Economics 9708/22 — May/June 2022

Background Concept

Goods are classified based on two key characteristics: excludability and rivalry in consumption.

• Excludability: A good is excludable if it is possible to prevent people who have not paid for it from using it. Non-excludable goods cannot be restricted to paying users only.
• Rivalry in consumption: A good is rival if one person's consumption reduces the quantity available for others. Non-rival goods can be consumed by multiple people simultaneously without reducing availability.
  Private goods (economic goods) are both excludable and rival. Public goods are both non-excludable and non-rival, leading to the free-rider problem where people can benefit without paying, so private firms will not provide them. Merit goods are goods that are under-consumed because consumers underestimate their private benefits, while demerit goods are over-consumed as consumers underestimate their private costs.

Understanding the Question

This 4-mark question asks you to explain whether free school lunches provided by the Russian government are private or public goods. The mark scheme requires you to: (1) demonstrate understanding of excludability/non-excludability, (2) demonstrate understanding of rivalry/non-rivalry, (3) apply both criteria to free school lunches, and (4) reach a correct conclusion. The question is not asking about merit goods, only the public/private classification.

Approach

First, define the two key classification criteria clearly. Then apply each criterion to free school lunches: explain why they are excludable (the government can limit access to school children) and rival (one child's lunch cannot be eaten by another). Finally, conclude that they are private goods, as they meet both criteria for private goods and neither for public goods.

Step-by-Step Reasoning

1. First mark (excludability): Define excludability as the ability to prevent non-payers from using a good. Free school lunches are excludable because the government can restrict provision to children enrolled in state schools, and prevent non-eligible people (e.g. adults, children not in school) from accessing them.
2. Second mark (rivalry): Define rivalry in consumption as a situation where one person's use of a good reduces the amount available for others. Free school lunches are rival because each lunch is a physical good that can only be eaten by one child; if one child eats it, it is no longer available for another child.
3. Third mark (application): Apply both criteria to the good, confirming it is excludable and rival.
4. Fourth mark (conclusion): State that since free school lunches are excludable and rival, they are private goods, not public goods. Note that while they are provided free at the point of use by the government, this does not make them public goods: public goods are defined by their characteristics, not by who provides them.

Key Takeaways

• The classification of a good as public or private depends on its inherent characteristics (excludability and rivalry), not on who provides it or whether it is free at the point of use.
• Many goods provided free by the government (e.g. healthcare, education, school meals) are private goods, not public goods, because they are excludable and rival.
• Public goods are rare in real economies: examples include national defence, street lighting, and unpoliced open sea fisheries.

Common Mistakes

• Confusing the provider of the good with its classification: just because the government provides a good free of charge does not make it a public good.
• Failing to apply the criteria to the specific good: defining excludability and rivalry is not enough; you must link them to school lunches to earn the application marks.
• Claiming school lunches are public goods because they are provided by the government: this is incorrect, as they do not meet the non-excludable and non-rival criteria.

Things to Be Careful About

• Ensure you define both excludability and rivalry clearly to earn the first two marks.
• The conclusion must be based on the application of the criteria: do not just state 'they are private goods' without explaining why.
• Do not confuse merit goods with private goods: while free school lunches are a merit good (under-consumed if left to the free market), they are still private goods in terms of their excludability and rivalry.

Background Concept

Fiscal policy refers to the use of government spending (G) and taxation (T) to influence macroeconomic objectives including price stability (low inflation), low unemployment and economic growth. A budget deficit occurs when government spending exceeds tax revenue, while a budget surplus occurs when tax revenue exceeds government spending. A move from deficit to surplus is contractionary fiscal policy, which reduces aggregate demand in the economy.

Aggregate demand (AD) is the total demand for goods and services in an economy at a given price level, calculated as AD = C + I + G + (X - M), where C is consumer spending, I is investment, G is government spending, and (X - M) is net exports. Aggregate supply (AS) is the total supply of goods and services in an economy at a given price level. Short-run AS (SRAS) is upward-sloping, as firms increase output when the price level rises, while long-run AS (LRAS) is vertical at the potential output level.

Inflation is a sustained increase in the general price level. Demand-pull inflation occurs when AD rises faster than AS, pushing up the price level, while cost-push inflation occurs when AS shifts left (e.g. due to higher input costs), pushing up the price level even if AD is constant.

Understanding the Question

This 6-mark point-based question asks you to assess the impact of the changes in Table 1.1 (the Russian government's move from a budget deficit to a surplus) on the rate of inflation, using AD/AS analysis. The mark scheme awards marks for: (1) analysis of the AD impact of contractionary fiscal policy and its effect on inflation (up to 3 marks), (2) analysis of the possible AS impact of the policy and its effect on inflation (up to 2 marks), and (3) a valid conclusion (1 mark). You need to cover both the demand-side and supply-side effects to reach the top mark band, and reach a justified conclusion.

