Model Essays for A Level & IB Economics
Model Essay 1
- Income elasticity of demand (YED) is a measure of the responsiveness of demand for a given good to the change in income, ceteris paribus. It provides information on the direction and magnitude of change in demand given a change in income.
- Profit-seeking firms would be motivated to find means to increase their Total Revenue (TR), thereby possibly also increasing their economic profits, which is the amount by which Total Revenue exceed Total costs. This can be accomplished using the concept of YED.
- Primary products are products which are in their raw form and have not gone through manufacturing or processing. Examples include coal and agricultural products. On the other hand, manufactured products are products that have been processed from raw materials, for example consumer products like TVs.
- The YED for primary products tend to be the lower than that of manufactured products and services. This is because primary products tend to be of the highest degree of necessity, as they are often essential in the production of other goods. For instance, cotton is used in the production of clothing. As a result, primary products tend to be normal necessity goods, with a YED value between 0 and 1.
- On the other hand, manufactured products are often of lower degree of necessity (higher YED value), followed by services (like entertainment or travel) which have the lowest degree of necessity and oftentimes, considered luxury goods (YED > 1).
Thesis: Usefulness of YED
- Knowledge of YED enables a firm to develop a production and marketing strategy, both in terms of the amount of output and the type of good or service.
- Over time, as countries experience economic growth, the real income per capita is likely to increase, which causes the demand for primary and manufactured goods and services to increase.
- The demand for primary goods is likely to increase less than proportionately to the increase in income, whereas the demand for manufactured goods is likely to increase by a greater extent and the demand for services being income elastic will increase more than proportionately. The converse holds true in times of an economic downturn.
- Insert Figure on different relative extents of shifts in Dd curves for Primary vs Manuf Goods & Services. (Taught in class).
- Consequently, this allows the producers to decide on an appropriate production strategy. In times of economic growth, producers of primary products will want to increase output but not drastically. In contrast, producers of manufactured goods and especially services should seek to expand output by a lot more. This will allow them to realise significantly more sales and hence revenue and profits.
- Similarly, coffee growers may want to produce more Arabica beans as demand increases even more. Hence, coffee producers could sell coffee made from the more premium Arabica beans, instead of the more common Robusta beans.
- Producers of manufactured goods might also be incentivised to expand into the production of products that are considered more luxury or high-class.
- In contrast, during a recession or times of economic downturn, a firm should consider focusing on the production of normal necessity goods (for which the decrease in demand is less than proportionate), or even inferior goods (whose demand actually increases). A coffee grower may choose only to produce Robusta beans.
- Large companies should consider producing a range of products with different YED values for greater revenue and profit stability. For example, the Volkswagen Group sells a large variety of vehicles, including luxury passenger cars under brands such as Bentley, Lamborghini and Porsche, as well as more pedestrian offerings under brands like SEAT or Skoda.
- The Group also sells commercial vehicles such as trucks. These vehicles vary widely in YED – luxury vehicles have a YED value that is positive and greater than one, whereas its mass-market brands have a YED that is below 1 or even negative. This allows the company as a whole to be versatile – the company can easily vary the focus in terms of production according to changes in income, thereby ensuring stability in sales and profitability regardless of economic performance.
Anti-Thesis: Limitations of YED analysis
- YED data might not be completely accurate. It is hard for market research and economic studies to accurately simulate consumers’ behaviour in reaction to changes in income. Furthermore, conducting such research and studies takes long periods of time – consequently, the collated data might already be out-of-date and hence inaccurate by the time the firm decides to act on them.
- Knowledge of YED might be insufficient to determine consumption effects, since the ceteris paribus assumption often does not hold true in real life. When planning its product line-up and production quantities, a firm has to assess not only changes in income levels but also take into consideration other factors that might have an impact on the demand for its product.
- For example, an increase in a nation’s income might imply a rise in the demand for technologically advanced televisions, but consumers will have a range of brands from which to choose. Some firms could experience little effect on sales if consumers have a preference for substitute brands. Hence, firms need to take into account of other factors such as consumer tastes and preferences, and not merely YED values.
