AJC 2016 H1 Economics CSQ 2 answers

© Property of Anderson Junior College 1 GCE ‘A’ Level 2016 H1 Economics Case Study (Suggested Answers) Question 2: Problems in commodity markets (a) Using the data in Table 1, compare the changes in the prices of tropical beverages with those of food during the period 2000-2013. [4] Similarity: Both the prices of tropical beverages and prices of food generally increased Difference: Prices of tropical beverages increased 74% over the years while prices of food increased more significantly by 155%. (b) (i) With reference to Extract 5, and using supply and demand analysis, explain how upward pressure on demand, combined with increased agricultural production costs, is likely to influence the world price of food. [6] The upward pressure for demand is due to continued population and economic growth and greater use of biofuels (Ext 5). This leads to an increase in demand for food and a rightward shift of the demand curve from D 1 to D 2. At the same time, demand for food is price inelastic (PED<1) as the degre e of necessity is high. Thus, the demand curve is steeper as shown in the diagram below. The supply for food is likely to be price inelastic as it takes a longer time to grow and harvest agricultural crops. Since the production process is long and complex, it is harder for producers to respond to change in price. Increased agricultural production costs means that there is higher cost of producing food which leads to a fall in supply. This results in the leftward shift of the supply curve as shown from S 1 to S2. At the initial price, P1, there is a shortage of food, indicated by the distance QdQs. Consumers will compete for the limited quantities available and offer higher prices. Producers, recognising the shortage, will begin asking for higher prices. There will therefore be an upward pressure on price , causing a movement along the demand and supply curves until the new equilibrium price of P2 at new equilibrium E2 is reached. S2 S1 D2 Price of food P2 P1 E2 E1 D1 Qty of food Qs Qd

© Property of Anderson Junior College 2 As a result, world price of food increases significantly. (b) (ii) How might increased investment in agricultural technology affect your conclusion about the world price of food? [2] With increased investment, there could be an improvement in production techniques or technological progress. This will increase productivity (Ext 5) resulting in a lower cost of production per unit of output of agricultural product and increasing the supply of food The increase in productivity due to more investment also means that there is spare capacity in the industry. It is now easier to increase the production of agricultural products as prices increase. Therefore, the supply of the good is more price elastic. With the supply curve shifting to the right and becoming more gently-sloped, this partially offsets the initial significant increase in the world price of food, causing the final increase in price to be less significant/more gradual. (c) (i) Use the concept of price elasticity of demand to explain the assertion in Extract 8 that a rapid growth in coffee supply would cause price falls that are ‘severe’. [2] According to Extract 8, the price elasticity of demand for coffee is low which suggests that demand is price inelastic. Demand for coffee may be price inelastic due to the low proportion of income spent on the beverage as well as its addictive nature. Given an inc rease in supply, price will decrease more significantly relative to the rise in quantity, hence explaining the assertion. (c) (ii) Explain the impact of a severe price fall for the incomes of coffee producers in these circumstances. [2] As demand for coffee is price inelastic, price would fall more significantly relative to the rise in quantity. Hence, the fall in revenue due to the fall in price of coffee is more than the rise in revenue due to the rise in q uantity, thus total revenue fell . This reduces the incomes of coffee producers. (c) (iii) Comment on two possible macroeconomic consequences of a severe fall in the price of coffee for coffee-producing economies. [4] Firstly, given an inelastic demand, t he severe fall in price of coffee will cause the total revenue of coffee producers to decrease. With coffee accounting for almost half of total net exports (Extract 8), this will lead to the current accounts of these economies to worsen significantly and their currencies to fall in value. As long as these countries continue to rely on coffee as the single most important tropical commodity, they will be vulnerable to sudden changes in the price of coffee and it is unlikely that continued good export performance can be sustained. Secondly, investors will perceive the poor export performance of these economics as a n unhealthy sign an d reduce FDI. This leads to a fall in aggregate demand since AD = C + I + G + (X -M) and hence actual growth decreases and demand- deficient unemployment rises . This in turn will adversely affect the material standard of living of millions of families in Latin America, Asia and Africa (Extract 8). However, the extent of the impact on actual growth depen ds on the state of the economy. If the coffee-producing countries are initially facing high inflation, such a

© Property of Anderson Junior College 3 fall in AD helps to alleviate demand pull inflation without reducing real national income by too much, hence lowering the cost of living for the people. (d) Extracts 5 to 8 emphasise the volatility over time in the price of commodities such as coffee. (i) State the principle of comparative advantage. [2] The theory of comparative advantage states that even where one country has absolute advantage over another in both industries, specialisation and trade can still benefit both countries in term of higher consumption level and world output , if each country has a comparative cost advantage. (d) (ii) Discuss the view that countries that rely heavily for their export revenue on a crop such as coffee ought to be cautious about engaging in a policy of free trade. [8] Engaging in free trade policy means there is no restriction in the flow of imports and exports among countries. While free trade brings about various benefits, countries relying heavily on export revenue also need to be aware of the costs that free trade brings about. Countries that rely heavily on a crop such as coffee for their export revenue ought to be cautious due to the possible costs. Engaging in free trade may mean an increase in size of the export market. When demand for coffee increases, there will be increase in expo rt revenue and hence aggregate demand (AD). If net export takes up a larger proportion of AD, the economy is vulnerable to demand-pull inflation, especially when the economy is near or at full employment level. Thus this would eventually worsen price competitiveness of other exports in Brazil. In addition, demand for coffee is likely to be price inelastic as the proportion of income spent on coffee is insignificant. Taking reference from Extract 8, when price falls are severe, there will be a less than proportionate increase in quantity demanded causing total revenue for coffee exports to also fall. This worsens the current account and in turn BOP position deteriorates . Moreover, this leads to a fall in investor confidence and hence investment expenditure. AD falls and hence worsen actual growth. Fo