prelims summary

Document Sample
prelims summary Powered By Docstoc
					J1 Topics

No.                                       Title                                      Page No.
1     Chapter 1: Scarcity, Choice and Opportunity Cost                                 2-3
2     Explain two ways in which an economy might move from a point within               4
      its PPC to a point on it.
3     Discuss the most effective economic policies to move the PPC outwards.            5
4     What is meant by the basic economic problem of scarcity?                          6
5     Discuss whether economic growth solves the problem of scarcity.                   7
6     Chapter 2: Resource Allocation in Competitive Markets I                          8-9
7     A manufacturer wishes to sell more of his product. How may he try to             10
      achieve his aim?
8     Chapter 3: Resource Allocation in Competitive Markets II                        11-13
9     Explain price elasticity of demand and income elasticity of demand.              14
10    A government is proposing to increase the tax on petrol. Examine the             14
      relevance of price elasticity of demand and income elasticity of demand
      for this proposal.
11    Assess the relevance of elasticity concepts in explaining the effects of the    15-16
      worldwide recession caused by the 911 terrorist attacks on the airline
12    Chapter 4: Microeconomic Problems: Market Failure                               17-18
13    Policies on Pollution and Evaluation Summary                                    19-21
14    Policies on Pollution and Congestion caused by Cars Summary                     22-23
15    Chapter 5: Government Intervention in the Market I                               24
16    Chapter 6: Firms and How They Operate I                                         25-30
17    Discuss whether rising costs limit the size of firms over time.                  31
18    Banking Merger in Singapore Analysis                                             31
19    Chapter 7: Firms and How They Operate II                                        32-38
20    Discuss the view that the profit motive will always lead to a few large          39
      firms dominating the market for each and every type of product.
21    Explain what is meant by productive and allocative efficiency.                  40-41
22    ‘A firm should be encouraged to maximize profits because this makes it           42
      efficient.’ Discuss whether this argument is true for a firm operating in an
      imperfect market.
23    Distinguish between monopolistic competition and oligopoly.                      43
24    Explain why oligopoly is a common market structure in many economies.            44
25    Explain why governments throughout the world have been involved in               45
      the supply of services such as electricity.
26    Chapter 8: Government Intervention in the Market II                             46-48

Chapter 1: Scarcity, Choice and Opportunity Cost

1. Introduction
 Study of the use of scarce resources to satisfy unlimited human wants
 Wants: things people would consume if they had unlimited income
 Resources: inputs to produce goods and services
 Scarcity exists due to unlimited wants + worn out goods + newer goals
 Positive (can be checked by facts) vs. normative (statement of value)

2. Factors of Production
 Land: productive resources supplied by nature
 Labour: human effort directed to the production of goods and services
         Supply: number of workers + average number of hours each worker is
            prepared to offer
         Specialisation
                 Dexterity, greater use of machinery and more sophisticated
                   production techniques
                 Monotony, loss of craftsmanship, increased risk of structural
 Capital: man-made resource used in further production
         Involves postponing present consumption
 Entrepreneurship: takes risk of being in business
 Information: data for the basis of knowledge-based economy

3. Opportunity Cost
 Real cost in terms of the next best alternative foregone
 Calculating opportunity cost requires time and information
 Opportunity cost may vary with circumstance
 Economic rent: difference between what is earned and what could have been
 Used in specialization and trade

4. Production Possibility Curve
 Maximum attainable combination of two goods and services that can be produced in
    an economy, when all available resources are used fully and efficiently, at a given
    state of technology
 Assumptions: fixed amount of resources, factors fully and efficiently employed,
    technology fixed, time period give, 2-product model
 Fully: using all resources available
 Efficiently: do as many things you can with the resources used
 Scarcity: unattainable combinations outside PPC + society has to choose among
    combinations of 2 goods
 Shift: quantity and quality of resources (think FOP) + technology – skewed?
 Choice between instant gratification and improving economy in the future


                                         *Draw dotted line to show comparison
                                         between 2 countries with a common

    0                                  Cloth

5. The Marginalist Principle
 Consume till MPB = MPC: cost of producing an additional unit of good = benefit of
    consuming an additional unit of good
 For the price mechanism to work, information need not be known with perfect
    accuracy by every individual acting in the marketplace: dependent on marginal
    buyers who keep suppliers on their toes

6. Efficiency
 Static efficiency: how much output can be produced now from a given stock of
    resources at a given point in time
 Dynamic efficiency: changes in the amount of consumer choice available in markets
    together with the quality of goods and services available
 Productive efficiency: absence of waste in the production process = minimizing the
    opportunity costs for a given value of output
 Allocative efficiency: society produces and consumes a combination of goods and
    services that maximizes its welfare
 Distributive efficiency: goods and services produced to those who want or need

Explain two ways in which an economy might move from a point within its PPC to a
point on it. [10m]

Define PPC

 Good X

                                             A: resources not fully utilized –
                                             underemployment and
                                             B: efficient use of resources – full
          A                                  employment

   O                              Good Y

A. Increase employment of resources
     Lower wages to be more competitive – may be enticed to produce more goods
     Fiscal policy: increase government spending eg. circle line – multiplier effect
     Monetary policy: lower interest rate – firms borrow more, increase investment

B. Increase efficiency in use of resources
     Pay based on productivity: but only for jobs where output can be measured
        (factory workers)
     Reallocate resources to more efficient uses
     Retraining

Discuss the most effective economic policies to move the PPC outwards. [15m]

Outward shift: increase in productive capacity – sustain economic growth over long run

A. Labour
     Increase birth rate but difficult to do so in developed countries – female labour
       force participation + need lots of incentives
     Education and training but takes long time and does not necessarily yield results
     Foreign talent through tax incentives

B. Capital
     MNCs – investment (machines) + learn their technological knowledge
     Invest in r+d

C. Entrepreneurship
     Incentives and subsidies to start businesses

D. Land
     Reclamation

Depends on which country
Eg. For USA: encourage capital goods, less consumption goods. For China:

What is meant by the basic economic problem of scarcity? [12m]

Scarcity – scare resources, unlimited wants

Scarcity – choice – opportunity cost

1) Individual: time; consumer; how to maximize use of limited resources – more labour /
more machines

2) Firm: least-cost combination of resources in order to maximize profits

3) Government: choice between competing projects; cost-benefit analysis

4) Economy: problem of how to allocated scare resources efficiently best illustrated by
the PPC

                       Good X



                           O           5 6               Good Y
(Brief) Implications:
     Trade as a solution to alleviate scarcity
     Trade-off between consumer goods and capital goods
     What (how scarcity affects decision-making of an economy), how much, for
         whom and what to produce (market system)

Discuss whether economic growth solves the problem of scarcity. [13m]

Economic growth – increase in national income – generally get to consume more goods
and services

1) Increase in quantity and quality of resources – increase in productive capacity
     Labour: due to reduction in unemployment and underemployment
     Skills and educational level
     Land
     Capital stock: most effective way to alleviate problem of scarcity – more capital
        economy produces in one period, more output capital can produce in the next to
        satisfy wants in society

2) Technological improvement – increase in productive capacity: better and new
methods of producing goods
    R + d – technological breakthrough – new products – create more wants

3) Increase in income – consumers able to satisfy wants
     But with greater affluence, people have more wants due to advertising and
        promotions – luxury goods of the past may become necessities

4) Supply limited
     Demand accelerating – China / India economic growth
     Crude oil important as it is a source of fuel
     Eg. land in Singapore
     But technological improvements allow society to make use of renewable
       resources as sources of energy
     But more wants created

5) Equity in distribution
     Economic growth does not guarantee a reduction in income gap
     Corruption, food shortages

Chapter 2: Resource Allocation in Competitive Markets I
*Assumption: Many buyers and sellers such that no single buyer / seller can exert
control over market price (price takers)

1. Demand Theory
 Demand: amount that consumers are willing and able to purchase at each given
    price over a given period of time
 Demand curve slopes downwards
         Income effect: effect of change in real income resulting from change in price
            of good
         Substitution effect: effect of change in price on quantity demanded arising
            from consumer switching to, or from, alternating products
 Determinants
         Price
         Taste: education, culture, age group, health scares
         Interrelated goods: substitute vs. complement
         Population: absolute change, change in composition
         Seasonal changes: climate, festival
         Expectations of the future: future changes in price / income
         Real disposable income: changes in taxes / money income
         Redistribution of income
 Consumer surplus: difference between maximum amount consumers willing to pay
    for a given quantity of good and what they actually pay

2. Supply Theory
 Supply: quantity of a good or service producers are willing and able to offer for sale
    at each given price over a given period of time
 Determinants
         Price
         COP: change in price of factor inputs
         Other prices: joint / competitive supply
         Innovation: lower production costs
         Natural factors: climate, unexpected events
         Government policies: indirect taxes, subsidies
         Number of sellers
 Producer surplus: difference between amount received by producers and minimum
    amount they are willing and able to accept for the supply of a commodity

3. Market Equilibrium
 Buyers and sellers satisfied with current combination of price and quantity bought or
    sold, and are under no incentive to change their present economic actions

   Adjustment to equilibrium
         Below equilibrium
                 Shortage – consumers compete for goods, bidding up prices – price
                   increases, quantity supplied increases – shortage eliminated – market
                   settles at equilibrium
         Above equilibrium
                 Surplus - producers reduce prices to get rid of stocks – increase sales
                   and decrease production – price falls, quantity demanded increases,
                   surplus eliminated – market settles at equilibrium
   Shifts in supply and demand: consider individual effects on price and quantity then
    sum up
   Interrelated demand and surplus
         Joint / competitive / derived demand
         Joint / competitive supply

4. Case Study
 When asked to explain how a group of people intend to affect a certain market,
    bring in limitations
         Elasticity of demand
         Responses of other firms / groups of people
 Analyse theoretically first, then see how and why the data fits / does not fit the
 Desirability: consider for whom: producer, consumer, society
 Effectiveness: limitations, long run vs. short run

A manufacturer wishes to sell more of his product. How may he try to achieve his aim?

Sell more – only considering equilibrium quantity – increase demand / supply
Effect: long run vs. short run

1) Increase demand: explain effect on quantity demanded
     Advertising and promotion: create product differentiation and brand loyalty
         Competitive market: other firms will do likewise as they fear losing market
         Huge funds need to be devoted – increase COP – reduce profits
                 If firm passes cost increase to consumers in terms of higher prices –
                    fall in quantity sold – assuming demand elastic – total revenue falls
                 But unable to increase price in competitive market – firms may
                    engage in price wars
                 But in long run if campaign successful in altering people’s taste and
                    preference – rise in quantity sold
     Expanding number of markets: go regional / global
         Easier to penetrate markets where demand for product more price elastic
                 Increase supply – fall in price – more than proportionate rise in
                    quantity demanded
     Improve quality of product / increase product differentiation through better
        sales service / improved packaging
         Effect of money spent for r+d on
                 Costs then price of product
                 Market share in long run (increase)
     Deliberate attempt to reduce price of good through discounts
         Price elasticity of demand
         How long discount can be sustained without eroding profits

2) Increase supply: explain effect on quantity demanded
     Investment in r+d
         Lower COP, more efficient production methods, better quality products
     Raising productivity through greater specialization and better labour-capital
     Sourcing cheaper sources of raw materials
     Evaluation
         Reduces price – may conflict with profit maximization
         More effective strategy if selling product that is price demand elastic – mass
           produce – reap EOS – lower prices – increase sales volume more than

Chapter 3: Resource Allocation in Competitive Markets II

1. Price Elasticity of Demand
 Measure of degree of responsiveness of quantity demanded of good to a change in
    its price, ceteris paribus
 Coefficient: sensitivity of consumers to price changes
 Negative: inverse relationship between price and quantity demanded
 Determinants
          Availability of substitutes
          Necessities vs. luxuries
          Proportion of income
          Time period: longer – switch to substitutes – more price elastic
 Usefulness
          Government taxation policies: raise revenue, discourage consumption
          Firms’ pricing policy
          Effectiveness of trade unions: can ask for higher wages if demand for product
             is price inelastic
          Price stability: prices more volatile if demand more price inelastic when
             supply shock

