MI 2023 PU3 H2 Econs EOY P2 Suggested Ans

1 Section A 1 Global wholesale gas and electricity prices were al ready rising in 2021 due to higher demand as economies reopened from Covid-19 l ockdowns, and as competition for supplies between regions intensified. Russia’s invasion of Ukraine led to sharp cuts in gas supplies to Europe, sending European natural gas prices to a record high, thus triggering a rise in electri city prices, since natural gas is required to produce electricity. To deal with the high prices, UK is imposing a price cap on energy prices. Source: CNBC, 22 Aug 22 (a) Explain how the above events may have led to the su rge in electricity prices. [10] (b) Discuss the policies that might be used by a government to mitigate the significant surge in electricity prices. [15] Question Analysis for (a): Command word = ‘explain’  explain the factors that lead to surge in electricity prices Content  Demand, Supply, PED, PES Context  Electricity market in UK Requirement 1: Rise in demand with inelastic supply will lead to surge in price of electricity Requirement 2: Fall in supply with inelastic demand will lead to surge in price of electricity Requirement Suggested answer Intro: As economies reopen and recover, there will be high er demand for electricity. Russia’s invasion of Ukraine will lead to a fall in supply of electricity as the input – natural gas has fallen. All these factors coupled with the inelastic demand and supply will lead to a surge in price of electricity. Requirement 1: Rise in demand with inelastic supply will lead to surge in price of electricity As the economies reopen, the economies will recover . This will lead to an increase in income for many households. The inc rease in income results in an increase in purchasing power and incr ease in ability and willingness to consume normal goods. Normal goods a re goods where a rise in income would lead to a rise in its demand . Electric appliances is an example of Normal goods. Electrical appliances and electricity are complement goods, as use of electricity is essentia l to ensure their

2 proper functioning of the electrical appliances. He nce the increase in income will lead to an increase in the demand for e lectricity by households. The increase in demand will lead to a shortage of electricity in the market and upward pressure on equilibrium price and increase in quantity. Firms will also tend to increase production of goods and sometimes the production of goods require the use of electricity as a factor of production. The rise in demand for electricity from D0 to D1 wi ll lead to a shortage of electricity Q0Q3 at the original price, P0. This will lead to upward pressure on the market price. As price increases, q uantity demanded falls and quantity supplied rise. This continues until equilibrium price and quantity is reached. Supply of electricity is likely to be price inelast ic due to the length and complexity of production process and the availabili ty of resources to produce electricity is limited, given shortages in natural gas, thus it is difficult for firms producing electricity to respon d to the rise in demand. Thus, a rise in price in electricity is likely to l ead to a less than proportionate rise in quantity supplied. As supply of electricity is price inelastic, the ri se in price leads to less than proportionate rise in quantity supplied. Thus, the overall rise in electricity prices has surged. P D1 Sinelastic Q0 P1 Q P0 Q1 D0 Q3

3 Requirement 2: Fall in supply with inelastic demand will lead to surge in price of electricity Russia’s invasion of Ukraine led to sharp cuts in gas supplies to Europe, sending European natural gas prices to a record high, thus triggering a rise in electricity prices, since natural gas is re quired to produce electricity. The cost of production of electricity has increased, causing the supply of it to fall. The fall in supply for electricity from S0 to S1 wi ll lead to a shortage of electricity Q2Q0 at the original price, P0. This wi ll lead to upward pressure on the market price. As price increases, q uantity demanded falls and quantity supplied rise. This continues until equilibrium price and quantity is reached. Demand of electricity is price inelastic as it is a necessity. Thus, a rise in price in electricity is likely to lead to a less than proportionate fall in quantity demanded. Thus, this will further lead to a surge in the price electricity. Conclusion Hence, the above factors have led to a s urge in the price of electricity. P S1 S0 Q0 P1 Q P0 Q1 Dinelastic Q2

4 Markers’ Comments  Many candidates were able to provide the demand an d supply factors that cause the price to increase. However, some of them did not bring in any elasticity concepts. A 10 mark question will require minimally 2 factors with the relevant elasticities. In addition, the key word “surge” should have given the students the hint to bring in the relevant elasticities.  Good responses were also able to analyse clearly h ow the supply and demand factors as well as making good use of PED and PES to explain w hat leads to the sharp rise in the price of electricity. Students were also able to ex plain the price adjustment process, highlighting how shortages will lead to upward pressure on the price.  Some students did not understand the relationship between natural gas and electricity. See preamble- “Natural gas is required to produce electricity.” Many incorrectly saw them as complements.  For weaker students who are in the low L2 range, t here were two main mistakes that were made. o Firstly, a minority of students in this range did not use any elasticity concept and only explained the demand and supply factors. o The second mistake was misconceptions of the elast icity concepts to be used. Weaker students used PES to explain the extent of c hange in price of electricity after talking about the shift in supply. This is a misconception. PES is relevant to explain the surge in the price when there is an increase in demand whereas PED is relevant to explain the surge in the price when there is a fall in supply.  Some students were also confused with the cause-an d-effect relationship between quantity demanded/quantity supplied and price. Thes e students explained that, when |PED| < 1, the fall in quantity demanded led to a less than proportionate increase in price. Level Knowledge, Application/Understanding and Analysis Mark L3 An answer that provides a clear and thorough explanation of both factors given in the preamble. A clear elaboration on the application of PES and PED (elasticity concept). Max 8 if there is only one elasticity 8 – 10 L2 An answer that provides a good explanation of both factors in the preamble. Some elaboration on the application of PE S and PED (elasticity concept). 5 – 7 L1 An answer that demonstrates weak knowledge and appl ication of the characteristics of market, possibly with multiple conceptual errors. 1

5 This is wrong. It should be, the increase in price led to a less than proportionate decrease in quantity demanded.  In terms of diagrammatical analysis, students shou ld label the diagrams properly indicating the market they are analyzing. Some students labelled the X-axis of the diagram as natural gas instead of electricity. Read the que stion properly! Students are reminded of the need to make reference to the diagrams. b) Discuss the policies that might be used by a government to mitigate the significant surge in electricity prices. [15] Question Analysis for (a): Command word = ‘discuss’  what the policies are and their limitations Content  policies to deal with the surge in price of electricity Context  Electrici