Nov 2009 Case Study Q1

(a)

Compare the change in food prices between 2000 and 2007 with the change in petroleum [2]
prices over the period.
Similarity
Between 2000 and 2007 the prices of both food and petroleum have risen. [1]
Difference
However the price of petroleum was more volatile. It fell initially before rising sharply. * Moreover
prices of petroleum have also risen much faster than food. ** [1]
Skill: Ability to read from data in the form of Price index.
The question is a little tricky. Since 1995 =100 some might misread the 78.9 index for 2000 as a fall in food
prices initially. However according to this question, the starting point for comparison is 2000 not 1995!
Change:
(1) Direction i.e. rise/fall/flat
(2) Pace i.e. fast/slow or sharp/gradual
(3) Stable ( steady) or volatile (unsteady)
Weights
It is interesting to note that as a whole petroleum takes up a heavier weightage (nearly 40% of primary
commodities) compared to food (about 21.7%) suggesting expenditures on petroleum (energy) is more
significant than food.

(b)

With the help of a diagram explain the effect of the introduction of food price controls as [2]
described in extract 1.
Extract 1 makes references to price controls on food items e.g. milk, bread, beef and chicken in
countries like Russia and Venezuela which resulted in food shortages.
Effects
With reference to figure 1 below, the aim of such price control is to impose a legal price ceiling (Pc)
below the prevailing market equilibrium price (P). Sellers cannot sell legally at any price above Pc.
At Pc there will be a shortage since the quantity demanded (q2) exceeds quantity supplied (q1).
[1m]
Figure 1 (1m)

Shortage

P
S

P
Pc
D
Q
q1

q2

(c)

Explain why an increase of 70 million mouths to feed each year may cause food prices to rise, [4]
showing how low stocks of food would affect the extent of this rise in the short run.
Figure 2

S1
S2

P1

P2
P
D

D1

Q
With reference to Figure 2, in the short run, the supply of food tends to be relatively inelastic as
shown by the vertical S curve S1. This is due to the fact that there is low stocks of food ie. producers
will not be able to respond to an increase in demand by running down stocks.
On the other hand, with rising population the demand for food increases shifting the D curve
rightwards. The diagram illustrates the difference in terms of impact on prices - if supply is inelastic,
prices soar/ rise sharply to P1. However if supply is relatively elastic as depicted by S2, prices will
rise moderately to P2.
(d)

Extract 3 describe the use of subsidies in the market for bio-fuels.

[4]
With the use of diagrams, explain the way in which subsidies affect the allocation of
resources between bio-fuels and food.
Figure 3: Biofuel crops

S
S1 (subsidy)
P
P1

Q1

Q2

Figure 4: Food crops

S4
S3
P4

P3

Q4 Q3
Analysis:
Extract 3, para 3 refers to the surge in land use from 12m to more than 80m hectares worldwide
over 6 years for biofuels due largely to subsidies provided by the government. This can be
explained with reference to figure 3 and 4.
The land for growing crops has alternative uses. They could be used either to grow food crops or
biofuel crops. In other words, food crops and biofuel crops are in competitive supply. In figure 3,
government subsidies for growing of bio-fuel crops would give more incentive to devote more land for
such activity. This is shown by a rightward shift of the S curve from S to S1. As a result more
resources are allocated to produce biofuel crops as indicated by an expansion of the market
equilibrium quantity from Q1 to Q2.
On the other hand, as more land is devoted to produce biofuel crops, less is available for producing
food crops. Figure 4, illustrates the fall in supply from S3 to S4 of food crops. As a result the market
equilibrium quantity contracts from Q3 to Q4.
(e)

