. Once they have achieved a
comparative advantage, the protection can then be removed when they are able to compete
internationally. With reference to the previously drawn tariff diagram, the imposition of tariff allows
the infant industries to better compete with more efficiently produced imports as illustrated by the
rise in domestic production by AB units.
An example is the protection given to Airbus by the EU government to enable it to compete with
its more established competitor Boeing. Protectionism has enabled the company to create a full
product line of aircraft and export to the world market, contributing to the economic growth of the
UK economy.

[Ev]: In a globalised world where countries are exposed to significant competition from imports,
there may be a place to ‘engineer’ comparative advantage by nurturing industries with potential.
However the execution often does not match the intent leading to less than desirable results.
Protectionism may cause such industries to become contented and remain internationally
uncompetitive and inefficient. This can been seen in the sustained protection of the Malaysian
automotive industry to help it attain the same economies of scale and other advantages to enable
it to compete with the other established automobile exporters. However, the supposed efficiencies
was never materialised. Furthermore, once protection is given, it is hard to remove. Vested
interests are created, and the industries concerned would fight strongly against the removal of
trade barriers. Lastly, governments also often fail to identify the right industries to protect. Given
the dynamic and unpredictable nature of the world, it is difficult to accurately identify the industry
with the potential comparative advantage. Hence, due to the above reasons, desired comparative
advantage often fails to materialise successfully.

Note: Students can also consider how protectionism may help to counter dumping and limit its
adverse impact on economic growth and employment.

Anti-Thesis: Protectionism would not be beneficial to an economy

[AT1] Protectionism would limit economic growth and result in inflationary pressures
[E,E] For a country like Singapore that relies heavily on imported inputs with the demand for
imports being price inelastic, the use of devaluation as a protectionist policy will not be beneficial
to the economy. This is because while export revenue has increased, its import expenditure has
also increased since the rise in price of imports will lead to a less than proportionate fall in quantity
demanded of imports. However, the rise in export revenue is likely to be greater than the rise in
import expenditure given that Singapore’s export market is larger. This results in a limited rise in
AD and hence limited actual growth. In addition, the use of protectionist measures like tariffs and
devaluation in Singapore will also raise import prices, leading to cost-push inflation and lower
purchasing power since import substitution is limited

[E,E] Furthermore, the use of protectionism to protect jobs also tends to be self-defeating as
trading partners who suffer a loss in export demand will ultimately buy less from the country. The
use of tariffs and devaluation may result in a ‘beggar-thy-neighbour’ effect, where these measures
may cause the country to buy less from its trade partners and the latter may then experience a
fall in income. This has a feedback effect on the economy that carries out the devaluation as trade
partners now demand less of its exports, causing a fall in its own income.

In addition, devaluation may cause trading partners to experience a fall in their exports revenue,
due to other countries choosing to buy exports from the country that carries out the devaluation
instead. If the trading partners retaliate by devaluing their own currencies and this results in
competitive devaluation, this would offset the intended improvement in export competitiveness for
the country that first initiated devaluation of its exchange rate. The rise in exports revenue may
thus be marginal, causing a limited rise in AD and hence economic growth.

Conclusion:

[Stand] The extent to which protectionism would be beneficial to an economy depends on the
nature of the economy and the time period under consideration.

[Substantiation] For a small economy such as Singapore, the costs of protectionism far outweigh
the benefits. As a resource poor country, Singapore’s demand for imports is price inelastic. If
Singapore practises protectionist measures, this will result in cost-push inflation and lower
purchasing power. Furthermore, substitution towards domestically produced goods and services
when available may not be ideal since local SMEs may not able to match foreign firms in terms
of price, quality and variety. This is because being relatively smaller firms that cater to the
domestic market, their ability to engage in R&D and reap economies of scale are limited. Material
welfare will be reduced, and local firms may become even less competitive due to complacency.
In addition, if Singapore’s trading partners retaliate by imposing tariffs on her goods, Singapore’s
AD would fall significantly since Singapore is export-oriented, leading to lower growth and higher
unemployment. On the other hand, for larger economies such as China and the USA, protection
of its domestic industries gives them time to grow and develop their comparative advantage. Once
these industries gain maturity, they can become drivers of growth in the countries. AD is likely to
gain significantly and hence these industries can contribute to economic growth significantly.

In the short-term, it may be beneficial for larger economies like the USA as it has a large domestic
market to better ‘weather’ the repercussions of protectionism, although there will be a trade off
with efficiency in doing so. But protectionism ultimately offers only a temporary solution to the
affected industry as it does not deal with the underlying root cause of loss of comparative
advantage. A long-term solution is to adopt supply-side policies such as training of its workers to
focus on lowering costs and increase labour market flexibility.