2. Income Elasticity of Demand
 Measure of degree of responsiveness of demand of good to change in consumers’
    income, ceteris paribus
 Coefficient
         Negative: inferior good
         Positive: normal good
                Less than one: necessities
                More than one: luxuries
 Usefulness
         Production plans: boom vs. recession
         Targetting different income groups: segment market

3. Cross Elasticity of Demand
 Measure of degree of responsiveness of demand of good to change in price of
    another good, ceteris paribus
 Coefficient
         Negative: complement
         Positive: substitute
 Usefulness
         Effects on products’ demand when faced with change in price of rival’s
         Strong complements – can sell jointly

4. Price Elasticity of Supply
 Measure of degree of responsiveness of quantity supplied of good to a change in its
    price, ceteris paribus
 Positive: direct relationship between price and quantity supplied
 Determinants
         Time period: longer – supply more price elastic because possible to change
         Factor mobility
         Number of firms: more – supply more price elastic
         Stocks and spare capacity: more – can produce more – supply more price
         Length of production period: shorter – supply more price elastic
 Usefulness
         Taxation: incidence
         Price stability

5. Government Policies
 Taxation / subsidies
        Demand more price inelastic – higher incidence
              Incidence: distribution of burden between consumers and sellers
 Minimum price
        Protect income of producers
        Creates surplus for future shortages
        Financing annual surpluses – burden on taxpayers – not good in long run
        Cushion inefficiency
        New producers attracted – increase surpluses unless government has
          measures to increase demand
 Maximum price
        Lower-income consumers to afford necessities
        Protect consumers
        Allocation of goods may be biased
        Black market, especially during war time
        Government can encourage supply by drawing on past surpluses, giving
          subsidies and tax relief, reducing demand by controlling income

6. Case Study
 Note difference between elasticity of the product and the elasticity of the final
    product (which involves the use of the product)
 Note difference between less inelastic and more elastic
 When asked how a strategy might affect a company, consider effect on total
    revenue then profits

7. Essay
 Limitations to using elasticity concepts to explain price changes
         Elasticity concepts are static – need to relax ceteris paribus assumption in
          reality – simultaneous changes occur – need to consider relative magnitudes
          of changes in demand and supply
         Coefficients of elasticity mere estimates
         Consumers not homogenous group
               Among high-income earners, there are the yuppies seeking the high
                   life and are likely to be more price and income sensitive compared to
                   foreign investors who would consider socio-political factors
               May not consider some goods as substitutes

Explain price elasticity of demand and income elasticity of demand. [10m]

   Definition
   Formula
   Sign
   Coefficients: range of values for elastic / inelastic
   Examples with their estimated values

A government is proposing to increase the tax on petrol. Examine the relevance of
price elasticity of demand and income elasticity of demand for this proposal. [15m]

Assume specific tax for simplicity
Uses of petrol: firms’ and commuters’ transportation
Normal good: income increase – demand for cars increase – demand for petrol increase

1) Demand for petrol price inelastic: explain why
     Increase in indirect tax – supply falls at given price – supply curve shifts vertically
      upwards by amount of tax
     Demand for petrol inelastic – fall in quantity demanded less than proportionate
     Relevance: need high tax if government wants to reduce consumption to desired

2) Income elasticity of demand less relevant because it is due to changes in income – tax
on petrol affects price directly, not income
     Government likely to be less successful if they increase tax on petrol in period of
       economic boom
     Boom: incomes rise – demand for cars (luxury good) – increase by more than
       proportionately – derived demand – increase demand for petrol

The terrorist attack on New York on 11 September 2001 caused a worldwide recession
and an increased fear of flying, both of which severely affected the demand for travel
by air. This led to the closure of some of the major airlines in the world.

Assess the relevance of elasticity concepts in explaining the effects of these events on
the airline industry. [15m]

1) Price elasticity of demand
     Definition
     When supply of airlines fell due to closure of major airlines – price expected to
        increase – quantity demanded fall by more than proportionate – total revenue
     Relevance
         Airlines should expect that reducing supply causing a rise in price can lead to
             a fall in total revenue
         But the demand for travel for business is likely to be inelastic. So price
             increase – less than proportionate fall in quantity demanded – total revenue
         Effect on total revenue depends on size of business market vs. holiday
         Due to the ceteris paribus assumption, the above will only take place if other
             factors remain constant. In this context, incomes have changed causing
             demand curve to shift – total revenue fall

2) Income elasticity of demand
     Definition
     Air travel luxury good for most, necessity for business travelers
     Relevance
        Recession – fall in income – fall in demand – fall in total revenue
        Implication: individual airlines need to reduce price / engage in non-pricing
          strategies to increase market share

3) Cross elasticity of demand
     Definition
     Potential substitutes: train / coach / ship
        Degree of substitutability depends on the length of flight
                 Long haul flights: weak substitutes especially for business travelers
                 Short distance: stronger substitutes
     If another airline (eg. Qantas) reduces price to increase market share – fall in
       demand for a particular airline (eg. SIA) – SIA reduces price – price war – may not
       cover costs – erode profits
        Budget airlines also pose as competition

      Airlines close down routes / less schedules – fall in supply – increase price
        Demand inelastic: long haul flights – no close substitutes – total revenue
        Demand elastic: short distance flights – switch to trains / coaches – total
           revenue falls

4) Price elasticity of supply
     Definition
     Fall in price – fall in quantity supplied
     But short run: supply price inelastic – less than proportionate fall in quantity
     Reasons
         Labour: need time to retrench / reallocate labour to other departments
         Flight schedule / routes: need time to deliberate which routes / schedules to
            close – choose the unprofitable / lowest passenger volume

Cannot look at each value separately because in real world many variables change at the
same time

Chapter 4: Microeconomic Problems: Market Failure

1. Market Failure
 Scarce resources – need to allocate resources efficiently – objective: maximize
    society’s welfare (social optimality)
         MSB = MSC: benefit to society from one additional unit of good = cost to
            society of producing one extra unit of good
 Ways to allocate resources
         Total government intervention
         Free market (based on price mechanism)
         Mixed economy (free market with some government intervention)
 Free market economy
         Private ownership of resources + individual decision-making guided by self-
         Price serves as signal for resource allocation
         Automatic working of supply and demand – spontaneity – allocative
         Equilibrium where demand = supply: maximization of consumer and
            producer surplus
         Assumes no externalities + perfect competition
 Market failure occurs when
         Allocative inefficiency: externalities / public goods, imperfect competition
         Inability of market to achieve social objective eg. income equity

2. Externalities
 Cost / benefit on a third party not involved in the consumption / production of good
 Negative
         Types: industrial pollution, pollution and congestion from vehicles, demerit
            goods eg. cigarettes
                 External cost: second-hand smoke – health problems, fire hazard,
                   environmental cost – littering, anti-smoking campaigns – money
                   comes from taxpayers who largely do not smoke
         To tabacco company: profit-maximising private producer: MPB = MPC
         To society: to attain social optimality: equilibrium level MSB = MSC = MPC +
         Overproduction: deadweight loss
 Positive
         Types: merit goods eg. healthcare, education
                 External benefit: higher standard of living of everyone because of
                   highly-skilled jobs
         Under-production by free market: deadweight loss
 Because of partial market failure, government intervention comes in

3. Public Goods
 Non-excludable: impossible / costly to exclude non-paying consumers from receiving
    the good
 Non-rivalrous: consumption by one person does not reduce amount available to
 Eg. National defense
 Free rider – conceal demand – private producer cannot gauge demand – will not
    produce – non-production in free market – total market failure
 Government provision necessary since public goods are socially desirable and largely

4. Inequality
 Represented by the Lorenz Curve / Gini coefficient
 Singapore: 0.485 in 2007
 European countries: 0.25 – 0.3
 Latin America and the Caribbean: 0.6
 Average worldwide: 0.4

5. Essay
 When asked to suggest new policies, consider whether it is possible / practical to
    enact them
 Policies may be difficult to administer, and policing expensive
 Opportunity costs involved in attempted to control negative externalities
 Political implications eg. public satisfaction

Policies on Pollution and Evaluation Summary

1) Identify:   Taxation

Explain:       Tax polluters per unit of MEC – COP increases for private firms – supply
               falls from MPC to MSC by amount of MEC

Evaluate:      * Negative externality internalized by firm: incentive for firm to be more -
               cost-effective to maximize profits / reduce pollution
               * Provides revenue for government to finance other social and
               community development projects
               * Able to allow market to continue operating according to market forces
               and reach state of equilibrium
               x Requires accurate valuation of MEC / amount of pollution
                       - Over-valuation: output below socially optimal level, reducing
                       society’s welfare / deters production – affects economic growth
                       - Under-valuation: output still not brought to socially optimal level
               x Difficult to apportion blame
               x Effectiveness dependent on price elasticity of demand: if highly price
               inelastic, effect of tax on output ineffective unless tax very large / firm
               able to move burden to consumers and get away scot-free

2) Identify:   Quotas

Explain:       Ban production if pollution exceeds a certain limit – limits MEC by
               restricting output at socially optimal level
               Clearly defined amount of pollution each firm can have

Evaluate:      * Able to control level of pollution in the country as a whole
               X Does not allow price to equilibrate quantity demanded to quantity
               supplied: firms may decide to produce less so they do not exceed the
               maximum amount of pollution they can have (compare this to taxation)
               X Difficult and tedious to gauge how much pollution each firm produces:
               waste of resources and time on inspection
               X Need vigilance and commitment of government

3) Identify:   Legislation

Explain:       Force producers to bear costs of more proper disposal of industrial
               wastes eg. antipollution equipment

Evaluate:      x Difficult and costly: spend resources on inspection
               X If chances of being caught and penalties are small, legislation
               X Need vigilance and commitment of government
               X Not immediately effective because of bureaucracy involved in
               establishing laws
               X Lose voters leading to loss in power

4) Identify:   Nationalisation

Explain:       Government takes over the polluters’ firms and ensures production at
               socially optimal output

Evaluate:      x Waste of resources: opportunity cost to other projects because less
               funds available
               X Difficult to accurately valuate quantity demanded
               X No competition: inefficient, no innovation

5) Identify:   Campaign / advertisements to educate public

Explain:       Raise awareness of pollution situation to public in hope they might do
               something to curb problem

Evaluate:      x Costs of these measures might outweigh benefits
               X Duration needed before effects can be felt and there is no guarantee
               that the campaign will be effective
               X May be effective for only a short period of time because the public is
               constantly bombarded by such campaigns that it is starting to lose its
               intended effect

6) Identify:   Subsidies

Explain:       Subsidise purchase of antipollution equipment so that firms’ COP does
               not increase that much by purchasing these equipment – firms more
               likely to buy the equipment than before

Evaluate:      x Opportunity cost to other public projects
               X No guarantee that firms will buy the equipment
               X Firms need time to incorporate use of new equipment: but in the long
               run probably mitigates the problem of pollution if firms use the

7) Identify:   Urban planning

Explain:       Locate factories away from residential areas eg. Jurong Island
               Greenery (to reduce impact)

Evaluate:      x Merely shifting the pollution to another area – does not solve the root
               of the problem but reduces external cost since less people affected by
               X Contentious as to whether greenery helps to reduce impact

Summation:     Air pollution may not be due to the country itself, so need international /
               regional cooperation
               Can integrate a few policies for better results

Policies on Pollution and Congestion caused by Cars Summary

1) Identify:   ERP per tax unit

Explain:       Restricts car usage (nowadays rely more on this policy)
               Increases cost of car journey – quantity demanded for car travel falls

Evaluate:      x Congestion in other areas / small roads
               X Increase business cost – pass to consumers

2) Identify:   COE

Explain:       Restricts car ownership

Evaluate:      x Increasing affluence – income elasticity of demand for cars
               X Cannot stem people’s aspirations
               X Needs vigilance and political will (in other countries, government might
               not be able to have COE)

3) Identify:   Efficient and affordable public transport

Explain:       Less pollution and congestion on roads

Evaluate:      x Not all countries have resources to build an effective public transport
               system – LDCs: no money, DCs: complex commuting patterns
               X For it to be affordable, possibly need government to finance. Otherwise
               if left to the private firm, they would want to charge more to maximize