In a competitive market a firms profit would be competed away, whereas Shell and other oil [8]
companies have been able to make large profits over a long period of time. Discuss.
Contextual reference
With reference to extract 2, giant oil companies like Shell was reported to have reap obscene
profits in 2007 amounting to 14 billion or the equivalent of 1.5m per hour. In theory this type of
profits is a reference to supernormal or excessive profits associated with monopoly power.
Analysis
Thesis
Thesis 1 Firms should earn only normal profits in
LR in a competitive market
In a competitive market if firms are earning
supernormal profits, new firms would enter the
market and compete away the supernormal profits
in the long run.
Illustrate with a diagram to show how in MoC
markets any supernormal profits would be
competed away by the entry of new firms.
Thesis 2 High Barriers to Entry
Shell and other oil companies are able to earn
supernormal profits because the oil market is
dominated by few big/major players or firms. There
are high barriers to entry, some of which are natural
(e.g. control over oil reserves; Oil exploration and
extraction entails high capital outlay) while others are
artificially erected (e.g. branding; mining license). The
presence of high entry barriers enable existing firms to
make supernormal profits even in the long run.

Anti-thesis

For some MoC firms, they remain as a

little monopoly in a particular location
with no entry of competitors. This may be
partly due to imperfect information.

Although it might be expected that these

profits would persist in the long run in
such a market, this is not inevitable. For
example, that a price war would break
out, leading to losses amongst some of
the oligopoly firms. Also, firms invested
billions in extracting oil from new oil
mines which ended up to be dry holes
and as a result incurred huge losses.
Evaluation: with globalisation, the market
may become more contestable and the
existing firms may experience lesser
profits than before.

Conclusion
In reality the large or supernormal profits are likely to stay as barriers to entry are high in this
industry. However, the government could intervene to bring about greater equity as suggested in
extract 2 para 2 by imposing a windfall tax to redistribute the excess profits away from the oil
companies to the rest of society.

(f)

As a consultant economist, what options would you present to the worlds governments as [10]
possible responses to the threat of food shortages and what would you recommend? Justify
your answer.
Introduction
The data suggest the root of the problem of food shortages is the inability of global supply to cope
with the rising demand for food as the world population grows at an estimated rate of 70 million new
mouths per year. The consequences are hunger and starvation especially for the poorer regions of
the world if the problem is left unchecked. As an economist I would recommend SR and LR
measures.

A) SR measures
These are measures with immediate impact:
1. Rationing
With food shortage, Qd>Qs, governments would need other methods to distribute the good. One way
is to ration the good according to needs. However, it may be difficult for the governments to decide
on who needs the good more. Hence, governments would need to collect accurate information on
needs of her people.
Synthesis
A combination of SR and LR policies is required as LR policies would not be able to address the food
shortage issue immediately. And SR measures alone would not be able to totally eradicate the
problem.
B) Long run measures
LR measures must be put in place to increase the supply of food on a sustainable basis and reduce
demand for food. These measures include:
1. Subsidies on R&D
Subsidy to encourage R + D on agricultural technology e.g. Increase yield of the land through
using better fertilizers, seeds and farming methods.
Subsidy to encourage R&D on increasing arable land e.g. better irrigation; drainage systems
can turn desert lands into productive arable land.
If successful, this can help increase the supply of food.
However, whether there will be new and viable technology is not guaranteed.
Note: should state clearly that the suggestion is to subsidise the R&D efforts and not subsidise
food production. There is a difference.
2. Reduce/Ban use of Biofuels + Reduce Global Warming
Biofuels: Since the production of biofuels plays an important role in reducing the supply of food
governments should instead subsidise the use of other forms of alternative fuels which are more
sustainable e.g. solar, wind. However, alternative fuels at current level of technology are at a

much higher price hence would require a much larger subsidy.

Note: Should not suggest removing subsidy on biofuel to prevent the allocation of resources towards
production of biofuel and away from food production. This is because the extracts have made it clear
that the situation for the subsidy on biofuel is that oil prices are rising and biofuel is the alternative.
Hence as a mere removal of subsidy on biofuel will only shift the problem back to the fuel market.

Global Warming : Moreover as the data suggests global warming plays a role in causing food
shortages. Hence policies to cut down on carbon emissions should help to alleviate food
shortages related to the harmful effects of global warming e.g. droughts; floods. However to be
effective such measures must be taken at a global level.

