Cambridge A Level Economics 9708 — 2018 Oct/Nov Paper 4 · Variant 3

1 The government and market failures Countries are seeking innovation-led growth that is more inclusive and more sustainable than in the past. Modern capitalism is facing challenges of climate change, youth unemployment and rising inequality. These challenges require rethinking the role of government and public policy. It requires a new justification of government intervention that goes beyond that of fixing market failures, to one of stimulating and facilitating change by creating markets which more fairly distribute both risk and rewards. This is not just about spending public money on different activities; it requires new indicators through which to evaluate public investments. Markets are ‘blind’ and the direction of change they provide often represents inefficient resource allocation from a society’s point of view. Market failure theory (MFT) justifies government intervention in an economy in order to correct a situation of inefficient resource allocation. This involves taking measures such as devising market mechanisms to internalise external costs or the direct provision of public goods. MFT has developed methods to evaluate government actions, usually through cost-benefit analysis (CBA) – which has limitations in its effectiveness. The CBA then informs an assessment of the ‘principal-agent’ structure that will force private agents to do what the government wants. Critics of MFT say that it assumes that the government only fixes existing problems and this is not as useful as a policy that creates dynamic new markets or products. However, this can lead to accusations of ‘crowding out’ private sector businesses. The argument against those criticisms rests on showing how government investments cause both a larger national output that can be shared between private and public sectors, and creates cost savings. However, this argument does not include the idea that the goal of public investment is about more than just increasing output. It should also be, as Keynes wrote, to ‘do those things which at present are not done at all’. In fact, new events that have transformed economies have also been influenced on both demand and supply sides by policymaking. The iPhone, Global Positioning Systems (GPS), touch-screen displays, solar power and wind farms, for example, were all publicly funded. Source: RSA Journal, Issue 2, 2015 (a) Explain what is meant by the ‘principal-agent’ problem and describe how it can be applied to governments and private sector businesses. [4] (b) Outline what the article means when it mentions ‘inefficient resource allocation’. [4] (c) The article refers to ‘internalising external costs’. Explain what economists mean by this and consider whether cost-benefit analysis can be used to achieve it. [6] (d) Consider whether the article provides sufficient evidence to conclude that market failure theory (MFT) is inadequate as a government policy tool. [6]

Mark scheme: Question Answer Marks 1(a) • It is usually applied to possible conflicts of interest that may result 4 between shareholders (principal) and the management (agent) of a firm (1 mark) • or in this case between those who form the rules (government - principal) and those who carry out the rules (businesses – agent) (1 mark) • The conflict could occur because businesses do not seek to achieve what is good for the wider society (up to 2 marks) 1(b) Producing at an output which is either: 4 • not productively efficient – minimum cost for the output in question (up to 2 marks) • or allocatively efficient – marginal social cost does not equal marginal social benefit (up to 2 marks) 1(c) • Internalising externalities – transferring costs that are currently paid by 6 those who do not cause them to those that are responsible for their cause (up to 2 marks) • Comment on the meaning of c-b analysis and an explanation that c-b analysis can give a monetary value to the costs which can then be allocated to the business. Comment on the difficulties of calculating all of the costs (up to 4 marks) 1(d) Inadequate: cost-benefit has limitations – but it does not say what limitations; 6 directives result in an inefficient public sector – although this is not specified why this is; there is crowding out – private businesses are discouraged from investing by large government expenditure which may well require borrowing money and rises in interest rates; it does not create a dynamic new environment or new products. Current economies have to deal with challenges of climate change, youth unemployment, and rising inequality and there is no evidence that the current situation achieves this. Adequate; government creates a bigger national output which benefits everyone; new products have been funded by government – examples are given. Article is mainly against MFT as a solution to the current situation but there could be other evidence to support the justification which is not given.