Approach

First, explain what the move from deficit to surplus implies for fiscal policy (contractionary). Then analyse the demand-side effect: how lower G or higher T reduces AD, shifting the AD curve left, lowering the equilibrium price level and thus inflation. Next, analyse the supply-side effect: how fiscal contraction could raise firms' costs or reduce investment, shifting SRAS left, which increases the price level and raises inflation, offsetting the AD effect. Finally, conclude on the net impact, noting that the AD effect is likely to dominate but the AS effect will moderate the reduction in inflation.

Step-by-Step Reasoning

1. Interpret Table 1.1: The budget balance was negative (deficit) from 2015 to 2017, and positive (surplus) from 2018 to 2019. This means the government reduced spending, raised taxes, or both to move from borrowing to running a surplus, which is contractionary fiscal policy.
2. AD analysis (up to 3 marks): Contractionary fiscal policy directly reduces the G component of AD, and indirectly reduces C (via higher taxes lowering disposable income) and possibly I (via higher taxes reducing firm profits and investment). This shifts the AD curve to the left. At the original equilibrium, this creates a surplus of goods and services, so firms lower prices, reducing the equilibrium price level. A lower price level means a lower rate of inflation, so this effect reduces inflation.
3. AS analysis (up to 2 marks): The fiscal contraction may also affect AS. For example, cuts in government spending could reduce subsidies to firms (e.g. for energy or transport), raising their per-unit production costs and shifting the SRAS curve to the left. Higher taxes could also reduce firms' retained profits, lowering investment in new capital, which reduces productive capacity and shifts SRAS left over time. A leftward shift in SRAS reduces output and raises the equilibrium price level, increasing inflation, which offsets the demand-side reduction in inflation.
4. Conclusion (1 mark): The net impact on inflation depends on the relative size of the AD and SRAS shifts. In most cases, the demand-side effect of contractionary fiscal policy is larger, so inflation will fall, but the supply-side effect will moderate the extent of this fall. If the government cuts subsidies heavily, the SRAS effect could be large enough to offset the AD effect entirely, leading to higher inflation.

Key Takeaways

• A move from budget deficit to surplus is contractionary fiscal policy, which reduces AD and lowers inflation via the demand side.
• Fiscal policy can also affect AS: cuts to spending or tax rises can raise firms' costs or reduce investment, shifting SRAS left and increasing inflation, which offsets the demand-side effect.
• When assessing the impact of fiscal policy on inflation, you must consider both AD and AS effects to get full marks.

Common Mistakes

• Only analysing the AD effect: this will earn a maximum of 3 marks out of 6, as you miss the AS analysis marks.
• Only analysing the AS effect: this is incorrect, as the primary effect of fiscal contraction is on AD.
• Forgetting to conclude: the 1 mark for a valid conclusion is reserved, so you must end with a judgement on the net impact on inflation.
• Confusing budget deficit/surplus with expansionary/contractionary policy: a move to surplus is contractionary, not expansionary.

Things to Be Careful About

• Explicitly link the change in the budget balance to contractionary fiscal policy: do not just say 'the government cut spending' without linking it to the move to surplus.
• Explain the direction of both AD and SRAS shifts clearly, and link each shift to the resulting change in the price level and inflation.
• Ensure your conclusion addresses the specific question: the impact on the rate of inflation, not on output or employment.

Background Concept

Russia is a major exporter of oil and gas, so its economy is heavily dependent on commodity export revenue. Exchange rate changes affect the relative price of a country's exports and imports: a depreciation (fall in value) of the domestic currency makes exports cheaper for foreign buyers and imports more expensive for domestic consumers. The impact of a depreciation on the trade balance depends on the price elasticity of demand (PED) for exports and imports, as described by the Marshall-Lerner condition: the trade balance will improve only if the sum of the PED of exports and the PED of imports is greater than 1 (elastic).

A fall in the price of a major export commodity like oil has mixed effects: it reduces production costs for domestic firms that use the commodity as an input (an opportunity), but reduces export revenue for commodity producers if demand for the commodity is price inelastic (a threat). The terms of trade (the ratio of export prices to import prices) falls when export prices fall relative to import prices, which reduces a country's purchasing power over imports.