3. Population control
One of the causes of food shortage is the rising demand due to increasing population (Extract 1 last
para). Governments should implement population control to slowdown population growth.
Conclusion
In my view, given that the root of the problem is the due to food supply, the most effective policies
would be those that aim at boosting agricultural productivity such as the use of better farming
technology to increase agricultural output over time. Moreover since the problem extends beyond
national boundaries such as global warming there is also a need for all governments to collaborate to
solve the problem of food shortages.
Nov 2009 Case Study Q2
(a)

Compare the change in Chinas balance on current account between 2003 and 2006 with that
of the US over the same period.

[2]

Chinas CA showed an increasing surplus; whilst USAs CA showed an increasing deficit.

(b)

State how Chinas current account on the balance of payments will be affected in the future
by:
(i)
Increasing overseas investment,

[1]

CA (net income flow) will improve / increase in the future.

(ii)
Sending 351 000 people to work overseas.

[1]

CA (unilateral transfer) will improve / increase in the future.

(c)

Explain a likely advantage to Chinese firms of buying competitor firms overseas.

[2]

Cost advantage: Chinese firms can reap internal economies of scale such that its unit cost of
production falls as it increases its scale of production. This would allow Chinese exports to gain
export price competitiveness and larger global market share.
OR
Revenue advantages: The resultant increase in market share will increase Chinese firms market
power such that they can raise prices to earn greater revenue and hence greater supernormal profit.
(d)

Comment on the likely size of the multiplier in the three economies shown in Table 3
The multiplier (k) is the number of times a change in income exceeds the change in injections (or
autonomous expenditure) that caused it. The size of the multiplier is inversely related to the

[6]

marginal propensity to withdraw (MPW), which comprised marginal propensity to save (MPS),
marginal propensity to tax (MPT) and marginal propensity to import (MPM). This means that a high
degree of leakage from the circular flow will result in a small multiplier.
Briefly explain multiplier: For example, given an autonomous increase in investment, it will
generate income for households employed by firms in the capital goods industry. The household will
tend to spend a proportion of the additional income on consumption, depending on their marginal
propensity to consume (MPC), whilst the remainder will be leaked out from the circular flow of income
and expenditure (depending on MPW). The consumption further creates income for households
employed in the consumer goods industry who will further spend their additional income on
consumption. This cycle of spending and re-spending will continue until the increase in income
becomes negligible. The eventual increase in national income is several times the initial increase in
AE. Hence the eventual increase in national income is dependent on the size of MPW or MPC as at
each stage how much of the increase in income is channelled into consumption is dependent on the
MPC or MPW. The larger the MPW or smaller MPC, the multiplier effect will be smaller and the
smaller the MPW or larger the MPC, the multiplier will be larger.
The multiplier, K, represents how many times the national income increases with respect to the initial
change in AE. The multiplier process comes to a halt because not all income received during one
period is passed on in the next period, as there are leakages in the form of savings, taxes and
imports.
In a four sector economy, the multiplier, K, is given by K = 1/MPS + MPT + MPM = 1/MPW
From Table 3, the relevant item was the figure provided for imports as a proportion of total
expenditure.
Singapore is an exceptionally open economy, with imports being 2.3 times of GDP. This means that
any increase in autonomous expenditure would have a very high degree of leakage from the circular
flow, i.e. there is very little passed on in the circular flow to create increased income for others. As a
result, the multiplier is small in Singapore and it is likely that it would be smaller than the multiplier in
the United States and China, which were much more closed economies, with 0.16 and 0.32 times of
their respective GDP.
However, it should be noted that there was insufficient information provided to arrive at an accurate
size of the multiplier, because figures were not available for the tax rate and the marginal propensity
to save.
(e)

Discuss how current and future living standards are affected by the composition of national
incomes in terms of the expenditure components as shown in Table 3.
National income measures a countrys level of production but may be a poor indicator of the
consumption level by a countrys residents. This is because a countrys output includes both
consumption goods and investment goods but current living standards depend only on consumption
goods.
Hence, for judging changes in consumer welfare, it is important to consider the composition of GDP
as well as its size. We must determine which part of the GDP is for consumer use and which part for
producers use. If a large proportion of the increase in GDP is derived from higher spending on
defence or space exploration, then we cannot say that consumers are better off especially if these
goods are produced at the expense of consumer goods. Furthermore, a rise in national income that
stems from a rise in exports will not contribute to a rise in living standards if the income generated
from exports is not spent on consumer imports. Similarly, a fall in national income due to an increase
in consumer imports does not lead to a fall in living standards. It should be noted that the opportunity
cost of private consumption is gross fixed investment.