- The use of YED is mainly geared towards increasing revenues. However, to maximise profits, costs of production also have to be considered. By widening range of products and also by producing more luxury versions, higher unit costs of production may be incurred.
- As production and marketing strategies take time to implement, firms may attempt to use economic growth forecasts to make their decisions. However, such forecasts may be inaccurate, leading to wrong decisions that reduce profits instead.
- While knowledge of YED is important as it does provide a firm with useful and relevant information to help achieve its goals, there are limitations to its application.
- The knowledge of YED would be more important for firms in manufacturing and services since the demand they face would be more sensitive to income changes.
- Knowledge of other elasticities, such as the price elasticity of demand (PED) and XED would also be important in guiding the firm’s strategies, as many factors have to be taken into account.
- Information regarding costs of production would also be vital.
The problem of limited resources and unlimited wants is known as the problem of scarcity. Consumers have unlimited wants - ever higher levels of consumption of goods and services. However, this is not possible, due to limited resources (land, labour, capital and entrepreneurship). Hence, society must make choices on how to allocate scarce resources. Through the signalling, rationing and incentive functions, the price mechanism will help to decide what and how much to produce, how to produce and for whom to produce.
Signalling and Incentive Functions
In the free market, consumers 'vote' for what they want firms to produce through their purchases, and 'vote' against a product by not buying them. Through the use of 'dollar votes', consumers determine 'what to produce'. Firms then respond by producing only those goods using the scarce resources.
Consumers also determine how much to produce by signalling to the producers their preference for a particular good or service through the price they are willing and able to pay for it. The higher the consumer's preference for the good, the higher the price they are willing and able to pay. These preferences are transmitted to producers, who have to make production decisions according to their willingness and ability to sell (i.e. supply). For example, when income level increases, demand for cars increases. At the initial price, P1, there is a shortage as Q2 (quantity demanded) is higher than Q1 (quantity supplied). This leads to an upward pressure on the price of cars and therefore price increases.
The new, higher price signalled or conveyed information to producers that there is a shortage in the car market (signal to producers to expand production). The increase in price is also an incentive for producers to increase the quantity of cars supplied; at the higher price, car production is more profitable, so producers increase quantity supplied from Q1 to Q3. This is the incentive function of the price mechanism.
The new, higher price is also an incentive for consumers: it signals that cars are now more expensive, and is an incentive for them to consider alternatives (such as public transport), buy fewer cars and thus decrease their quantity demanded.
This process continues until quantity demanded= quantity supplied, and the shortage has disappeared. Equilibrium is established at price P2 and quantity Q3.
To increase the quantity supplied, producers of cars will need to enter the factor input markets (e.g. labour) and hire more factor input. In this way, more resources have been allocated to the production of cars, and away from other markets. The price mechanism thus guides resource allocation by solving the problem of 'what to produce' and'how much to produce'.
The incentive function will also mean that profit-maximising producers will use the most efficient (least-cost) way to produce goods and services. For example, when supply of labour decreases due to aging and declining population, the wages of workers will increase and incentivise firms to hire less workers. This is because it is now less profitable to do so and firms will thus seek out relatively cheaper capital goods to replace labour.
Thus, the price mechanism also helps to answer the question of 'how to produce'.
The rationing function of the price mechanism will solve the problem of 'for whom to produce'. As the price for cars increases, some consumers may realise that they are unwilling and/or unable to pay the higher price, hence quantity of cars demanded falls (movement from point B to C.) The rationing function of the price mechanism hence ensures that the limited cars produced using limited resources are rationed out only to those consumers who are most willing and able to pay for it.(Diagram will be taught in our classes.)
- A market that is “more perfect” is one that more closely resembles a Perfectly Competitive (PC) market.
- The PC market has several key characteristics - an infinite number of buyers and sellers; perfect information; free entry and exit of firms and homogenous goods.
Thesis 1: Lowered Barriers to Entry
- The internet has drastically lowered the barriers to entry (hindrances that prevent or discourage prospective firms) for many markets.