4) Identify:   Registration tax, annual road license

Explain:       Restricts car usage

Evaluate:      *May work if there is vigilance and commitment by government

5) Identify:   Rebates for green vehicles eg. 20% off purchase price

Explain:       Lower price – quantity demanded higher

Evaluate:      x Still not widely advocated
               X May still be too expensive to afford

6) Identify:   Weekend cars

Explain:       Restricts car usage

Evaluate:      x Still not widely advocated
               X People associate cars with prestige (eg. Americans love for SUVs)

Chapter 5: Government Intervention in the Market

1. Tacking Externalities
 Negative externalities [details on page 21-23]
 Positive externalities
         Subsidies: external benefit internalized (works like the tax)
                Can be easily implemented to bring about increase in production and
                Difficult to valuate external benefit generated
                High government expenditure – high tax rates can subsequently
                  discourage investment in country
                Firms lose incentive to be more productively efficient – inefficient
                  firms may survive
         Direct provision of merit goods
                Social justice: merit goods should be accessible to all and not
                  provided according to ability to pay
                Large positive externalities: eg. free healthcare combats spread of
                Dependants: eg. free education to protect children from irresponsible
                  parents who fail to provide children quality education
                Ignorance: consumers may not realize how much they will benefit and
                  if they had to pay, they would rather go without it

2. Government Failure
 Allocative efficiency reduced following government intervention to correct market
 Problem of incentives
         Imposition of high taxes can distort incentives
                High marginal tax removes incentive for people to work harder to
                   earn more
                Disincentive to produce and consume
         Desire by politicians to get elected: popular policies introduced (eg. minimum
            wage law)
         Profit motive of private sector largely removed
 Problem of information
         Difficult to valuate external cost / benefit
         Difficult to accurately estimate level of consumer demand for product
 Problem of distribution
         Increase inequity
         Eg. tax on use of domestic fuel (kerosene in Indonesia) – low income
            households may feel greatest effect as tax on fuel oil may make life of poor
            worse since they use proportionately more domestic fuel than others
 Bureaucracy and inefficiency: administrative costs; time lags
 Shifts in government policy: too frequent changes – difficult for firms to plan ahead

Chapter 6: Firms and How They Operate I

1. Production in the Short Run
 Short run: at least one fixed factor
 Long run: period of time long enough for all factors to vary, except level of
    technology, which varies in the very long run
 LDMR: as more units of a variable factor are applied to a given quantity of a fixed
    factor, there comes a point beyond which the extra output from additional units of
    the variable factor will eventually diminish
         Stage 1: TP increases at an increasing rate, MP rises – due to specialization of
         Stage 2: TP increases at a decreasing rate, MP falls, LDMR sets in – due
            inefficient use of fixed factor
         Stage 3: TP falls, MP falls
         MP = change in TP / change in L

2. Theory of Costs in the Short Run

Factor     Total Fixed Cost              Total Variable Cost            Marginal Cost
Definition Sum of all costs of           Costs incurred for use of      Additional cost incurred in
           production do not vary        variable factors like labour   producing an extra unit of
           with the level of output      Varies     directly     with   output in the short run
           aka overhead costs            output level                   while some inputs remain
           Must be paid even                                            fixed
           without production                                           MC = change in TC /
                                                                        change in Q
Examples    Rent of factory building, Raw materials, labour
            interest     on    capital
            invested in equipment


Average   AFC: amount of fixed               AVC: total variable costs
curves    costs per unit of output           per unit of output
ATC     = AFC = TFC / Q                      AVC = TVC / Q
AVC     +

   Stage 1: AVC falls, AFC falls. Since AFC and AVC fall, ATC also falls
   Stage 2: AVC rises, AFC falls. Since fall in AFC > rise in AVC, ATC still falls
   Stage 3: AVC rises, AFC falls: Since fall in AFC < rise in AVC, ATC rises

3. Objectives of Firms
 Profit-maximisation: equilibrium level of output since there is no tendency to change
         Before equilibrium level, MR > MC so firms want to produce more
         After equilibrium level, MR < MC and rational firms will not produce at this
           output level
         Firm continues production as long as it can cover variable costs
 Motivation of owners vs. motivation of managers: separation of control and
    ownership – principal-agent problem: managers tend to pursue their alternative
    goals while maintaining minimum level of profits to appease shareholders
 Revenue maximization: managers aim to maximize firm’s short run total revenue
 Long-run profit maximization: managers aim to shift cost and revenue curves so as
    to maximize profits over some longer time period
 Growth maximization: managers may aim for expansion to maximize growth in sales
    volume over time

4. Theory of Costs in the Long Run
 Returns to scale: measure of resulting change in output when all inputs are changed
    in the same proportion (can be increasing, decreasing or constant)
 LRAC: lowest average cost for given level of output when all inputs are variable
 Minimum efficient scale: smallest plant size beyond which no significant additional
    IEOS can be achieved
 IEOS: savings in costs that occur to a firm due to the firm’s expansion, and have been
    created by firm’s own policies and actions
         Technical: concerned with production process
                 Factor indivisibility economies: larger plant size makes it possible to
                    effectively use indivisible factors (combine harvesters, power
                    transmission: large and costly) – raises average output and reduces
                 Specialisation of labour: simpler and repetitive jobs which require less
                    training + more efficient eg. car manufacturing
         Managerial: functional specialization by employing experts to increase
            efficiency as a whole
                 Greater use of existing staff
                 Decentralisation of decision-making: increasing efficiency of
                    management because of faster flow of information within firm –
                    distortions and delays of information avoided
         Commercial
                 Bargaining advantage and accorded preferential treatment by
                    suppliers because they buy raw materials in bulk
                 Bulk sales from bulk advertising and large-scale promotion

         Financial
                Easier and cheaper to raise funds: given lower interest rate and larger
                  loans because better credit ratings and more collateral
                Raise capital through issue of shares to public who has more
                  confidence in reputed firms
         Risk-bearing
                Advantage in bearing non-insurable risks eg. conditions of demand for
                  final products and supply of raw materials
                Diversification of products and markets
                Diversification in sources of supply
         R+d
                Better quality products – increased market share and demand
                Better methods of production – more productively efficient – lower
                  average cost
         Welfare: making workers feel they belong to the company – more apt to
           increase efficiency and productivity of company
   IDOS
         Complexity of management
                Principal-agent problem
                Bureaucracy
         Strained relationships: impersonal – no loyalty to firm – apathy, strikes
   EEOS: savings in costs that occur to all firms in an industry due to the expansion of
    the industry
         Economies of concentration
                Availability of skilled labour: demand for labour large enough –
                  special educational institutions / firms can collaborate to develop
                  training facilities
                       No lack of labour to employ because experts want to migrate
                           there eg. Silicon Valley
                Well-developed infrastructure to cater to that industry
                Reputation: builds up name which consumers associate with quality –
                  encourages brand loyalty and steady clientele
         Economies of disintegration
                Subsidiary industries developed to cater to needs of major industry
                       Eg. car industry in Japan: range of firms specialize in
                           production of different inputs for car manufacturing – provide
                           output at lower prices to main industry because specialization
                           allows subsidiary firms to produce at large scale – enjoy EOS
                Process waste products into useful products and sell them to cover
         Economies of information: publications help improve productivity of firms
           (research and expertise)

   EDOS
        Increased strain on infrastructure: taxed to limits eg. congestion – loss of
         time and increased fuel consumption
        Rising costs of FOP: growing shortage of specific raw materials / skilled

5. Growth of Firms
 Methods of growth
        Internal expansion: make more of existing product or extending range of
          product when it builds a new bigger plant
        Merger
                Vertical integration: firms engaged in different stages of productive
                      Backward integration vs. forward integration
                      Eg. Starbucks merge with firm producing coffee beans – wants
                         guaranteed access to raw materials
                Horizontal integration: firm takes over similar firm at same stage of
                  production in the same industry
                      Eg. Coffee Bean and Starbucks merge
                      Eg. DBS and POSB
                      Market domination
        Conglomeration
                Eg. bank taking over developing firm to build properties
                Diversify output

6. Survival of Small Firms
 Demand-side factors
         Nature of product
                 Bulky and perishable goods: small, localized markets eg. fresh fish
                 Variety preferred to standardization eg. fashion
                 Specialised products: limited markets eg. highly specialized machines
         Prestige markets: limited by price eg. sports cars, luxury yachts
         Direct and personalized services eg. lawyers, doctors
         Geographical limitations: high transport costs for bulky products – local
            market rather than national market
 Supply-side factors
         DEOS set in early: optimum size of firm small
         Vertical disintegration: entire production process broken into series of
            separate processes and different small firms perform each process
         Low BTE
         Lack of capital

        Unwillingness to take greater risks
              Larger firm – higher expenditure – greater risk of investment
              Fear of future fall in price of final product: expansion of output –
                 increase market supply – excess supply – lower prices and lower
        Banding: small firms may band to gain advantages of bulk buying while still
         retaining their independence
        Profit cycles: early stage of product cycle – total demand for product low
        Non-profit maximization attitudes
              Owner values independence or wants to maintain control among
                 family members
              Contented with reasonable income from domestic market
              Unwilling to take increased risks associated with expanding into
                 foreign market

7. Case Study
 Factors: think long run vs. short run, demand-side vs. supply-side
 EOS – lower LRAC – able to reduce price
        Profits plough to r+d – better quality products + further reduction in AC
        Block new entrants due to enormous FC – less existing competitors –
           increase market share
 Always end EOS with AC
 If a particular industry is stated in the extract, try to give egs of EOS specific to the

8. Essay
 Survival of small firms: for conclusion, use banding / small firms may want to merge
    in the face of globalisation

Discuss whether rising costs limit the size of firms over time. [15m]

 Size: sales revenue / turnover, level of output, market share
 Over time – long run – firm no longer constrained by fixed factor

1) Can limit
     Short run cost
         Reason: over-use of fixed factor, inefficient labour-capital combination –
            increase MC – eventual increase in AC
         Increase costs – fall in profits if total revenue is constant – constrain firm’s
            ability to expand

2) Will not limit
     Long run
         All inputs can vary – firm can expand – enjoy fall in LRAC due to internal EOS
            (list 2 egs)
         Fall in LRAC – fall in price to ward off competitors (erecting barriers to entry)
            – increase profits – plough into r+d – better quality products + if yields results
            – further fall in AC due to better production methods
         Size of firm determined by demand for firm’s product – if firm making
            supernormal profits – can still expand in size even if cost increases eg.
            monopoly selling unique products

Conclusion: However, size of firm over time constrained by MES (list 1 eg of internal
DOS). MES huge eg. electricity / water compared to MES limited eg. fashion.

