Cambridge A Level Economics 9708 — 2017 May/June Paper 2 · Variant 1

1 Fall in price of oil but Colombia can look forward to growth Fig. 1: Colombia’s growth and the oil price annual % change oil price in output (US$ per barrel) 7 120 6 100 5 4 80 3 2 60 1 0 40 2012 2013 2014 2015 Source: Thomson Reuters Datastream Fig. 2: Colombian peso against the US dollar (peso per US$), inverted scale 1800 2000 2200 2400 2600 2800 3000 2012 2013 2014 2015 Source: Thomson Reuters Datastream Over the past year, the halving of crude oil prices has hit Colombia and much of South America hard. Venezuela’s economy, for example, is expected to shrink by 7% this year. Colombia’s national oil production was running at 1 million barrels a year, accounting for half of its exports and a fifth of government revenues. In Puerto Gaitan, which only a year ago was the centre of Colombia’s oil industry, the town’s population had tripled to 45 000 in just a few years. Property prices had soared and hotels overflowed. Today, though, business profits have fallen, leading to a fall in spending by entrepreneurs. “For Sale” signs now hang over Puerto Gaitan’s closed stores, car parks in shopping malls are empty and 10 000 people have left the town. Towns throughout Colombia are experiencing similar problems. Colombia’s government is feeling the effects as well. Every US$1 drop in the oil price per barrel cuts an estimated US$200 million from government revenues. As a result, the government has cut spending and raised taxes to keep its budget deficit down. More worryingly, the collapse in the price of oil has opened a large current account deficit equivalent to 7% of national income. Yet not all is bleak. Colombia’s economy is forecast to grow this year. And unlike in neighbouring Venezuela, where oil accounts for more than 90% of exports, there is concern but no panic. Firstly, the peso’s depreciation could reverse Colombia’s current account problems, boosting traditional exports such as coffee, textiles, car parts and flowers — if not to its immediate neighbours, then to the United States. Colombia produces oil, but it is not only an oil-producing country. Secondly, Colombia’s government is having peace talks with Marxist rebels to end the country’s five decades of unrest. The government’s military expenditure will be reduced and estimates suggest that this ‘peace dividend’ could add as much as 2 percentage points to growth. Source: The Financial Times, 2015 (a) (i) With the help of a diagram, explain one possible cause of the fall in the price of oil shown in Fig. 1. [2] (ii) Explain how the fall in the price of oil has resulted in the fall in the value of the peso shown in Fig. 2. [2] (b) With the help of production possibility curve diagram(s), explain how the ‘peace dividend’ might lead to the growth of Colombia’s economy. [4] (c) Use the information to explain how each of the components of aggregate demand in Colombia has been affected by the fall in the price of oil. [6] (d) The fall in the value of the Colombian peso shown in Fig. 2 is expected to reduce Colombia’s current account deficit. Discuss any factors that will determine whether the fall in the value of the peso will have this effect. [6]

Mark scheme: 1(a)(i) For a diagram showing an increase in supply or a decrease in demand. (1 mark) • For an accompanying explanation giving possible reasons for the shift in supply or demand. (1 mark) supply or a decrease in demand. 1(a)(ii) For an explanation that • the fall in the price of oil has resulted in a fall in export revenues (1 mark) • and a fall in the demand for the peso (1 mark). (2 marks maximum) 2 The context of the case study makes it clear that the fall in the price of oil has resulted in a fall in Colombia’s export revenues. This has resulted in a fall in the demand for the peso. 1(b) For a clear diagram of production possibility curves. (Up to 2 marks) For an explanation of the increased possibility of the production of capital goods or the development of human capital that will generate growth in the economy. (Up to 2 marks) Maximum of 2 marks if no diagram. 4 The prospects of the end of the rebel insurgency will allow the Colombian government to spend less on the military. Resources can be diverted to the production of capital goods or to enhanced training of labour that will shift the PPC outwards. This is the ‘peace dividend’ Question Answer Marks Guidance 1(c) For explaining how each component is affected with due reference to the data. Consumption has fallen because of the fall in incomes and the rise in taxes. (Up to 2 marks) Investment has fallen because of the fall in activity (Puerto Gaitan). (Up to 2 marks) Government expenditure has fallen because of the fall in government revenues. (Up to 2 marks) Net exports have fallen because of the fall in oil prices and export revenues. (Up to 2 marks) (6 marks maximum) (If only 3 components are explained, then 5 marks maximum) 6 Candidates need to interpret the data to explain how each of the four components has been affected. 1(d) At least two factors must be explained for full marks. • For any one factor explained (Up to 4 marks) (6 marks maximum) 6 The relevant factors include • the price elasticity of demand for Colombia’s exports and imports and whether the Marshall-Lerner condition is fulfilled. • The price elasticity of supply of Colombia’s exports. • The time period under consideration; J-curve effect. • The reaction of Colombia’s competitors in world trade.

