2013_DHS_H2_EC_P2 Prelim Ans Scheme

1 Question 1: China experienced a slowdown in GDP growth in the aftermath of the Eurozone crisis. Under the European Union (EU)-China Free Trade Agreement (FTA), China is reducing tax rates on European exports, ranging from Louis Vuitton accessories to beverages and tobacco. (a) Explain how China’s reduction in tax rates might affect expenditure by Chinese consumers on the different types of European goods. [8] (b) Assess the impact of the above changes on the sales volume of different types of goods both in EU and in China. [17] Suggested Answer: Part (a) Question Interpretation  To explain the impact of fall in tax rates on expenditure by Chinese consumers (equivalent to total revenue earned by EU exporters) on different types of goods  To identify that a fall in tax rates is expected to reduce the prices of goods, due to a fall in cost of production, resulting in an increase in supply  To consider the ‘different types of goods’, PED can be used as a tool of analysis to determine the impact on expenditure Introduction Unpack key terms:  Expenditure by Chinese households = Total revenue earned by EU exporters  A fall in tax rates will affect expenditure by Chinese consumers on different types of goods, according to differences in price elasticity of demand (PED)  PED is a measure of the degree of responsiveness of quantity demanded to a change in price of a good, ceteris paribus.  As evident from the preamble. EU exports both luxury goods that are non-necessities, such as Louis Vuitton accessories and neces sities with few substitutes, such as beverages and tobacco. Development I. Impact of a reduction in tax rates on European exports: <Point> A fall in tax rates will result in an increase in supply <Elaboration> A fall in tax rates will reduce MC of production  the same quantity of output can be supplied at a lower price  illustrated by a rightward shift of the supply curve from S 0 to S 1, in Fig 1. At the initial, equilibrium price, P 0, quantity supplied exceeds quantity demanded creating a surplus. To get rid of the excess stock, producers will be willing to lower the price. Consumers observing such behaviour of producers will be willing and able to increase quantity demanded, ceteris paribus. Furthermore, as prices fall, producers will also lower quantity supplied, represented by a movement along the new supply curve, S 1. This process will continue and stop when the demand and new supply of intersects at the lower equilibrium price (P 1) and higher equilibrium quantity transacted (Q1).  <Link> The impact on total revenue and hence total consumer expenditure may rise or fall, depending on the PED values of the goods.

2 Fig 1: Impact of fall in tax rates on EU exports to China II. Consider the impact on expenditure when goods have PED>1 <Poin