VJC H2 ECON P2 MARK SCHEME

2011 VJC2 JC2 H2 Economics Prelim P2 Mark Scheme Essay 1 As the world experiences soaring internationa l oil prices, countries like Malaysia and Indonesia have provided fuel subsidies while Singapore and Australia have not. Discuss the impact of soaring international oil prices and fuel subsidies on society. [25] Approach: Candidates should recognise that soaring internat ional oil prices can be explained using a Demand/Supply/elasticity (DSE) framework. Although not explicitly required by the question, the possible DSE reasons for soaring international o il prices should be briefly explained/described (as it may have some bearing on the impact on the various sectors of the society). Candidates must use the DSE framework and welfare co ncepts (consumer and producer surplus) to evaluate how society, broadly (1) crude oil producers (e.g. oil producing countries, oil producing firms etc), (2) crude oil consumers (e.g. oil refi ning firms, manufacturing industries, consumers of processed fuel – households and firms etc) wi ll be impacted (negatively or positively) by soaring oil prices. Clear illustrations using clearly labelled diagrams and good examples are a requirement for strong marks. Strong candidates might even differentiate the analysis further by evaluating how the impact on specific groups within a broad group might be different (e.g. low- income vs high-income households, manufacturing sector vs service sector firms). As the question hints that some countries (government s) have implemented fuel subsidies, candidates must evaluate (using the DSE and welfare/efficient concepts) how the fuel subsidies (e.g. price ceiling, subsidies) might have affected the respective impact on the various sectors (include government) of the society. Therefore, diagrams and examples showing fuel subsidies measures must be included. Possible concepts/discussion to be applied (do not need all to score full marks) - Soaring international oil prices o DD, SS, Ep, Es factors - Impact of soaring international oil prices on producers and consumers (and some governments and workers) o Net oil exporter countries (government) vs net oil importer countries o Oil producing firms vs oil consuming firms o High oil-dependent firms vs low oil-dependent firms o High oil-dependent households vs low oil-dependent households o High-income vs low-income households o P and Q, TR and TE analysis o Consumer and producer surplus o Efficiency vs equity trade-off - Impact of fuel subsidies on producers, consumers, governments, workers o Price ceiling vs subsidies o Consumer, producer surplus and government expenditure o Efficiency vs equity trade-off o Equity in distribution of government subsidies Intro  Briefly identify that soaring oil prices is due to increase in demand and fall in supply/no change in supply.  Soaring oil prices can have positive and/or negative effects on consumers (oil refining firms, oil/fuel consuming firms, households etc), producers (crude oil firms/countries).

 Identify that some countries like Malaysia and Indonesia provide fuel subsidies in response to dealing with the soaring international oil pr ices. Define fuel subsidies (price ceiling or subsidies) as payment made by the government to lower the price of fuel.  Subsidies have positive and/or negative effects on consumers (firms which use oil and households) and the government. We also need to consider the impact on allocative efficiency and equity. Body Impact of soaring international oil prices 1. Explain reasons for soaring oil prices Demand side: - Rising demand caused by increased demand from industrialized countries and rapidly expanding economies such as China and India which need oil for production. Rising affluence leading to a greater need for crude oil which is processed into fuel mainly used for transport, manufacturing for industrial products, electricity generation - Hedge funds and other specula tors betting on the possib ility of higher prices have exacerbated price pressure in the market. Supply side: - Slow down in oil supply growth, crude oil is a limited resource, and the remaining accessible reserves are more technically difficult to extract. - Events such as violence in the Middle East have led to disruptions in oil supply. - Climate changes, freezing weather, storms, caused disruptions to the shipments of crude oil. - Restriction of supply by OPEC. (Accept explanation for no change in supply) The increase in demand coupled with a fall in supply lead to the increase in oil prices. Large increase in price as the demand is price inelastic due to the lack of substitutes and supply for it is rather price inelastic as it is difficult to extract oil in the short run. 2. Negative impact of soaring international oil prices  Consumer of crude oil will be negatively affected. The consumers of oil include oil refinery firms and households. As prices increase sharply, these consumers will face an increase in Price Quantity D1 D2 S1 S2 P2 P1 Q2 Q1 0 a b

total expenditure (P x Q) of area P 2bQ1Q20. Show increase in total expenditure with reference to a diagram. EV: The impact could be more adverse for low-income consumers as a larger proportion of income is spent on fuel to generate power for basic needs e.g. lighting, electrical appliances. The impact could be less adverse on firms which are in the services industry where their dependence on fuel might be lower. Oil refinery industries (Venezuela, South Korea, Singapore) experience increase in cost of production and hence see falling profits. EV: The demand for processed fu el is also inelastic, therefore these firms can transfer the increase in cost of production to the buyers of processed fuel. Households experience higher cost of living which adversely affects their standard of living. EV: Those living in countries such as Australia and Singapore which do not provide fuel subsidies will experience a greater rise in cost of living compared to countries such as Malaysia and Indonesia which provide subsidies.  (Answers which explain impact of soaring international on macro economic objectives are acceptable but must ultimately link answers to impact on households, workers, firms) 3. Positive impact of soaring international oil prices  As oil faced a sharp increase in price, oil producers will benefi t. As prices in crease sharply, total revenue (P X Q) earned will be much higher. Increase in to tal revenue is area P 2bQ1Q20. Countries in the Middle East such as Saudi Arabia and Iran will see huge increases in revenue as they control a large pr oportion of the world’s oil reserves. EV: Their governments do not need to tax to raise tax revenue, therefore consumers and producers in such countries benefit as they not need to pay taxes.  (This market has –ve externalities. Production/consumption of oil results in pollution that is harmful to the health of 3rd parties. Briefly explain that the market mechanism results in over-production of petrol resulting in welfar e loss. With less quantity produced/consumed soaring international oil prices reduces allocative inefficiency and hence causes less welfare loss.) Impact of fuel subsidies 1. Explain fuel subsidies The rationale for implementing fuel subsidies is to help firms which use fuel lower cost of productions so that their goods are cheaper and al so as it is a basic necessity for households, so the subsidies help households especially the poor afford it. Types of fuel subsidies a) A subsidy given by the government has the effect of decreasing the marginal cost of production. Imposing a subsidy will shift the supply rightwards, i.e. supply increases. Producers will now need a lower price to offer the same quan tity for sale. (Explain with reference to a diagram)

b) The government may impose a maxi