2013 AJC H1 Econs CaseStudy

Question (a) (i) (ii) n 1 Fuel pr Using Tab 2009 and 2 Oil consum Oil consum Explain wh balance in The curren goods, cur Indonesia’ s position till Perspecti v balance. Oil consu m been incr e domestic o needs to m that the nu account ba Perspecti v account b However, t The data f o at thousan consumed taking into comprehe n price of oil OR The data o other exp o explain the balance. [ 1 revenue of and net tra JC2 201 rices and th ble 1, comp 2012. mption gene mption was a hether the n Table 1. nt account b rently rende s current a a deficit po ve 1: The a mption con s easing ov e oil producti o meet this s h umber of im alance. [1m] ve 2: The a alance. there are lim or oil produc d barrels da . [1m] How e considerat nsive analys has to be c only conside orts and im e impact of 1m] As cu r f other good ansfers, the Anders 13 H1 Econ Case he need for pare Indone rally increas always grea above exp balance is t ered service account g e osition in 20 above expl sistently ex c er the yea r on has de c hortfall by i ports would ] above does mitations to ction and co aily. As such ever, curren ion net infl o sis of the c h considered. ered the oil ports in th e changes in rrent acco u ds and servi data on oil 1 son Junio nomics Pr Study Qu r renewable esia’s produ sed while oi ater than oil lains the ch he balance es, income f enerally wo 12. ains the c h ceeds dom e rs becaus e creased. T h mporting fr o d be rising [ s not expl a the data in T onsumption h the data o nt account b ow or net o hanges to t [1m] componen e current a n oil produc t unt also co ices and oth production or College relims Exa uestions e energy uction and il production production hanges in I of the tran flows and un rsened ov e hanges in estic oil pr o e oil cons u his sugges t om other c 1m] and thi ain the ch a Table 1. in Table 1 only reflects balance is m outflow of m the export r nt. Hence, h ccount bal a tion and c o nsists of i m her compon and consu aminations consumpt n generally throughout Indonesia’s sactions of nrequited tr er the yea Indonesia’ oduction a n umption h a ts that Ind o ountries. H s is likely to anges in I n is presente s quantities measured in money. Henc revenue or i how significa ance has t o onsumption mport expe nents such a mption is lim s tion of oil b decreased. the years. s current a currently p ransfers. rs from a s current a nd the sho r as increas e onesia incr e ence, we c o worsen its ndonesia’s ed in absolut of oil produ n monetary ce, to have import expe ant oil is r e o be consi d on current nditure an d as net incom mited to exp between [1m] [1m] ccount roduced surplus account rtfall has ed while easingly can infer s current current te terms ced and y values, a more enditure, elative to dered to account d export me flows plain the [2] [4]

2 changes to current account balance. [1m] (b) (i) (ii) Using demand and supply diagram(s), explain the impact of an introduction of a fuel subsidy on the Indonesian government discuss whether consumers or domestic producers of fuel in Indonesia are more likely to benefit from the introduction of a fuel subsidy [2] [8]

3 (i) (ii) The Indonesian government will have to bear the entire burden which is shown by the sum of the 2 shaded areas in Figure 1 which is also calculated by subsidy per unit multiplied by the equilibrium quantity. As mentioned in Extract 1, this spending on fuel subsidy will strain the government’s finances, leading to budget deficit [1m] that has threatened to swell to $30 billion in 2013. (1m for diagram) Fuel subsidy lowers the cost of production which increases the quantity supplied by the producer at every price. Hence, the supply of fuel increases and the price of fuel falls from P1 to P2. The introduction of a fuel subsidy will benefit both consumers and domestic producers of fuel in Indonesia. However, the relative share of benefit for the consumers and producers would differ under different time periods. The relative values of Price Elasticity of Demand (PED) and Price Elasticity of Supply (PES) will determine which party will benefit more. A subsidy favours the side of the market that is less price elastic. PED is defined as the degree of responsiveness of the quantity demanded to a change in its price, ceteris paribus. PES is defined as the degree of responsiveness of the quantity supplied to a change in its price, ceteris paribus. In the short run, demand is likely to be relatively more price inelastic than supply as consumers find it difficult to adjust their consumption pattern. Given the fuel subsidy, the consumers’ share of the benefit from the subsidy is the proportion of the government funding that leads to a reduction in the market price from P 1 to P 2. The domestic producers’ share of the benefit from the subsidy is the proportion of the government funding that allows them to receive a higher price (P 3) which is inclusive of the subsidy. Hence, the consumers’ share of the subsidy will be greater than that of the domestic producers of fuel, as shown in Figure 1 . Hence consumers benefit more in the short run relative to the domestic producers of fuel. In the long run, demand is likely to be relatively more price elastic than supply as consumers are better able to adapt and adjust their consumption pattern. Given the fuel subsidy, the consumers’ share of the subsidy will be lesser than that of the domestic producers of fuel, as shown in Figure 2. Hence domestic producers of fuel benefit more in the long run relative to the consumers. Quantity Price SS SS + subsidy DDPrice inelastic P1 P2 Q2 Q1 S P3 Consumers’ share Producers’ share Figure 1: Subsidy to consumer and producer

4 Evaluation S: Whether consumers or domestic producers benefit more from the fuel subsidy depends on the price elasticity of demand/ supply which can be caused by the different time period considered. In this case, price elasticity of demand differs under different time period, hence giving rise to the different share of the subsidy. Knowledge, Application, Understanding and Analysis L3 Comprehensive knowledge of whether consumers or producers are likely to benefit from the fuel subsidy, with evaluation Balanced answer, with well-labeled diagram 6 – 8 marks L2 Good knowledge of whether consumers or producers are likely to benefit from the fuel subsidy Balanced answer, with well-labeled diagram (if no reference to diagram, max L2) 3 – 5 marks L1 Insufficient application of relevant economic concept to determine whether consumers or producers are likely to benefit from the fuel subsidy For an answer that showed conceptual errors One-sided, no/inaccurate diagram 1 – 2 marks (c) Explain how cutting fuel subsidies can improve the allocation of resources. [6] Quantity Price SS SS + subsidy DD Price elastic P1 P2 Q2 Q1 S P3 Consumers’ share Producers’ share Figure 2: Subsidy to consumer and producer

5 Briefly explain the market failure problem arising from fuel consumption. Fuel subsidies further hinder the effective working of the market mechanism by encouraging even more consumption of fuel. Hence, cutting fuel subsidies is in the right direction to improve the allocation of resources. The cut in subsidies would increase the private marginal cost of consuming fuel. As consumption of fuel inflicts external costs such as health problem experienced by third parties who live in the environment polluted by the consumption of f uel. Social marginal cost is greater than its private marginal cost. It is therefore necessary to factor in the external costs in the consumption of