Download Economics Scholarship Exam 2007 These are my Economics

Economics Scholarship Exam 2007
These are my Economics Scholarship Exam answers for the 2007 exam. My final mark was 35/48,
which just qualified me for the Outstanding Scholarship Award. If I got 34/48, I would have only got
scholarship. There were 6 questions, all worth 8 marks each for a total of 48 marks.
My marks are as follows (this is what the assessors flap looked like):
Question Number
Marks
(a) and (b)
6
(8)
One
(c)
6
(8)
(a) and (b)
4
(8)
Two
(c)
7
(8)
(a) and (b)
8
(8)
Three
(c)
4
(8)
TOTAL
35
(48)
To download the resource booklet, go to:
http://www.nzqa.govt.nz/scholarship/subjects/resources.html
I originally scanned this, but the file size was too big to upload on studyit (hence why I’m typing
these answers).
Question 1
(a) Dairy prices have increased, whereas lamb prices have decreased (see Resources A and B).
(6 out of 8 marks)
(i) Using supply and demand analysis, illustrate and explain why the world price of
milk powder has increased
Milk Powder market for New Zealand
S
Price ($US
per tonne)
P’
P
D’
D
Q
Q’
Quantity (tonnes)
Supply in overseas countries such as Australia and China primarily caused by water shortages has
created an increase in demand for New Zealand produced milk as these countries are unable to
meet demand locally by themselves. As a result, demand for New Zealand milk increases. This shifts
the demand curve to the right. If farmers continued to sell their milk at the previous equilibrium,
there would be a shortage. Consumers would therefore bid up prices as they compete to buy the
milk powder they want. This causes the price to rise and also causes quantity to increase as well as
farmers would want to make the most of the increased demand for milk and try to match their
supply with what is demanded.
Note: There were two crosses next to this part of the question, so it is completely wrong. The
reason why I got this question wrong is because I talked about the New Zealand price of milk and
not the world price of milk (the marker circled ‘world price of milk’ in the question and ‘New
Zealand’ in the title of my diagram). Also, the marker drew a red line to the left of the supply
curve, showing that the supply curve shifts, not the demand curve.
(ii) Illustrate and explain how this will result in a perfectly competitive dairy farmer earning
supernormal profits in the short run.
MC
Costs/Price
($US per
tonne)
AC
P’
AR’ = D’ = MR’ = P’
P
AR = D = MR = P
Q
Q’
Quantity (tonnes)
Because dairy farming is perfect competition, previously they would have been operating at normal
profits. Since perfect competitors, the rise in price for the world market for milk powder has caused
the individual dairy farmer to increase their price to match the world price. This causes their AR
curve to increase. This now causes AR to be greater than AC which therefore means they are
earning supernormal profits in the short run. The supernormal profit is shaded in blue above.
Quantity would automatically change to the new MR = MC.
(iii) Meanwhile, as a result of falling lamb prices, some sheep farmers will be earning
subnormal profits in the short run.
Define subnormal profits and explain clearly how the situation will change in the long run.
Subnormal profits happen when Average costs are greater than Average Revenue. Therefore profit
is not enough to keep the entrepreneur in their present activity. As a result of dairy farmers earning
greater profits, sheep farmers would realise this and shift their resources into dairy farming. This is
because the opportunity cost of lost profits is greater if they do not enter the dairy industry.
Therefore supply for the lamb industry would decrease causing the supply curve for the lamb
industry to shift to the left. This causes price to rise and quantity to decrease. In the long run this
would cause individual sheep farmers’ AR curves to rise (as perfect competitors are price takers)
until they earn normal profits. So in the long run, sheep farmers will still earn normal profits.
(b) The size of dairy farms is increasing, leading to economies of scale (see Resource C).
(i) Illustrate and explain how dairy farmers can gain economies of scale.
Costs
Short run
Average Cost
for 1st firm
(SAC1)
SAC8
SAC7
SAC2
SAC3
SAC6
SAC4
SAC5
Long run
average cost
Quantity
In the long run all factors are variable. This is because over time new farms can be built or
amalgamated. This leads to economies of scale. By amalgamating dairy farms, farmers can operate
more efficiently with bigger herds. This is because fixed costs are reduced as less cow sheds are
needed and less other machinery such as tractors are needed. As a result the effect of diminishing
returns is minimised (which would have happened in a single firm in the short term) as there is no
longer one fixed factor to work with. Therefore long run average costs gradually decrease. This
allows for more efficient dairy farmers and economies of scale.
