Suggested Answers (Resource Allocation in Competitive Markets II)

Section A: Got Milk? (aii) With the aid of a diagram, account for the change in the price of milk in 2011. ii) Step 1: There was a rise in the price of milk in 2011 and this can be attributed to an increase in demand for milk as well as an increase in supply of milk. Step 2: On the Demand side, - Increase in demand due to increasing incomes of consumers in developing countries, where people are getting wealthier and changing lifestyles of mothers tries, leading to changes in tastes and preferences as they have less time to breastfeed due to increasing participation in the workforce as more women are choosing to work instead of being full full-time mothers rightward shift of DD curve from D0 to D1 Step 3: On the Supply side, Increase in supply due to increase in milk production by nearly 3% in 2011 in the US and other countries as farmers may expect future increase of prices of milk due to increasing demand. Such positive expectations can be seen from milk futures surged 41% last year Hence, more farmers are producing more milk as they see opportunities to reap higher level of profits levels rightward shift of SS curve However, the increase in demand outstrips the increase in supply, eventually resulting in a shortage thus creating an upward pressure on price of milk in 2011. Evidence from text: Para 3 Even with milk production up nearly 3 per cent in 2011, global demand was strong enough to absorb it

Step 4: -

(ci) In your opinion, based on the extract, what will be the value of the cross elasticity of demand for corn and wheat? CED value between wheat and corn is positive and greater than 1.

(cii)Explain your answer. Corn and wheat are close substitutes in consumption/share a high degree of substitutability. They are also seen in the extract, as goods in competitive demand. Evidence from text: Para 6 does not expect (corn) to hit the highsas there are ample global supplies of wheat, which can be used as a substitute for corn in animal feed

Section B: Practice Ex 1 (Elasticities of Dd & SS) (e) Explain the significance of the income elasticity value of -0.29 for margarine. Define YED. The value of YED ranges from positive infinity to negative infinity. For normal goods, as income increases demand increases, demand has positive income elasticity. For inferior goods, as incomes increase, demand decreases resulting in negative income elasticity. The YED value of margarine is negative. This suggests that, as income rises, demand for margarine falls as consumers switch to consuming better quality and more expensive substitutes. Thus, margarine is said to be an inferior good. (f) Would you expect the above figures on income elasticity to differ from those of a less developed country such as China? Why? Yes, the YED figures are expected to differ. What is an inferior good for one country could be a normal good for another country. This is due to the different levels of income existing in different countries. E.g. margarine is an inferior good in UK but not so in China. Demand for instant coffee and meat would also be more income elastic as they are not considered necessities in a Chineses household expenditure in China. Moreover, certain items like meat tends to take up a large portion of the budget in a UKs household but not a Chinese one.

Practice Exercise 2: Land Transport in Singapore (biii) Based on the deduced PED for (i) smaller cars that are less than 1600cc, (ii) bigger cars that are of 1600cc and above, how will the car sellers revenue affected by the new COE quota? The new COE quota would affect the car sellers revenue based on the price elasticity of demand of cars. This is because, based on the extract, the new COE quota would be nearly 30 per cent smaller and this translates to higher prices of owning cars.

For motor traders of smaller cars, a rise in the price of cars is likely to reduce their total revenue. Since demand for smaller cars (less than 1600cc) tends to be price elastic as mentioned in (bii), hence with a rise in the price of cars, the quantity demanded for smaller cars will fall more than proportionately leading to a fall in total revenue for the motor traders. For motor traders of larger cars, a rise in the price of cars is likely to increase their total revenue. Since demand for larger cars (1600cc and above) tends to be price inelastic as mentioned in (bii), hence with a rise in the price of cars, the quantity demanded for larger cars will fall less than proportionately, leading to a rise in total revenue for the motor traders instead.

(biv) Besides the COE quota, what other factors can affect the car sellers revenue? Discuss. Besides the COE quota (hence the higher prices of car ownership), car sellers revenue can also be impacted by other factors. These are factors that shift the demand curve and are due to changes in tastes and preferences and income levels. With a softening economy (Extract 1 para 3), the level of income falls. This would cause the demand for motor cars to shift to the left, assuming they are normal goods, hence reducing total revenue for all the motor traders. However, motor traders of smaller cars are likely to be impacted more as demand from buyers of smaller cars is likely to fall relatively more since this group of buyers are the hardest hit. Moreover, there can be changes in tastes and preferences towards driving. With more new ERP gantries and a recent increase in parking charges (Extract 1, para 5), people may have shifted their preferences towards public transport instead. This would reduce the demand for cars, which are seen as substitutes to public transport, and subsequently total revenue for all the motor traders will fall. In conclusion, the impact on car sellers revenue has to be analysed from many factors, not just the new COE quota.