Banking Merger in Singapore Analysis

Why merge?
   Face competition from foreign banks – Singapore wants to expand beyond our
     shores: big – enjoy EOS – fall in AC – can compete with foreign banks
   Core part of Singapore economy – 1997 Asian financial crisis – big  stable

Why should not merge?
   Possible monopoly power
       Increase price
       Quality of service
              Reduction / removal of familiar products and services – affects
                consumer satisfaction
              Neglect lower-income group
   Retrenchment

Chapter 7: Firms and How They Operate II

1. Comparison of the 4 Markets

Type             Perfect Competition       Monopoly                        Monopolistic Competition     Oligopoly
Number of         Large                    Only one firm                  Large                       Few large firms
buyers / sellers  No one buyer / seller    Firm price setter              FOP relatively mobile       Interdependent
                    can influence price                                     When firm makes
                  Firm price taker                                          decisions, does not
                                                                             have to worry how its
                                                                             rivals will react
Barriers to        None                      High                         No / Low                      Substantial
entry              FOP perfectly mobile      Natural: huge sunk costs  Firm lowers price –              Natural
                   No transaction /           (AFC falls over very          profits spread thinly         Artificial: legislation,
                    transportation costs       large output – AC falls       over many rivals –             collusion / mergers,
                   Minimal sunk costs         continuously – enjoys         rivals suffer negligibly       non-price
                                               huge IEOS), exclusive        Retaliation unlikely           competition,
                                               ownership of essential       No collusion – keen            advertising
                                               raw materials                 competition
                                              Artificial: non-price
                                               competition, contrived
                                               barriers (cartel), legal
                                               protection: exclusive
                                               rights (patents, tariffs to
                                               block foreign firms)
Nature of          Homogeneous               No close substitutes         Differentiated:               Homogeneous /
products           Buyers no preference      CED and PED very low          quality, design,               differentiated
                    for any firm                                             location, promotion
                                                                            Demand price elastic

Knowledge         Perfect                       Imperfect                    Imperfect                    Imperfect
                  Seller knows rivals’          Consumers not fully          Production methods and
                   prices, market costs and       aware of COP                  prices
                   available technology                                        Cost structures differ as
                  Buyers know all sellers’                                     some firms enjoy more
                   prices, quality and                                          favourable locations /
                   availability of products –                                   rentals
                   will not purchase at a
                   higher price than
                   equilibrium price
Firm’s curve

                                                                               P > MR                       P > MR
                  P = AR = MR                   P > MR                       Some degree of control       Firm increases price –
                                                 Cannot increase both          over own prices               other firms will not
                                                  output and price at the      No single equilibrium        Firm decreases price
                                                  same time as curve is         price in market – no          – other firms follow –
                                                  downward sloping              market demand curve           may lead to price war
                                                                                                             Price rigidity: menu
                                                                                                              costs, fear of harming
                                                                                                              firm’s image (fall in
                                                                                                              price – fall in quality)

Examples         Stock market                Utilities                     Bubble tea                  UK brewery industry
                 Forex market                Starhub’s EPL coverage                                     Taxi companies
                 Agricultural products:      SMRT for NS and EW                                         OPEC
                  many farmers in LDCs         lines                                                      Mobile service
Firm’s SR                                           Supernormal, normal / subnormal profits
equilibrium                                            MC = MR and MC must be rising
Firm’s LR        Normal profits              Normal / supernormal      Normal profits                  Normal /
equilibrium      New firms will enter         profits                                                     supernormal
                  industry to erode           Firm will shut down if
                  supernormal profits          subnormal profits

Productive       Efficient                   Inefficient unless by       Inefficient               Inefficient unless by
efficiency       Firm produces at MES         coincidence                 Will settle at LRAC that    coincidence
                                                                            is not necessarily at
                                                        Firm’s POV: all points on LRAC
                                                            Society’s POV: MES
Allocative       Efficient                                                     Inefficient
efficiency       P = MC                                                          P > MC
                                                      Could be seen as premium society pays for product differentiation

2. Analysis of Imperfect Market Structures

Type          Monopoly                                  Monopolistic Competition                Oligopoly
Economic       Allocative inefficiency: P > MC,         Allocative inefficiency: P > MC        Allocative inefficiency: P > MC,
efficiency      output below optimum                     Productive inefficiency: do not           output below optimum
               Productive inefficiency                   utilise optimal plant capacity, do     Productive inefficiency
               X-inefficiency but increasingly           not exhaust potential for further      Dynamic efficiency: r+d
                reduced due to globalisation,             EOS because all small firms
                reduced customs duties and               Dynamic inefficiency: no r+d
                barriers to trade
               Dynamic efficiency: r+d
Variety of     Unique                                     Large variety – increase in            Differentiated
products       Possible innovation and new                 consumer welfare
                products: BTE stimulus to the
                creativity required to destroy
                barriers – monopoly profits
                stimulates new entrants
                producing new and competing
R+d and        Profits lead to unequal income             More equity: no redistribution of      Supernormal profits ploughed into
new profits     distribution: dollar votes + shift of       income from consumers to                r+d
                consumer surplus to producer                shareholders
               Supernormal profits – plough into          Normal profits: no additional
                r+d – better quality products +             profits to plough into r+d
                better methods of production –
                lower AC but there is no
                guarantee that monopolies will do

Theory vs       MES high – IEOS – lower MC than           Wasteful competition                High price rigidity: price stability
empirical        PC industry – lower P and higher          Advertising provides better         Wasteful competition: more likely
evidence         o/p but monopolies charge high             consumer information which           to engage in extensive advertising
                 prices by restricting output               helps move market structure          – encourages price competition,
                                                            closer to PC model but loss of       with increased sales volume and
                        MCpc                                consumer sovereignty                 reaping of EOS, price reduce
                 Pc                                                                              further
                                                                                                But possible monopoly power
                                                                                                 through collusion
                                                                                                But multiple branding gives
                               MR         AR                                                     consumers misguided information
                   0                                                                             in thinking products are from
                       Q Q                Q
                Practise price discrimination [has
                       c m                                                                       different firms
                 both costs and benefits]
                Natural monopolies
                Perfectly contestable markets:
                 costs of entry and exit by
                 potential rivals are zero, and when
                 such entries can be made very
                 rapidly eg. deregulation of airline
                 industry in 1978
                Hit and run competition: market
                 contestable for certain seasons
                 eg. parcels service during festivals
                Reduces wasteful competition
                 (instead of extensive advertising,
                 money can be spent to produce
                 more goods)

3. Price Discrimination
 Producer sells specific commodity to different buyers at two or more different prices
 Same consumer charged different prices for same product for reasons not
    associated with cost differences
 Conditions
         Possible
                 Seller has control over market supply
                 Market segmentation and identifiable groups + no resale
         Profitable: each market as different PED
 First degree
         Practice of charging each customer his reservation price
         Captures all consumer surplus as revenue
         Eg. auction sites
         Impractical to charge each customer a different price
         Firm usually does not know the reservation price of each
            customer: consumers do not tell and producers may not
            want to spend time and resources to find out
 Second degree
         Charge different prices for different blocks of the same
            product to the same buyer
         Eg. photocopying shops
 Third degree
         Sells same product at different prices to different customers
         Conditions
                 Two or more markets which can be separated
                 PED of each market must be different
         Higher price charged in market with more price inelastic demand

   Cost: loss of consumer surplus
   Benefits
        Firm: higher profits and may use these profits from one market to withstand
            possible price war in breaking into another market
        Consumer
                 Consumer may not have been able to afford good otherwise

 Higher profits may be reinvested into r+d – better quality products +
  better methods of production
 Provision of goods that would otherwise not be produced due to high
  costs if production and consumption of good is one that confers
  positive externalities on society
      Additional profits might exceed losses such that firm will still
          continue producing the good

Discuss the view that the profit motive will always lead to a few large firms
dominating the market for each and every type of product. [15m]

1) Barriers to entry
     Few large firms merge – greater market share – reap EOS – fall in LRAC – fall in
        price – ward off rivals / block new entrants (natural BTE) – able to maintain
        supernormal profits
     If plough into r+d – better methods of production – further fall in AC - make
        more profits
     But some industries have low BTE (technology easily replicated) – low sunk cost
        eg. retail, grocery

2) Market size
     Small: eg. Singapore television broadcasting Mediacorp vs. Mediaworks
        Firms will eat into each other’s market share – erode profits – so to keep
           profits just let one firm dominate
     Market big: eg. US then can afford to have few large firms

3) Nature of product
     Large firms: unique products with no close substitutes
     Small firms: availability of substitutes, prestige market / services, localized
       demand, perishables, limited MES – fashion, specialization, personalized services

4) Government Intervention / public’s desire
     Few large firms will help to reduce price – increase in consumer surplus –
       increase in consumer welfare
     Supernormal profits – plough into r+d to produce better quality products
     Will still have competition unlike monopoly – still have the incentive to be more
       cost-efficient / innovative

Explain what is meant by productive and allocative efficiency. [10m]

1. Allocative efficiency
     Definition: situation in which it is impossible to change the allocation of
        resources in such a way as to make someone better off without making someone
        else worse off
     Assumption: no externalities / public goods – P = MC – right amount + type of
        good produced to maximize societal welfare

                                                     S (MC)

                                                     D (MB)

                          0                         Quantity
        If MB < MC, last unit of good less than opportunity cost of producing that
          unit – society benefits from not producing that last unit
        If MB > MC, last unit of good more than opportunity cost of producing that
          unit – society benefits from producing that last unit
      Assumption aside, MSB = MSC
        Perfect competition: firm price taker
        MR = MC = P – allocatively efficient


                       P1                                     MR

                            0                   Q1      Quantity

2. Productive efficiency
     Long run concept
     Firm’s POV
        Any given level of firm’s output produced at lowest possible AC – all points
           on LRAC curve are productively efficient
     Society’s POV
        LRAC minimum – firm is at optimum size / MES – all IEOS exploited



                    P1                                     MR

                         0            Q1             Quantity

‘A firm should be encouraged to maximize profits because this makes it efficient.’
Discuss whether this argument is true for a firm operating in an imperfect market.

*When comparing efficiency, only talk about long run

1) Allocative efficiency: P > MC true for all imperfect markets because they are price
setters – deadweight loss to society – allocatively inefficient

2) Productive efficiency: Not operating at MES (where LRAC cuts MC) – not fully
exploited all IEOS – productively inefficient
                                          Triangle = DWL


                                            MR                AR

                      0             Qm Qc                     Quantity
        PC industry needs to be at MES because it needs to be as cost-effective as
         possible – price taker – cannot pass cost increase to consumers
        Vs. imperfect market need not be at MES because price setter – can pass cost
         increase to consumers

3) X-inefficiency
     Monopoly: lax in cost control – no existing competition – can pass cost increase
        as price increase
     But monopoly can also be cost efficient due to fear of new entrants
         Globalisation and international competition
         If market is contestable
         Force monopoly to be cost efficient
     Oligopoly more likely to be cost-efficient compared to monopoly but wastage of
        resources – large scale advertising / promotion – increase cost for firm and
        opportunity cost to society as the money could have been used to produce more

4) Dynamic efficiency
     Supernormal profits in long run – able to invest in r+d – better methods of
       production – fall in AC in very long run
     Vs. PC industry: no dynamic efficiency

Distinguish between monopolistic competition and oligopoly. [10m]

Type         Monopolistic competition       Oligopoly
Number of     Many – one firm’s             A few large firms – interdependence –
sellers        action less likely to            one firm’s action likely to evoke
               affect others                    responses from rivals
Nature of     Differentiated eg.            Homogeneous / differentiated eg.
product        retail: restaurants –            mobile service provision, petrol
               affect demand curve –            companies / taxi companies, OPEC –
               demand price elastic             kinked demand curve
             P/R/C                               P/R/C

                                  AR            Pe

             0                   Quantity                         AR

                                                 0                            Quantity

                                                Firm increase price: rivals will not follow
                                                 – quantity demanded for firm’s product
                                                 falls more than proportionately –
                                                 demand price elastic
                                                Firm reduces price: rivals likely to follow
                                                 – price war + quantity demanded for
                                                 firm’s product increases less than
                                                 proportionately – demand price inelastic
Non-pricing     Smaller scale                  Larger scale
Likelihood      Less                           More: large market share
of colluding
BTE             Low / no – low sunk            High – natural: high sunk cost eg.
                 cost + technology               utilities, telecomm – TFC very huge –
                 easily replicated – long        LRAC keeps falling – enjoys huge EOS –
                 run normal profits              very low LRAC– new entrants cannot
                                                 produce at such low LRAC
                                                Artificial: patents
                                                Ensure supernormal profits in long run

Explain why oligopoly is a common market structure in many economies. [15m]

1) Firms want to be big to maximize profits
     Merger of small firms – EOS – fall in LRAC – fall in price – ward off rivals + block
       new entrants
     Monopoly – attracted by supernormal profits – monopoly loses its power

2) Society may desire oligopolies
     Oligopoly – competition – greater innovation through r+d which monopolistic
        competition cannot afford since it only makes normal profits
     Vs. monopoly – lax – X-inefficiency

3) Government’s intervention
     Singapore government – face of international competition in a free market, local
       firms have to be big eg. banking – go regional – liberalization and deregulation of
       industries: mobile service industry, taxi companies
     Firms prefer operate in oligopolistic structure rather than monopolistic:
       monopolies more closely watched by government vs. oligopolies harder to
       observe whether they are colluding

4) Some industries due to huge sunk cost – oligopolistic / even natural monopoly eg.
utilities, telecommunications, transport, TV broadcasting in Singapore since market size
is too small – one single player most efficient

Explain why governments throughout the world have been involved in the supply of
services such as electricity. [12m]

     Government – social benefits + social costs which private firms unlikely to take
       into account
     Electricity – essential good for households and businesses

