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 shortage is now at Qdd2 -Qss2 and the market has not cleared at expected Qe. OR Body Paragraph 2: Explain why the shortage still exists due to PED & PES < 1 While the shortage is expected to be cleared due to the price pressure upwards to Pe and Qe, this might not be expected in Sri Lanka as sellers of fuel may not be able to increase the quantity supplied of fuel due to their inability to import the oil resources. This may be exacerbated due to supply of oil being price inelastic. While the shortage might reduce from Qdd -Qss due to some increase in price, it may not clear fully. A shortage of Qdd2-Qss2 could still remain at least till Sri Lanka manages its economic problems and have resources to import fuel again. Conclusion: The lack of foreign reserves in Sri Lanka has affected the supply of oil to be sold in Sri Lanka. While the price mechanism theory expects the shortage to clear due to price pressures, this may not happen due to other factors in Sri Lanka.

Knowledge, Application, Understanding, Analysis L3 A + A = 10 A + C = 8 - 9 ▪ Accurate and clear analysis of o Why there is a shortage and the expected new equilibrium price to clear shortage due to PED AND o Why the shortage does not clear due to either a price ceiling set by the government or the inability to import for fuel ▪ Answer provides relevant examples of market for fuel in Sri Lanka 8 – 10 L2 C + C / A + K = 7 A + 0 = 6 C + K = 5 - 6 ▪ Undeveloped / One-sided or some inaccuracies of o Either why there is a shortage (due to SS falls) o OR PED or PES or Price Control used but insufficiently to explain why shortage still exists. ▪ Answer only explains one of the above requirements ▪ Answer provides some examples of market for fuel in Sri Lanka 5 - 7 L1 C + 0 = 4 K + K = 2 – 4 K + 0 = 1 - 2 ▪ Inaccurate and minimal analysis or descriptive answer ▪ Answer is largely irrelevant 1 – 4 (b) Discuss whether price control is the most effective government policy to maintain the affordability of fuel in Sri Lanka. [15] Question analysis Command Word “Discuss” – requires student to analyse and evaluate 2 government policies (inclusive of price control) to keep prices of fuel affordable in Sri Lanka Context Sri Lanka’s market for fuel Concept Government intervention – price ceiling, policies to increase supply of oil (extraction of own oil, diversifying trade),policies to decrease demand by exploring alternative sources of energy Introduction: Sri Lanka is a developing country where the average income of citizens are low. Moreover, there are a huge number of businesses, coach and tuk-tuk drivers that are highly dependent on fuel to survive. Fuel is also a necessity to generate energy. Hence, it is important for the government to maintain the affordability of fuel. Commented [LSS1]: A must have: R1: Supply shock - both to explain shortage and why it still exists (not just shortage exist as originally proposed) 1. Explanation of shortage (S fall, at P0, Qtd D > qty S) 2. And PED and/or PES analysis (value, reason, implication on shortage existing) R2: Price control - both to explain shortage and why it still exists 1. unpack price ceiling + where the Pceil is (below the new higher equilibrium Price 2. explain why it prevents price from rising further NOTE: - If not price control, only R1 (one sided) award up to 6m (A + 0) -R1 just needs PED or PES to explain the reason shortage persists (in addition to supply shock) -R2, answers that explain market originally at equilibrium, but with P ceiling now shortage exists – get C. (rationale: the context is that price is increasing to eliminate the shortage that already exists. The starting point of R2 should be already having a shortage. Price must increase, but increase less, not fall.) -To remind students to USE diagram / aligned to their answers in prose

The government has implemented a price ceiling in order to keep prices low. There are also other policies that could be implemented to influence the demand and supply for fuel to keep price affordable in the long run. Body paragraph/Requirement 1: Price control can keep prices of fuel in Sri Lanka affordable Define price ceiling A price ceiling is the maximum price that sellers can legally charge. This price is below the equilibrium price and the government decides on this price depending on the country’s needs. Due to the falling supply of fuel in Sri Lanka, prices of oil have increased to P2. With the price ceiling at Pmax, prices are now more affordable to Sri Lankans. Evaluation: Price ceilings creates shortages and may lead to a black market. It also only works in the short run However, when a price ceiling is implemented, the quantity demanded (Qdd) for fuel is higher than quantity supplied (Qss) and creates a situation of a shortage. This may result in a black m