(ii) Explain why globalisation makes it increasingly important for farmers to achieve
economies of scale in the long run.
Globalisation means that farmers are sourcing their resources from all over the world and selling all
over the world. Since in the global world we are competing with many different countries and many
different dairy farmers, it is vital to keep costs down to a minimum. By economies of scale, the
overall cost of producing milk decreases. Also by sourcing resources from various places, the most
efficient and cost efficient practices can be used. Therefore dairy farmers are able to afford to
charge a lower price. By charging a lower price, New Zealand becomes a more competitive place to
buy milk from for the whole world as our prices would be comparatively lower. With lower prices,
we would be able to sell greater quantities of milk, which increases the profits for local dairy owners.
Therefore globalisation makes it increasingly important for dairy farmers to achieve economies of
scale in the long run.
(c) Using the dairy and sheep industries as your context, evaluate the effectiveness of the
price mechanism in reallocating resources in response to changes in the global market, so
as to achieve allocative efficiency. You should use a range of microeconomic models in
your answer (see Resource D). (6 out of 8 marks)
The price mechanism is very effective in reallocating resources in response to changes in the global
market. This is in relation to both the sheep/lamb industry and the dairy industry.
World market for the sheep industry before resource allocation
S
Price
World market for the sheep industry after resource allocation
S’
S
Price
Surplus
P0
P0
P1
P1
D
D
D’
D’
QD
Q
QS
Quantity
QD
Q
QS
As a result of the decrease in demand for lamb on the world market, the demand curve would shift
to the left. If sheep farmers remained at the old equilibrium, there would be excess supply or a
surplus of lamb. Producers would not want to invest the same amount of sheep production if they
are unable to sell it. They would also not like the fact that they have to accept a lower price on the
world market, as they are perfect competitors. This is because they would lose out on profits. If
they chose to stay at the old equilibrium it would be illogical as no one would buy from them
because there are many sheep farmers and it is not allocatively efficient as demand does not equal
supply at the old equilibrium. Since sheep farmers’ prices would decrease, they would be earning
subnormal profit. Therefore this profit is not sufficient to keep them in their present activity. When
they see higher commodity prices for dairy farmers’ milk, they will shift their resources to dairy
farming. They can do this as resources are similar as land is a crucial part of any sheep or dairy
farmer. As many sheep farmers exit the industry, supply of sheep decreases. The decrease in supply
is also caused by lost productivity as less workers are required for less sheep farms. Therefore
supply for the whole industry would decrease causing the price to rise back to approximately its
original position at P0 and quantity to decrease even further from Q1 to QD. This therefore restores
the market to where supply equals demand which is therefore allocatively efficient. This shows how
the price mechanism in the sheep industry achieves allocative efficiency.
This effect also happens in the dairy industry, but in reverse. Firstly, there has been an increase in
the global demand for milk products. This causes the demand curve to shift to the right. If dairy
farmers remained at the old equilibrium, there would be a shortage of milk products as there would
be excess demand on the world market. Therefore they will happily raise prices from P0 to P1 and
quantity from QS to Q1. However, sheep farmers, as discussed before, would realise this fact. They
Quantity
will notice that because of the increased price on the world market, dairy farmers would now be
earning supernormal profits. They would want to earn supernormal profits as well as opposed to
the subnormal profits that they are earning in the sheep industry. This causes sheep farmers to shift
their resources to dairy farming. Therefore the supply curve would shift to the right. This is also
caused by the increased amount of workers that came from the sheep industry into the dairy
industry causing more productivity. Because of the increase in supply, price would decrease as there
would be a surplus at P1Q1 and quantity would increase. This therefore results in allocative
efficiency for the dairy industry as well.
World market for the dairy industry after resource allocation
S
S’
Price
World market for the dairy industry before resource allocation
S
Price
P1
P1
P0
P0
Shortage
D’
D’
D
D
QS
Q
QD
Quantity
QS
Q
QD
This shows that the price mechanism is very effective in reallocating resources to changes in the
global market to achieve allocative efficiency. For the sheep industry, the decrease in demand has
been met with a decrease in supply and for the dairy industry, the increase in demand has been met
with an increase in supply. Since society wants more milk and less lamb, sheep and dairy farmers
have changed quantity supplied to meet their demands and achieve allocative efficiency.
