IB Economics HL 2.7 Role of Governmen…roeconomics

Covered syllabus points

2.7.1—Reasons for government intervention 2.7.2—Main forms of intervention 2.7.3—Consequences of intervention 2.7.4 (HL)—Consumer nudges 2.7.5 (HL)—Intervention calculations

[Maximum number: 25]

(a)

Explain why governments provide subsidies.

[ 10 ]

(b)

Evaluate the effectiveness of price floors in achieving a reduction in the consumption of demerit goods.

[ 15 ]

Answers may include:
- definitions of price floor, demerit goods
- diagram showing the imposition of a price floor, resulting in increased price and decreased quantity demanded (consumed)
- explanation that the imposition of a price floor on the market for a demerit good would increase the price and reduce the quantity demanded (and consumed) of the good, moving consumption of the good closer to the socially optimal quantity
- examples of cases where price floors have been imposed to discourage the consumption of demerit goods
- synthesis or evaluation.

Evaluation may include:
- Consideration of the limitations of the policy: unlike indirect taxes, price floors do not increase government revenues;
may lead to surpluses and attempts by the producers to sell the surpluses at a price below the legally set minimum (in parallel markets);
may increase the producers' revenues and profits (if the demand for the demerit good is inelastic).
- Consideration of the strengths of the policy: the threat of a price floor may cause the suppliers to modify the product to reduce the negative externalities;
price floors may be used in cases where the local government is not legally allowed to impose indirect taxes or ban the use of the demerit good. A price floor allows government to set the price, a tax might be absorbed by abnormal profit-making producers.
- Consideration of the strengths and limitations of alternative policies such as indirect taxes and government regulations (restrictions).

Examiners should be aware that candidates may take a different approach which, if appropriate, should be rewarded.

Assessment Criteria

Level ..... Marks
0 The work does not meet a standard described by the descriptors below. ..... 0
1 There is little understanding of the specific demands of the question. Relevant economic terms are not defined. There is very little knowledge of relevant economic theory. There are significant errors. ..... 1-5
2 There is some understanding of the specific demands of the question. Some relevant economic terms are defined. There is some knowledge of relevant economic theory. There are some errors. ..... 6-9
3 There is understanding of the specific demands of the question. Relevant economic terms are defined. Relevant economic theory is explained and applied. Where appropriate, diagrams are included and applied. Where appropriate, examples are used. There is an attempt at synthesis or evaluation. There are few errors. ..... 10-12
4 There is clear understanding of the specific demands of the question. Relevant economic terms are clearly defined. Relevant economic theory is clearly explained and applied. Where appropriate, diagrams are included and applied effectively. Where appropriate, examples are used effectively. There is evidence of appropriate synthesis or evaluation. There are no significant errors. ..... 13-15

[Maximum number: 6]

"Best Meals" is one of many small catering companies, each of which prepares a variety of different meals for airlines in Country X. Table 1 shows the costs of production in US dollars (US$) on a per hour basis for "Best Meals".

Table 1

The information that follows refers to the aviation industry, which is considered a significant contributor to global warming and climate change.

$Table 2: Energy used and carbon dioxide ( \(\mathrm{CO$

Table 2: Energy used and carbon dioxide ( \(\mathrm{CO

${ }^{1}$ joule: a standard unit of energy
${ }^{2}$ passenger kilometre: one passenger travelling one kilometre

Table 3: Estimates of price elasticities of demand (PED) for leisure and business air travel and estimates of income elasticities of demand (YED) for domestic and international air travel routes

- The aviation sector creates emissions that account for about 4.9 % of human made global warming and its share of greenhouse gas emissions is rapidly growing.
- A flight from San Francisco to Paris can produce around 1.25 metric tons of carbon emissions per passenger. This is more $\mathrm{CO}_{2}$ than the average person in certain countries generates in an entire year.
- The energy source for aircraft is not easily substitutable. Road and rail-based passenger vehicles can switch from carbon-based fuels to renewably sourced electricity. Aviation emissions are thus not expected to be easily reduced.
- The aviation industry's growth has also accelerated as a result of subsidies, including general sales tax and fuel tax exemptions, which are unavailable to other modes of transport.

The catering companies buy tomatoes from the domestic market to prepare their meals. Figure 1 illustrates the domestic market for tomatoes, which is perfectly competitive. S is supply and D is demand.

Figure 1

In order to support the incomes of the tomato farmers, the government of Country X has set a price floor (Pmin) at US$2.80 per kilogram.

(a)

Using Figure 1, calculate the change in the consumer surplus resulting from this government intervention.

[ 2 ]

Initial CS $=(4-2.4) \times 16 \times 0.5=12.8$
Final CS $=(4-2.8) \times 12 \times 0.5=7.2$
Any valid working is sufficient for [1]
Change in CS $=7.2-12.8=-\$ 5600$ (or, a decrease) [1]
An alternative approach with valid workings should be fully rewarded. eg Change in CS $=0.5 \times 0.4 \times(12+16)=\$ 5600$ (decrease)

For full marks to be awarded the response must provide valid working, specify the decrease and include correct units.

(b)

With reference to Figure 1, explain how the price floor will impact on allocative efficiency in the market for tomatoes.

