JJC H1 Economics Solution

1    1      JURONG JUNIOR COLLEGE 2014 JC2 ECONOMICS 8819 (H1) PRELIMINARY EXAMINATION ANSWER BOOKLET

2    2    Answers to 2014 Preliminary Examination Case Study Question 1 (a) Compare the prices of gas and coal & smokeless fuel in the UK between 2008 and 2013. [2] The price of gas and coal and smokeless fuel rose in UK between 2008 and 2013. The price of gas rose by 70% much faster than the rise in price of coal & smokeless fuel which rose 30.5% in the same period. (b) Using information in Extract 1, explain one demand and one supply factor causing the price of gas to rise in the UK. [4] China has experienced rising GDP growth and this implied that there is a rise in purchasing power of the population. This will lead to a rise in demand for goods and services which in turn encourage production. Firms' demand for gas as an input in production will increase leading to a rise in the price of gas price. The power outage at a Norwegian gas plant and the leaking crude oil pipeline in Scotland blocking the supply of natural gas from fields further up the production chain reduce the supply of gas which in turn raise the price of gas in the UK. (c) According to Extract 1, UK consumers' domestic gas bill increased by 11.8% when the price of gas rose by 13.1%.between 2011 and 2012. Comment on what this might imply for the price elasticity of demand for gas. [4] The demand for gas is price inelastic. This means that when the price of gas increased, there will be a less than proportionate fall in quantity demanded for gas. Consumer expenditure on domestic gas rose as the percentage increase in price is greater than the percentage fall in quantity demanded. But the ceteris paribus assumption may not hold. The rise in consumer expenditure on domestic gas bill could be brought about by a rise in demand for gas. This could be due to longer period of winter which could use a lot of gas to heat homes. (d) Using economic analysis, explain why economists would support the burning of natural gas rather than coal in a country's power station. [4] As mentioned in extract 2, the burning of natural gas rather than coal in a country's power station is preferred by environmentalists as gas-powered plants emit less than half the carbon dioxide emitted compared to coal-fired plants. This implied that the amount of external costs generated in production by gas-powered plants could be reduced. Carbon emission by gas-powered plants could pollute the environment and cause a deterioration of air quality. Residents staying within the surrounding area could likely fall sick and subject to rising medical costs. The presence of external costs in production is indicated by the MSC curve that lies above the MPC curve.

3    3    MSC1 The figure above shows that the gas-powered station will equate MPC to MPB and will produce Q P gigwatts of gas. The producer ignores the external costs generated from production equal to AE p amount. The socially optimum level of production should be at Q s gigwatts of gas where MSC=MSB. Hence, the presence of external costs leads to overproduction and welfare loss of area EsAEp as the total costs to society for the production of QsQp amount exceeds total benefits to society. As external costs generated by gas-powered plant is lesser than a coal-powered plant, which is ZA amount in the figure above, the welf are loss of the former is indicated by area E2ZEp which is lesser than the latter given by area E2ZEp. e) Discuss the policy measures adopted by the Australian government to correct market failure resulting from carbon emissions. [8] Carbon tax priced at A$23 per ton in July 2011 was introduced in Australia. It has the effect of raising firms' cost of production by an amount equal to the MEC= AE p amount and shift their MPC curve upwards to coincide with the MSC curve shown in figure 1 (part d of the answer). Firms are forced to internalise the external costs generated on others and they will reduce production level to Q s as they equate MPC 1 to MPB to reach the socially optimum level of production as greenhouse gas emission is reduced. As mentioned in extract 3 the carbon tax is easier to implement as the authority needs merely to attach a fixed price to be charge to each unit of the good produced. However, it is difficult to estimate the amount of external costs generated as the intangible costs like the deterioration of the quality of the environment could be difficult to quantify. The over and underestimation of the amount of external costs generated may lead to over and underestimated of the welfare loss. In addition, since the carbon tax does not cover agricultural and fuel used by light commercial vehicles and passenger that constitute 30% of carbon emission (extract 3), the adverse impact of rising costs on firms that lead to the slash of production and jobs could be kept lower. Z 0 MPB = MSB Es Ep A Qc Qs Qp Quantity of gas MPC MSC Costs/ Benefits E2

4    4    The cap-and-trade system involves the Australian government to determine the maximum amount of carbon emissions allowed per year. Go vernment will issue permits to firms which allow them to pollute up to the quota specified. Those firms that exceeded their quota will have to buy excess credits will those with excess credits ca sell them to increase their revenue. There is more certainty on the results of this policy as Australian government could better control the level of carbon emissions. While firms that pollute above the quota could trade for more permits in the market, it acts as a disincentive for them to innovate and be more efficient in energy usage particularly if the rising costs could be passed on to consumers in the form of higher prices. Carbon tax could be a better policy in the short run and if target at specific sectors that emit highest amount of carbon emissions, its adverse impact of rising costs on firms and subsequently households on the economy could be reduced. It also provide firms and households time to adjust to increase their usage of eco-friendly sources of energy. In the longer time, cap-and-trade policy could replace carbon tax as in the case of Australia which target at all polluting agents. It would be effective provided Australian government does not issue abundance of pollution permits like the case in Europe that could dramatically reduce the price of the permit and render the policy ineffective as polluting firms are not encourage to switch to green energy. (f) Do you agree with the view that UK’s "dash for shale gas" policy (Extract 4) would bring about more benefits than costs to the UK economy? [8] UK’s "dash for shale gas" policy will help reduce the country's high dependence on imported gas. The discovery and successful exploration of shale gas would help to drive down gas prices, just like the United States (extract 4). As gas is used for heating purposes at home, households domestic gas bill may not rise which benefit the lowest income group the most and to some extent help prevent rising cost of living. The extract mentioned that 74,000 jobs are created in the shale-gas industry. As workers are employed in the shale-gas industry, they will spend on consumer goods and result in a spill- over beneficial effects on other sectors in the economy via the multiplier effect. The country's real GDP will increase. Businesses will also experience lower cost of production as gas prices fall. This will be translated into ex port competitiveness. As demand for export is elastic, export revenue will increase. As UK import lesser amount of natural gas, import expenditure may fall. The rise in export revenue and fall in import expenditure will lead to a surplus in the current account. However, there ar