- The start-up costs for establishing an online store is significantly lower than a brick-and-mortar store. There is no need to pay rent for a physical shopfront and labour costs are reduced due to lowered manpower requirements (for instance, retail positions like that of cashiers are no longer needed in an online store).
- Furthermore, it is extremely simple to set up an online store. Many platforms exist for the sole purpose of serving as a platform through which sellers can sell goods online. These range from global platforms like Amazon or eBay, to ones that are more niche and serve smaller markets, like Carousell that operates in Singapore. There are also companies, like Wix and SquareSpace, which allows sellers to create their own dedicated website with e-payment services - without the need for any knowledge of coding. It merely takes a few ‘clicks’ to get an online store up and running.
- Thus, barriers to entry have been lowered, allowing for many more sellers in the market. The market also now more closely resemble the characteristic of free entry and exit of firms and hence it is more perfect.
Thesis 2: Global Marketplace
- The internet has also brought together a global marketplace. Increased interconnectivity now allows buyers to connect with sellers around the world with virtually no geographical restrictions in place.
- For example, Zelos is a Singapore-based start-up that makes and sells watches. While it only has physical shopfronts in Singapore, it has used Internet retail platforms to sell watches to a global audience, including Americans and Europeans. Owing to the internet, Zelos is now able to enter the American and European markets whereas previously it would have been limited to only the Singaporean market.
- The number of sellers and buyers in every market has now increased dramatically. Hence, the market is more perfect.
Thesis 3: Increased Access to Information
- The internet has also increased buyers’ and sellers’ access to information. With the internet facilitating the explosion and exchange of information, many sellers are able to ‘copy’ ideas of each other and learn new methods of production quite quickly.
- Similarly, the internet has also allowed buyers to easily compare different products online, from their price to their perceived quality. Buyers can have all the information at hand when they make a decision to purchase a particular product over another. There are also portals like Trip.com that allow easy comparison of flights and hotel prices and services.
- All in all, the Internet now allows for information to be more accessible to buyers and sellers alike, allowing markets to become more perfect.
Anti-Thesis 1: Large firms can still dominate
- Large firms have the financial resources to tap into more advanced, more highly-specialised technologies, exploiting the use of the internet to increase their market share. Such firms are also able to spread out the IT costs incurred over a greater number of output, reducing the cost per unit output.
- For example, large companies could employ AI technologies to better analyse preferences of buyers and their online behaviour, allowing them to come up with products and offers that better appeal to consumers. These can be costly investments, which smaller firms would be unable to engage in and lack the scale to achieve a lower average cost.
- Due to their resources and the economies of scale, large firms may also be able to dominate online advertising, for example, through paying for many banner ads and on more prominent spots. This can result in small firms being drowned out by the advertising bombardment of large firms.
- As a result, large firms remain dominant, both in the physical as well as online and the markets remain imperfect.
Anti-Thesis 2: Internet-based Monopolies
- The rise of the internet technology has also facilitated the creation of technological behemoths, effectively internet-based monopolies in the newly-emerged markets in which they operate. One example is Google, which is the dominant search engine in the world, holding 92% market share. It has become so dominant that the word “google” is now synonymous with “searching for something online”. This has allowed Google to be virtually a monopoly over online advertising. Amazon is also a near-monopoly over book sales online.
- As the internet has led to such new monopolies, it has not made markets more perfect.
Anti-Thesis 3 : High Barriers to Entry still exist
- The internet has not been able to reduce the barriers to entry for all industries.
- For example, in industries with high capital outlay like the shipping industry , which relies on an immense amount of physical capital - large freight ships to move cargo between countries. The rise of the internet has not changed the fact that an immense start-up capital is needed to acquire such physical capital in order for a shipping company to be established.
- Therefore, in such markets, the internet has not made them more perfect.
- The internet has indeed made certain markets more perfect, specifically retail markets boosted by the rise of e-commerce.
- However, this cannot be said for all markets concerned. Only industries where production methods have been simplified thanks to internet technologies, do we find more perfect markets. In others, the internet has little to no effect on production activities at all, and does not make the markets concerned more perfect. The internet also gives rise to new industries and markets, such as social media, where monopolies have formed.
1. Economic growth is a macroeconomic goal of all countries, and is defined as the increase in the value of all the final goods and services produced in an economy, over time.
2. Overall, a rapid economic growth can only be achieved with a combination of a few factors - a large initial rise in Aggregate Demand, Large Multiplier value and sufficient spare capacity in the economy.
Large Initial Autonomous Rise in AD needed:
1. Firstly, a large increase in AD would be necessary to have rapid economic growth.
Diag - Comparing Extent of Increase in AD on economic growth
(Done in class)
2. This is likely to occur if several or all components of the AD, C, I, G (X-M), is increasing.
3. A rise in confidence in the economy would make households more willing to spend on goods and services, hence increasing consumption.
4. Firms with greater business confidence would also see higher expected rates of return on investment projects and hence they would invest more due to the projected profits of the investment.
5. An increase in government spending on infrastructure or other public works could also increase the G component, increasing AD.
6. Furthermore, the net exports component can increase if there is overseas economic growth that led foreign purchasing power to increase, hence foreigners increase demand for this country’s exports, increasing export revenue and the net exports component.
Large multiplier value
1. With a large multiplier, the increase in real national income and hence economic growth rate would be greater, given the same increase in AD.
2. This can be seen through the formula:
3. This is because a large multiplier value occurs when marginal propensity of withdrawal is low.
4. This can be seen through the formula:
(Done in class)
5. This could for example be due to a consumerist culture, which would cause the Marginal Propensity to Save to be very low as households prefer spending rather than saving the marginal increase in income.
6. With a low MPW, more of the increase in income leads to greater induced consumption instead of being leaked out of the economy. This in turn will lead greater increase in output and more rounds of income generation and more spending.
<Diagram: Contrasting Small versus Large Multiplier Effect> (Done in class)
7. With the same amount of increase in autonomous spending from AD1 to AD2, the initial increase in income, induces more spending, generating more income, and through more rounds of spending and income generation, a larger increase in RGDP (YL) than YS. Hence, a more rapid economic growth rate.
Adequate Spare Capacity
1. Finally, even with a large increase in AD and a large multiplier size, rapid economic growth may not occur if there is a lack of spare capacity to accommodate the increasing AD.
2. Therefore, to enable rapid economic growth, there should also be increases in the long run aggregate supply (LRAS), in other words, potential economic growth.
Diag - Comparing Extent of Economic Growth with and without Potential Economic Growth
(Done in class>
3. This can be brought about by increasing the quality and quantity of factors of production.
4. For example, if there is immigration of foreign labour, the labour force would increase. Furthermore, if they are skilled labour, the quality would also increase, increasing the productive capacity.
- Market-oriented supply-side policies refer, broadly, to government policies designed to influence the level of Aggregate Supply (AS) by reducing intervention and increasing competition within the economy.
- Demand-side policies include both Fiscal and Monetary Policy.
- Fiscal Policy (FP) refers to the government deliberately manipulating the level of taxation and government expenditure to influence AD.
- Monetary Policy (MP) refers to the central bank manipulating money supply and interest rates to influence the level of AD.
- Economic growth refers to an increase in the Real Gross Domestic Product (RGDP) produced by an economy over time.
- Economic growth can refer to actual growth or potential growth.
- Potential growth can happen through the expansion of the amount of output that could be produced if all resources are fully employed. Hence, the productive capacity of the economy could be expanded due to an increase in the quantity or quality of factors of production (FOP).
- On the other hand, actual growth refers to the annual percentage increase in the RGDP of an economy.
Brief Explanation of Policies
- Market-oriented supply-side policies work by reducing costs of production and increasing the quantity and quality of factors of productions (FOPs). This leads to increases in short-run AS (SRAS) and long-run AS (LRAS) which drives economic growth.<br />
- On the other hand, expansionary FP involves reducing direct taxes (income and corporate tax) and increasing government expenditure. Reduced income tax allows households to have more disposable income, increasing consumption (C). Reduced corporate tax increases the after-tax profits of firms, making more investment projects profitable, increasing investment (I). The increases in C and I work alongside increased government expenditure (G), leading to increases in AD which allow for economic growth.
- Expansionary Monetary Policy similarly aims to increase AD. This is accomplished through central banks increasing the supply of money in the economy, which consequently decreases interest rates. Decreased interest rates reduce the cost of borrowing by consumers to finance big-ticket purchases, increasing C. Decreased interest rates also serve to increase the expected rate of return to investment projects, incentivising firms to invest, increasing I.
- Referring to the diagram below the increases in C and I lead to an increase in AD from AD1 to AD2. As a result, real GDP increases from Y1 to Yfe, signifying actual growth.
Thesis: Market-Oriented Supply-Side Policies are more effective
- Market-oriented supply-side policies are effective in combating supply-side causes of weak EG. Rising costs of factor inputs, like imported materials or labour may be the result of excessive government intervention (in the form of tariffs or minimum wages). Therefore, it would be wise for the government to tackle these root causes head on through such policies, which stand to be more effective.
- Moreover, by removing minimum wage, reducing power of Trade Unions, privatisation and deregulation, an increase in I would be encouraged, leading to increased AD and hence boosting EG.
- This is unlike demand-side policies, which mainly target AD, and would thus be less suitable in this case. Without dealing with the problems raised above, policies to reduce corporate taxes and lower interest rates may also be ineffective to spur I.
- Additionally, market-oriented supply-side policies promote increased competition and efficiency, avoiding problems of government failure. Policies such as privatisation and deregulation spur productive efficiency, which in the long term is beneficial for the economy and helps to drive growth.
- For example, during the 1970s, in the United States, there were heavy regulations placed upon banks involving interest rates and the lending/borrowing of funds. Today, with the deregulation of the banking industry, ceilings on interest rates and deposits have been removed and the industry is more competitive.
- Also, market-oriented supply-side policies increases the productive capacity of the economy through investments which increases the quantity or quantity of capital goods, allowing for a more efficient utilisation of existing resources.
- This is especially important when an economy is ‘overheating’ or facing too high levels of AD with supply-side constraints. In such cases, market-oriented supply-side policies are crucial in allowing for sustained economic growth to take place in the future.
- Referring to the diagram below, an increase in AD from AD1 to AD2 while AS remained constant would have led to overheating of the economy. However, with an increase in the AS from AS to AS', RGDP can continue to increase while inflationary pressures are relieved.
Anti-Thesis: Demand-Side Policies are more effective
- For one, certain market-oriented supply-side policies tend to be politically unpopular, and thus many governments are hesitant to implement them. Labour market reforms, in particular, face a large amount of opposition from the working class. As a result, such policies might not be implemented to a full extent, causing them to be ineffective. For example, the UK government’s plan to reduce unemployment benefits, drew widespread opposition and protests from many on the streets.
- On the other hand, expansionary demand-side policies generally do not evoke such opposition from the populace; a decrease in taxes (under fiscal policy) would be a welcome measure by many. Therefore demand-side policies can be implemented more aggressively and thus more effective at promoting growth.
- Due to resistance from Labour Unions, etc, some market-oriented supply-side policies can take quite a long time to implement.
- This is unlike Monetary Policy, which can be unilaterally implemented by the Central Bank, and thus can be quickly put into place.<br />
- Market-oriented supply-side policies may also have uncertain outcomes. Unlike fiscal policy, where there is a direct and certain effect on AD through increased government expenditure, supply-side policies may not be as effective in ensuring an increase in spending and output.
- Also, there is an additional benefit from demand-side policies through the multiplier effect where one person’s spending is another’s income, leading to multiple rounds of spending and income generation. Through the successive rounds of increase in AD leading to real GDP increasing, the increase in RGDP is greater than the initial increase in G.
- Market-oriented supply-side policies are not always more effective than demand-side policies.
- For one, demand-side policies might be most effective in promoting economic growth during a recession – monetary policy can be implemented immediately during the onset of a recession with fiscal policy as a direct and aggressive measure of increasing AD through an increase in G.
- Market-oriented supply-side policies are more effective as a long-term solution to increase productivity and competition while promoting a conducive environment for I and thus EG, rather than a short-term solution to reverse a recession.
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