1) Could be a natural monopoly
     Market size cannot operate with more than one player at MES: huge sunk cost –
       AC keeps falling – private firms likely to be monopolistic – charge very high prices
       – need for regulation



             Pc                                                 AC

                                 MR               AR            MC
                  0       Qm             Qc                     Quantity

2) Private – does not cater to lower income group vs. government more likely to do so

3) Huge initial investment – private firm likely to charge higher price to cover costs vs.
government can subsidise from revenue / taxes

4) If there is competition among a few private firms – wastage + duplication of resources
vs. government: save costs for advertising

5) Earns revenue for government since it is essential

Main point is that government does not want to risk anything because electricity and
similar services are so essential

Chapter 8: Government Intervention in the Market II

1. Regulation of Natural Monopolies
     MC pricing: monopoly charge a price that is equal to MC in order to achieve
       allocative efficiency
        But monopoly incurs a loss – shut down – public deprived of vital service
        Need to be supplemented with government subsidies: costly to government,
           burden on taxpayers
        2-tier pricing: consumers pay a fixed sum of money for access to service and
           price per unit consumed to cover marginal cost
                Eg. electricity, gas
                Producer meets all COP and minimizes loss of social welfare
     AC pricing: monopoly charge a price equal to AC – lower price and greater
       output – increase in society’s welfare
        Normal profits – viable in long run
        Still not allocatively efficient
        Firms no incentive to keep costs low since price is at whatever AC they are at
     Problems
        Difficult to obtain accurate information on demand and cost estimates: firms
           tend to overstate cost, market conditions change constantly, costly to
           acquire new information
        Regulatory lag: firms may have to operate at a loss during time lag
        Costly to administer

2. Taxation
     Lump-sum tax on monopolist’s excessive profits – shifts AC curve upwards –
       profits reduced – normal profits
     Redistribute income from producer to consumer
     Use tax revenue to subsidise welfare schemes / production of merit goods
     May create disincentive for monopolist to be cost-efficient
     Monopoly can pass burden to consumers due to price inelastic demand
     Dynamic efficiency compromised

3. Legislation
     Anti-trust laws: Anti-trust Act (US) / Competition Law (Singapore): break up
         Eg. Microsoft Corporation: one firm own Windows operating system, the
            other will own applications
     May not be applicable to natural monopoly / monopolies with great incentives
        to undertake r+d
     Forbidding certain practices: eg. predatory pricing: setting price below COP to
        eliminate competition

      Imposing standards of provision eg. Public Transport Authority in Singapore
       governs standards of public transportation to ensure guaranteed quality of
      Insisting on certain levels of competition in industry: Singapore government
       increasingly deregulates monopoly

4. Nationalisation
     Growth
         Industries with major investment eg. steel and coal industry, large spending
           on r+d required
         Unfair competition of state-owned enterprises with private sector
     Efficiency
         Natural monopoly, presence of positive externalities, eliminate wasteful
         Lack of competition pressure – lack of incentive – X-inefficiency
         Bureaucracy – heavier burden on tax payers
         Sunset industry
         Decision may be made for political rather than economic reasons eg. just to
           keep employment figures high
     Equity
         Special pricing policies eg. free bus rides for pensioners
         Service which would otherwise not be provided eg. bus route to remote
         State monopoly no less disadvantageous to consumer than private one – no
           higher authority to maintain checks and balances
     Stability
         For strategic reasons eg. national defence
         Seen as a move towards communism

5. Privatisation
     Competition
         Increased competition – cost efficiency + benefits for consumers eg. lower
            prices, wider choice, improved quality
         Unfair competition of state-owned enterprises with private sector
         Could be worse outcome
                 If state monopoly replaced with private monopoly, possibly lower
                    output and higher price
                 If high BTE

   Efficiency
     Greater efficiency
             Commercially sounder decision making eg. higher returns on
             Greater accountability to public – constantly need to perform well or
               risk takeover by another firm
     Natural monopolies, externalities, equity issues
   Revenue
     Revenue from selling state assets
     Higher corporate tax receipts if privatized company is profitable
     Long term loss of revenue had the privatized firm been profitable

J2 Topics

No.                                      Title                                      Page No.
29    Chapter 9: Key Economic Indicators                                             50-51
30    How far can this information lead you to conclude that there is a rising       52-53
      standard of living in Singapore?
31    Discuss the factors that contribute to economic growth in a country.            54
32    Chapter 10: Income and Employment Determination                                55-58
33    Explain what information an economist would require to decide whether           59
      the US needed ‘an economic stimulus’.
34    Explain what is meant by the equilibrium level of national income.              59
35    Analyse the effect on the equilibrium level of income of an increase in         60
      the level of savings and an increase in the level of exports.
36    Discuss the extent to which the US fiscal stimulus might lead to a              61
      sustained increase in national income.
37    What are the main causes of Singapore’s recessions?                             62
38    Chapter 11: International Economics                                            63-66
39    Explain the theory of comparative advantage.                                    67
40    To what extent does the theory of comparative advantage explain the            68-69
      pattern of trade between Singapore and the rest of the world?
41    Discuss whether protection offers any advantages over specialization.          70-71
42    Explain the rationale for free trade and discuss the extent to which FTAs      72-74
      are beneficial.
43    To what extent can economies benefit from globalisation?                       75-76
44    Discuss the opportunities and threats of globalisation for Singapore and        77
      other Asian economies.
45    Consider the effects, other than on the general price level, of Singapore’s     78
      changing tax structure.
46    Policies to remedy Singapore’s recession                                        79
47    Evaluate methods the Malaysian government might use to slow down                80
      import growth and increase new export business.
48    “To be considered successful, an economy needs to achieve low                   81
      unemployment, low inflation and stable economic growth.” How far do
      you agree with the statement?
49    “To be considered successful, an economy needs to achieve low                   81
      unemployment, low inflation and stable economic growth.” Explain this
50    Discuss whether fiscal policy is the most effective way for Singapore to        82
      sustain a successful economy.
51    In the fourth quarter of 2004, Singapore’s unemployment rate rose to            83
      3.7%. Discuss whether supply-side policies are the best way of achieving
      full employment in Singapore.
52    Why Singapore does not use interest rate policy                                 84
53    Problems with exchange rate instability                                         84

Chapter 9: Key Economic Indicators

1. Key Macroeconomic Aims
 Strong sustained economic growth
 Low inflation
 Low unemployment rate
 Healthy BOP

2. National Income Statistics
 Gross domestic product: value of all final goods and services produced within a given
    country during a given period of time
         Measure economic growth
         Limitations
                 Understate nation’s output: omission of non-market activities
                   (voluntary welfare services) and underground economy
                 Difficulties in measuring SOL
                        Leisure time
                        Externalities
                        Production does not equal consumption: expenditure could be
                           for potential growth
                        Income distribution
                        Other social factors: eg. crime rates, freedom
                 International comparisons
                        Difference in account procedures and items included
                        Exchange rates: need to use PPP
                        Population: need GDP per capita
                        Difference in climate and culture: different needs – different
                        Difference in underground economy: Sweden’s underground
                           economy 13% of GDP
         Alternative measures of SOL
                 HDI: life expectancy, education, GDP per capita at PPP rates
                 MEW: leisure, GDP per man hour
 Gross national product: value of all final goods and services produced by residents of
    a country, regardless of the location of production, during a given period
 Net national product: GNP – depreciation
 Nominal: at current prices vs. real: at constant prices

3. Inflation Rate
 CPI: measures change in price of fixed basket of goods and services commonly
    purchased by households in a specified time period
 Limitations
          Not an accurate measure of COL
          Substitution bias: consumers substitute toward goods that have become
            relatively cheaper – overstates COL
          Quality adjustment: CPI increase might be due to quality adjustments –
            overstate inflation
          New products: price declines sharply a few years after introduction – not
            added to market basket until years after introduction – price declines not

4. Unemployment Rate
 Unemployed: people aged 15 and over who are without work but were available for
    work and were actively looking for a job
 Frictional unemployment: unemployment because time taken for workers to search
    jobs and for firms to search for suitable workers
 Structural unemployment: workers do not have the skills needed to obtain long-
    term employment
 Cyclical unemployment: unemployment during recession

5. Balance of Payments
 Record of country’s international transactions
 Current account
         Visible: imports and exports of goods and services – BOT
         Invisible: profit repatriation, interest, dividends, unilateral transfers
 Capital account
         Portfolio: bonds, shares, money in banks
         Direct: FDI
 Financial account: something like bank reserves

Singapore has enjoyed another year of robust growth in 2007, and the real GDP
growth was 7.5% for the year. A record 172000 jobs were created in the first 3
quarters. However, in recent months, inflation has picked up and the inflation rate for
the month of November alone was 4.2%.

How far can this information lead you to conclude that there is a rising standard of
living in Singapore? [25m]

 SOL – material and non-material well being of each citizen

A) Material well being
 Real GDP per head: on average how much goods / services each citizen gets to
       Real: adjusted for inflation as converted to constant prices
       High for a developed country
       Limitation: does not show effect of changes in population size
       Per head: effect of population size eg. if GDP increases by 7.5% but
           population increases by 9%, GDP per head falls
       Singapore: over 1 year: changes in population size little but could have been
           some increase due to open-door policy
 Income gap – Gini coefficient
       Gini coefficient globally used as a measure of income disparity, with 0
           indicating perfect equality and 1 perfect inequality
       Singapore: 0.52 in 2006
       Increasing gap in Singapore due to globalisation: displaced by machines,
           structural changes, influx of foreign workers, outsourcing
 Type of spending
       Capital vs. consumption goods
       Government spending
       Defence vs. spending that directly increases SOL
 172000 jobs
       High incomes – increase consumer spending which increases demand for
           goods and services, generating more jobs and employment
       Due to investments by foreign companies eg. in 2007 plant specializing in
           harnessing solar energy set up in Singapore – indicates investor confidence
       Limitations: 60% jobs went to foreigners, number of jobs destroyed vs.
           number of jobs created, size of labour force may have changed so it is not
           that unemployment rates fell, composition of jobs (for lower-skilled
           workers?), ratio of dependants to working population

   Inflation rate
         Real: adjusted for inflation
         Cause: mainly cost factors like high imported oil price, imported food
            shortages, partly GST
         Lower-income group suffers more in the face of further increase in prices /
            income gap

B) Non-material well being
 Education – literacy rate
        Singapore: high literacy rate due to compulsory primary education, heavily
        Government emphasis on upgrading of skills and training subsidies to firms
         for such purposes
 Healthcare – infant mortality rate / life expectancy
        Singapore: individual responsibility + government spending – 3M framework
         – Medisave, Medishield, Medifund
        Avoid excessive burden on state and tax payers
        With increasing medical costs + ageing population, QOL of some (lower-
         income group?) may be affected
        Means-testing
 Leisure: GDP per man hour
 Others: negative externalities eg. pollution

 Other indicators: HDI, MEW, GNP

Discuss the factors that contribute to economic growth in a country. [12m]

 Economic growth measured by GDP growth rate and is the means to improve living

1) Quantity and quality of resources
 Quantity and availability enhance growth potential
        Land: includes natural resources like mineral deposits and oil eg. oil-rich
           Saudi Arabia
        Labour – labour-abundant countries like China and India
        Entrepreneurship – availability of talents and risk-taking individuals eg. self-
           made entrepreneurs in Hong Kong
 Quality can be enhanced through government effort and policies
        Increase labour productivity through training and education
        Entrepreneurship
        Capital – government efforts to make it more conducive for fixed capital

2) Role of government
 Augment quality of labour through education and training
 Strategise economic direction eg. change structure of economy in face of loss of
    comparative advantage and nurture comparative advantage in new areas
 Conducive environment for business
         Political stability
         Price stability: reflection of good macroeconomic management by
            government, competitive price and lowered COP – ability to attract FDI due
            to lower wages
         Efficient infrastructure
         Attractive corporate taxes
         Less bureaucracy and red tape
         Ability to explore new markets / help businesses go global

3) Level of consumption, investment and government spending in economy
 High consumption conducive when economy has unutilized resources while high
    savings conducive when economy near or at full employment
 Savings provide investment funds necessary for growth
 Government fiscal and interest rate policies
 High export revenue due to competitiveness