Quantity
Question 2
(a) Refer to Resource E (4 out of 8 marks)
(i) Calculate the change in the level of real wages for the year to December 2006 and
explain why wage earners would be more interested in this figure than in the
change in nominal wages.
The growth in real wages in the year to December 2006 is 4.9% - 2.6% = 2.3% increase. Wage
earners are more interested in their real wages as this represents the increase in the purchasing
power that they have. If inflation increased at a faster rate, they would be in fact losing out because
they would be able to purchase less than before. An increase of 2.3% in their real wages means that
they are able to spend 2.3% more money on goods and services and would actually reap the benefits
of their pay increases, rather than just trying to keep their wages up with inflation.
(ii) Explain why a government imposes a minimum wage
The government imposes a minimum wage to increase the standard of living of lower income
earners. It would be unfair for employers to pay a wage at a rate that would not sustain a
reasonable standard of living. By imposing a minimum wage, legally they can’t pay wages at a rate
less than $11.25 per hour for adults and $9 for 16 and 17 year olds. Along with it being equitable, it
also achieves a greater level of equality across income earners as the gap between the rich and poor
would be decreased as poorer people would have a higher income.
(iii) Some people do not support government intervening in the labour market by imposing a
minimum wage. Use a supply and demand diagram to analyse the implications of
increasing the minimum wage. (This answer is half right, I got 1 tick and 1 cross)
If there was no minimum wage, the labour market would be at the wage equilibrium as employers
would push down the wage rates to equilibrium as there is no minimum wage law to prevent them
from doing so. At this point there is only actual employment and people who are voluntarily
unemployed and will only work if the wage rate rises. However if there is a minimum wage, which
would be set above equilibrium, otherwise it would not be effective as employees would push up
wage rates, there is a group called involuntary unemployed. These people are willing and able to
work at this wage rate, but are unemployed as employers would find it too expensive to hire them.
These people would be structurally unemployed (so they have to spend money in training to upskill
to re-enter the workforce), frictionally unemployed (looking for work between jobs) and cyclically
unemployed (unemployed due to a down turn in economic activity). Also the number of actual
employed has reduced causing an increase in welfare payments.
Labour market with a minimum wage
SL
Wage rate
Involuntary
employed
Actual employed
Minimum wage
Wage equilibrium
Voluntary
employed
Voluntary employed
Actual employed
DL
Q1
Qe
(b) To some people, rent controls may seem like a good idea (see Resource F). However, most
economists would recommend that government use other ways to ensure that those on
low incomes have access to accommodation.
(i) Identify and explain the welfare gains and losses that will occur in the market for
rental accommodation if a government imposes rent control (i.e. a ceiling or
maximum price on rental accommodation. (This part of the question was wrong)
S
Rental market
Price
Pe
Pmax
D
QS
Qe
QD
Quantity
A ceiling price is not the best option for rental accommodation. As a result of the ceiling price,
quantity demanded is greater than quantity supplied. Therefore people who do get rental
accommodation do pay a reasonable price. However the excess demand would mean that some
people would end up on the streets as there is not enough rental properties for everyone. This
would cause many societal problems such as crime as people would not be able to sustain a job if
they did not have a home to shower in each night. Therefore they would have to resort to crime just
to get by. A better solution would be to provide a subsidy towards landlords so that there is an
increased supply of rental homes for these homeless people to live in.
(ii) Discuss whether the loss of welfare you identified in (b) (i) should be classified as ‘market
failure’ or ‘government failure’. (Half right – 1 tick and 1 cross)
This should be labelled as government failure. It is their duty to reallocate resources in the best
possible manner to benefit society as a whole. A maximum price only benefits the lucky people who
are able to obtain a rental home to live in. They should provide a subsidy so that the supply of rental
homes matches the demand for them.
(c) Refer to Resources G and H. Discuss the use of redistributive policies to increase
horizontal and vertical equity. Discuss what economists mean by economic efficiency, and
evaluate the relevance of the equity efficiency trade-off. (7 out of 8 marks)
Horizontal equity is the belief that people on the same income should pay the same amount of tax.
This has been achieved because everyone at $38,000 has to pay a marginal tax rate of 33% and
everyone at $60,000+ has to pay a marginal tax rate of 39%. Also people who receive tax credits on
working for families pay the same amount of tax as others with the same income as the amount you
get from working for families is based on your income. If your incomes rises, the amount of tax
credits you receive decreases. Therefore horizontal equity has been achieved.
