ECON3 January 2013 - Grade: A PDF

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AQA ECON3 ANSWERS 25 MARK QUESTIONS JANUARY 2013 I wish to make clear that these answers are my own suggested approach and are not endorsed by AQA. There are other approaches to the question besides the ones taken here, although the intention is that these are examples of good answers to the questions set. In particular, different evaluative judgements to those which I have made in answer to a question may be equally valid if supported by well-placed economic theory or real world evidence or examples. The guidance below provides some support in approaching questions. Good luck with your studies and the exam. Peter Cramp

Symbols – The answers here are annotated in much the same way that they would be by the examiner when marking candidate scripts. The symbols are designed to highlight the skills being demonstrated at each point in the answer: D Definitions Knowledge, for example of economic events or data Kn Issue – A relevant issue or point is raised. This is often in the first sentence of a I paragraph. Application – Applying the information in the extract, or knowledge of economic Ap events or data, to help support the answer to the question. An Analysis – The use of relevant economic theory in answering the question, building up logical chains of reasoning. E Evaluation – Making judgements about the significance of particular factors, especially in providing a final answer to the question. Evaluation should be supported by relevant economic theory, information from the extract or the candidate’s own knowledge

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GUIDANCE 1. It is common exam practice to define key terms in the question in the introduction to your essay. 2. The first sentence of each main paragraph of your work should clearly specify the point or issue which will be analysed in the paragraph. 3. The issue to be analysed in each paragraph should be clearly related to the question. Suppose the question is “Evaluate ways in which governments can make markets more competitive.” It is appropriate to use paragraphs beginning “ One way in which governments can make markets more competitive is………” 4. The analysis in each paragraph should be a logical chain of reasoning. The more detailed this analysis is, the better, so include as many “links” in your chain as possible. 5. Appropriate use of economic diagrams is another way of demonstrating the skill of analysis 6. You must have tight focus on the question set. Good economic analysis, but based on material which is irrelevant or of borderline relevance may result in a lower mark than if the material had not been included. 7. The skill of evaluation is vital to scoring high marks for 25 marks answers. This involves making reasoned judgements in response to the question. 8. The main place that evaluation is expected in your work is in your conclusion. You must reach a final judgement that answers the question set and your judgement must be backed substantially by appropriate economic theory and/or “real world evidence” 9. You are also likely to include some evaluation in the main body of your essay. This can usefully be undertaken at the end of a paragraph following substantial analysis, or in a separate evaluative paragraph following on immediately. 10. The more specific your judgement can be the better. Suppose for instance that the question is “Evaluate the view that the government should not regulate prices in utility industries such as gas, electricity and water”. A candidate might argue that the government does not need to regulate prices if there is sufficient competition in the market to ensure that prices are kept low. This is indeed an example of evaluation. It would be stronger evaluation if the point were supported by an assessment of how competitive utility markets are in reality. Suppose a second candidate were to take the same starting point, but went on to argue that the water industry is not competitive, and this is associated with the fact that it is a natural monopoly. Further, in gas and electricity markets, there are several firms for customers to choose from, but there has been some evidence that demand for the services of any one firm is inelastic, due to consumer inertia or lack of knowledge. This has allowed firms to raise prices to customers more than any increases in their

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costs of production. If the second candidate cited this evidence and concluded that it provides a basis for the government to regulate prices, he or she would have undertaken much stronger evaluation than the first candidate. This is because a specific and supported judgement has been made about how appropriate regulation of prices would be in the utility industries stated in the question. It is a good idea to study previous questions and to have a stock of examples and real world data that would help to answer them. You can pick up such examples from these suggested answers.

© Peter Cramp, 2013.

AQA ECON3 JANUARY 2013 CONTEXT 1 D Trade unions are organisation which workers join in a bid to improve pay and working conditions. Ap Unions replace ‘individual bargaining’ with ‘collective bargaining’ (Extract B, Line 12), An and work because when negotiating with their employer as a group workers become more powerful than they would be if acting alone. I/E The claim that governments should intervene in labour markets to increase trade union membership holds good only if market failure is present to justify intervention in the labour market. An It could be argued, for example, that low wages paid to some workers in competitive labour markets constitute an unfair outcome and that market forces create a lack of equity. This is contentious and matters of fairness are a highly normative issue. The question of what is fair and unfair in the distribution of income cannot be settled through economic analysis. Nevertheless, it is widely accepted in developed countries that the distribution of income should not be determined entirely by market forces. This provides justification for redistribution of income through taxes and benefits. It may also provide a reason for governments to intervene in markets to encourage union membership. I This poses a question as to which method of lessening inequality is the best to pursue. I/Ap Trade union membership can raise wages for low paid workers . “Union members earn on average nearly 17% more than other workers (Extract B, line 19) as the union may act as a monopoly supplier of labour. An Its power to raise wages tends to be greatest when there is a ‘closed shop’ such that all workers in a particular profession have to be a member of the same union, although closed shop agreements are illegal in the UK. Union power is also raised by inelastic labour demand. When unions act to raise wages, there will be some workers rendered unemployed because the wage is raised above their marginal revenue product, meaning that profit-maximising firms will not want to employ them. This contraction of labour demand is not so great when demand for labour is inelastic. To raise the wage, the union restricts the supply of labour and effectively imposes a minimum wage in the labour market. This situation and the resulting unemployment are shown in the diagram below.