Chapter 10: Income and Employment Determination

1. Aggregate Demand
 Total level of spending in an economy
 AD curve slopes downwards because
        Wealth / real balance effect: GPL higher – purchasing power of financial
           assets falls – discourages domestic consumption – lower level of output
        Interest rate effect: higher GPL – increase demand for money from
           households and firms + might shift wealth out of financial assets – decreasing
           supply of loanable funds – increase in interest rates – more expensive to
           purchase goods and services on credit – households purchase less goods +
           businesses invest less – lower national output
        International substitution effect: higher GPL – locals buy more foreign goods
           + foreigners buy less domestic goods – net exports fall – lower national
 Factors that cause a shift
        Changes in expectations: income and profits, real wealth, inflation
        Changes in government policies
        Changes in world economy: income abroad, foreign price level, exchange

2. Aggregate Supply
 Total output of goods and services that firms as a whole would like to produce and
    sell at each possible price level
 Shape
          Horizontal: producers can produce all they want due to abundant resources
          Upward sloping: output rises but pressure on prices
          Vertical: need time to adjust to new cost structures
 Factors that cause a shift
          Change in input prices
          Change in quality of labour input
          Change in expected rate of inflation
          Change in technology
          Government policies (local and foreign)

3. Consumption Function
 Act of using income for the purchase of goods and services to satisfy current wants


                                                         C = a + bY


                     W = dissavings, X = breakeven point, Z = savings

   C = a+bY
         a represents autonomous consumption: level of consumption that does not
           vary with income – still need to consume even though no income
         bY represents induced consumption: household expenditures that vary
           directly with income
         b: MPC = change in C / change in Y
   Non-income determinants
         Wealth: amount of money, fixed assets and financial assets households have
         Expectations of future prices and income
         Distribution of income
         Interest rate and availability on credit
         Tastes and attitudes

4. Investment
 Act of acquiring new fixed capital assets and accumulating stocks and inventories
 Autonomous: not influenced by national income vs. induced
 Expected rate of return > rate of interest – will invest
 Factors that cause shift
         Business confidence and expectations
         Cost and availability of capital goods
         Rate of change of income: accelerator effect
         Government policies
         Change in technology

                 Interest rate


5. Equilibrium Level of Income

                                                                   Y = AE


                                 c                         a

          Autonomous                 d
                                                                   National output
                                 Y2      Y0

At OY1                                        At OY2
AE = aY, Y = by  AE < Y                      AE = dY2, Y = cY2  AE > Y
 unplanned inventory investment ab            excess demand, firms draw on stocks
 next period firms reduce output              unplanned disinvestments cd
 Y1 falls to equilibrium Y0                   next period firms increase output
                                               Y2 rises to equilibrium Y0

6. The Multiplier Effect
A change in any component of aggregate expenditure (ie. C, I, G or X) will work through
the multiplier to change the national income more than proportionately. As shown in
the diagram below [refer to diagram above], an increase in AE will cause the AE curve to
shift from AE0 to AE1. At the original level of national income Y0, since AE is now greater
than actual national output, there is an unplanned fall in stocks of AB. In the next
period, firms would increase output, causing the level of national income to rise
eventually to Y1, where the new AE equates the national output.

The initial rise in income due to (any rise in component: depends on question context)
will induce consumption by recipients of the income. As one man’s spending generates
income for the next person, the national income will eventually rise by a multiple of the
initial rise in the AE. Assuming an initial injection of $100m and a constant MPC of 0.5,
the national income will eventually rise by 2 times the initial injection.

In short, the multiplier measures the change in national income as a result of the change
in AE. It has a direct relationship with the MPC, expressed as k=1/(1-MPC).

 Magnitude of increase in NY depends on size of multiplier
 Larger the MPW, smaller the multiplier
 May lead to demand-pull inflation if near or at full employment
 BOP – inflation affects price of exports and may have adverse effect on BOT

7. Inflationary / Deflationary Gap
 Amount of AE that falls short of (cd)/ exceeds (ab) the level necessary to achieve FE

Explain what information an economist would require to decide whether the US
needed ‘an economic stimulus’. [10m]

Weak economy – assume pending recession – fall in GDP for 2 consecutive quarters
(negative GDP growth)

 Fall in real GDP
 Components of AD: fall in AD – fall in GDP
       Consumption level of households: due to fall in income / saving in fear of
       Fall in investment: business pessimism, induced: fall in GDP – fall in
 Inflation: fall in GDP – fall in AD – fall in GPL / fall in inflation rate
       Need inflation rate to arrive at real GDP
 Firms and bankruptcy, firms and decreasing profits
 Stock markets: indices fall – confidence fall

 Fall in real GDP
 What causes fall: C/I/G/X-M: BOT: more relevant for Singapore since Singapore’s
   recession mainly due to BOT
 GDP – income, wages and profits, bankruptcy
 Inflation: fall in GPL but stagflation (economy weakening but price increasing) – price
   increase in US not due to recession: not AD factors but AS factors
 Unemployment rate – rough guide: 4% - cyclical – no job – demand deficient

Explain what is meant by the equilibrium level of national income. [10m]

   NY: as measured by GDP (definition)
         Equilibrium: no tendency to move from that equilibrium
   Describe briefly components of AE
         C (households): shape of AE follows shape of consumption function C=a+by
         Simple explanation of components
   Sign of 45 degree line: every point is an equilibrium point where AE=Y
   Equilibrium level of NY: planned AE = Y. AE curve cuts 45 degree line
   Adjustment to equilibrium
   Conclusion: when economy is in equilibrium, may not be at full employment /

Analyse the effect on the equilibrium level of income of an increase in the level of
savings and an increase in the level of exports. [15m]

A. Savings
 Y=C+S
 Increase in S – fall in C – AE falls – AE curve shifts from AE1 to AE2
 Show adjustment to equilibrium
 Summation: increase savings – fall in C – works through multiplier – fall in NY by a
    few multiples
 Evaluation
         Savings can be good for economic growth – increase supply of loanable funds
           – interest rate falls – cost of borrowing falls – increase I – increase productive
           capacity – increase AS – increase NY
 Summation: S decreases actual growth but increases potential growth

B. Exports
 Increase X – increase AE – AE curve shifts from AE2 to AE1
 Show adjustment to equilibrium
 Evaluation
        Increase X – if have unemployed resources – increase NY
        Increase X – if near / at FE – NY may not increase as fast / demand-pull
 Discuss multiplier process in detail

 Magnitude of change in national income depends on size of multiplier
 Larger MPW, smaller K
 Eg. Singapore

Discuss the extent to which the US fiscal stimulus might lead to a sustained increase in
national income. [15m]

 Fiscal: increase G, decrease T
 Sustained: actual + potential growth

 How fiscal stimulus works: lower taxes (increase C/ increase I) + increase G –
   increase AD – increase NY: actual growth, cannot sustain
 Multiplier in detail
 Evaluation: depends on size of multiplier
        USA – MPM could be high because hug e trade deficit – may reduce size of k
        Crowding out effect: increase in G if borrowed from public – decrease in
          supply of loanable funds – increase in interest rate – crowd out C/I – cannot
        Effects of taxes on C and I unpredictable due to pessimism
        Reaches FE: cannot sustain
 Therefore need supply-side measures to increase AS for sustained growth –
   potential growth / increase in productive capacity
 Increase in G on infrastructure – facilitates business – increase AS
 Tax – increase NY (potential)
        Decrease personal taxes – increase incentive to work – increase AS
        Decrease corporate taxes – increase I – increase LRAS
        Condition: if rebates are permanent but according to preamble, rebates
          seem to be one-off

 More policies to boost AS – education and training – increase productivity – increase

What are the main causes of Singapore’s recessions? [10m]

1) Factors leading to fall in AD
 External factors – pessimism eg. 911, SARS (only caused a slowdown in Singapore’s
    economy), 1997 Asian crisis – C/I fall
 Trade deficit: value of X fell due to 911
        Lose CA – goods more expensive
        Fall in income of trading partner

2) External recessions
 US recession – US GDP fall – buy less Singapore goods – Singapore’s X falls – AD falls
    – GDP falls (multiplier effect)
 Singapore may not be that affected – can ride on growth of China / India
 But China huge trade partner of USA
 Singapore: international momentum
         Extension of MRT – increase G – k – increase NY
         IR: increase I – increase NY + tourist revenue
         YOG: tourist revenue
         Cannot sustain since k is small

3) Supply-side factors
 Supply shocks: 1973 oil crisis – increase COP – fall in AS

But overwhelming cause is due to AD, but recognize that fall in AS can also create a

Chapter 11: International Economics

1. Theory of International Trade
 Exchange of goods and services between countries, involving the use of different
    currencies and crossing international borders
 Theory of comparative advantage: produce good at lower opportunity cost than
    another country
         Sources
                Differences in factor endowments that can change over time
                Differences in technology
                Dynamic comparative advantage
 Advantages of trade
         Greater world output and higher consumption of goods and services
           (possible at previously unattainable levels)
         Reduction in unit cost of production: EOS, countries gain experience over
         Stimulate economic development and growth: enlarge market, increase
           competition in home market
         Facilitate transfer of technology and ideas: increase efficiency of production
           – economic growth, help developing countries leap frog stages
         Promotes beneficial political links
         Benefits consumers: more choice and higher satisfaction levels, lower prices
           compared with local products, better quality products
         Dynamic gains from trade: gains grow larger over time
 Disadvantages of trade
         Unfair competition and dumping / unnecessary government subsidies
         Over dependence on other countries
         Import harmful goods
 Terms of trade: rate at which country exchanges its exports for imports
         Factors
                Change in demand conditions: population, income, availability of
                Change in supply conditions: technology, depletion of natural non-
                   renewable resources
         Consequences of change in TOT
                Change in BOT and SOL: dependent on PED of exports and imports,
                   cause of change, responses that follow
                Reallocation of resources
                Change in consumption patterns

2. Barriers to Trade
 Natural
         High transport costs – raises COP and lowers relative efficiency
         Lack of mobility of factors
         Increasing COP due to LDMR beyond certain level of output
         Other market imperfections: imperfect information and market conditions –
            may not specialize to extent that theory suggests
 Artificial: protectionism
         Tariff: custom duties imposed on imports of goods and services by
                 Depends on PED of imports and how much foreign suppliers are
                   willing to absorb – may not protect domestic producers, just a source
                   of government revenue
                 Cuts volume of imports – improve BOT – exchange rate appreciates –
                   exports more expensive abroad – reduce exports in the long run
         Non-tariff: import quotas
                 Greater certainty of protection since revenue earned by foreign
                   suppliers may not be as badly affected as tariff
         Export subsidies: cash grants by government to local producers
                 Reduces COP – sell more of good at prevailing price
                 May induce complacency
                 Drain on government funds
         Foreign exchange control: government control over sale and purchase of
            foreign exchange
                 Financial quotas, charges made on people purchasing foreign
                 Malaysia used this method to recover from 1997 Asian financial crisis
                 Difficult to enforce and might result in black market for foreign
                 Works best in communist countries because government
                   monopolises money conversion
         Others: embargo, trade agreements, international cartels
                 New protectionist measure: technical specifications and standards
                   which discriminate in favour of domestic producers
                 Administrative regulations regarding import procedures to delay and
                   reduce volume of imports
                 Voluntary export restraints (VER): exporting country voluntarily
                   reduces its exports under threats of all-round trade restrictions eg. US
                   automobile industry vs. Japan’s

3. Arguments for Protectionism
 Economic
        Protect infant industry eg. Singapore had protective duties covering ~300
          items in 1960s
               Difficult to identify currently unprofitable industries that might
                  acquire comparative advantage in the long run
               Difficult to decide when industry can be independent of protection
               Encourage inefficiency
        Reduce BOP deficits
               Dependent on PED of imports and exports
               Need to look at root causes
               Invite retaliation – reduced exports – reduced total volume of world
        Prevent unfair trade practices
               Dumping – distorts market – justifiable
               If consumers benefit in the long run from lower import prices – not
        Diversify economic structure
               May not support theory of comparative advantage
               Pattern of comparative advantage can change over time naturally
                  (discovery of new raw materials) / through deliberate policies
        Protect mature industries
               Trade unions
               Misuse of resources since protectionism will not increase total
               Retaliation
        Protect against low-wage foreign labour
               Rejection of theory of comparative advantage
               Could shut down industries and divert resources to more productive
               Consumers denied opportunity to buy from cheaper source – benefits
                  of trade lost
        Increase domestic production: counter-cyclical measure
        Increase government revenue
               To be effective, should be imposed on goods which are price inelastic
               Retaliation
        Retaliation
               Unhealthy for word trade and ineffective
               Distort and reduce differences in comparative advantage
               Welfare loss
               Misallocation of resources: firms unnecessarily retained
               Difficult to remove protectionist measures once in place
               Other industries may demand for protectionism
               Better alternative: stimulate export competitiveness by increasing AS