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2 (a) Using examples, explain the difference between a merit good and a public good. Explain why a profit can be made from the provision of one of these types of good, but not the other. [8] (b) Discuss whether it is better to impose an indirect tax or conduct an awareness campaign to deal with the problem of demerit goods such as alcohol. [12]

Mark scheme: 2(a) For knowledge and understanding • of the meaning of a merit good (Up to 3 marks) • and a public good (Up to 3 marks). (4 marks maximum) For application showing • understanding of the reasons that profit can be made in the supply of merit goods, • but not in the supply of public goods. (4 marks maximum) excludability, diminishability and rejectability. The explanation should be based upon the free-rider problem that occurs in the supply of public goods. Question Answer Marks Guidance 2(b) For analysis that explains: • The way in which an indirect tax is used to reduce the consumption of alcohol with due reference to the strengths and weaknesses of this approach. (Up to 6 marks) • The way in which an awareness campaign is used to reduce the consumption of alcohol with due reference to the strengths and weaknesses of this approach. (Up to 6 marks) (8 marks maximum) For evaluation that assesses and compares • the relative strengths and weaknesses of each approach (Up to 3 marks) • and for reaching a conclusion on which approach is likely to be most effective. (1 mark). (4 marks maximum) 12 A demerit good should be explained in terms of incomplete information of the harm that it can cause. An indirect tax is designed to reduce supply and increase price. An awareness campaign is designed to decrease demand for the demerit good. Evaluative points include the following: • the fact that the demand for alcohol might be price inelastic • the fact that an awareness campaign might be costly • the fact that an awareness campaign might take a long period to take effect

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3 (a) Explain how equilibrium price and equilibrium quantity change to allocate resources when there is a successful advertising campaign for a normal good. [8] (b) Discuss the difficulties of introducing a widespread system of maximum prices for essential food to protect low-income families in a period of high inflation. Consider whether this system is likely to be successful. [12]

Mark scheme: 3(a) For knowledge and understanding • of the term equilibrium (Up to 3 marks) • and where it occurs in the context of the market for a normal good.(Up to 3 marks). (4 marks maximum) For application • showing how price allocates resources when there is an increase in demand. (4 marks maximum) price or quantity to change’. In the market for a normal good, it occurs where the demand and supply curves intersect. If there is an increase in demand the demand curve will shift to the right causing an excess demand for the normal good. This will cause market forces to raise equilibrium price and quantity. 3(b) For analysis that explains: • How maximum prices operate when imposed below equilibrium. (Up to 2 marks) • The difficulties that arise when maximum prices operate during a period of high inflation. (Up to 6 marks) (8 marks maximum) For evaluation: • commenting on whether difficulties can be overcome (Up to 3 marks) • and for reaching a conclusion on the likelihood that this will be successful. (1 mark) (4 marks maximum) 12 The difficulty in imposing maximum prices below equilibrium is that shortages will occur. These shortages will become more pronounced as inflation occurs unless the maximum prices are continually moved upwards. Other difficulties include the administrative costs and the extent to which the price legislation can be policed. The problems could be overcome, e.g. with rationing, but whether this will be successful depends upon a number of factors.

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4 (a) Explain how a fall in an economy’s foreign exchange rate can cause both cost-push and demand-pull inflation. [8] (b) Discuss the use of supply side policy as a means of solving the problem of inflation. Consider whether this policy is likely to be effective. [12]

Mark scheme: 4(a) For knowledge and understanding • of demand-pull inflation (up to 3 marks) • and cost-push inflation (up to 3 marks) (4 marks maximum) For application • showing how a decline in an economy’s exchange rate can cause cost-push inflation (Up to 3 marks) • and demand-pull inflation. (Up to 3 marks). (4 marks maximum) exports and a rise in the price of imports. This will lead to a rise in net exports and this will increase aggregate demand that could result in inflation. The rise in the price of imports will increase import prices and this might increase input costs leading to cost-push inflation. 4(b) For analysis that explains: • The aims and objectives of supply side policies with appropriate examples. (Up to 6 marks) • How the methods adopted are designed to solve the problem of inflation with due reference to the strengths and weaknesses of these methods. (Up to 6 marks) (8 marks maximum) For evaluation that assesses and compares • the relative strengths and weaknesses of different supply side policies (Up to 3 marks) • and for reaching a conclusion on their likely effectiveness. (1 mark). (4 marks maximum) 12 Supply side policy is designed to increase the aggregate supply curve of the economy. Methods that might be adopted include • measures to increase the supply of capital goods • measures to increase the labour supply to prevent upward pressure upon costs Evaluative comment might include: • the expense of supply side policy • the fact that it might take a long time to be effective

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