More questions on Private costs and benefits, externalities and social costs and benefits

2 A city bus company proposes to reduce passenger fares. Explain whether consumers always buy more of a good at a lower price than a higher price. Consider what might be the effect on demand for bus journeys and the revenue of the bus company of the lower fares. [25]

Mark scheme: 2 Explanation of change in demand caused by lower price; mention of income 25 and substitution effects and the difference between normal, inferior and Giffen goods. Revenue change will depend partly on the type of good and partly on the price elasticity of demand. Revenue will increase with a normal good with elastic demand. Bus journeys used to be classified as inferior goods but candidates could debate whether that is still the case. Increasingly, they are preferred to travel by car because of congestion and parking charges. L4 (18–25 marks): for a clear explanation of different types of good, of income and substitution effect and of the possible changes on revenue depending on the price elasticity of demand, and a comment on the likely elasticity of bus travel. L3 (14–17 marks): for a more limited explanation of different types of good, with weaker distinctions between income and substitution effects. A comment should be provided on elasticity but the particular link to bus travel will probably be omitted. L2 (10–13 marks): for a brief explanation but with no distinction between income and substitution effect, no link to bus travel in particular and a general comment on price elasticity of demand. L1 (1–9 marks): for an answer that has some basic correct facts but includes irrelevancies and errors of theory.

More questions on Price elasticity, income elasticity and cross elasticity of demand

3 (a) Two major hotel groups agreed to charge a lower rate for rooms booked through a booking agent than if guests asked for a room upon arrival at the hotel. Explain how price discrimination can occur and how it can be profitable and consider whether the above situation is an example of price discrimination. [12] (b) It has been said that where monopoly occurs rather than a competitive market, the public is the victim; prices are high and output is restricted. With the help of a diagram, consider how far economic theory can be used to support this statement. [13]

Mark scheme: 3(a) Price discrimination requires separate markets – either by ignorance, 12 irrationality, or geography; no possibility of re-sale of product; similar products. It can be first degree discrimination – different price for each person reflecting consumer surplus; second degree – discounts for bulk purchases; 3rd degree – different prices for different groups of consumers. To be profitable the markets need to have different elasticities of demand. L4 (9–12 marks): for a clear explanation of how it occurs, explaining the separate markets and the requirement for different elasticities. Types of discrimination may be mentioned for 11–12. Costs are the same for the room whichever way it is booked as it is for the same time period; practice of different rates is price discrimination. L3 (7–8 marks): for a weaker explanation of the possibilities of price discrimination but with a comment on the profitability. A judgement on the example in the question should be given. L2 (5–6 marks): for a poor explanation of the possibility, no comment on the profitability (or vice versa) and poor link to the example given. L1 (1–4 marks): for an answer that has some basic correct facts but includes irrelevancies and errors of theory. 3(b) This question requires a comparison of monopoly and perfect competition 13 showing higher prices, supernormal profits and lower output in monopoly. The analysis presumes that the cost curves are identical for both markets and this need not be the case particularly with economies of scale. L4 (9–13 marks): for a clear comparison of the markets and a discussion of the effect of economies of scale on the cost curves, and thus on the price, profit and output. The diagram should be accurate, clearly labelled and a judgement on the universality of the theory should be given. L3 (7–8 marks): for a less developed discussion on the comparison or an answer that concentrates too much on possible economies of scale without considering the effect of these on the comparison with perfect competition. The diagram will have lack of clarity but a judgement on the theory should be given for 8. L2 (5–6 marks): for a weak answer with an unclear comparison or a more descriptive account of different economies. The diagram will be poor and badly labelled. L1 (1–4 marks): for an answer that shows some knowledge but does not indicate that the question has been fully grasped or where the answer is mostly irrelevant.

More questions on Different market structures

4 Discuss how economic theory analyses wage rate determination. Consider if the theory can be used to explain the fact that the highest pay is often given for the work that is most agreeable while those occupations that are most unpleasant, such as rubbish collection, receive low pay. [25]

Mark scheme: 4 Candidates should consider each part of the statement. The theory of wage 25 determination should be explained and a comment given on how the outcome may be affected by the existence of trade union bargaining, by minimum wages affecting the supply, by large monoposonies forcing down wages from the competitive level, by whether the worker is in the private or public sector. A link to the specific examples given should be made and a conclusion of the possible usefulness of the theory should be given. L4 (18–25 marks): for a thorough explanation of the analysis of wage determination with a clear comment on how unions, minimum wages and large monopsonistic businesses, public/private sector may be used to explain the difference in wages. There should be a conclusion and a well-structured answer. L3 (14–17 marks): for a weaker explanation of the theory with an undeveloped comment on how the outcome might be affected by unions, minimum wages, public/ private sector. Their explanation may still be competent but the link to the particular examples would probably be brief. L2 (10–13 marks): for a correct but undeveloped analysis with much briefer comment on the different factors affecting the outcome and little, if any, link to the examples given. L1 (1–9 marks): for an answer that shows some knowledge but does not indicate that the question has been fully grasped or where the answer is mostly irrelevant.

