AS Paper 3: Prices, Policy and Growth
Covers Demand, Supply and Price Determination, Elasticity of Demand and Supply, Government Intervention in Markets, Aggregate Demand and Aggregate Supply, Fiscal and Monetary Policy and Supply-Side Policy and Economic Growth.
Questions
Question 1 [3 marks]
Demand, Supply and Price Determination
In the market for takeaway pizzas in a town, the demand function is Qd = 600 - 40P and the supply function is Qs = 100 + 60P, where P is the price in pounds and Q is the number of pizzas sold per week.
Calculate the equilibrium price and quantity, and calculate total consumer expenditure on pizzas per week at this equilibrium.
Question 2 [3 marks]
Fiscal and Monetary Policy
The marginal propensity to consume (MPC) in an economy is 0.75, and there are no other withdrawals from the circular flow of income.
Calculate the value of the simple Keynesian multiplier, and the resulting change in national income from an initial increase in government spending of 8 billion pounds.
Question 3 [3 marks]
Aggregate Demand and Aggregate Supply
In a given year, a country's consumption is 900 billion pounds, investment is 220 billion pounds, government spending is 400 billion pounds, exports are 300 billion pounds and imports are 340 billion pounds.
Calculate aggregate demand.
Question 4 [3 marks]
Government Intervention in Markets
Define "subsidy", give one example of a good the UK government subsidises, and explain its purpose in one sentence.
Question 5 [5 marks]
Fiscal and Monetary Policy
The Bank of England raises the UK base interest rate significantly above interest rates in other major economies.
Explain, using the exchange rate transmission mechanism, how this interest rate rise could help to reduce UK inflation.
Question 6 [5 marks]
Elasticity of Demand and Supply
Explain why the supply of bicycles from a factory is likely to be more price elastic in the short run than the supply of copper ore from a mine.
Question 7 [5 marks]
Supply-Side Policy and Economic Growth
A government passes legislation making it easier for firms to hire workers on flexible, short-notice contracts and reducing the legal requirements firms must meet before making a worker redundant.
Explain, using the concept of labour market flexibility, how this policy could act as a supply-side policy to raise long-run aggregate supply.
Question 8 [4 marks]
Elasticity of Demand and Supply
Explain two factors that make the supply of fresh-cut flowers more price inelastic in the short run than the supply of bottled water.
Question 9 [5 marks]
Government Intervention in Markets
The government introduces a subsidy of 4 pounds per unit on electric bicycles. The demand function is Qd = 800 - 20P, where P is the price in pounds paid by consumers and Q is the number of bicycles per month. Before the subsidy, the supply function was Qs = 200 + 20P; the subsidy shifts it to Qs = 280 + 20P.
Calculate the equilibrium price and quantity before and after the subsidy, and state the total cost of the subsidy to the government per month.
Question 10 [6 marks]
Supply-Side Policy and Economic Growth
A government spends 8 billion pounds on a major increase in higher education funding, expected to raise the economy's potential output by 0.3% once graduates enter the workforce in several years' time, in an economy with a current potential output of 2200 billion pounds. The same 8 billion pounds could instead have funded an immediate expansion of NHS hospital capacity.
Calculate the expected increase in potential output, in pounds, from the higher education spending, and evaluate whether the government is right to describe this as clearly a better use of the money than expanding hospital capacity.
Question 11 [6 marks]
Government Intervention in Markets
A specific tax of 5 pounds per unit is imposed on a good. Before the tax, 2000 units were sold per week; after the tax, 1600 units are sold per week.
Calculate the government's weekly tax revenue, and analyse why this figure alone does not capture the full cost of the tax to society.
Question 12 [6 marks]
Fiscal and Monetary Policy
During a period of very low interest rates, a central bank creates new money electronically to buy large quantities of government bonds from financial institutions, as part of a programme of quantitative easing (QE).
Evaluate the effect of this policy on the government's cost of borrowing, and consider one significant risk associated with using QE on a large scale.
Question 13 [6 marks]
Demand, Supply and Price Determination
The launch of a highly anticipated new smartphone model coincides with a global shortage of the semiconductor chips used to manufacture it, caused by a fire at a major chip factory.
Analyse the likely effect of these combined events on the equilibrium price and quantity in the market for this smartphone model, and identify what would need to be true for the equilibrium quantity to end up higher than before either event occurred.