Vertical equity has also been achieved by the government here. Vertical equity is the belief that
people on higher incomes should pay more tax than people on lower incomes. This has been
achieved by the progressive tax system. The marginal tax rate is low for incomes under $38,000 at
19.5%. It is slightly higher at $38,001 to $60,000 at 33% and higher still at 39% for over $60,000.
Therefore the average tax rate that people pay increases as their income increases and the actual
nominal amount of tax they pay increases as well. Therefore vertical equity has been achieved.
Economic efficiency is where a country is producing at their maximum level. On the production
possibility model, an economy is efficient if it is operating on the production possibility curve.
Therefore at this point all resources are employed in their best possible manner including land,
labour, capital and entrepreneurship.
Production possibility curve
x
x
x
x
In the economy there is a trade off between efficiency and equity. Generally efficiency is similar in
regards to horizontal equity as people are earning the same disposable income as they are paying
the same amount of tax at the same rate. However efficiency may be affected with regards to
vertical equity. As discussed before, vertical equity is the belief that workers earning more wages
should pay more tax. People who earn higher incomes normally have a higher education, do a more
difficult job requiring more skills, do a more dangerous job or work longer hours than people on
lower incomes. Therefore it is fair that these people get paid more money. However, because of
vertical equity, this has resulted in the progressive taxation system. Therefore higher income
earners who do more difficult, more dangerous and longer jobs are being punished as they have to
pay more tax. Because of this, these workers would be reluctant to work the longer hours or get the
education required to get a more difficult job. This results in inefficiency as these workers would not
be utilising their skills to the full extent, so therefore resources are not fully employed causing the
economy not to operate on the production possibility curve. This loss in efficiency has been caused
by a more equitable taxation system. The equity efficiency trade off can be represented by a
production possibility curve. Because of the progressive taxation system, equity has increased and
efficiency has decreased. This causes a movement from B to A on the diagram.
Equity/efficiency trade off
Equity
A
x
x
B
Efficiency
Question 3
(a) As stated in resources I, J and K, saving can mean different things to different people. (8
out of 8 marks)
(i) With the aid of a diagram, explain why saving is vital for the New Zealand
economy.
To survive, households need goods and services. These can only be produced by households
providing their resources to firms to process them into goods and services. In exchange for
resources we get income and in exchange for goods and services we give consumption spending.
However these firms need to establish themselves by investment spending and have to borrow from
financial intermediaries to do so. To fund these loans, there must be funds held by financial
intermediaries from the savings of New Zealanders. No saving means no investment, so firms would
be unable to establish themselves creating a downturn in the economy. This is shown in the circular
flow model below.
Two sector Circular Flow model
Resources
Income
Households
Firms
Consumption Spending
Goods and services
Savings
Financial intermediaries
Investment
(ii) Comment on this quote:
“It is unlikely to be of benefit to the New Zealand economy if all New Zealanders were to
significantly increase their level of saving.”
This quote is true. If all New Zealanders significantly increased their savings, their consumption
spending would also decrease significantly. This would cause the aggregate demand curve to shift to
the left causing economic activity to decrease. This is therefore not beneficial to the economy. Even
though more investment is possible, the extra goods and services would not be demanded because
of the decrease in consumption spending. Therefore overall economic activity would decrease and
firms would lose out on profits.
AS
Price
level
P
P’
AD’
Q’
Q
AD
Economic activity
(iii) Referring to Resource I, outline how the saving performance of the New Zealand
household sector has impacted New Zealand’s current account balance since 1990.
There is a correlating trend between the deteriorating current account balance and the general fall
in the trend in the saving by the household sector. A fall in savings means that more income is spent
on goods and services. Since many goods and series are imported, more money would be spent on
imports. An increase in the spending of imports makes the current account balance worse as
imports are subtracted from exports in the current account. That is why the poorer saving
performance of households since 1990 has caused deterioration in the current account balance.
(b) The New Zealand economy is experiencing inflation pressures
(i) Draw an AD/AS diagram showing the New Zealand economy with an inflationary
gap. Identify and explain evidence in the resource material provided that supports
the existence of this inflationary pressure.