   Political
         Essential to produce on military weapons in case of crisis – subsidies industry
            to ensure continuous supply eg. US 1980s semiconductor industry for high-
            tech weaponry vs. Japan’s
         Nation poorer but value of national security higher
         Trade as weapon of foreign policy eg Gulf war: US imposed trade sanctions
            against Iraq
   Social
         Subsidise agricultural sector to avoid further depletion of population in rural
            areas / prevent further rural-urban migration to overpopulated cities
         Restrict import of harmful goods

4. Tariff Diagram

Loss in consumer surplus = a + b + c + d
a becomes producer surplus, c become tax revenue, b + d becomes deadweight loss

Consumption effect:
- Reduce consumption from OQ4 to OQ3
- Reduce consumption of imports and switch to domestically produced substitutes
- Pay extra amount (P2 – P1)
- Consumer surplus falls

Production effect:
- Expand production from OQ1 to OQ2
- Increase revenue
- Producer surplus increases

Government revenue effect:
- Receives as tax revenue extra amount paid by consumers for the imported quantity

Explain the theory of comparative advantage. [10m]

 Comparative advantage: specialize based on lower opportunity cost – less of the
    other good foregone

 Assumptions: 2 countries 2 goods, no transport costs, constant returns to scale:
   LRAC remains constant

Assume USA and China each has 20 units of resources, initially use 10 units to produce
each good

Table 1: Before specialization
                         Cars                  Textiles                Opportunity Cost
USA                      100                   60                      1C: 0.6T
China                    5                     10                      1C: 2T
Total                    105                   70
USA: CA in production of cars – give up less textile
China: CA in textile – give up less cars

USA devotes 1/10 more to car, China complete specialization.

Table 2: After specialization
                        Cars                   Textiles
USA                     110                    54
China                   0                      20
Total                   110                    74
World output increases

Terms of trade: mutually beneficial 0.6T < 1C <2T – 1C traded for 1T
USA exports 10 cars, gets 10 textiles

Table 3: After trade
                       Cars                    Textiles
USA                    100                     64
China                  10                      10
Total                  110                     75

Gains from trade: higher level of consumption
 Comparative advantage – gains from trade, more choices, increase growth
 Limitations of CA: relax assumptions

To what extent does the theory of comparative advantage explain the pattern of trade
between Singapore and the rest of the world? [15m]

 Singapore’s constraints – lack of natural resources; small geographical size and
    population – human capital our only resource
 Singapore’s relative strengths – good geographical location
 Our constraints and strengths determine where our CA lies
 Pattern of trade: type of exports and imports of goods and services

A) Yes

Type of exports
1970s    Textiles and simple manufactured      Labour-intensive industries:
         products                              Cheap, unskilled and surplus labour
1980s    Move towards higher-end products      Capital-intensive industries:
         and electronic products; moving       More educated workforce and
         towards services like banking and     improved technology
         finance, tourism                      Loss of CA in labour-intensive
                                               industries to countries like Malaysia
                                               and Indonesia which have huge
                                               labour force
1990s    Electronics, pharmaceuticals,         High value-added, knowledge-
and      telecommunication equipment, disk     intensive, technology-intensive
beyond   drives, integrated circuits           industries:
         Services: banking and finance,        Highly qualified labour force, r+d
         tourism, educational hub, medical     infrastructure
         hub                                   Continue to lose CA in manufacturing
                                               industries to countries like China and

Type of imports
                                               Lack of CA
         Imports: consumer items, food, raw    Lack of natural resources especially
         materials, capital goods for          lack of land for agriculture and to
         development and infrastructure        support huge export base

B) No, there are other factors
 Trade based on world demand
         CA only gives rationale for trade but countries try to augment and develop
            CA in industries with world demand
 For country to develop and provide opportunities for its population of diverse
    talents, needs to have spectrum of industries
 Diversification to reduce negative consequences of over-dependence
 Desire not to rely on foreign supplier for essential goods
 National pride / security eg. Newater
 Re-exports

Discuss whether protection offers any advantages over specialization. [13m]

 Protectionist measures
 Advantages of specialization based on CA: gains from trade, increase X – economic
    growth, wider choice, EOS – fall in LRAC – competitive prices, efficiency in resource
    allocation in the world, welfare gain if world price cheaper than domestic price

 Infant industries
       Rationale: NIE, reasons of economic diversification – impose quotas / tariffs –
          allow new industries to grow and develop EOS
       SR implications: applies for all reasons to protect as long as use quotas /
                Society: DWL
                Consumers: increase price
                Other firms (some extent): increase COP if good protected is
                  important input eg. steel
       LR implications
                Grow – enjoy EOS – lower LRAC – lower price of exports – able to
                  compete internationally – BOT improves if demand is price elastic –
                  increase in total revenue from exports – increase exports – increase
                If do not grow
                If government subsidizing – waste of resources – could have been
                  used elsewhere – education / healthcare / develop infrastructure
                Consumers and society continue to suffer from inefficiency – higher
                Shut down – massive retrenchment
       Summation: To the extent that infant industries grow. However, the infant
          industries normally do not grow and may become inefficient due to
          government subsidies. Protectionism cannot be long term.
 Inefficient industries
       Eg. US steel industry, textile: ‘slap’ tariffs / quotas on Chinese textiles /
          imported steel – allow inefficient firms to eventually be able to be more
          efficient – develop new technology / adjust cost structures
       Eg. steel – affects COP in many other industries eg. housing, cars – cost-push
          inflation – affects domestic market and erodes export competitiveness
       Summation: protect jobs in inefficient industries but more jobs lost
          elsewhere eg. car industry
       Alternative solution: develop CA in new industries: capital-intensive,
          technology-intensive, services, training

   Dumping
         Foreign country selling goods below its actual COP – local firms driven out –
           eventually foreign country gains monopoly power
         Difficult to ascertain if it is dumping / country really has CA in production of
           these goods – Chinese textile + abundance of cheap labour
         Could be baseless accusation
         Solution: force firms to be more cost-efficient (don’t protect), training
           (subsidise firms for training), subsidise r+d
   Economic diversification
         Reduce over-dependence on a few key products / industries
         Eg. Zambia: copper exports – what if world demand falls
   Balance of trade deficit – value of imports > value of exports
         Eg. US huge trade deficit – USA consumes a lot, including on imports – breed
           further inefficiency
         Alternative solution: increase interest rates – encourage people to save +
           discourage consumption
         LR: high C – low S – low investment – affects productive capacity – low LRAS
   National security
         Eg. steel – war weapons

 If country protects, other countries retaliate – world inefficiency

Explain the rationale for free trade and discuss the extent to which FTAs are
beneficial. [25m]

 Free trade – based on CA – lower opportunity cost ratio – gains from trade
 FTA – remove tariff and non-tariff barriers – in theory – in practice eg Singapore’s
    FTAs – also include investment

A) Expounding theory of CA – difference in factor endowments
 Assumptions
 3 tables
 Summation: gains from trade, increase choice / increase society’s welfare, increase
    economic growth and SOL

B) Are FTAs beneficial
 On trade
         Increase X – k – increase NY / N – associated benefit of large-scale production
           – EOS – fall in LRAC – able to price goods more competitively – may improve
         Singapore: small domestic market
         China: may not be as dependent on X revenue because people are getting
           more affluent. C increase can sustain itself based on internal economy
         Cambodia / Vietnam: NIEs because people are poor
         But increase X – demand-pull inflation when near / at FE – price of exports
           increase – volume of exports – may affect BOT – NY falls affects economic
 Inflation
         Access to cheaper consumer goods + raw materials / inputs – fall in COP – fall
           in price of exports – X increase – may increase BOT
         Fall in COL – extra savings can be used to buy domestic goods – increase C /
                 Price of consumer goods

                                          a        b


                     0              10        30       50   Quantity of consumer goods
        a+b = welfare gain
        a: production effect, inefficient domestic firms forced to reduce output from
            30 to 10
        b: consumption effect: increase C from 30 to 50
        From diagram, firms forced to be more cost-efficient – cut costs in order for
            profits not to be eroded since P is at Pw
   Trade creation / diversion
        Creation: increase volume of trade – from high-cost producer to low-cost
            producer – increase welfare of people
        Diversion: from low-cost non-member to high-cost member – away from
            optimum allocation of resources
        Draw diagram to illustrate effects
   Jobs: increase in X – increase N
        But loss of CA – forced to restructure – move towards CA – structural
        Outsourcing – firms benefit by relocating – increase BOT – increase GNP
        But cost jobs in previous country
   On FDI
        Outward investment to China from Singapore
        Increase investment – increase productive capacity – increase AS
        Increase investment – increase AD – increase N / NY
        Transfer of technology
        Useful for NIEs – lack wealth / local entrepreneurs eg. Singapore depends on
        But footloose
        But local firms cannot compete
   Others
        Vulnerability to external shocks due to over-dependence – recession /
            imported inflation
        Interdependence: economies become intertwined eg. USA recession –
            Singapore recession, worldwide food prices increase

 Possibility of unequal gains
        Singapore
               More ST capital outflow to China but LT profits – increase GNP
               Loss of jobs as companies go to China
               Shifted focus to capital-intensive / technology-intensive – focus on
               Gain – education: Chinese students come here to study

        USA
              USA spend a lot because lost CA in lots of goods – need to buy more
                imports – worsen trade deficit – less savings – less investment –
                reduced productive capacity
        India
              Demand for capital goods
   Summation
        FTA: macroobjective – increase NY – increase SOL, fall in price – increase BOT
        Trade creation > trade diversion

*FTA means freer trade – no restrictions among countries vs. free trade, so arguments
similar, only difference is trade creation / diversion

To what extent can economies benefit from globalisation? [25m]

 Globalisation – free movement of goods and services, capital, labour
 Economic integration: FTA, customs union

A) Goods and services
 Trade based on CA – gains + EOS
 Poor – NIEs + Singapore (small domestic market) – increase X – increase NY / N –
    increase SOL
 Access to cheaper goods
         Consumer goods – lower COL
         Raw materials – Singapore / Hong Kong
         Capital goods for infrastructure – Cambodia / Vietnam – increase societal
            welfare + potential growth
 Draw in free trade diagram and illustrate gains
 Trade diversion vs. trade creation: diagram
 Loss of CA eg. USA steel and textile industry, Europe car industry – but restructure
    and move towards new CA
 Inter-dependency eg. USA affect China / India
 Over-dependency due to CA and complete specialization – that’s why countries tend
    to partially specialize / diversify their economies
 Effect on prices – imported inflation
 Tariffs due to protectionism: draw in diagram

B) Capital (associated technology) – FDI (inward and outward)
 Receiving country
        Increase inward investment – increase AS / AD – increase NY / N
        Growth of local supporting industries
        Transfer of technology
        Footloose – may cause massive retrenchment if suddenly leaves
        Local industries cannot compete – lack of SMEs
 Source country
        SR: loss of jobs
        SR: outflow of capital
        LR: restructuring
        LR: More companies internationally – increase GNP
        LR: Create jobs

C) Labour
 For LDCs, provide jobs for labour – cheap
         May be SR exploitation – but vs. no jobs
         Eg. Vietnam – inflation ~19% - lower income wage rise < price rise
 Free flow of labour – influx of foreign workers – depress wages in jobs where supply
    elastic (abundant supply of manual workers) – no skills
         Eg. Singapore / EU – influx of workers into UK
         Solution: provide training
         Brain drain
 Inequity issue
         Manual workers wages fall
         Skills demanded globally – increase demand for work – increase wages for
             skilled jobs
         Dual economy
                   Caters to international market – people grow richer
                   Caters to domestic market – people do not really get richer