Model solutions
| Question 1[3 marks] | |
|---|---|
| Answer or working | Marks |
| setting Qd equal to Qs, 600 - 40P = 100 + 60P | M1 |
| solving to find P = 5 and Q = 400 | A1 |
| calculating total expenditure as price x quantity = 5 x 400 = 2000 pounds per week | A1 |
| Final answer: Equilibrium price = 5 pounds, equilibrium quantity = 400 pizzas per week, total consumer expenditure = 2000 pounds per week. | |
| Question 2[3 marks] | |
|---|---|
| Answer or working | Marks |
| using the multiplier formula, k = 1 / (1 - MPC) | M1 |
| calculating k = 1 / (1 - 0.75) = 4 | M1 |
| the resulting change in national income = 8 x 4 = 32 billion pounds | A1 |
| Final answer: Multiplier = 4; national income rises by 32 billion pounds. | |
| Question 3[3 marks] | |
|---|---|
| Answer or working | Marks |
| using AD = C + I + G + (X - M) | M1 |
| substituting the values, 900 + 220 + 400 + (300 - 340) | M1 |
| AD = 1480 billion pounds | A1 |
| Final answer: Aggregate demand = 1480 billion pounds. | |
| Question 4[3 marks] | |
|---|---|
| Answer or working | Marks |
| a correct definition of a subsidy as a payment by government to producers (or consumers) to lower the cost of production or price and encourage output or consumption | 1 |
| a valid example, e.g. renewable energy generation or public transport fares | 1 |
| explaining the purpose, e.g. to encourage a higher level of output or consumption than the free market would otherwise provide | 1 |
| Final answer: A subsidy is a payment from government to producers (or consumers) to lower costs and encourage output, e.g. subsidies for renewable energy generation, aimed at encouraging more output than the free market would provide. | |
| Question 5[5 marks] | |
|---|---|
| Answer or working | Marks |
| explaining that a higher UK interest rate, relative to other countries, makes holding funds in pounds more attractive to foreign and domestic investors seeking a higher return | 1 |
| explaining that this increases demand for pounds in the foreign exchange market | 1 |
| explaining that this causes the pound to appreciate against other currencies | 1 |
| explaining that an appreciation makes imported goods and raw materials cheaper in pound terms, directly reducing cost-push inflationary pressure | 1 |
| a developed point, e.g. an appreciation also makes UK exports more expensive abroad, reducing net exports and aggregate demand, which further helps to reduce demand-pull inflationary pressure | 1 |
| Final answer: A higher UK interest rate attracts foreign capital seeking a better return, raising demand for pounds and causing the currency to appreciate; this makes imports cheaper, directly easing cost-push inflation, while also making exports more expensive and reducing net exports and aggregate demand, further easing demand-pull inflation. | |
| Question 6[5 marks] | |
|---|---|
| Answer or working | Marks |
| identifying that bicycle factories can typically increase output using spare machine capacity and by adding extra shifts of workers | 1 |
| explaining that this allows a fast supply response to a price rise, making bicycle supply more price elastic | 1 |
| identifying that increasing copper ore output usually requires opening new extraction sites or expanding mine infrastructure | 1 |
| explaining that this is time-consuming and often requires new planning permission or capital investment, making copper supply price inelastic in the short run | 1 |
| a further valid point, e.g. bicycle parts and finished stock can be held in a warehouse, whereas usable copper ore reserves at an existing mine may be limited by geology, restricting a further supply response | 1 |
| Final answer: Bicycle factories can use spare capacity and extra shifts to raise output quickly, making supply elastic; copper mines need new extraction sites or infrastructure, which takes time, so copper supply is price inelastic in the short run. | |
| Question 7[5 marks] | |
|---|---|
| Answer or working | Marks |
| explaining that easier hiring and firing reduces the cost and risk to firms of taking on new workers | 1 |
| explaining that firms may therefore be more willing to expand their workforce when demand rises, since they are less worried about being unable to reduce staff again if conditions worsen | 1 |
| explaining that this can help to reduce structural unemployment, as firms are more willing to take a chance on hiring workers whose suitability is less certain | 1 |
| explaining that a larger, more flexible workforce willing and able to move between jobs and firms raises the economy's productive potential | 1 |
| a developed point, e.g. this may come at the cost of greater job insecurity for workers, illustrating a common trade-off with market-based labour market reforms | 1 |
| Final answer: Making hiring and firing easier reduces the cost and risk to firms of employing workers, encouraging them to expand their workforce and take on staff whose suitability is less certain, which can reduce structural unemployment and raise the economy's productive potential, though often at the cost of greater job insecurity for workers. | |
| Question 8[4 marks] | |
|---|---|
| Answer or working | Marks |
| identifying that fresh-cut flowers take a fixed growing time and cannot be produced more quickly even if price rises | 1 |
| explaining that this limited ability to increase output quickly makes flower supply price inelastic in the short run | 1 |
| identifying that bottled water producers typically hold spare factory capacity and stocks of finished product | 1 |
| explaining that this allows bottled water producers to raise output relatively quickly in response to a price rise, making their supply more price elastic | 1 |
| Final answer: Flowers take a fixed growing time and cannot be produced faster, making supply inelastic; bottled water producers can use spare capacity and stocks to respond quickly, making their supply more elastic. | |
| Question 9[5 marks] | |
|---|---|
| Answer or working | Marks |