YF
AS
Price
Level
PL
Inflationary
gap
AD
Q
GDP/Growth/
Economic activity
In Resource I it can be seen that savings by households has decreased dramatically. This would
cause an increase in consumption spending which shifts aggregate demand to the right. In Resource
J, it can be seen that there are rising resource pressures in both labour and capacity. As firms
compete for the limited labour and limited resources, this has caused aggregate supply to shift as
costs of labour and resources have increased by the competition. Also in Resources J, government
spending has increased from $150,600 million to a forecasted $164,600 million from 2005 to 2007.
An increase in government spending causes aggregate demand to shift to the right. A shift in
aggregate demand to the right causes demand pull inflation and a shift in aggregate supply to the
left causes cost push inflation. Therefore these 2 curves’ shifts have caused inflationary pressures.
(ii) With the government’s fiscal surplus increasing, there have been calls from many sectors
for the government to cut taxes.
Use the axes below to illustrate and then explain the impact on the economy if the
government cuts direct taxes.
YF
AS
Price
Level
shows the
inflationary gap
PL’
PL
AD’
AD
Q
Q’
GDP/Growth/
Economic activity
If the government cuts direct taxes, effectively the disposable incomes of consumers would rise.
Therefore households would have more money to consume or save. If they choose to consume
more goods and series, the aggregate demand curve would shift to the right. If they choose to save
more money, this would lead to an increased amount of funds available for firms to borrow for
investment. Therefore investment spending would increase causing aggregate demand to shift to
the right. Therefore no matter what, aggregate demand would increase. This would be good for the
economy as firms can expand and consumers are willing and able to buy more goods and services.
However this would be bad for inflation because as a result of the tax cuts, inflationary pressures
would be greater creating higher inflation. Considering the fact that inflation is already high, this is
not a good solution.
(iii) Outline how government provision of tax cuts and a compulsory savings scheme (e.g.
KiwiSaver) might avoid the problem identified in (b) (ii).
KiwiSaver effectively decreases the disposable income of households as a portion of their wages are
put into their KiwiSaver account. With a decrease in disposable income, households would demand
less goods and services causing aggregate demand to shift to the left. Therefore if tax cuts are
implemented, the government would have to make sure they are not too extensive as they would
want to reduce the possibility of aggregate demand rising because of inflationary pressures.
However tax cuts are possible because the decrease in aggregate demand caused by KiwiSaver
would be helpful in reducing the likelihood of aggregate demand increasing.
(c) Discuss the extent to which current monetary and fiscal policies are in conflict as the New
Zealand government attempts to manage the macro economy. Include in your answer a
discussion on the issues of rational savings, national investment, and the country’s balance
of payments position. (4 out of 8 marks, mainly because I ran out of time and had to rush
this question)
There is some conflict with current monetary and fiscal policies as the New Zealand government
attempts to manage the macro economy. It can be seen from government budgets from 2005 to
2007 that the government plans to increase their spending over time. The growth in spending is 9%
from 2005 to 2007. Increases in government spending means that the aggregate demand curve
shifts to the right. This fiscal policy conflicts with monetary policies as the shift in aggregate demand
causes inflation since inflation is already very high at the moment, monetary policy is aimed at
reducing inflation. Therefore there is a conflict with their fiscal and monetary policies.
As the reserve bank tries to counter this inflation, they have decided to raise the official cash rate.
Indirectly this causes an increase in interest rates offered by banks. Therefore many overseas
investors choose to save their money in New Zealand as New Zealand has comparatively higher
interest rates to other countries in the world. Because the income from these savings are going
abroad, this creates an unfavourable trend in the current account balance. This conflicts with the
government’s fiscal policy as it is their aim to try and reduce the size of the deficit of the current
account balance. However if they keep increasing their spending, the reserve bank has to increase
the official cash rate in order to keep inflation between 1% and 3%.
It is also the government’s aim to increase savings by New Zealanders. This is evident as it has
introduced the KiwiSaver scheme. In this scheme funds are automatically taken out of the pay for
KiwiSaver members and are unable to touch their funds until they reach 65. This conflicts with what
New Zealanders want as household saving rates have decreased since 2000. The government is
trying to reduce spending, but are unsuccessful as people are saving less. This therefore creates
inflationary pressure causing another conflict with monetary and fiscal policies.
So therefore overall there is a conflict between fiscal and monetary policies of the government. This
includes their increasing spending, trying to reduce the current account deficit and trying to force
New Zealanders to save more.