[ 4 ]

Level	Descriptor	Marks
0	The work does not meet a standard described by the descriptors below	0
1	The written response is limited. - The market equilibrium moves away from D=S(MB=MC) / OR excess supply is created [1] - So allocative efficiency is no longer achieved because of overproduction ( OR that social surplus is not maximized) [1]	1-2
2	The written response is accurate Allocative efficiency requires MB=MC for the last unit traded [1]. This occurs at 16,000 kg, where MB=MC=US\$2.40 [1]. At the US\$2.80 price floor, suppliers offer 20,000 kg but buyers demand only 12,000 kg [1]. Without government purchases, only 12,000 kg are traded; at that quantity MB=US\$2.80 exceeds MC=US\$2.00, so mutually beneficial trade is lost and allocation is inefficient [1]. Alternatively, if the government purchases the surplus and total production reaches 20,000 kg, MC=US\$2.80 exceeds MB=US\$2.00 at the last unit, giving overproduction and inefficiency. Credit a clearly stated, internally consistent interpretation. Candidates who do not make reference to the diagram may be awarded a maximum of [3].	3-4

If the government purchases the 8,000 kg unsold surplus and it has no additional consumption value, an alternative approach is to calculate the welfare loss resulting from the price floor
Change in CS =-5600
Change in PS $=0.5 \times 0.4 \times(16000+20000)=7200$ [1]
Change in G $=-2.8 \times 8000=-22400$ [1]
Net welfare loss =-5600+7200-22400=-$ 20800 [1]
Any valid working is sufficient for [1]

OFR applies if the change in CS, PS or G is incorrect, but the calculation of net welfare loss is accurate.

Therefore the market is not allocatively efficient [1]

[Maximum number: 4]

Read the extracts and answer the questions that follow.
Text A - The economy of Argentina

Read the extracts and answer the questions that follow.
Text A - The economy of Argentina

(1) Argentina, the third-largest economy in Latin America, has experienced several cycles of high economic growth and deep recessions over the last 70 years. It has vast natural resources in energy and agriculture and potential for renewable energy. Its leading exports include soybeans and beef products, which contribute significantly to gross domestic product (GDP) and employment and are major sources of foreign currency. However, Argentina faces unfavourable climate conditions that create problems for the agriculture sector. A drought in 2023 caused over 20 billion United States dollars (USD) in losses for soybean farmers.

(2) Argentina faces high relative poverty rates despite redistribution policies such as transfer payments. Argentina is known for extensive government intervention, including price ceilings on rent and strong protection for labour unions and workers.

(3) For many years, Argentina managed its exchange rate by limiting the amount of foreign currency that citizens could purchase as well as by restricting imports. The aim was to protect reserve assets and prevent currency depreciation. This led to the establishment of an informal (unofficial) foreign exchange market and discouraged foreign direct investment (FDI). However, the foreign currency limitations resulted in an overvalued currency and failed to stop the level of reserve assets from decreasing.

(4) In 2018, Argentina requested a loan from the International Monetary Fund (IMF) to help fund its budget deficit and large external debt repayments. However, Argentina defaulted on its debt repayments to the IMF, which led to low consumer and business confidence, causing large FDI and portfolio investment outflows. To receive future loans, the IMF requires Argentina to promote good governance, reduce government spending, increase reserve assets and control inflation.

(5) In 2022, Argentina's economic challenges continued with high inflation and a persistent budget deficit, leading to unsustainable debt. High inflation has led to declining real wages. Moreover, uncertainty about future prices has contributed to lower business investment.
Text B - Argentina's new economic reforms

(1) In December 2023, Argentina's new government initiated reforms to help solve its economic challenges. The new economic reforms included:
- deregulating markets, such as removing price controls and restrictions on buying foreign currency
- privatization of 41 state-owned enterprises to improve efficiency, including the national airline, rail networks, state media, and major oil, water and sewage companies, many of which were recording losses and burdening the government budget
- increasing labour market flexibility by reducing labour union power and lowering labour costs
- reducing government spending by cancelling infrastructure projects, reducing the size of the public sector and eliminating transport and energy subsidies.

(2) The immediate result of removing restrictions on foreign currency purchases was a large depreciation of the Argentine peso (ARS), Argentina's currency, as predicted by speculators. Moreover, inflation increased to over 250 %. The new government maintained that while the reforms may cause a short-term recession, the policies would ultimately lead to long-term price stability and economic growth, despite predictions that relative poverty rates could increase to 60 %. However, the government has stated it will continue spending on programmes to decrease poverty.

(3) To address the budget deficit and maintain a trade surplus, the government increased taxes on cigarettes and imposed tariffs on imports such as laptops. Income taxes were increased, but the level of income on which no income tax is paid was raised from ARS 1.35 million to ARS 1.55 million per month.

(4) The IMF supported the reforms and agreed to grant future loans to Argentina. The loans are important to establish international credibility and finance government spending.

Table 1: Argentina's exchange rates

Text C - Education and productivity in Argentina
Despite significant investments in education, achievement levels are not improving. Experts recommend that Argentina focus on improving the quality of education to decrease poverty rates and increase the economy's productive capacity. Additionally, Argentina's low female labour force participation rate indicates an underutilized resource. An improved education system could increase female participation in the economy and raise household incomes.

Table 2: Development data for Argentina

Table 3: Economic data for Argentina

Using a demand and supply diagram to indicate the total cost of the subsidy to the government, explain how eliminating energy subsidies may affect government spending (Text B, paragraph 1).

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IB Economics HL 2.7 Role of Government in Microeconomics Topic Practice

Covered syllabus points

Question 1

Question (a)

Question (b)

Question 2

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Question 3