2012 H1 Prelims answer

Question 1 Debt Time Bomb (a) Compare the fiscal balance of Greece and Spain in 2010. [2] For comparison question, answers need to be p resented in a horizontal format, showing one similarity (where relevant) and one difference. Similarity [1m] both in deficit Difference [1m] size of deficit as a % of GDP larger in Greece than in Spain (b) Explain what determines the effectiv eness of the tax increases outlined in Extract 3 in raising tax revenues. [2] The taxes outlined in Extract 3 are indirect taxes, i.e. taxes on goods and services as opposed to taxes on incomes and wealth. Indi rect taxes are levied on producers but may be passed on to the consumers. To calculate indirect tax revenue, tax revenue = tax per unit × number of units Identify the determinant [1m] (any one) price elasticity of demand (or supply) Explain the determinant [1m] The more price inelastic the demand, the lesser responsive the consumers to price changes  smaller fall in quantity transacted  greater the revenue with larger number of units taxed The more price inelastic the supply, the lesser the producers are able to respond to the indirect tax  smaller the fall in quantity transacted  greater the revenue with larger number of units taxed Accept other relevant factors (c) With reference to Extract 3, using a supply and demand diagram, explain the effect of the austerity drive on the market for alcohol in Greece. [5] This is a question that tests candidates on the determination of market outcome – equilibrium price and quantity transacted. Using demand-supply analysis, candidates are to identify and explain how the auste rity drive could have impacted the demand and/or supply of alcohol in Greece and fr om there, analyse th e effect on market equilibrium. Where demand and supply change simultaneously, it is important to consider the direction and relative magnitude of the shifts to determine the overall effect on market outcome.

Max of 3m Explain the effect of an increase in excise tax on supply [2m] An increase in excise tax will reduce the market supply Reasoning: increase marginal cost of production  increase in minimum price that firms are willing and able to accept to supply the given quantity of output  upward shift of the supply curve Explain the effect of scrapping bonus payments for public sector workers on demand [2m] Scrapping bonus payments for public sector workers will reduce the market demand Reasoning: reduce disposable income, reduce purchasing power  reduce willingness and ability of consumers to buy alcohol (assume normal good)  reduce Qd at each and every price level, shifting the entire demand curve to the left Effect of market outcome by combining the demand and supply changes [2m] Diagram to show decrease in dd + decrease in ss  fall in equilibrium quantity,  effect on price indeterminate, depends on relative extent of the shift. Explain the more likely case with justification (d) With reference to Extracts 3 and 4, discuss whether indirect taxes and subsidies hinder the effective working of the market mechanism. [8] The “indirect taxes” in Extract 3 refers to the VAT and excise taxes while the “subsidies” in Extract 4 refers to the US government subsidies to its cotton producers. When the market mechanism is said to be working effectively, it means that resource allocation by the free market delivers an out come that will maximise economic welfare. If this were indeed the case, then any form of government intervention will only serve to distort price signals and “hinder the effective working of the market mechanism”. Conversely, if prices do not reflect the true benefits and costs of an economic activity, the market outcome may be sub-optimal, i. e. economic welfare is not maximised and market failure is said to have occurred. Indi rect taxes and subsidises can actually help to ‘get the prices right’, raising / lowering prices so that they reflect the full benefit / cost of the market transacti on helping to align the market outcome with the socially optimum level. Thesis: indirect taxes and subsidies can improve working of the market mechanism by helping to reduce allocative inefficiency Extract 3: excise tax on fuel, alcohol and tobacco  Alcohol and tobacco: demerit goods which also produce negative externalities  Fuel, especially fossil fuel: produce negative externalities Demerit goods are goods that the government deems to be undesirable and whose consumption should not be determined by the free market. Reasons include: o Imperfect information – consumers are not aw are of the full extent of the costs e.g. detriment to their own health of consuming tobacco / alcohol o Bounded rationality – even with all the public education campaign, consumers may not be in the position to make the best decision for themselves as government deems that they might not be able to rationally weigh the cost and benefit o Negative externalities – external cost e.g. adverse effect of passive smoking, damage to public property by binge drinkers are ignored by consumers who only

weigh their MPC and MPB when deciding on the quantity to consume, hence consuming more than the socially optimum amount Combining the above 3 factors, effective dd > level of dd as deemed desirable by government  consume at Qp instead of Qs Excise tax  increase the marginal cost of production  shifts ss curve upwards from S0 to St  reduce quantity consumed at equilibrium to Qs Or For the case of negative externalities, explain excise tax as a pigouvian tax where tax per unit = MEC at Q s = AD  internalise the external cost, shifting MPC upwards to MPC’  consumers face the full social cost of their consumption  reduce Qp to Qs By the same line of reasoning, providing subsidies to encourage the consumption of merit goods / goods that generate positive externalities can help to reduce allocative inefficiency. Dd (level deemed desirable by govt) Effective demand St Quantity Price S0 Qs QP D B A C Cost/Benefit MSC MPC MPB=MSB Quantity Qs Qp MPC’

Antithesis: the use of indirect taxes and subsidies may introduce allocative inefficiency and hinder the effective working of the market mechanism Extract 4: cotton subsidies to farmers in US It is the developing countries such as those in Africa, with their relatively abundant supply of labour and land, that enjoy co mparative advantage in the production of cotton. However, USA, with its subsidies to farmers, reduce the unit cost of production, allowing them to expand production and even export cotton despite their not enjoying the comparative advantage. More resour ces are expended on producing cotton in the USA given its higher opportunity cost than would be the case if they had chosen to import cotton from African countries at a lower opportunity cost. The outcome is allocative inefficiency, lower world output and lower economic welfare all round. OR Subsidies  reduce marginal cost of production, shifting MPC down to MPCS. Farmers produce up to the point where MPB = MPC S  output increase to Q P, beyond QS the socially optimum level wher e MSB = MSB. The cost to society of producing the additional units Q SQP = Q SABQP but the additional output only brings a benefit of QSACQP to society  welfare loss or DWL = area ABC Conditional evaluation Depends on  the start state: If there initially exists some form of market failure, use of indirect taxes and subsidies can help to bring consumption / production in line with the socially optimum level. If however the mark et works efficiently on its own, indirect taxes and subsidies only serve to distort price signals and introduces inefficiency in the working of the price mechanism. Even if there initially exists some form of market failure, use of indirect taxe