| setting the original Qd equal to Qs, 800 - 20P = 200 + 20P | M1 |
| the original equilibrium, P = 15 and Q = 500 | A1 |
| setting the new Qd equal to Qs, 800 - 20P = 280 + 20P | M1 |
| the new equilibrium, P = 13 and Q = 540 | A1 |
| the total cost of the subsidy as 4 x 540 = 2160 pounds per month | A1 |
| Final answer: Original equilibrium: P = 15 pounds, Q = 500. New equilibrium: P = 13 pounds, Q = 540. Total cost of the subsidy = 4 x 540 = 2160 pounds per month. | |
| Question 10[6 marks] | |
|---|---|
| Answer or working | Marks |
| calculating the expected increase in potential output, 2200 x 0.003 | M1 |
| an expected increase in potential output of 6.6 billion pounds | A1 |
| identifying that this increase in potential output would only be realised several years in the future, once graduates enter the workforce, whereas expanded hospital capacity could improve health outcomes and workforce productivity much sooner | 1 |
| identifying the opportunity cost of the decision, e.g. the 8 billion pounds not spent on hospital capacity represents healthcare improvements that will not now happen | 1 |
| an evaluative point, e.g. improved health outcomes from hospital spending could also raise long-run aggregate supply, by reducing worker absence and extending working lives, so the comparison is not simply extra output versus no extra output | 1 |
| a reasoned overall judgement, e.g. whether higher education spending is clearly the better choice depends on the relative size and timing of each policy's effect on both output and wellbeing, which is not obvious from the potential output figure for education alone | 1 |
| Final answer: The higher education spending is expected to raise potential output by 6.6 billion pounds, but only after several years once graduates enter the workforce, whereas the same money spent on hospital capacity could improve health and productivity sooner and also raises long-run aggregate supply in its own right; whether higher education spending is clearly the better choice is therefore not obvious from the potential output figure alone, and depends on the relative size, timing and wellbeing effects of each option. | |
| Question 11[6 marks] | |
|---|---|
| Answer or working | Marks |
| tax revenue = tax per unit x post-tax quantity | M1 |
| tax revenue = 5 x 1600 = 8000 pounds per week | A1 |
| identifying that the fall in quantity traded, from 2000 to 1600, represents mutually beneficial transactions that no longer take place | 1 |
| explaining this creates a welfare (deadweight) loss to society, since neither consumers, producers nor the government gain from the 400 units no longer traded | 1 |
| identifying that this deadweight loss represents lost consumer and producer surplus on those foregone units | 1 |
| a developed point that the size of the deadweight loss depends on the price elasticities of demand and supply, being larger the more elastic they are | 1 |
| Final answer: Weekly tax revenue = 5 x 1600 = 8000 pounds; this does not capture the deadweight loss from the 400 units (2000 to 1600) no longer traded, representing lost consumer and producer surplus, which would be larger the more elastic demand and supply are. | |
| Question 12[6 marks] | |
|---|---|
| Answer or working | Marks |
| explaining that when the central bank buys large quantities of government bonds, this raises demand for those bonds | 1 |
| explaining that higher demand for government bonds pushes up their price, and because bond yields move inversely to price, this lowers the yield, the effective interest rate, on government debt | 1 |
| explaining that a lower bond yield directly reduces the government's cost of borrowing on both new and refinanced debt | 1 |
| identifying that this could be especially useful when a government wants to borrow heavily, for example to fund a large fiscal stimulus, without pushing up its own borrowing costs sharply | 1 |
| identifying a significant risk, e.g. the large expansion of the money supply from QE could eventually contribute to excessive inflation, or asset prices such as shares and property, which QE also tends to inflate, could become unsustainably high | 1 |
| a reasoned overall judgement, e.g. QE can be an effective way to hold down government borrowing costs during a crisis, but sustained large-scale use carries a real risk of longer-term inflationary pressure or inflated asset prices, particularly if not reversed once the economy recovers | 1 |
| Final answer: By buying large quantities of government bonds, QE raises their price and lowers their yield, directly reducing the government's cost of borrowing; but sustained large-scale QE risks contributing to future inflation or unsustainably inflated asset prices, particularly if the resulting expansion of money and credit is not reversed once the economy recovers. | |
| Question 13[6 marks] | |
|---|---|
| Answer or working | Marks |
| identifying that strong anticipation for the new model represents a rightward shift in demand | 1 |
| identifying that the chip shortage is a rise in a key production cost, shifting supply to the left | 1 |
| explaining that both shifts unambiguously raise the equilibrium price | 1 |
| explaining that the effect on equilibrium quantity is ambiguous, since the demand shift raises quantity while the supply shift lowers it | 1 |
| correctly identifying that quantity would end up higher only if the rightward shift in demand is proportionately larger than the leftward shift in supply | 1 |
| a developed point describing, in words, how this would appear on a diagram, with the new equilibrium lying to the right of the original quantity because the demand curve has shifted further right than the supply curve has shifted left | 1 |
| Final answer: Price rises unambiguously because both shifts push it up; quantity is ambiguous and depends on the relative size of the shifts, ending up higher than before only if the rightward demand shift outweighs the leftward supply shift. | |