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An Diagram – Trade unions may raise wages at the expense of causing unemployment

I/E The possibility of unions causing unemployment is one reason why governments should think carefully before encouraging union membership. Trade unions are meant to help to improve the living standards of workers, but this cannot be said to be the case for those who are made unemployed. I/E It should be noted, however, that the case for union membership is stronger when a monopsonist is present in the labour market. An Monopsonists use their power as the sole buyer of a particular type of labour to drive down wages, and such power can be countered by trade unions without causing unemployment. This is because trade unions can reduce the marginal cost to the monopsonist of employing an extra worker. Ordinarily, a monopsonist has to pay a higher wage to attract an extra worker and must pay this higher wage to all other workers as well, meaning that the cost exceeds the wage paid to the additional worker. By effectively imposing a minimum wage on the market, the union turns the firm into a wage taker, such that the marginal cost of employing an extra worker is only his wage. In this situation, unions may raise not only wages but employment. I While cases of pure monopsony are rare, it is true that there are many labour markets in which some employers are large enough to exercise some influence over wage rates. An Wherever the pay is lower than the marginal revenue product of the last worker it can be said that some monopsony power exists. E If a degree of monopsony power is widespread in the labour market this strengthens the case for government intervention to support union membership. This suggests a role for the government in researching the extent to which workers are paid less than their marginal revenue products. I It should also be noted that some trade unions act in partnership with firms to produce outcomes which are in the interests of both workers and firms. An It could be argued that the interests of workers and their employers are well aligned as when the company is profitable it helps to protect the jobs of workers. It is possible that unions might be able to achieve higher wages for their workers by signing productivity deals. If wages are raised in line with productivity, unit labour costs do not increase and this means that jobs are © Peter Cramp, 2013.

protected. The firm is able to remain at least as competitive as it was previously, more so if productivity has increased faster than wages. I/E If this nature of union activity as partnership with the firm can be encouraged, there may be a strong case for governments to intervene to increase union membership. Otherwise there is a danger that unions are seen by firms and governments as simply raising the costs of production. Any increase in wages is then seen as being to the detriment of the firm. Ap This explains why “some large companies have adopted an anti-union strategy in the countries in which they operate” (Extract C, Line 5). I A further argument for encouraging union membership is that unions can help to protect vulnerable groups of workers from discrimination and exploitation. Ap This argument might be applied to members of minority groups or women, especially in some developing countries. An Such workers might be paid a lower wage because employers perceive their marginal products to be lower than they actually are, or simply because cultural values make it possible to pay lower wages and thereby to reduce production costs. By standing up for the rights of workers, it is possible that union activity can reduce such discrimination. Evaluation/final judgement (s) I In final judgement, the case for governments intervening to encourage union membership relies crucially on the claim that low wages constitute a market failure; this is a claim that cannot be settled by economic analysis. I It also leaves open the possibility that there might be superior methods to close the gaps between the better and less well off in society. An These might include redistribution through the tax and benefit system, although this itself carries drawbacks such as a possible detrimental effect on incentives. By raising the pay of low paid workers, union activity should improve the incentive to work rather than diminish it. I It might also be suggested that the case for increasing union membership may differ in value according to the country to which it is applied. An Wages in China are often very low and may fail to meet even basic needs and some would argue this strengthens the case for union activity, but with unions who act for the workers not under the direction of the government as appears to be the case with the ACFTU in the extract. This said, the cultural basis for seeing unions and firms as partners, which could lead to productivity deals to the benefit of both parties, may not exist in China. K In the UK, although wages are generally higher and absolute poverty is not such a concern as in China, there is still considerable inequality, with a Gini coefficient which has risen since union powers were curtailed in the 1980s. It is doubtful whether such large scale inequality is a good thing. I On this basis, governments should give careful consideration to measures to reduce inequality. An Encouraging union activity is one way in which this could be done, but care should be taken to ensure that any increase in wages goes hand in hand with

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increases in productivity so that the competitiveness of UK firms is not damaged. This view is supported by the UK’s current need for export led growth. This would become more difficult to achieve if the cost of labour was raised unduly in the UK relative to other countries.

© Peter Cramp, 2013.

