A Level 2014 Paper 1 CSQ Answers

1 CSQ 1 (a) (i) The price of oil relative to the price of natural gas is significantly higher in 2012 than in 1993. (a) (ii) According to Extract 1, the practice of fracking has led to a substantial increase in the supply of both oil and natural gas. However, the price of oil has increased relative to the price of gas. This is due to differences in the change in demand. The demand for both oil and gas is expected to increase due to economic growth and improvement in standard of living. However, the demand for oil is expected to increase more than the increase in demand for gas. The extensive applications of oil, including transportation fuel, electricity generation, and manufacturing of chemicals and synthetic materials, compared to natural gas will lead to a stronger increase in demand for oil from economic growth. Also, possible oil hoarding due Middle East turmoil will lead to countries stockpiling oil in speculation of possible decrease in supply in the future. Hence, countries will choose to buy oil now in anticipation of possible shortages in the future, increasing the demand for oil. Assuming that the increase in demand for oil is dominates the increase in supply of it, the price of oil will increase from P0 to P1 according to the diagram below.

2 On the other hand, it is expected that the increase in demand for gas will only marginally dominate the increase in supply of gas. Hence, the price of gas will increase by a smaller extent from P0 to P1 according to the diagram below.

3 This divergence will lead to the increase in the price of oil relative to the price of gas. (b) The fracking boom in the US has led to a large increase in the supply of US oil and positioned it to potentially be the largest oil producer in the world (Extract 1). Assuming that OPEC does not increase its oil production or only marginally, the proportion of the supply of US oil in the world market will increase relative to that of the OPEC, as OPEC forecast that non-OPEC oil supply would grow significantly according to Extract 2. Under the same pricing of oil, US will gain a larger market share while OPEC’s market share will be reduced. Due to availability of substitutes from other countries, this reduces the world’s dependency on OPEC oil. Traditionally, OPEC is able to cut back on production of oil in order to drive prices up to increase their revenue as the demand for oil is price inelastic. However, if OPEC’s market share of 40% (Extract 2) continues to decline, it may find itself losing market power and the cartel losing its effectiveness. This is because it will be increasingly difficult for them to influence the price of oil given that their oil supply is now a smaller proportion of the world’s output. As such, any decision to reduce oil production will not significantly affect the world’s supply and will thus cause only minimal change in price. In fact, this will only serve to further reduce their market share. In the worst scenario for OPEC, the cartel may lose its traditional advantage as coordinated efforts to manipulate the market for their gain loses its effectiveness. With an increase in oil supply, all OPEC members will suffer a fall in export revenue due to a fall in demand as some consumers switch from consuming OPEC oil to US oil. This worsens balance of trade and current account, hence negatively affecting balance of payments. If balance of payments is in a deficit, it indicates an erosion of foreign reserves, which may pose a problem for future generations. Furthermore, with a reduction in export revenue, aggregate demand will decrease according to the diagram below.

4 As illustrated in the diagram above, a fall in AD from AD0 to AD1 will lead to a multiple decrease from national income from Y0 to Y1. This indicates a reduction in people’s purchasing power and their ability to afford goods and services, an indication of a decline in material standard of living. Furthermore, it will result in higher unemployment. Due to their high dependency on oil revenue, OPEC members may experience a reduction in ability to fund developmental projects including construction of transport networks and housing and improvement in healthcare and education. This can negatively affect the standard of living of the people and also lead to a budget deficit. OPEC members with a lower cost of production will be expected to suffer less than their counterparts. They will likely experience only a reduction in profits from the price fall as opposed to incurring losses for members with high cost of production. As this reduction in profits is global, OPEC members can hope for non-OPEC manufacturers to exit the industry due to oil price being too low in order for them to regain back their market share. Members with lower cost of production will be better positioned to weather through this period of low oil price. (c) Barriers to entry refer to obstacles that restrict potential entrants from entering the industry. Potential entrants to guar farming will likely face significantly lower barriers

5 to entry compared with those to oil production by fracking. The increasing number of guar farms in India, Pakistan, Africa, Australia, and Texas (Extract 3) is a strong indication of the low barriers to entry. The availability of land for guar farming appears to be the most significant barrier to entry. However, this will not pose a strong deterrence to most potential entrants as existing farmers can easily switch from producing other crops to guar without incurring much cost as guar seeds are not expected to be very expensive. This is compounded by the large amount of guar seeds given away to encourage increased production of guar (Extract 3). In contrast, potential entrants to oil production by fracking will face high barriers to entry due to the high initial capital outlay required. This includes the rights to drill, and high equipment and skilled labour costs (Extract 2). It is also difficult for potential entrants to compete with existing firms who are reaping extensive economies of scale. The relatively higher cost of production of potential entrants will make it difficult for them to compete with incumbent firms. (d) The fracking boom has led to an exponential increase in demand for guar as it is a crucial ingredient to successful fracking. This has led to a sharp price increase (Extract 3) which will increase the profits of guar farmers assuming that cost of production remains constant. This can lead to improvement in the standard of living of guar farmers in India in both quantitative and qualitative aspects. With an increase in profits, guar farmers will experience an increase in income and hence higher purchasing power. This will allow them to increase consumption of material goods including buying better house and food, travel abroad or buy gold (Extract 3). This improves the quantitative aspects of their standard of living Furthermore, guar farmers can also invest their higher income in areas such as education and healthcare. This improves the qualitative aspects of their standard of living as they will have higher education level and better health condition. If most of the increase in income is channelled into material goods consumption, the long-term sustainability of such improvement in the standard of living will be dependent on guar’s high price and derived demand from the growth of fracking and lack of competition. Guar farmers will only be able to enjoy long-term improvement in

6 the standard of living if current trend persist. However, this is unlikely as the high profits of guar together with low barriers to entry will encourage more producers to enter the market, as evident from Extract 3 where guar farms have sprouted all over the world, increasing the supply of guar. Furthermore, the demand for guar is expected to decr