SRJC H1 ECONS ans

1 © SRJC 8819/01/JC2PreliminaryExam/2016/SuggestedAnswers SERANGOON JUNIOR COLLEGE 2016 JC2 H1 ECONOMICS PRELIMINARY EXAMINATION SUGGESTED ANSWERS SECTION A – QUESTION 1 (a) (i) Using Figure 1, describe the trend of oil prices from 2005 to 2016. [2]  Overall fall in oil prices  Sharp fall in oil prices from 08 to 09 [1] OR from 2014 onwards (ii) Using relevant case material, account for the trend in oil prices from 2014 onwards. [4]  Ext 2 “global demand particularly from China, appears to be dropping” OR Ext 3 “slowing China economy”  Implies a global economic slowdown had led to greater uncertainty and pessimism which resulted in a fall in economic activities. Hence a fall in derived demand for oil especially from a large buyer like China  Ext 2 “fracking in USA” created an exponential growth in oil production which led to a rise in global supply of oil.  Both fall in demand & rise in supply reinforced each other to result in a large fall in price of oil (b) Explain the relationship between oil price and food prices as seen in Figure 1. [3]  Direct relationship: fall in price of oil  fall in price of food  Fall in price of oil rise in Qdd of oil, cp.  Since biofuel & oil are substitutes which satisfy the same want, ie generates energy to drive economic activities  fall in demand for biofuel  Fall in TR for biofuel producers since both P & Q fall  less resources are allocated to the production of biofuel  Since biofuel and food are in competitive supply as they require the same inputs such as corn and sugarcane, more resources are diverted to the production of food  rise in supply of food  surplus  fall in price of food.  Thus there is a direct relationship between the prices of these 2 goods (c) Account for the value of price elasticity of supply for oil. [2]  Define PES: Degree of responsiveness of quantity supplied of a good to a change in its price, ceteris paribus.  PES<1: When supply of crude oil is relatively price inelastic, a price rise will lead to a less than proportionate rise in quantity supplied, ceteris paribus.  Reason being it takes time to locate oil deposits and considerable effort is needed to extract it from the ground. Oil drilling is part of a very long and complicated process used to locate, extract, and pump oil from wells. (d) Using Extract 3, explain the likely effects of the ‘growth in supply’ (Extract 1) on producers’ revenue in the markets for oil and one other related product. [6] A growth in supply of crude oil ceteris paribus, will result in a large fall in its price, given PED < 1

2 © SRJC 8819/01/JC2PreliminaryExam/2016/SuggestedAnswers (1) Revenue of oil producers Since demand for crude oil is price inelastic due to very few close substitutes, a fall in price (due to a growth in supply) will lead to a less than proportionate rise in its quantity demanded, ceteris paribus. Thus total revenue of oil producer falls. Diagram (Rightward shift in SS curve given PED<1) But revenue outcomes are mixed for producers of related products (2) Cars market (impact on “businesses”) A growth in supply of crude oil will lead to a fall in the price of petrol. It results in cost savings for owners of large fuel hungry cars. Since car and petrol are in joint demand, demand for such cars is likely to rise hence producers of such cars will enjoy a rise in total revenue from P1 x q1 to P2 x q2 On the other hand, total revenue will fall for producers of electric cars. Diagram of rise in demand for conventional petrol fuelled cars Evaluative comment: However, the extent of rise in revenue for producers of non - electric cars depends on the price of substitutes like electric cars. (e) In the light of Extract 1, explain why ‘world leaders are more committed to switch their economies away from oil’ to achieve efficiency in resource allocation.” [5] The world leaders pledged to switch their economies away from oil at the United Nations Climate Change Conference . They want to reduce the negative externalities generated from the burning of oil which results in partial market failure. The free market operates based on the self -interest of producers and consumers who seek to maximise profits and s atisfaction respectively. The burning of oil to

3 © SRJC 8819/01/JC2PreliminaryExam/2016/SuggestedAnswers run economic activities produces toxic by-products which pollutes the surrounding air and water. This gives rise to negative externalities. Hence, the total social cost of consumption is underestimated. With reference to the diagram below, this leads to a divergence between the marginal social cost (MSC) and marginal private cost (MPC) by the amount of marginal external cost (MEC) or negative externality. The market equilibrium is determined where MPB=MPC. The market equilibrium output is thus 0Qm. The socially optimum level of output is attained at a lower output 0Qs where MSB=MSC. The society’s welfare is maximised as the benefit society gains from the last unit of thi s good is exactly equal to the value of the next best alternative goods forgone. Since the market equilibrium output 0Qm is greater than the socially optimum level 0Qs, there is overconsumption of oil by QsQm amount in the free market. There is deadweight loss to society which is equal to the area EE sA. By switching towards cleaner form of energy, the world leaders hope to eliminate the welfare loss arising from overconsumption of oil. (f) How far do you agree that the oil price slump will bring about more benefits than costs to an economy? [8] Introduction  Clarify ‘economy’ : The economy refers to the economic growth, employment, balance of payments and inflation of a country.  Direction: Whether the oil price slump is beneficial or detrimental to an economy depends on whether the economy is a net oil importer or exporter Thesis: The oil price slump will bring about more benefits than costs to an economy if the country is a net importer of oil. China: 2nd top net importer of oil (Figure 2).  Oil price slump  since demand for oil is price inelastic due to very few close substitutes rise in quantity demanded of oil by less than proportionately, ceteris paribus  fall in import expenditure. oil

4 © SRJC 8819/01/JC2PreliminaryExam/2016/SuggestedAnswers  Since oil is a necessity in the production process of manufactured goods which China has comparative advantage in, fall in oil price  fall in cost of production  rise in SRAS  surplus of final goods and services exerts downward pressure on GPL  As GPL falls, level of AS falls and level of AD rises  GPL continues to fall until surplus is eliminated  export becomes more price competitive  rise in demand for export  rise in export revenue, ceteris paribus.  Currently at Y0, the economy is operating at less than full-employment. When there is an increase in net exports, the AD curve will shift to the right from AD0 to AD1. There is now a shortage of goods and services at original general price level P0. There will be an upward pressure on prices. Prices will rise until the shortage is eliminated and new equilibrium real national output is at a higher level, i.e. Y1. Hence, there is economic growth and a rise in employment for the China economy. Or any other relevant economy with data supported Anti-thesis: The oil price slu mp will bring about more costs than benefits to an economy if the country is a producer/net exporter of oil.