2024 MI Prelims H1 Econs (A) Micro CSQ

1 2024 H1 EOY Exams – Micro Case Study Suggested Answers (a) With reference to Figure 1, compare China’s domestic and international passenger traffic recovery (to 2019 levels) for the period between January 2020 and January 2024. [3] • Domestic passenger traffic fluctuated widely between February 2020 and January 2023 while international passenger traffic showed little or no change till after January 2023. [1] • Both domestic and international passenger traffic began to recover around January 2023. [1] • Domestic passenger traffic experiences complete recovery to 2019 levels by April 2023 but international passenger traffic did not recover to 2019 levels at all. [1] • Overall, domestic passenger traffic increased slightly while international passenger traffic decreased by about 42 % compared to 2019 levels. [1] Any three points for 3 marks. (b) (i) Explain the opportunity cost of Chinese government subsidies to the tourism industry. [2] • Opportunity cost is the next best alternative forgone. [1] • Extract 1 says that subsidies to tourism cost China over 500 billion dollars. • This money could have been better used in an alternative area such as healthcare for its citizens. [1] (ii) Using a Production Possibility Curve diagram, explain two benefits of the sharp increase in domestic tourism in China. [5] • Due to covid19 lockdowns, the Chinese economy is operating inside PPC 1, at point A in Figure 1 below, implying unemployed and underemployed resource utilization. • With a sharp increase in domestic tourism , as evidenced in extracts 1 & 3, this situation will be reversed leading to better resource utilization. [1] The economy moves from operating inside the PPC to the boundary of PPC1, at point B , representing actual growth. [1] • In addition , more investments may improve the quantity and quality of capital goods in the economy enhancing the productive capacity. Extracts 1 & 3 suggest improvements to infrastructure such as rail and air networks as well as innovations arising in the industry. [1] As a result the entire curve shifts outwards to PPC2, and the possibility of operating at point C, representing potential growth. [1] • Clearly labelled, correct diagram. [1]

2 Figure 1: PPC for China (c) (i) Using information from Extracts 1 & 3, identify and explain one demand factor and one supply factor that contributed to recovery of the domestic airline market in China. [4] • Demand factor – Demand increasing, shifting rightwards (Any 1, well elaborated) o Taste and preference (extract 3) ▪ Renaissance of domestic tourism ▪ Pent-up travel demand ▪ CNY family reunions o Substitutes (extract 3) ▪ High-speed rail alternative is costlier o Income (extract 3) ▪ Lowered income due to economy not doing well, high youth unemployment etc, therefore overseas travel not a preferred option o Government policy (extract 3) ▪ Covid19 travel restrictions for overseas travel • Any of the above demand factors will cause the demand for domestic airline services to rise and shift to the right. [2] • Supply factor - Supply increasing, shifting rightwards (Any 1, well elaborated) o Lowered unit cost of production ▪ Subsidies provided by government (extract 1) ▪ Use of widebody aircraft (extract 3) enables airlines to carry more passengers per flight o Upgrading of airports, technological innovations (extract 1) ▪ Increases the airports’ capacity enabling more flights to operate • Any of the above supply factors will cause the supply of domestic airline services to increase and shift to the right. [2] • With both demand and supply increasing , the quantity traded will increase, thus, contributing to the recovery of the domestic airline market in China. (ii) Using price elasticity of demand, explain how ‘ the inevitable rising costs due to capacity building activities’ (Extract 3) is likely to affect total revenue on domestic air travel in China. [4] • The combination of the PED for domestic air travel and changes to supply caused by rising costs are likely to affect the total revenue of domestic air travel in China.

3 • PED for domestic air travel [1] o Domestic air travel is seen as a service with a high degree of necessity, due to pent-up demand, CNY reunions. o Alternatives like high-speed rail is more expensive , therefore contributing to a low number of substitutes. o Demand for domestic air travel is therefore, likely to be price inelastic, with values <1 • Changes to Supply [1] o Revival of domestic travel sector likely to use up all spare capacity o Purchase or leasing of more airplanes to increase capacity is ‘a very expensive affair’ (extract 3) o Thus, the costs of production will inevitably rise o Supply is reduced, shifting leftwards • The effect as shown in diagram below will raise prices to P1 • Given that the demand for domestic air travel is price inelastic, the rise in price leads to a smaller proportionate fall in quantity demanded [1] • Total revenue is price x quantity. Therefore, while area B is lost, there is an overall net gain as area A is larger. Hence, the total revenue of domestic air travel will increase. [1] Figure 2: Total Revenue on domestic air travel in China (d) (i) With the use of a diagram, explain how the market for air travel fails. [4] The market for air travel is failing due to negative externalities. These are third party costs incurred by those not directly involved in the economic transactions of the air travel industry and are not compensated for the effects. [1] Explain how market fails due to negative externalities Air travel generates negative externalities in terms of the damage to the environment . Carbon emissions from flights are extremely high and it contributes to air pollution and global warming (Extract 5). This process hastens climate change and causes third party effects. Such negative externalities cause a divergence between marginal social cost (MSC) and marginal private cost (MPC) as MSC = MPC + marginal external cost (MEC).

4 Figure 3: Negative externalities arising from air travel In the diagram [1] above, the market equilibrium would be at Q e where MPB = MPC as consumers and producers of air travel are self-interested and do not consider external costs. However, the socially optimal output is at Qs where MSB = MSC. Since Qe exceeds Qs, there is overproduction / overconsumption of air travel. [1] This causes a deadweight loss of the shaded area as MSC exceeds MSB for the output between Qs and Qe. [1] Hence, the market for air travel fails due to allocative inefficiency, warranting government intervention to reduce consumption level to Qs. (ii) Discuss the appropriate policies a government could adopt to overcome the carbon intensive nature of air travel and achieve an efficient allocation of resources in this market. [10] Question Analysis Command word: Discuss, two sided with evaluative conclusion Content: microeconomic policies to overcome the negative externality and