2023 Prelim SL P1 Ans Collated

Suggested answers for SL P1 Q1 (a) Explain that when producer surplus and consumer surplus are maximised, allocative efficiency is achieved. [10] Answers may include:  Definitions of consumer surplus, producer surplus, allocative efficiency  Diagram (demand and supply) to show producer and consumer surplus and allocative efficiency  An explanation that consumer surplus is the difference between the price the consumer is willing and able to pay for a good and its selling price; an explanation that the producer surplus for a good is the difference between the price the producer is willing and able to sell the good for and its selling price; an explanation that the sum of consumer and producer surplus is maximised in competitive market equilibrium and allocative efficiency is achieved Consumer surplus is defined as the highest price consumers are willing and able to pay for a good minus the price actually paid. The highest price they are willing and able to pay is given by the demand curve. Producer surplus is defined as the price actually received by producers for selling their good minus the price that they are willing and able to accept. The lowest price they are willing and able to accept is shown by the supply curve. The price actually paid and received by the consumers and producers is determined at the market equilibrium via demand and supply forces. Allocative efficiency is achieved when scarce resources are allocated to produce the right amount of right goods desired by the society. In a competitive market, this is achieved when the social surplus (i.e. the sum of producer surplus and consumer surplus) is maximised. The demand curve also depicts the marginal benefit as the extra benefit derived from consuming an additional unit of the good decreases as the quantity increases (hence, the

price consumers are willing and able to pay for every subsequent unit falls according to the law of demand). The supply curve also depicts the marginal cost as the extra cost incurred from producing an additional unit of the good increases as the quantity increase (hence, to cover the rising cost, the price producers are willing and able to accept for every subsequent unit must increase in accordance with the law of supply). The competitive market equilibrium occurs at E, where the demand (DD=MB) and supply (SS=MC) curves intersect. This is the point where the extra benefit to society of consuming an additional unit of the good equals to the extra cost to society of producing an additional unit of the good. At this point where Qe units of the good transacted in the market, the sum of consumer surplus (AEPe) and producer surplus (0EPe) is maximised. Allocative efficiency is achieved. If Qa units are transacted instead, consumer surplus area will be lower at PeABC and producer surplus area will be lower at 0PeCD. This results in a welfare loss to society of area BDE. Since MB>MC for all units between Qa and Qe, this means that the society places a greater value on the last unit of the good produced and consumed, than it costs to produce it. There is an underallocation of resources. Hence, more resources should be allocated to the production and consumption of the good till all net benefit is reaped by the society (i.e. Until Qe where MB=MC). On the other hand, producing beyond Qe would result in MB<MC. For every unit beyond Qe, society incurs a greater cost than the value derived from an additional unit. Resources should be allocated away from this market such that less units should be produced and consumed in order not to incur a net cost to the society. Thus, society’s welfare is maximised and allocative efficiency is achieved when Qe units of good are produced, where DD=MB meets SS=MC. At this point, consumer surplus and producer surplus are at their maximum. *In order to access L4/L5, students need to illustrate the effect on consumer surplus and producer surplus when MB>MC (i.e. producing lesser than Qe). Markers’ comments: This question was not done well.  Most candidates could define consumer and producer surplus and identify the relevant areas in a DD/SS diagram. However, most stopped here and asserted that area A is the consumer surplus and area B is the producer surplus and they are at their maximum at the market equilibrium and thus, allocative efficiency is achieved. This is just restating the question with nothing explained.  A handful of students were able to use a quantity lower/higher than the market equilibrium output, to show that the consumer surplus and producer surplus areas would be smaller. Thereafter, it is asserted that hence, it is better for the society to be producing the market equilibrium output for a larger social surplus area.

 However, to fully address the question on how the market equilibrium where the CS and PS areas are maximised achieves ‘allocative efficiency’, candidates are required to use the marginalist approach to prove the condition of MB=MC.  Many students made conceptual errors to claim that a discrepancy between quantity demanded and quantity supplied indicates allocative efficiency (e.g. If price is lower than Pe, there is a shortage where Qs < Qd, indicating that there is an underallocation of resources and hence, allocative inefficiency).

(b) Using real world examples, discuss the possible consequences of the imposition of a price ceiling for the different stakeholders in a market. [15] Answers may include:  Define price ceiling  Diagram (supply and demand) to show the impact of a price ceiling  An explanation that governments impose price ceiling to protect low income consumers; an explanation of the possible consequences of a price ceiling in terms of keeping price below the equilibrium level, excess demand, inefficient resource allocation, underground market, non-price rationing and welfare impacts, in context of a RWE  Synthesis and evaluation Price ceiling refers to the maximum price that can be legally charged by sellers. It is usually set in order to make certain goods more affordable to people of low income. To have an effect, the price ceiling must be set below the equilibrium price. An example of a price ceiling is rent control. Rent control is a policy that limits the amount of rent that can be charged for a rental unit, how much the rent can be increased per year, or both. One such rent control is implemented in San Francisco since 1979 and enforced by the San Francisco Rent Board. As of 2019, the board has set the percentage by which landlords can raise the rents to a maximum of 10% per year. This new state law of California applies to buildings in San Francisco that were built after 1979 but before 2005. More than 60% of San Francisco rental units fall under this rent control. The landlords cannot increase the rent due to a new roommate or a new baby arriving, except through petition proving increased operating expenses. Although the rent board does not set a maximum rent which is in theory how price ceilings work, since landlords are prevented from raising the rent freely, rent will be capped at Pc, below the otherwise equilibrium price of Pe which is based on market demand and supply forces without any control.

Figure 1: Effect of rent control on the market for rental housing Consequences on consumers (i.e. tenants) (+) Lower rent of Pc for those who are able to secure a rental unit. (+) The rent board also offers protection for tenants from landlords’ negligence and unfair eviction. (-) However, a shortage of QsQd ensues at the lower price of Pc. This means that not all interested tenants who are willing and able to rent will be able to do so. (+/-) Consumer surplus thus increases by area PePcDC but decreases by area BCE (Overall change in CS from area AEPe to ABDPc). (-) Dissatisfied people who have no