AQA ECON3 JANUARY 2013 CONTEXT 2 D Competition occurs in price and non-price forms as firms attempt to win market share. Price competition is generally thought to be to the advantage of the consumer, who enjoys a greater surplus (the gap between the price he actually pays and the maximum price he would have been willing to pay) when prices are low. This explains why governments might be keen to promote competition in markets such as that for domestic gas. I Indeed, the absence of competition can be considered a market failure. An When firms have monopoly power they are able artificially to restrict the supply of the good in order to raise its price. If the price is raised above the marginal cost of production, this implies that the consumer values the last unit of the good produced more highly than its cost, which suggests that overall welfare could be increased if more resources were allocated to the good. As compared to a competitive market, a monopoly produces a deadweight welfare loss as shown in the diagram below An Diagram Monopoly compared to competition

I One way in which the authorities could promote competition in the domestic gas market is by subsidising new entrants. Ap At present the market is highly concentrated (“six energy firms control 99% of the market”) and “there are no signs of significant new entrants into the market”. An It is likely that the incumbent firms enjoy substantial economies of scale

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which would give them cost advantages over any new entrant. This, along with other barriers to entry such as brand loyalty to incumbents and substantial capital requirements, protects the position of the big six suppliers. A subsidy for new entrants would reduce their costs and help them to compete until they achieve sufficient size to enjoy economies of scale similar to the incumbents. I/An/E Encouraging new entry into the market may prove very difficult even with subsidies, because the economies of scale enjoyed by the incumbent firms are very large, as there are substantial fixed costs in the industry which can be spread across higher volumes of output. An There are also issues about the affordability of the subsidy, especially given the current constraints on government finances. It is possible that the money could be better used elsewhere and opportunity cost should be considered. There could even be questions about the legality of the subsidy, as it would not be available to all firms in the market and might contravene EU rules if the new entrants compete in other European markets too. I A second way of promoting competition is to regulate prices, effectively setting a price ceiling. An In a way, this is not so much promoting competition as mimicking its effects. The job of the regulator would be to set prices similar to those which would prevail if the market were competitive. Regulators such as OFGEM can use an “RPI + X” pricing formula to limit the extent to which real prices are allowed to rise. While the price cap restricts the revenue earning potential of the firm, it has the advantage that firms retain incentives to increase efficiency. If they are able to make cost savings, the gap between revenue and cost grows, enabling the firm to make increased profit. I/E The job of setting prices by intervention in a market is far from easy. An It requires full information about the revenue and costs of the firms in the market, for example, and this information is often supplied by the firms themselves. The regulator is also likely to come under pressure from the industry, for example through suggestions that price controls will limit profits and in so doing deny firms funding for important investments. It may even be suggested that the regulator is threatening consumer safety if price controls are too stringent in a market such as gas. Such pressures may create concerns about regulatory capture, which can also stem from situations where the regulator is too close to the firms he is supposed to control. The regulator may himself have worked in the industry previously and be keen to be well regarded by his contacts within it. I/E A further method of promoting competition is to take measures to prevent markets becoming further concentrated (intervening to block mergers) or, where markets are already concentrated, taking action to prevent anti-competitive practices. An Within concentrated markets such as domestic gas supply there may be a danger of collusion between firms to raise the price of the product. Substantial resources are devoted to the detection and punishment of such behaviour. K In the case of formal price fixing, for instance, fines of up to 10% of turnover can be applied and company directors can be sent

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to jail. E Such measures are likely to be effective simply because of the scale of the punishments involved which should act as a significant deterrent. I A final method of promoting competition is to encourage ease of switching between suppliers. Ap “In 2011, A BBC consumer affairs programme suggested that companies were…………locking customers into long term contracts”. An If consumers are unable to switch providers, firms do not have to compete to win their business with the result that there is little downward pressure on price. Consumers are often reluctant to switch suppliers even when not locked into a contract. They may find it too time-consuming to establish which supplier is cheapest, especially given the complexity of pricing in the market. K The government has recently intervened to force firms to reduce the number of tariffs on the market, with suggestions that firms may also be forced automatically to move consumers onto whichever tariff is cheapest for them. An Consumer inertia is also a barrier to switching and the easier the government can make it for consumers to switch suppliers the more effective competition is likely to be. Evaluation/final judgement I Given the inherent difficulty of subsidising new entry into the gas market or regulating prices these are not desirable options for the government to pursue. An Indeed, they are unnecessary if consumers are able and willing to switch freely between suppliers, because in doing so they force firms to compete for their business. This suggests that governments should continue to focus on ensuring that consumers have simple and clear information about prices and that switching can occur with as little inconvenience to the customer as possible. I Other measures are very much “second best” options to be considered only if these measures do not work. K Indeed, OFGEM ceased to regulate prices in the UK a number of years ago because it judged that domestic energy markets were already sufficiently competitive for price caps no longer to be needed. This can be called into question by current evidence of “sticky prices” to consumers when wholesale prices come down. Ap Price increases of 18.5% in 2011 compared with inflation of 4% suggest that real prices may have risen faster than they would have done if prices had been regulated. The government should attempt to tackle this problem by co...