Understanding the Question

This 6-mark point-based evaluative question asks you to discuss whether the huge decrease in the oil price and the fall in the value of the rouble bring more opportunities than threats to the Russian economy. The mark scheme requires you to: (1) analyse opportunities from both shocks (up to 3 marks, maximum 2 if only one shock is considered), (2) analyse threats from both shocks (up to 3 marks, maximum 2 if only one shock is considered), and (3) reach a well-reasoned conclusion on whether opportunities outweigh threats (1 mark). You must cover both shocks for both opportunities and threats to reach the top mark band.

Approach

First, identify opportunities from each shock: lower oil prices reduce input costs for non-oil firms, and a weaker rouble makes exports cheaper and imports more expensive, boosting export revenue if demand is elastic. Then identify threats from each shock: lower oil prices reduce export revenue for the oil sector if demand is inelastic, and a weaker rouble causes imported inflation and higher costs for import-dependent firms. Finally, weigh the two sides, noting that Russia's high dependence on oil exports means the oil price fall is likely to be a larger threat, though the weaker rouble provides some offsetting benefits, and reach a justified conclusion.

Step-by-Step Reasoning

1. Opportunities from the oil price fall: Oil is a key input for transport, manufacturing and energy production. A fall in the global oil price reduces production costs for Russian firms that use oil, making their non-oil exports more price competitive in international markets. This could increase non-oil export volumes, improve the current account balance, and raise output and employment in non-oil sectors.
2. Opportunities from the fall in the rouble's value: A depreciation of the rouble makes all Russian exports cheaper for foreign buyers. If the PED for Russia's exports is elastic (greater than 1), the percentage rise in export volumes will exceed the percentage fall in price, so total export revenue rises. It also makes imports more expensive for Russian consumers, so if the PED for imports is elastic, the percentage fall in import volumes will exceed the percentage rise in price, so total import expenditure falls, improving the current account. A weaker rouble also makes Russia a cheaper destination for foreign tourists, boosting service export revenue.
3. Threats from the oil price fall: Russia is one of the world's largest oil and gas exporters, so oil export revenue makes up a large share of its national income and government budget. Oil demand is typically price inelastic in the short run (PED < 1), as it is a necessity for transport, heating and industrial production. A fall in the oil price will therefore reduce total oil export revenue, worsening the current account balance, lowering national income, and potentially causing job losses and lower profits in the oil and gas sector. It may also reduce government tax revenue from the oil sector, leading to cuts in public spending.
4. Threats from the fall in the rouble's value: A weaker rouble increases the price of imported goods, including food, machinery and consumer durables. This leads to imported inflation, which reduces the purchasing power of households if nominal wages do not rise as fast as import prices, lowering living standards. It also raises production costs for firms that rely on imported inputs, reducing their profitability, output and employment.
5. Weighing opportunities and threats: The net impact depends on the size of the two shocks, the elasticity of Russia's imports and exports, and the structure of its economy. Given Russia's high dependence on oil and gas exports, and the likelihood that oil demand is inelastic in the short run, the revenue loss from the oil price fall is likely to be large. The weaker rouble provides some offsetting benefits for non-oil exporters, but these are unlikely to fully compensate for the loss of oil revenue. Overall, threats are likely to outweigh opportunities.

Key Takeaways

• The impact of a commodity price fall depends on whether the country is a net exporter or importer of the commodity, and the price elasticity of demand for the commodity.
• The impact of a currency depreciation on the trade balance depends on the Marshall-Lerner condition: the sum of the PED of exports and imports must be greater than 1 for the trade balance to improve.
• When evaluating external shocks, you must consider both the sector-specific effects (e.g. oil exporters vs non-oil exporters) and the economy-wide effects (e.g. inflation, living standards).

Common Mistakes

• Only analysing one of the two shocks: the mark scheme caps the mark at 2 for opportunities or threats if only one shock is considered, so you must cover both oil price fall and rouble depreciation for both sides.
• One-sided analysis: if you only discuss opportunities or only threats, you will not earn the evaluation marks, as evaluative questions require two developed sides.
• Forgetting to conclude: the 1 mark for a justified conclusion is reserved, so you must end with a clear judgement on whether opportunities outweigh threats.
• Assuming a depreciation always improves the trade balance: this is only true if the Marshall-Lerner condition holds, which may not be the case in the short run.

Things to Be Careful About

• Ensure you link each point to the Russian economy specifically, rather than giving generic points about oil prices or exchange rates.
• When discussing the oil price fall, distinguish between the effect on oil exporters (negative) and firms that use oil as an input (positive).
• When discussing the rouble depreciation, distinguish between the effect on exporters (positive) and importers/consumers (negative).
• Your conclusion must be justified: do not just say 'it depends' — explain which side is stronger and why, based on the Russian context.