Discuss the opportunities and threats of globalisation for Singapore and other Asian
economies. [12m]

Globalisation: high degree of freedom of movement of goods and services (trade),
capital, technology (MNCs) and talent (labour)

1) Globalisation and free trade
 Opportunities
        Export revenue and higher rate of economic growth
        Increase in X – k – increase N / NY
        Increase M of capital goods / raw materials eg. Vietnam / Cambodia /
 Threats
        Competition causes countries to lose CA
                Singapore lost CA in labour-intensive industries in mid-80s to NIEs like
                   China and Indonesia
                SR: structural unemployment
                LR: efforts may pay off if country realizes CA in new industries
                Singapore shifted to capital-intensive then knowledge-intensive
        Specialisation and over-dependency on few major products
                If some countries adopt protectionist measures, trading partners
                   could be adversely affected
        Interdependency of countries
                Economies of major trading partners take a slide, countries will be
                   affected eg. 911, US recession

2) Presence of MNCs and out-sourcing
 Opportunities
        Influx of MNCs in Asian countries helped their economies grow
                Creation of jobs and contribution to GDP
                Transfer of technical know-how
        Outsourcing eg. UK IT companies phone service operations to India
 Threats
        Fear of over-dependency: MNCs footloose – if pull out, adverse effect on jobs
           and economic growth
        Dearth of local firms

3) Influx of talent
 Increase quantity of resources – shift PPC outwards
 But cheap foreign labour – wages in city fall – lower income

Consider the effects, other than on the general price level, of Singapore’s changing tax

A) Inflation
 Effect of increased reliance on indirect taxes – definite inflation – shift in SRAS
         Increase indirect taxes – increase COP for all firms – fall in AS – fall in NY
            (contractionary) + rise in GPL – cost-push inflation – BOT may worsen
            (depending on PED)
 Effect of decreased reliance on direct taxes – may or may not have inflation – shift in
    LRAS and AD
         Fall in direct taxes – C/I increase – AD increase – NY increase (growth) / N
            increase – if near / at FE: demand-pull inflation (a little may be desirable
            because increase output) – BOT worsen (depending on PED)
         Lower income taxes – income / substitution effect – may increase incentive
            to work – increase AS – increase NY – fall in GPL – BOT improves
         Lower corporate taxes – increase I – increase NY – fall in GPL – BOT improves
 Singapore: keep / attract talent – increase efficiency
 Attract MNCS – increase FDI – increase AD (increase N) and increase AS (increase
    productive capacity)

B) Equity
 Income taxes (direct) – progressive – higher the income, the higher the percentage
    to tax – reduce income gap
 Indirect taxes – regressive – lower the income, the higher percentage to tax –
    increase income gap – affects poor more
 Cost-push inflation – increase COL – affects poor more
 Lower direct taxes – increase income gap because rich pay proportionately less
    (usually reduce the percentage tax of rich more)
 Corporate taxes fixed at 18%: neither progressive or regressive

C) Tax base
 Increase indirect taxes – widens tax base – better to rely on due to ageing
    population – increase number of dependants / decrease in size of labour force
 Decrease direct taxes: on working population and firms

D) Ability to evade
 Indirect taxes: difficult to evade
 Direct taxes: can evade but not in Singapore (jailed) – can under-declare

Policies to remedy Singapore’s recession

Recession in Singapore: externally induced: fall in X

1. Fiscal Policy
 Increase G to reduce business costs + training – need to subsidise firms and training
         Fall in COP + increase productivity – increase LRAS – fall in GPL – price of
            exports fall – volume of exports increase
         Evaluation: buy only if they recover from recession
 But increase G to boost increase in NY limited effect in Singapore
         Small k – need huge increase in G
         Prudent
 Why not increase G on public works
         Limited land

2. Monetary Policy
 Why not policies to directly increase X with exchange rate management
        Short run solution: depreciation of S$ - price of exports fall in foreign dollars
          – volume of X increase
        Government prefers soft option
        Price of imports increase in S$ - import all raw materials – COP increase –
          goods more expensive
 Long term policy stance: gradual and modest appreciation of S$ - price of imports
    lower for S$ - import raw materials more cheaply – COP falls – prices more
        Modest: small increments – export competitiveness not drastically eroded in
          the immediate period
        Gradual: firms can have time to adjust their cost structures – find ways to be
          more cost-efficient
        Deals with cost-push inflation

3. Other Ways
 Explore new markets through trade missions and signing of FTAs – reduce over
    dependence on a few trading partner
 Long term measure

 Fall in X is beyond our control
 Measures can only be long run or interim ones

Evaluate methods the Malaysian government might use to slow down import growth
and increase new export business.

A. Slow down import growth
 Devaluation – weaken ringgit
          Price of exports fall in foreign currency – volume of exports increase – total
             revenue from exports increase
          Price of imports in ringgit increase – volume of imports fall – total
             expenditure on imports fall
          BOT improves
          Depends on price elasticity of demand for X and M – Malaysia demand for
             imports of capital goods could be price inelastic – COP rises
          Can only be short term if Malaysia needs to import capital goods and raw
          Persistent devaluation can lead to loss of confidence in economy
 Tariff – tax on imports – price of imports rise – volume of imports fall – total
    expenditure on imports fall
          Increase in COL
          Deadweight loss to society
          Retaliation
 Contractionary policies: interest rate rise – investment and consumption falls – AD
    falls – k – fall in NY – fall in demand for imports
          Malaysia may have small multiplier
          Malaysian firms may want to buy capital goods
          Malaysia still developing, cannot afford to have fall in rate of growth
          Use only if overheating

B. Increase new export business
 Subsidies to export firms
         COP falls – increase AS – GPL falls – price of exports fall
         Inefficiency, burden on government and taxpayers
 FTA / Trade missions to new countries – increase X – k – increase NY
         Reduce over dependence on just a few major trading partners
         Takes time – long term
         Firms may not want to take the risk – uncharted territory – businessmen may
           be risk averse
 Supply-side
         Education and training – increase productivity – increase LRAS – fall in GPL –
           price of exports fall
         Best measure, yield results in the long run

“To be considered successful, an economy needs to achieve low unemployment, low
inflation and stable economic growth.” How far DYA with the statement? [12m]

 Healthy BOPs – especially open economy – macro objective
 Equity in distribution – micro objective
 Efficiency in resource allocation – micro objective

“To be considered successful, an economy needs to achieve low unemployment, low
inflation and stable economic growth.” Explain this statement. [12m]

A) Low unemployment – success [any 2 well-discussed]
 Maximise use of resources – reduces loss of potential output due to unemployment
 Burden on government
         Less tax revenue collected
         More unemployment benefits
         Increase budget deficit, opportunity cost – less for other areas – healthcare,
         Singapore: GST offset package, growth dividends, Singapore shares, one-off
 Low unemployment – people have jobs – higher C – fuels growth
 Social problems – crime rates – social unrest – loss of man hours + deters
    investment (confidence)

B) Low inflation – success [internal and external]
 Internal: stimulates output, induces confidence, increase investment due to
    certainty, increase FDI, encourages savings – increase investment in the long run
 External: BOT improves [PED]

C) Stable economic growth – success [any 2 well-discussed]
 Sustained growth: actual and potential growth: increase AD and As – continual
    increase in SOL
 Confidence – increase investment + FDI – good macroeconomic management of
 Why unstable growth undesirable
         AD keeps increase may cause overheating – demand –pull inflation –
           increase COL + affects BOT – instability
         If economy lapses into recession: negative growth – hardship – fall in SOL

 Brief mention of other criteria for success
 Conflict between growth and inflation: relentlessly pursues growth – demand-pull
   inflation: stable growth vs low inflation
 Which criteria most important: low inflation – price stability – Singapore

Discuss whether fiscal policy is the most effective way for Singapore to sustain a
successful economy. [13m]

 Sustainable + stable growth + low inflation – one of the keys to sustainable growth

A) How FP works to attain growth
 Increase G + decrease T – increase AD – k – increase NY
 K brief + diagram
 Evaluation
       Size of k – small k – huge leakages – high savings / M – need huge increase in
          G – prudent: budget surplus
       Small C / I by domestic firms – need export revenue – policies should target X
       Crowding out: increase G financed by borrowing from public – increase
          interest rate – crowd out C/I/X
               May not need to borrow – huge reserves – reserves can be depleted
               More concerned about fall in X
       Time lag: recognition, implementation, response
               Small – shorter time lag
       Taxes – unpredictable effect on C/I – k works only on the extra disposable
          income that is spent
               Expectations: pessimism / optimism
               Fall in direct taxes – rely more on indirect taxes (GST) (increase COL) –
                  regressive – increase income gap

B) Summation: FP in Singapore – limited role
 If economy weakens (fall in GDP) – usually due to external factors like fall in X eg.
    911 US recession – policies should target X
 Policy exchange rate management – sustainable growth
        Gradual and modest appreciation of S$
        Price of imports fall in S$ - check imported inflation (low inflation) +
           Singapore depends a lot on imported raw materials – lower COP – LT able to
           price competitively – stable growth – BOT increase (PED)
        Price of X increases in immediate period
        Gradual: Singapore firms to find other ways to reduce cost
        Modest: not to totally erode export competitiveness
 Supply-side policy: education and training, welfare benefits, taxation incentives

 FP in Singapore limited effect on Ad, serves as supply-side measure to increase NY
   over long term + exchange rate management – to boost long term export

In the fourth quarter of 2004, Singapore’s unemployment rate rose to 3.7%. Discuss
whether supply-side policies are the best way of achieving full employment in
Singapore. [25m]

 Full employment: natural (frictional) rate of unemployment (some structural)
 Cause for concern (very briefly): if structural severe, if cyclical

A) Supply-side
 Education and training – Budget 08
        Schools and vocational institutes gear Singapore workers for the challenges
           of new economy – grants, scholarships, places in university – focus:
           biomedical – increase employability
        Subsidise firms for workers training – Skills Development Fund – upgrade
           skills – reduce structural unemployment
        Life-long learning – knowledge can become obselete – constant upgrading of
           skills – reduces prospect of being structurally unemployed
        Long term and may not yield results
        Increase employability and attracts MNCs
 Welfare benefits
        Singapore no unemployment benefits – reduce frictional unemployment
        Forced to upgrade skills – reduce structural unemployment
 Reduce power of trade unions
        NTUC: government body – harmonious relations – no labour unrest: attracts
           investment (FDI)
        NWC: wage recommendations – wage increase < productivity increase –
           keep COP low
        Increase employability of workers

B) Policies to deal with cyclical unemployment: fall in AD
 Supply-side – structural, cannot solve cyclical
 FP: increase G, decrease T but small k, external factors
 Exchange rate management
         Recession due to fall in X: depreciation / appreciation
         Depreciation: price of exports fall – immediate solution but Singapore cannot
            afford to – price of imports increase – COP increase – later price of exports
            increase (growth cannot sustain)
         Singapore’s choice: gradual and modest appreciation (long term solution)

 Increase G on education and training + taxation incentives – supply-side policies –
   effect on AD and some effect on cyclical unemployment – limited role in Singapore
   due to small k

Why Singapore does not use interest rate policy
 Very dependent on overseas funds – small
 Eg. if Singapore’s interest rate falls to curb recession – ‘hot’ money outflow - $ in
  Singapore banks fall – MS falls – interest rate increase – no control
 Discuss interest rate only if not Singapore

Problems with exchange rate instability

Exchange rates determined by
 Trade and investment between trading partners
 Speculation
 Government management / manipulation of exchange rate eg. buy US bonds to
   keep USD up

1) Trade
 Affects business planning: need for certainty to forecast profits
 Eg. If S$ depreciates
        Price of Singapore exports fall in foreign currency – volume of exports
        Price of imports increase in S$: dependent on raw materials (same for
           developing countries which need capital goods)
 Eg. If S$ appreciates – price of exports increase in foreign currency – affects export

2) Investment
 Persistent depreciation – loss of confidence in economy – fall in investment

3) Developing countries
 Foreign loans in US$ denomination – if your currency depreciates – pay back more in
    your country’s $


Shared By: