MJC H2 ECONS EQ1

Prelim 2018 H1 Paper 2 Essay Q1_Suggested Answer Essay Q1 1 Due to scarcity, resource s have to be allocated between competing uses. For instance, farmers in India are increasingly allocating mo re land to growing cotton instead of tea leaves. Such decisions ma y be influenced by fast-changing clothing trends. (a) Explain how the price mechanism can allocate scarce resources efficiently with increasing demand for a product. [10] (b) Given these farmers’ decision on t he use of their land, assess the relevance of elasticity concepts in explaining the impact on consumers’ expenditure on tea and other beverages. [15] Part (a): Explain how the price mechanism can allocate scarce resources efficiently with increasing demand for a product. [10] Intro The central economic problem of scarcity arises due to limited resources and unlimited wants. As society cannot have all the output it desire s, choices have to be made by consumers and producers. The price mechanism is the proce ss in a market economy where consumers and producers interact to determine the allocation of these resources among competing uses. Development: Roles of the price mechanism Prices perform two key roles which are the signalling function and rationing function. [Signalling Function] Consumers use prices to signal to producers their changing preferences and ability to buy goods and services. Price is the value consumers place on for each unit of good consumed. Producers use prices to signal to consumers their ability and willingness to produce each unit of good. Producers are profit motivated and will charge prices which maximize their profits. Adjustment process Assume that there is perfect competition and there are no externalities. Referring to the figure above, the initial equilibrium is where demand (D1) = Supply (SS) and price will be at P1 and quantity will be at Q1. Given that there is now an increase in demand for cotton, it means that there are more dollar votes cast for cotton. Demand will increase from D1 to D2. At initial price P1, a shortage of Q1Q3 is crea ted. This causes an upward pressure on price.

Prelim 2018 H1 Paper 2 Essay Q1_Suggested Answer This will signal to producers to allocate more resources to increase production to Q2 due to possibility of earning greater profits, thus quantity supplied increases from Q1 to Q2. In the long run, the increase in price may lead to increase in producers entering the market, resulting in an increase in supply and even more resources like land allocated into the market for cotton. What to produce Hence, higher prices signal to producers what they need to produce and lower prices signal what need not be produced. Producers allocate more resour ces to the market of cotton. Resources like land used to produce tea leaves are reallocated to produce cotton. Hence, price mechanism determines what to produce in the market. How to produce In the market for cotton, producers are in competition with each other for the dollar votes of the consumers. Consumers will buy from pro ducers which offer the lowest price. So producers must produce at lowest cost if they are to survive in the market in the long run, creating incentive for firms to adopt the le ast cost method of production. This thus determines how goods are produced. Changes in the goods market will then be reflected in the factor markets. Demand for resources in cotton industry like land and labour will rise. There will thus be a transfer of resources from other industries like tea leaves into the cotton industry. [Rationing] Prices also serve to ration goods and services to consumers who are willing and able to pay. The amount of goods purchased depends on their income, prices and preferences. Producers will only supply goods and services to those who are willing and able to pay while those who are unable or unwilling to pay will be driven out of the market. For whom to produce With reference to the diagram, as price of cotto n increases, there is a decrease in quantity demanded from Q3 to Q2. Consumers who are unwilling or unable to purchase cotton will be rationed out of the market. Hence, price also determines for whom to produce. Conclusion/Synthesis In a market economy, prices have a signalling and rationing function, which helps to allocate resources efficiently. However, in reality, price mechanism may fail to allocate resources efficiently due to imperfect competition or presence of externalities. Mark scheme: Knowledge, Understanding, Application, Analysis L3 For an answer that gives a clear econom ic analysis on the functions of the price mechanism in terms of resource allocati on between goods and factor markets for cotton. 8-10 L2 Underdeveloped answer or an inadequate attempt to explain the functions of the price mechanism in terms of resource allocation between goods and factor markets. OR Only explains in detail either function of the price mechanism. 5-7 L1 For an answer that demonstrates some relevant knowledge or brief description on the functions of the price mechanism. 1-4

Prelim 2018 H1 Paper 2 Essay Q1_Suggested Answer Part (b): Given these farmers’ decision on the use of their land, assess the relevance of elasticity concepts in explaining the impact on consumers’ expenditure on tea and other beverages. [15] Intro From part (a), farmers are likely to allocate more land to the production of cotton rather than tea leaves. Since these two goods are in competitive supply, less tea leaves will be produced at every price, resulting in a fall in supply and increase in price of tea leaves. Development 1: Relevance of PED in the market for tea Since tea leaves are a factor of production for tea, unit cost of production for tea increases. Potential profits per unit falls, and profit motivated producers will cut down on production of tea at every price. As SS for tea decreases, equilibrium price increases and equilibrium quantity decreases. The change in consumers’ expenditure is dependent on the relative changes in price and quantity. This can be determined by the price elasticity of demand. Price elasticity of demand (PED) measures the degree of responsiveness of quantity demanded of a good to a change in the price of the good itself, ceteris paribus. Price elasticity of demand for tea = % change in quantity demanded of tea/ % change in the price of tea The numerical sign of the price elasticity of demand for normal goods is necessarily negative due to the inverse relationship between the price and quantity demanded of the good. Assuming PED>1: the demand for tea is price elastic i.e. for a given increase in the price of tea, there will be a more than proportionate fall in the quantity demanded, ceteris paribus. This is possible in the case whereby tea is d eemed to have many close substitutes available such as caffeinated beverages like coffee and coke. Consumers are very responsive to price increase as they can easily switch to purchasing other readily available substitutes. Thus, the increase in consumers’ expenditure due to incr ease in price is less than the decrease in consumers’ expenditure due to the fall in quantity demanded. Overall, consumers’ expenditure will decrease. Assuming PED<1: the demand for tea is price inelastic i.e. for a given increase in the price of tea, there will be a less than proportionate fall in the quantity demanded, ceteris paribus. This could be a case of heavy tea-drinkers who deem tea to have no close substitutes. In this case, consumers’ expenditure increases. Hence, PED is very relevant in determining changes in consumers’ expenditure in the market for tea. Development 2: Relevance of XED & PES in the market for other beverages As price of tea increases, consumers may switch to relatively cheaper substitutes like coffee and other beverages, in