Question 120 marks
Question
Governments and markets Prices, according to economists, are determined by supply and demand. In many times and places, however, prices have been set by governments. For example, in January 2020, the government of Argentina updated its list of maximum prices, setting guidelines for over 300 products. Consumers, via a smartphone app, can report any prices of these products that are above the maximum. The World Bank has collected data on the extent to which the governments of developing economies have intervened in markets to set prices. Table 1.1 shows the results of this research. Table 1.1: Government intervention in product markets to influence prices in developing economies Product market Percentage of Examples governments intervening in the market to influence price Energy 89 Petrol in Iran Bread in Benin Food 76 Rice in Haiti Building materials 13 Cement in Burkina Faso Source: Adapted from ‘In a fix’, The Economist, 11 January 2020 Governments generally impose price controls for one of three reasons: • to redistribute income in an economy: maximum prices help the poor afford the necessities of life, whereas minimum prices support the livelihoods of farmers • to stabilise a market: governments use stocks to smooth fluctuations in the price of a commodity like cocoa, buying when there is excess supply in the market and selling when there is excess demand • to control inflation: maximum prices have been used in many countries Many economists have been critical of the use of price controls by governments. In a market without government intervention, a product’s price acts as a signal of its scarcity and an incentive to overcome scarcity. However, minimum prices can lead to food rotting in warehouses while maximum prices can lead to hoarding and black markets. Another reason not to impose price controls in an economy is that they can be very unpopular. For example, in Santiago, the capital city of Chile, an increase in the minimum price on the public transport system led to widespread unrest in 2019. In the same year, the government of Iran decided to raise the minimum price of fuel sharply and suddenly, leading to a great deal of protest. A representative of the World Bank has stated that one reason not to impose price controls in an economy is that they can be hard to remove, expressing the view that ‘it is better not to have them in the first place.’ Source: Adapted from ‘In a fix’, The Economist, 11 January 2020 (a) Explain how ‘a product’s price acts as a signal of its scarcity’. [2] (b) Explain one possible reason why the Government of Iran may have decided to raise the minimum price of fuel in 2019. [2] (c) Explain, with the help of a diagram, how an effective minimum price would affect the market for a basic food, such as rice in Haiti. [4] (d) ‘Governments use stocks to smooth fluctuations in the price of a commodity like cocoa.’ Consider whether government action to smooth fluctuations helps the workings of the price mechanism. [6] (e) Discuss whether maximum price controls will always be effective in controlling inflation. [6] Section B Answer one question.
Mark scheme
1(a) Explain how ‘a product’s price acts as a signal of its scarcity’. 2 For a reference to a situation where there are limited resources to satisfy unlimited wants and needs and so price rations the available resources among competing buyers (1 mark) For a development in terms of a rising demand for a product, relative to its supply, will push up prices and act as an incentive to increase the quantity; the existence of scarcity giving rise to the need to make choices between the different uses that can be made of the scarce resources (1 mark) 2 marks maximum 1(b) Explain one possible reason why the Government of Iran may 2 Possible reasons could include: have decided to raise the minimum price of fuel in 2019. • the need to reduce the demand for fuel; an For an identification of one possible reason (1 mark) increase in the price could be effective if the PED for fuel is elastic For a more developed explanation of one possible reason (1 mark) • this could benefit the country’s current account on the balance of payments if a 2 marks maximum substantial amount of fuel is imported, although Iran does have a large amount of crude oil reserves • this will encourage producers to increase the supply of fuel which will help them to increase their profits • an increase in producer profits could lead to a substantial increase in government revenue from the taxes on profits • if subsidies have been reduced, the money saved could be reallocated 1(c) Explain, with the help of a diagram, how an effective minimum 4 Effective minimum price: price would affect the market for a basic food, such as rice in • a minimum price in a market is where a Haiti. price floor is established • to be effective, this needs to be above For an explanation of the effect of a minimum price in a market the equilibrium price (Up to 2 marks) • the equilibrium price in a market would For a correctly drawn and labelled diagram to show the operation of a be higher than would be the case if minimum price in a market for a basic food, such as rice in Haiti there was no government intervention (Up to 2 marks) • farmers are therefore guaranteed 4 marks maximum these prices • this is likely to have a positive effect on their incomes • it could lead to excess supply/surplus • this could lead to the possibility of food rotting in warehouses Diagram: • One mark for correctly labelled P, Q, D and S • One mark for showing a minimum price line above the equilibrium, for showing a price higher than the equilibrium price and for showing the change in quantity 1(d) ‘Governments use stocks to smooth fluctuations in the price of a 6 Government action might help the workings commodity like cocoa’. of the price mechanism: • it can help to stabilise a market Consider whether government action to smooth fluctuations • stocks can be used to smooth helps the workings of the price mechanism. fluctuations in the price of commodity, such as cocoa, avoiding/reducing large For an explanation of how government action to smooth price price variations fluctuations may help the workings of the price mechanism • a government could buy stocks when (Up to 3 marks) there was an excess supply of a For an explanation of how government action to smooth price product in the market fluctuations may not help the workings of the price mechanism • a government could sell stocks when (Up to 3 marks) there was an excess demand for a 5 marks maximum product in the market Reserve 1 mark for a conclusion Government action might not help the workings of the price mechanism: 6 marks maximum • it could distort the market by not allowing prices to reflect changes in the conditions of demand for, and supply of, a product • the consideration of how such action by a government might not help the workings of the price mechanism can be discussed in relation to the different functions of the price mechanism, i.e. rationing, signalling and the transmission of preferences 1(e) Discuss whether maximum price controls will always be 6 The advantages of establishing a maximum effective in controlling inflation. price in a market in the form of a price ceiling: For a discussion of the advantages of using maximum price controls • the price will be lower than what would to control inflation (Up to 3 marks) otherwise be the case if there was no government intervention For a discussion of the disadvantages of using maximum price • this would lead to a lower rate of controls to control inflation (Up to 3 marks) inflation in an economy • this helps the poor afford the 5 marks maximum necessities of life • these could include essential Reserve 1 mark for a conclusion foodstuffs, housing rents and transport • specific examples given include the 6 marks maximum price of foodstuffs, including bread in Benin and rice in Haiti The disadvantages of establishing a maximum price in a market in the form of a price ceiling: • lower prices could stimulate demand- pull inflation • the creation of a shortage as a result of the excess demand created in the market • hoarding • black/illegal markets which can charge relatively high prices • queuing or rationing • if the controls are not effective, it will not control inflation