H2 Prelims Paper 2 Q1_Suggested Answers

1 Sri Lanka faced its worst economic crisis ever, and there have been huge concerns about the affordability of fuel. The lack of foreign reserves to import resources has worsened the shortage situation. The government has responded with price control to counter the rising fuel costs. (a) Explain why a shortage of fuel can still exist in Sri Lanka after a rise in the price of fuel. [10] (b) Discuss whether price control is the most effective government policy to maintain the affordability of fuel in Sri Lanka. [15] Suggested Responses (a) Explain why a shortage of fuel can still exist in Sri Lanka after a rise in the price of fuel. [10] Question analysis Command Word “Explain” – requires student to explain why there is currently a shortage of fuel in Sri Lanka and why the market cannot reach an equilibrium even after price adjustment process Context Sri Lanka’s market for fuel Concept Demand and supply, shortage and price adjustment process Introduction: Fuel is a necessity for society has they are mainly needed to run vehicles. There are no substitutes to fuel, especially in Sri Lanka, where majority of vehicles are still fuel-powered instead of electric. As Sri Lanka is going through an economic crisis due to its political problems, there is a lack of foreign reserves to import fuel. To make matters worse, price of fuel has increased greatly due to other reasons such as the Russian-Ukraine war. Foreign reserves are the amount of foreign currency the central banks holds. Typically, they are used to manage the country’s exchange rate relative to foreign currencies. As there is a lack of foreign reserves available in Sri Lanka, the Sri Lankan government are unable to manage their depreciating currency due to their economic problems. This makes price of imported oil become very expensive in foreign currency. This would cause the supply of fuel in Sri Lanka to decrease from SSo to SS1. At current price P0, there is a shortage of oil in the market of Qdd-Qss, assuming all other things remain constant. According to the price mechanism, a price pressure upwards is expected in order to reach the new equilibrium and clear the shortage at Q e. As fuel has a lack of substitutes and a necessity, the demand for fuel is price inelastic. This would mean that the expected new equilibrium price would increase sharply and by more than proportionate to the decrease in Qdd.

Body Paragraph 2: Explain why the shortage still exists due to price controls According to the pre-amble, a price ceiling is implemented to keep the price of fuel affordable for households. A price ceiling is the maximum price that can be legally charged by producers. This price is lower than the equilibrium price. Due to the price control set by the government, the price pressure upwards due to the fall in supply will stop at Pmax. As a result, the shortage caused by the fall in supply will not fully be resolved. There is now new