2023 HCI Prelim CSQ answers

© Hwa Chong Institution 2023 9570/01/A/C2 Prelim 2023 2023 H2 Econ Prelim P1 CSQ 1 Suggested Answers (a) (i) Explain why Boeing is concerned about the poten tial entry of Embraer and COMAC into the aircraft manufacturing industry. [3] The aircrafts manufactured by Embraer and COMAC are considered substitutes to the aircrafts manufactured by Boeing. [1] The demand for Boeing’s aircraft may fall thus the AR/MR shifts leftwards as airlines may decide to buy the aircrafts from Embraer and COMAC. [1] Assuming the average cost curve and marginal cost curve are unchanged, the market share of Boeing would fall, reducing the profit. [1] (ii) Use a diagram to explain how Boeing could use limit pricing as a strategy to discourage the potential entry of Embraer and COMAC. [3] Diagram [1] In the above diagram, Boeing may decide to sacrifice some short-run profit by pricing lower at P1 and producing higher at Q1, instead of the profit maximising price (Pe) and output (Qe). Since P1 is below the estimated average cost of the potential entrant firm (Embraer and COMAC), this would imply that if Embraer and COMAC enters the market and competes, it may incur significant losses. [1] Thus if Embraer and COMAC enter the market, it would make subnormal profit. If the firm is rational, it would not enter based solely on the profit consideration. [1] (b) Using a relevant example from Extract 1, explain how average fixed cost is affected as an aircraft manufacturing firm increases its output in the short run. [2] Examples of fixed costs are the costs incurred to build factories, assembly lines, hangars and testing facilities. [1] As the output increases, the fixed cost remain unchanged hence average fixed cost will fall. [1] (c) Explain how average total cost will change as an ai rcraft manufacturing firm expands its scale of production in the long run. [2] As the firm increases its scale of production in the long run, such as building more factories, assembly lines, hangars and testing facilities, these costs are spread over a larger unit of output. The unit cost of production would fall due to internal economies of scale hence average

© Hwa Chong Institution 2023 9570/01/A/C2 Prelim 2023 total cost falls. [1] As the scale of production continues to rise and output is produced beyond the minimum efficient scale, internal diseconomies of scale would cause the average total cost to rise. [1] (d) (i) Explain what is meant by efficient allocation o f resources in a free market. [2] In a free market, assuming there are no external costs to third parties and no external benefits to third parties[1], resources are allocated efficiently at the equilibrium output where MSB=MSC [1]. (ii) Discuss whether negative externality is the ma in reason for a government to restrict recreational use of cannabis . [8] R1: Negative externality in the recreational use of cannabis Marginal Private Cost (MPC) measures the cost to pr oducers of producing additional units of cannabis such as the cost of raw materials and wages of workers. Marginal Private Benefit (MPB) measures the benefit to consumers from consuming additional units of cannabis. If recreational use of cannabis is allowed in the free market, it could create external costs to third parties. There are negative externalities in the consumption of cannabis. With reference to Extract 2, those who consume cannabis have low attendance r ate at work thus reducing their productivity, creating a loss in output of the employers. Some may turn aggressive and hurt their family members, which would cause their family members to incur medical costs. The third parties who incur the external costs are the employers and family members. Thus MSC>MPC, that is, MSC = MPC + MEC. The free market equilibrium is at Qm where MPC=MPB whereas socially efficient equilibrium is at Qs where MSC=MSB. There is overconsumption of QsQm in the free market, which caused the deadweight welfare loss of Area Y. EV1: Recreational use of cannabis may help to revive the tourism industry With reference to Table 1, the percentage change in total number of drug offences for possession of cannabis has increased by 21.5% which is larger than the percentage change of possession of controlled drugs. This suggests that the extent of the external cost on third parties is very high and the amount of overconsumption is also likely to be very high. R2: Other reason – Imperfection information in the recreational use of cannabis Marginal Private Cost (MPC) and Marginal Private Benefit (MPB) measures the cost and benefit respectively to an individual from consuming additi onal units of cannabis. An individual may underestimate his true marginal private costs from consuming cannabis if he only consider the price of the cannabis. He may be unaware of or underestimate the harm of cannabis to his health.

© Hwa Chong Institution 2023 9570/01/A/C2 Prelim 2023 As mentioned in Extract 2, regular cannabis use inc reases the risk of developing psychotic illnesses, such as schizophrenia. This health cost of consuming cannabis is not experienced immediately but only over time hence the individual’s perceived MPC lies below the actual MPC. With imperfect information, an individual consume quantity Q1 of cannabis where MPC perceived = MPB, thus Q1 will be the quantity of cannabis that he thinks optimises his welfare. However, at quantity Q1, the individual suffers a welfare loss of area ABC as his actual MPC is greater than his MPB. If he had perfect information about the true MPC of consuming cannabis to himself, the optimal quantity of cannabis consumption for him is Q2 where MPC actual = MPB. Thus there is overconsumption of Q2Q1 units of cannabis. EV2: The optimal consumption of cannabis should be zero For some individuals, the quantity of cannabis cons umed should be zero where MPC actual = MPB. This means it is a welfare gain for them to not only reduce the quantity of cannabis, but to drop the habit altogether or to not even start consuming cannabis. Summative Conclusion Negative externality and imperfect information are the two possible reasons why there is over allocation of resources in the free market for recreational use of cannabis. The overconsumption caused by imperfect information is likely to affect the individuals who are not aware of the actual costs. However, negative externality affects the society and as stated in the extract, the third parties identified are the employers and family members. Hence negative externality is likely the main reason as the area of the deadweight welfare loss on society could be very large (Area Y). If Area Y is larger than Area X, a government may even decide to ban it. (e) With reference to Extract 3, discuss whether the st andard of living of OECD countries would necessarily worsen due to the pandemic. [10] Real GDP per capita is often used to measure materi al standard of living while non-material standard of living is measured in terms of the well-being of the individual. R1: How standard of living is worsened by the pandemic. During the travel ban, tourist arrivals dropped sig nificantly, which caused the demand for air travel, hotel stays, food and beverages and other related services (Extract 3) to drop significantly. This caused a fall in the net exports (X-M), hence a fall in aggregate demand, and subsequently

© Hwa Chong Institution 2023 9570/01/A/C2 Prelim 2023 a fall in real national output via the reverse mult iplier process. The fall in real national output caused a fall in the demand for labour, which is a derived demand, and caused the unemployment to rise, such as what had happened to the countries in Southern Eur