[8]

In the context of the case material, to determine the extent of current and future living standards, we
would need to look at the components of private consumption and gross fixed investment from Table
3.
In the US, current living standards are expected to be high because of the high proportion of GDP
devoted to consumption (0.7 times GDP). From Table 3, it is seen that a smaller proportion of GDP
(0.17 times) is devoted to investment. As a result, there would be limited growth in productive
capacity, so that living standards in the future may be compromised. Similarly, for Singapore, her
gross fixed investment is of a lower proportion to GDP than her private consumption.
This is in contrast to China, where a much lower proportion of GDP is devoted to consumption (0.37
times) and much more to investment (0.42 times). This meant that current living standards in China
are kept low to increase living standards in the future.
(Use PPC to illustrate)

(f)

With reference to the data where appropriate, assess whether on balance the Singapore [10]
economy would benefit from a large increase in investment from China.
Question can be rephrased as: Assess the impact of a large increase in investment from China on
the Singapore economy. Hence an appropriate framework to use would be the macroeconomic
objectives.
Thesis: Benefit
Increase in economic growth and lower
unemployment
Increase in FDI would mean an increase in I,
hence AD would rise, via multiplier, real national
income would increase. Hence achieving
economic growth and lower unemployment rates.
However, k is small for Singapore as commented
in (d).

Anti-thesis: Would not benefit

Inflationary pressures may ensue
With an increase in AD due to increase in I,
demand-pull inflation may ensue if Singapore
is at full employment level. If inflation is above
trading partners, this could led to a loss in
export price competitiveness and hence lower
X

Moreover, increase in I would increase However, from Table 4, CPI increases at a

productive capacity, hence LRAS would increase very slow rate, hence inflationary pressures is
less of a concern.
and hence real national income.
If the FDI involves growth of industries which Moreover, if both AD and AS increase in
Singapore has a comp advg (i.e. growth of tandem, would result in non-inflationary
knowledge and technology industries), it will economic growth, which is ideal for Singapore.
enhance Singapores economic growth. This may
be inferred from Table 4 where economic growth
is very much in line with the growth of industrial
production.
The falling productivity faced by Singapore as
seen in Table 4 may be revived by the FDI which
may bring along technology transfer and skilled
labour.
Improved living standards in the future
Since there will be a focus on producing
investment goods, the future SOL will improve
(as explained in (e))

Living standards may be compromised

From Ext 5 para 4, if the profit generated form
the investment is not shared fairly, then current
and future living standards may be
compromised.

Improvement in BOP (SR)

Inflow of long term capital such as FDI will
improve Singapores financial account. Assuming
the other accounts remain constant, Singapores
BOP will improve

Worsening of BOP (LR)

In the long run, when profits from Chinese
firms are remitted back to China, this would
represent an outflow from Singapores current
account. Ceteris paribus, BOP will worsen. (as
explained in (b)(i))

Strengthening of SGD
Inflow of capital may cause the SGD to This may potentially cause our exports to be
strengthen making import price push inflation less less competitive. However, with our exports
having high import content (Table 3), the
of a concern.
stronger currency would mean cheaper imports
and hence mitigate the possible negative effect
of a currency appreciation.

Other benefits
Local firms will be forced to be more cost-efficient
since the market is now much more contestable
due to the influx if China FDI. Consumers will
benefit if prices are lowered due to the
competition, as well as have access to greater
variety of goods and services.

Other concerns
Physical crowding-out as well as possible
financial crowding-out if funds are raised in
Singapore
Highly specialised economic structure makes
Singapore more susceptible to industry specific
shocks

Evaluation / Stand / Judgment

Singapore is likely to benefit from a large investment from China as it will involve an upgrading of
Singapores economic structure if investments are in knowledge and technology intensive industries.
It will re-allocate human capital for more productive uses in the long run.