More questions on Labour market forces and government intervention

5 (a) Explain what is meant by the term ‘natural rate of unemployment’. Consider which types of unemployment would cause this rate to rise. [12] (b) Some economists argue that government intervention is the best way to reduce the natural rate of unemployment while others suggest that it would be better to allow market forces to reduce this type of unemployment. Compare both approaches and assess which is likely to be the more effective. [13]

Mark scheme: 5(a) Responses should relate the natural rate unemployment to a situation where 12 there is no excess or deficiency of demand for labour. It is also known as the equilibrium rate of unemployment and is caused primarily by frictions in the labour market. Types of unemployment which are likely to cause this rate to rise would include: structural; technological; frictional and seasonal. L4 (9–12 marks): for an answer that clearly explains the links between different types of unemployment and frictions in the labour market and makes some attempt to decide which of these types of unemployment might have the most significant impact on the natural rate of unemployment. L3 (7–8 marks): for an answer that attempts to analyse the relationship between equilibrium/disequilibrium unemployment and types of unemployment which can be used to explain the distinction between equilibrium and disequilibrium situations. Some reference to frictions in the labour market should also be referred to. L2 (5–6 marks): for an answer that provides a superficial definition which is not developed and makes no attempt to incorporate inflationary expectations or does not refer to equilibrium unemployment. L1 (1–4 marks): for an answer that has some basic correct facts but includes irrelevancies and errors of theory. 5(b) A clear distinction between the role of market forces which would rely heavily 13 upon the price mechanism to ensure that all those who want to work at the current wage rate and are willing and able to take a job and direct government intervention to achieve the same outcome. Would expect answers to recognise, with examples, how government policies could incorporate market forces as well as direct intervention. The focus should be upon how both occupational and geographical mobility can be increased to reduce frictions in the labour market. A comparison of alternative approaches should be evident throughout. L4 (9–13 marks): for an answer that focuses upon comparing alternative approaches and which makes an attempt to evaluate the relative success of each type of policy. Strengths and weaknesses should be identified and used to draw a conclusion as to which approach might be the most effective. L3 (7–8 marks): for an answer that attempts to analyse the links between alternative policy approaches and successful outcomes. A clear distinction between the role of market forces and the role of government intervention should be established. At least two policies in each case should be provided and compared. L2 (5–6 marks): for an answer that provides an outline of both approaches but with an unclear comparison and which only considers a very limited range of policy options. L1 (1–4 marks): for an answer that has some basic correct facts but includes irrelevancies and errors of theory.

More questions on Supply-side policy

6 (a) ‘Central banks can control interest rates but they cannot control the money supply. Commercial banks can control the money supply but they cannot control interest rates.’ To what extent would you agree with this statement? [12] (b) ‘Monetary policy alone is unlikely to have any significant effect on real variables such as the level of output but it is the only effective way to control inflation’. Critically evaluate this view. [13]

