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 <Point> Consumer expenditure will increase for goods with price elastic demand i.e. PED >1. <Exemplification> EU exports luxury goods, which are non-necessities such as Louis Vuitton accessories to China. Explain why (using one PED factor) demand for Louis Vuitton accessories is price elastic: <Elaboration> These goods take up a (i) large proportion of income OR (ii) have many available close subsitutes, such as other branded accessories from Gucci, Chanel, Burberry, Mulberry etc. Hence, the quantity demanded will be more responsive to changes in price since Louis Vuitton accessories are not necessary for an individual’s survival. A fall in price will lead to a more than proportionate rise in the quantity demanded, ceteris paribus. Diagrammatical Illustration: Relating to Figure 2, the increase in expenditure arising from the rise in the number of units bought (area Q 0cbQ1) exceeds the decrease in expenditure arising from the fall in price paid on the number of units bought (area P 0acP1). Price D S S Quantity transacted QQ P P Price D elastic S S Quantity  transacted QQ P P a b c Price D inelastic S S Quantity  transacted QQ P P e f g Fig 2: Impact on expenditure for PED >1 Fig 3: Impact on expenditure for 0<PED<1

3 <Link> For a good that has price elastic demand consumers’ expenditure will rise with the decrease in tax rates. III. Consider the impact on expenditure when goods have 0<PED<1 <Point> Consumer expenditure will decrease for goods with price inelastic demand i.e. 0<PED <1. <Exemplification> EU exports goods with few substitutes such as beverages and tobacco to China. Explain why (using one PED factor) demand for beverages and tobacco is price inelastic <Elaboration> These goods take up a (i) small proportion of income OR (ii) have few close substitutes, given the broadness of definition of the commodities, such as beverages OR (iii) high degree of necessity due to addiction to cigars and cigarettes made from tobacco. Hence, the quantity demanded will be less responsive to changes in price since beverages and tobacco are necessities for an individual’s survival. A fall in price will lead to a less than proportionate rise in the quantity demanded, ceteris paribus. Diagrammatical Illustration: Relating to Figure 3, the decrease in expenditure arising from the fall in price paid on the number of units bought (area P 0egP1) exceeds the increase in expenditure arising from the rise in the number of units bought (area Q 0gfQ1) <Link> For a good that has price inelastic demand consumers’ expenditure will fall with the decrease in tax rates. Conclusion In summary, expenditure by Chinese consumer s on on EU imported goods with PED>1 will be likely to rise while the expenditure on goods with PED<1 will likely to fall following the fall in the tax rates. Mark Scheme L3 (6-8) For an answer that demonstrates scope and depth Scope  Clear and accurate definition of PED  Impact of fall in tax rates on consumer expenditure of both types of goods; 0<PED<1 and PED>1 Depth  Identifying and explaining the relevant factors to account for the difference in PED for the various types if imported goods from EU  Explanation of the impact of decrease in tax rates on consumer expenditure on both types of goods along with necessary diagram(s) L2 (4-5) For an answer that lacks either the scope of the depth of explanation Scope:  Considers only one type of good Depth:  Under developed explanation of how fall in tax rates impacts consumer expenditure on different types of goods using PED concepts. Cap at 4m  No diagrams

4 L1 (1-3) For an answer that shows some knowledge of  how rising GST causes supply to fall but fails to explain the impact on consumer expenditure OR  the impact of rising GST on consumer expenditure but lacking in analysis  no diagrams and glaring conceptual errors Part (b) Question Interpretation  To identify the ‘above changes’ in EU and China  In EU, fall in income (Eurozone crisis) and hence fall in demand of the various types of goods produced in EU. There will be no change in supply.  In China, income is increasing albeit at a slower rate (slowdown in GDP growth). To use YED as a tool of analysis to determine the impact on sales volume of different types of good.  To use XED as a tool and analyse the impact of the EU-China FTA on sales volume of domestically produced substitutes in China. Introduction Unpack key terms:  Sales volume  analysis is on quantities (Q) and not expenditure (P.Q)  To assume that the rise in income is in real terms Development A) Impact on sales volume for different types of good in EU Note: There will not be any change in supply of the various types of goods in the EU nations, as the reduction in tax rates is only applicable for EU exports to China I. Explain the impact of the Eurozone crisis on normal necessities goods