VJC H1 ECONS answers

1 H1 Prelim Case Study Question 1 a (i) Describe the trend in India’s food prices from 2012 to 2018 [2] Food prices were generally increasing [1], with the increase slowing down from 2014 onwards [1] (ii) What might Figure 1 and 2 suggest about the price elasticity of demand for food in India? [3] Price elasticity of demand measur es the degree of responsiveness of quantity demanded of a good to a change in its price, ceteris paribus The demand for food is likely to be price inelastic where the increase in price in Figure 1 led to a less than proportionate fall in quantity consumed. As a result, the increase in expenditure from an increase in price is greater than the loss in expenditure from a decrease in quantity demanded, leading to a rise in expenditure as seen in Figure 2. Award 1m for the identification of PED of food Award up to 2m for an explanation of the link between Price and TE using the concept of elasticity b With the aid of a diagram, explain and comment on how a food subsidy might affect the consumers, producers and the government in India. [8] A subsidy is a payment made by the government to producers to encourage the production of certain good and services, but not made in exchange for any goods or services. To analyse the impact on the various economic agents, we will look at expenditure for consumers, revenue for firms and government expenditure. Before government intervention, the initial equilibrium is at point E 0, where DD0 intersects SS0, to give equilibrium price P0 and quantity Q0. A subsidy lowers the cost of selling food, therefore producers are willing to offer the more for sale at every price. This is represented by a downward shift of the supply curve, by the amount of the subsidy, from SS0 to SS1,

2 At the initial equilibrium price of P0, quantity demanded is Q0 and quantity supplied is Q2, resulting in a surplus of Q0Q2. Producers will lower the price in order to get rid of the surplus, which results in a rise in quantity demanded, and a fall in quantity supplied. This will continue until quantity demanded equals quantity supplied to arrive at a new equilibrium point of E1, with a lower equilibrium price P1 and a higher quantity Q1. Impact on Economics Agents Consumers’ expenditure decreases from 0P0E0Q0 to 0P1E1Q1. Due to the demand for food being price inelastic, the increase in expenditure from an increase in quantity (Q 0AE1Q1) is less than the decrease in expenditure from a decrease in price (P 1P0E0A), resulting in an overall fall in expenditure. Producers see an increase in overall revenue from 0P 0E0Q0 to 0P 2BQ1, which is the sum of consumers’ expenditure plus the subsidies from the government. The government will see an increase in gover nment expenditure by the area P1P2BE1. Evaluation: The extent of the above changes on the various economic agents will depend on the relative price elasticity of demand and supply for food. The more price inelastic the demand/supply is, the greater the impact of the subsidy on the consumer/producer. Up to 1m for a well-labelled diagram Up to 3m for an explanation of the impact of subsidy on the market, this includes a demonstration of what subsidy is /its impact on the supply curve and equilibrium price and quantity via the adjustment process. Up to further 4m for a discussion of the impact on the various economic agents (including evaluative comments on the extent) c In the light of rising inflationary pressure, discuss whether the Indian government should raise interest rates. [10] Inflation is a sustained increase in the general price level of an economy, which can be either demand-pull or cost-push inflation. In India’s case, there are both demand-pull (Ext 2 Para 2 and 3: economic growth) and cost-push inflation (Ext 2 Para 1: rising food prices pushed India’s retail inflation to…).

3 An increase in interest rate addresses inflation in India When the government raises interest rates, consumers and producers will be affected. Consumers will consume less as a rise in interest rates means that the cost of borrowing has increased. With a higher cost of borrowing, consumers will borrow less. The returns from saving will also increase, resulting in a higher opportunity cost of consuming. Thus, consumers will reduce their consumption (C). Firms will also borrow less with a higher cost of borrowing as previously profitable investment projects might now be unprofitable, resulting in a fall in investment (I). A fall in C and I will lead to a fall in AD from AD0 to AD1. The fall in AD will create surpluses at existing general price level and hence, there will be an unplanned rise in inventories. Firms will reduce production and hire less factors of protection, such as labour. As a result, households’ income will fall and this decrease in purchasing power will result in a fall in consumption of other domestic goods and services. Hence there will be lower national income as output decreases further. As a result, there will be less inflationary pressure in the Indian economy, lowering the general price level from P 0 to P1. Evaluation: • Contractionary Monetary Policy is easy to implement as the revision to interest can be announced by the central bank and effected with almost no time lag. • However, if Indian consumers and producers are optimistic about the economy outlook, a rise in interest rate might not discourage them from consuming and investing. This is likely given the growth of India in the last few years. • The effectiveness of the policy also depends on the proportion of AD that C and I take up. If C and I take up only a small proportion of AD, then the fall in GPL would not be substantial.

4 Increased interest rate may not address the inflation in India An increase in interest rate may raise business costs and producers may pass these increased costs to the consumers in the form of higher prices so as to maintain profitability. The more price inelastic the demand for the goods are (especially for raw materials, food, energy) the more likely it is for producers to pass on higher costs to consumers. In this case, not only will inflation not be solved, the consumers will be worse off with higher prices and falling material well-being than without government intervention. Furthermore, given that increases in food prices due to droughts (Ext 1 Para 1) are also contributing to inflation, a contractionary monetary policy is unlikely to address this source of inflation. Evaluation • Inflation in India seems to be a result of both demand-pull as well as cost-push. In light of the different causes of inflation, raising interest rates, which essentially addresses demand-pull inflation, would not be sufficient to tackle inflation in India. • Complementary policy to address the cost-push inflation e.g. implement supply side policies to help deal with rising food prices. This could come in the form of subsidising R&D efforts to increase crop yield. With an increase in crop yield, it will increase the amount of crops produced with the same amount of land used, thus alleviating the inflationary pressures brought about by rising food prices. One drawback about supply-side policies would be that it takes time for R&D to see results. The results are also not guaranteed and also takes up government funding, which could have been spent on other areas of development. Conclusion To effectively address inflation in the country, the Indian government should implement a mixture of demand-management and supply-side policies to tackle the various sources of inflation. While the problem of food price inflation might be temporary, India’s growth projection (Ext 2, Para 3), increased government spending, suggests that inflation may be more demand-pull and that would make de