Mark scheme: 6(a) Answers should address both parts of the statement. Central banks can 12 control interest rates in different ways. Some announce changes to the bank rate while others operate in short term money markets to influence interest rates Answers should also recognise that central banks also have access to a range of policies which can be used to determine the money supply. Responses should also discuss how commercial banks can influence both interest rates and the money supply. Part of the assessment should include recognition that interest rates and the money supply are closely related. L4 (9–12 marks): for an answer that evaluates the extent to which a central bank can control interest rates/money supply and the extent to which a commercial bank can control interest rates/money supply. A conclusion which makes an attempt to discuss how far the statement provides an accurate assessment of the ability of both organisations to control interest rates/money supply is required. L3 (7–8 marks): for an answer that attempts to analyse how a central bank can control interest rates and the money supply, as well as analysing how commercial banks can also influence both interest rates and the money supply. Some reference to the connection between interest rates and the money supply should be provided. L2 (5–6 marks): for an answer that provides a descriptive account of how central banks and commercial banks can influence both interest rates and the money supply. L1 (1–4 marks): for an answer that has some basic correct facts but includes irrelevancies and errors of theory. 6(b) Answers should refer to the monetary transmissions mechanism to show how 13 monetary policy might have some effect on real variables such as the level of output. Reasons why monetary policy might not work might include reference to the liquidity trap, elasticity of MEC curve and the effect of negative expectations on investment. Should discuss whether monetary policy is the only effective way to control inflation by considering alternatives such as fiscal policies and/or direct controls such as prices and incomes policies. L4 (9–13 marks): for an answer that discusses the effectiveness of the transmissions mechanism by questioning the relationship between changes in the money supply, changes in the rate of interest and investment and subsequent changes in output. Some discussion relating to the effectiveness of alternative polices used to control inflation would also be required. There should be a conclusion. L3 (7–8 marks): for an analytical approach that uses diagrams to explain the monetary transmissions mechanism and makes the links between money supply changes, changes in interest rates, changes in investment and, through the multiplier, changes in the level of output. Responses will also analyse alternative approaches which governments can use to control inflation. L2 (5–6 marks): for an answers that provides a description of different types of monetary policy and how these might affect real output, plus an explanation of a possible alternative approach to controlling inflation which does not involve controlling the money supply. L1 (1–4 marks): for an answer that has some basic correct facts but includes irrelevancies and errors of theory.

More questions on Effectiveness of policy options to meet all macroeconomic objectives

7 The Kuznets curve was based upon empirical evidence and it supports the hypothesis that as an economy develops, market forces first increase income inequality and then reduce it. (a) Explain this hypothesis and consider whether it still applies to both developing and developed economies. [12] (b) Significant income inequalities continue to exist in developed economies. Evaluate the use of government policy to redistribute income in developed economies. [13]

Mark scheme: 7(a) Answers should explain discuss the links between the process of economic 12 development and how this might impact upon income distribution. Worker migration from agriculture to industry and the movement from a rural to an urban environment should be explained in the context of economic development. These movements should then be linked to factors such as increases in income and access to education, to explain the first part of the hypothesis and then some attempt to explain how these benefits might be shared as productivity in general starts to rise. L4 (9–12 marks): for an answer that addressed both parts of the hypothesis and questions whether the preceding analysis is sufficient to justify the contention that inequality will initially become greater but then factors related to development will eventually lead to a more equal distribution of income. Alternative explanations should be given and evaluative comment provided in relation to both developed and undeveloped economies. L3 (7–8 marks): for an answer that attempts to analyse the relationship between changes in the structure of the economy by examining why the movement from a rural environment to an urban environment will initially increase the level of inequality and explaining this by referring to changes in income, employment and access to education. L2 (5–6 marks): for an answer that demonstrates some knowledge and understanding of some key characteristics of an undeveloped economy and which recognises that there are often significant differences in income distribution related to changes in the structure of the economy. L1 (1–4 marks): For an answer that shows some knowledge but does not indicate that the question has been fully grasped or where the answer is mostly irrelevant. 7(b) Candidates should ensure that responses focus on developed economies 13 and primarily the role of fiscal policies. Answers should attempt to explain why such inequalities exist and consider the role of a range of fiscal policies which might be used to address the problem. This might include reference to progressive taxation, maximum price controls, minimum wage controls and transfer payments. In each case candidates should discuss the potential of each to redistribute income and consider any long term negative consequences. L4 (9–13 marks): for an answer that recognises that all types of fiscal policy have costs and benefits and it is necessary therefore to consider the wider consequences for the economy of such polices. For example, candidate might refer to the potential negative impact of progressive taxation on investment and economic growth. A conclusion should emerge out of the preceding argument. L3 (7–8 marks): for answer that attempts to analyse the links between at least two changes in fiscal policy and in each case examine the impact on the current income distribution. An analysis of the potential costs of such policies and whether it is possible to rely solely on market forces might also be provided. L2 (5–6 marks): for an answer that is descriptive and which does not make it clear that it is assessing a problem facing a developed economy. Some reference will be made to the use of fiscal policy but the alternatives will be limited and there will be little attempt to analyse the links between changes in fiscal policy and their impact on income distribution. L1 (1–4 marks): for an answer that has some basic correct facts but includes irrelevancies and errors of theory.

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