MI H2 ECONS (9757 02) Answers

2018 Preliminary Exams H2 Economics Paper 2 Microeconomics Suggested Answers 1. The price of water in Singapore will be increased by 30%. Rising costs of resources and the use of more complex development approaches have exerted upward pressure on the costs of producing and delivering water. Source: Minister for the Environment and Water Resources Masagos Zulkifli, 2017 Discuss the demand and supply factors that determine the price of water and assess which is the most important factor. [25] Question Requirement: Command word: Discuss Concept: Demand, supply and relevant elasticities concept Context: Singapore Explain why price of water increased by a large extent due to demand and supply factors and the relevant elasticities concept. Conclude which factor is the most important factor contributing to the large increase in price of water. Requirement Suggested Answer Introduction: State the variables and market to be analysed as well as the demand and supply factors. The price of water in the water market is affected by the increase in cost of production of water, increase in income and increase in Singapore’s population size. The extent of large increase in price of water is determined by the price elasticity of demand, income elasticity of demand and price elasticity of supply. Body 1: Analyse how increase in COP affects price of water As mentioned in the preamble by the Minister for the Environment and Water Resources, there is an increase in cost of producing water due to more complex ways of producing water. With an increase in cost of production, producers find it less profitable to produce water, hence supply of water falls, leading to an increase in price and a fall in quantity. To find out the extent of increase of price of water, we need to look at the Price Elasticity of Demand (PED). PED of water measures the degree of responsiveness of a change in quantity demanded of water due to a change in price of water, ceteris paribus. Given that water has a high degree of necessity as households require water in their daily activities and certain industries such as the wafer fabrication industries require the use of water in its production process, PED of water is price inelastic. Hence, an increase in price of water leads to a less than proportionate fall in the quantity demanded for water.

Requirement Suggested Answer Figure 1: Impact of increase in COP of water As seen in the diagram above, the original price is at P0. When supply falls from S0 to S1, given the price inelastic demand curve, Di, price has increased by a larger extent to Pi as compared to the price elastic demand curve, De. Since price increased by a large extent due to the fall in supply and the price inelastic demand curve, this factor is likely to be important in explaining the large extent of the increase in price of water. Body 2: Analyse how increase in income affects price of water Another possible factor that could have caused an increase in price of water is the increase in income of households. Since there is an increase in income, purchasing power increases hence demand for water also increases. This leads to an increase in price and quantity of water. In order to determine the extent of increase in price of water, we will need to look at the Income Elasticity of Demand (YED). YED of water measures the degree of responsiveness of the change in demand of water due to a change in income, ceteris paribus. Given that water is a normal necessity, since water is required for many daily activities, YED is positive and between 0 and 1. Thus, an increase in income will lead to an increase in demand for water by a small extent. This can be seen in the figure below where demand increases from D0 to D1. Hence price of water increased by a small extent from P0 to P1. P of water S1 S0 QI PI Q of water P0 Q0 DI DE QE PE

Requirement Suggested Answer Figure 2: Impact of Increase in Income Since price of water increased only by a small extent, it is likely that the rise in income is not as important in explaining the large increase in price of water. Body 3: Analyse how increase in population size affects the price of water Singapore’s population size is also expected to increase. Hence this will increase the demand for water. Thus, price and quantity of water will increase. The extent to which price of water will increase depends on the Price Elasticity of Supply (PES). PES of water measures the degree of responsiveness of a change in quantity supplied of water due to a change in price of water, ceteris paribus. Since water production process is complex and the level of water available is declining due to the drying up of Malaysian reservoirs (one of our 4 national taps), PES of water is likely to be price inelastic. Hence an increase in price of water leads to a less than proportionate increase in quantity supplied of water. Figure 3: Impact of increase in population size P of water D1 SI Q PI Q of water P0 QI D0 SE PE QE P of water D1 S0 Q0 P1 Q of water P0 Q1 D0

Requirement Suggested Answer As seen in the diagram above, the original price is at P0. When demand increases from D0 to D1, given the price inelastic supply curve, Si, price has increased by a larger extent to Pi as compared to the price elastic supply curve, Se. Since price increased by a large extent due to the increase in demand and the price inelastic supply curve, this factor is likely to be important in explaining the large extent of the increase in price of water. Conclusion Explain which is the most important factor which led to the increase in price of water by a large extent. The price of water is going to increase by a large extent. This is likely due to the increase in cost of production of water. This is so as the increase in demand of water might be mitigated by campaigns by the government as well as the installation of water-saving showerheads, washing machines and taps that are adopted by more households. Furthermore, for businesses, as they want to maximise profits, they will put in place water-saving measures to reduce their cost of production. Thus, even though demand for water may increase, it is unlikely going to increase by a large extent. However, as the reservoirs in Malaysia are drying up due to inclement weather and the water agreement in Malaysia coming to an end soon, Singapore is urgently trying to find methods of producing water that requires lesser reliance on Malaysia. These methods of production likely require new and improved te chnology, e.g. improving the process of NEWater. Hence, the increase in cost of production coupled with the price inelastic demand curve and the price inelastic supply curve is a more important factor resulting in a large increase in the price of water. Mark Scheme Level Descriptors Mark Range L3 High L3 (18 – 20) For a clear explanation of how each demand and supply factor results in an increase in price of water using demand and supply analysis. The extent of increase in price of water is explained using relevant elasticity concepts for each demand and supply factor. Answer has no misconceptions and errors and it explains the importance of each factor in resulting in the increase in prices all the time. Low L3 (15 – 17) For a clear explanation of how each demand and supply factor results in an increase in price of water using demand and supply analysis. The extent of increase in price of water is explained using relevant elasticity concepts for some demand and supply factors. Answer has minor misconceptions and errors and it attempts to explain the importance of each factor in resulting in the increase in prices most of the tim