H2 Prelim Econs Paper 2 Suggested Answers

1 Anderson Serangoon Junior College 2022 JC2 H2 Economics Prelims Suggested answers PAPER 2 Question 1 1. Global electricity prices surged in 2021, driven by the rapid economic rebound and colder winters and warmer summers. Policymakers should be taking action to soften the impacts on the most vulnerable and to address the underlying causes. Source: IEA.org, accessed August 2022 (a) Using demand and supply analysis, explain how rapid economic rebound and colder winters and warmer summers may have led to the surge in electricity prices. [10] (b) Discuss the policies that might be used by a government to alleviate the sharp increase in electricity prices. [15] Suggested answer: Part (a) Rapid economic rebound and colder winters and warmer summers are both contributing demand factors which led to a surge in electricity prices. The surge in prices could also be due to the supply of electricity being price inelastic. Electricity is central to modern life and clean electricity is pivotal to energy transitions, but in the absence of faster structural change in the sector, rising demand over the recent years could result in volatility in electricity prices. The rapid economic rebound has led to an increase in income for many households. The increase in income results in an increase in purchasing power and increase in ability and willingness to consume normal goods. Normal goods are goods where a rise in income would lead to a rise in its demand. Conversely, a fall in income would lead to a fall in the demand for a normal good such as electrical appliances . Normal goods comprise of necessities and luxury goods. Electrical appliances and electricity are complement goods, as use of electricity is essential to ensure their proper functioning of the electrical appliances . Hence the increase in income will lead to an increase in the demand for electricity by households. The increase in demand will lead to a shortage of electricity in the market and upward pressure on equilibrium price and increase in quantity. In addition, when there is a rapid economic rebound, to meet the demand for normal goods, firms would tend to increase production of goods. If the production of these goods requires the use of electricity as a factor of production, there would be an increase in the derived dema nd for electricity. Next, with more extreme weather conditions in 2021, such as colder winters, warmer summers and droughts across the globe in countries such as United States, Mexico, China and Iraq, there would be an increase in the demand for electricity by households as demand for heating purposes such as the use of heaters during colder winters and also air -conditioners to tide the people through the hot summers increase exponentially.

2 The rise in demand for electricity from D0 to D2 will lead to a shortage of electricity Q0Q3 at the original price, P0. This exerts the upward pressure on the market price. As price increases, quantity demanded falls and quantity supplied rise. As supply is price inelastic the rise in price leads to less than proportionate rise in quantity supplied. This means that for the market to clear and reach a new equilibrium, the rise in price is greater in order for the increase in quantity supplied to clear the shortage. Thus, the overall rise in electricity prices has surged. The PES concept can be used to explain the surge in prices while the demand factors mentioned above explained the increase in the prices. Supply of electricity is likely to be price inelastic due to the length and complexity of production process and the av ailability of resources to produce electricity is limited, given shortages in coal and natural gas, thus it is difficult for firms producing electricity to respond to the rise in demand. In addition, there is also limited availability of storage facilities. Thus, a rise in price in electricity is likely to lead to a less than proportionate rise in quantity supplied. At the same time, it takes a few years to build the power plants to generate electricity. As shown in figure 1, If the supply of electricity is price elastic, the rise in price will be slower from P0 to Pe. If the supply is price inelastic, the rise in price will be much faster from P0 to P2. In this case, for the same increase in demand from D0 to D2, the increase in price is more significan t from P0 to P2 instead of P0 to P1 since the supply for electricity is price inelastic. From the above discussion, rapid economic rebound and more extreme weather conditions have led to the surge in electricity prices. In reality, there may be other factors such as rise in population which increases demand for electricity further as well as increase in the cost of production in the generation of electricity.

3 Part (b) Introduction Given that electricity is used to operate many of our equipment in households, commercial services and industrial needs, it is important for the government to intervene through a variety of policies to address the sharp increase in electricity prices. Policy: Subsidies to develop alternative more sustainable sources of energy To address the rising electricity prices, the government can intervene by providing a subsidy to encourage technology and innovation to develop alternative more sustainable sources of energy. For example, in the US, as the government recognises the economic and environmental benefits of using renewable energy to meet the electricity demands, the US government issued US$12 billion worth of subsidy in 2012, where a record of 6,700 wind turbines were installed and US$25 billion of private capital was invested. This brings wind capacity to about 3.5% of the country’s electricity supply which is en ough to power 15 million homes. And by 2030, 20% of America’s electricity demand can be met by wind energy. Progressively, more countries are generating electricity from renewables such as hydropower, wind and solar energy instead of electricity generated from coal plants. Thus, governments can provide subsidies to produce renewable energy. By providing a subsidy, it lowers the cost of production of renewable energy and hence more profitable for the producers, ceteris paribus. Producers are more willing an d able to supply, leading to an increase in supply for electricity. Supply curve shifts to the right, from SS 0 to SS1, as shown in the figure below. The increase in supply leads to a surplus and hence downward pressure on price from P0 to P1. Thus, equilibrium price falls. Level Knowledge, Application/Understanding and Analysis Mark L3 An answer that provides a clear and thorough explanation of both factors given in the preamble . A clear elaboration on the application of PES (elasticity concept). 8 – 10 L2 An answer that provides a good explanation of both factors in the preamble. Some elaboration on the application of PES (elasticity concept). 5 – 7 L1 An answer that demonstrates weak knowledge and application of the characteristics of market, possibly with multiple conceptual errors. 1 – 4

4 Figure : Market for electricity Limitation: However, providing subsidies may put a strain on government’s budget. This may result in resources being diverted from other areas such as education and healthcare in order to accommodate the provision of subsidies. Furthermore , it takes time for this research and development of using alternative energy sources to generate electricity extensively. Hence this may not be able to address the cur rent problem of rising electricity prices in the short run. Also, the cost of generating electricity from renewable energy sources is higher than from burning coal, thus many governments may not be willing to provide subsidies for renewable energy sources to generate electricity and continue to use coal-fired electricity pow