Paper 3 question: Subsidies, macroeconomic indicators and equity

Paper 3 sample question

This section includes a sample question for a paper 3 style examination question from the new syllabus.  The question and markscheme are based on the IB approach to setting paper 3 style questions which have a quantitative and policy approach. The question is based on data and some text that the students need to use to answer the different sub-questions. This question has sub-questions that cover subsidies, price elasticity of demand, measuring economic growth and equity.

Answer all the questions. Answers must be written within the answer boxes provided.

Country B subsidises cotton producers by paying them $0.40c per kg for each kg of cotton they produce. The effect of this subsidy is shown in the diagram with the supply curve for cotton shifting from S to S1. Using the data in the diagram calculate the following:

a. (i) Calculate the value of the subsidy paid by the government. [2]

$0.40 x 110,000 = $44,000

(ii) Calculate the value of the gain in consumer surplus. [2]

($0.30 x 90,000) + ($0.30 x 20,000) / 2 = 30,000

(iii) Calculate the value of the gain in producer surplus. [2]

($0.10 x 90,000) + (0.10 x 20,000 / 2) = $10,000

(iv) Calculate the value of the welfare loss from the subsidy. [2]

$0.40 x 20,000 / 2 = $4,000 [2]

(v) Calculate the price elasticity of demand for cotton. [2]

 + 22.2% / - 25% = - 0.89

The table below shows economic data for Country Y.

(iv) Calculate the real GDP for Country Y in 2019 and 2020. [2]

2019 $40,478m / 0.89  = $45,481m

2020 $48,894

(v) Calculate Country Y’s rate of economic growth in 2020. [2]

$48,894m - $45,481m / $45,481m x 100 = 7.50%

(vi) Define the term budget deficit. [2]

A budget deficit is a situation where the value of a country's government expenditure is greater than taxation over a one year time period and the government needs to borrow funds to make up the difference between government expenditure and taxation.

(vii) Using an appropriate diagram, explain what the change in the value of Country Y’s Gini coefficient tells us about the change in the country's income inequality. [4]

Country Y's Gini coefficient has increased from 0.37 to 0.39 which represents a widening of the distribution of income in Country Y. For example, this means the poorest 20% of Country Y's population accounts for a smaller proportion of its total income. This is shown in the diagram where Country Y's Lorenz curve moves further away from the line of perfect income equality.

b. Using the data provided and your knowledge of economics, recommend a policy the government of Country B could use to improve equity in the country. [10]

Possible policies may include (but are not restricted to):

  • Definition of equity
  • Increase in progressive taxation
  • Increase current government spending on healthcare and education
  • Increase in government capital spending on infrastructure
  • Increase in government transfer expenditure
  • Use of maximum price in markets for merit and necessity goods
  • Use of subsidies on merit and necessity goods
  • State provision of merit and necessity goods
  • Behavioural economic policies, such as Nudge theory, choice architecture.
  • A combination of policies.
  • Any other valid policy

Sample answer

Equity is the means of improving fairness in society and creating equal opportunities for the whole population to improve their future living standards. Inequity is a big problem for governments as some members of the population will not have the same opportunity as others to find quality work and contribute to the economy.

Through interventionist supply side policies the Government is spending tax revenue to benefit lower-income individuals and reduce income inequality. The subsidies Country Y spends on cotton could be used to support low-income farmers and reduce the price of clothing for poorer households. Country Y's government can also increase spending on health and education, to help give equal opportunity to all households.

This may help to reduce country Y's unemployment rate from 4.9% as individuals get the skills to take new jobs. This might be very useful for dealing with structural unemployment. Lower-income households can also be more productive at work and even take fewer days off. These supply side improvement will also benefit the whole economy as Country Y's LRAS curve shifts outwards to LRAS1 which increase Country Y's real income.

Government spending on healthcare also creates positive externalities as when more people are healthy, others are less likely to get sick. If Country Y invests in improved health services means that lower-income households can increase their share of income, and therefore receive as much opportunity as higher-income households.

However, increasing Country Y's government expenditure on health and education may not be the most effective or beneficial due to several reasons. Firstly, government expenditure is costly and there is an opportunity cost involved. There would be questions raised about where the expenditure comes from, for example, if it came from taxation or borrowing. Country Y's budget deficit has already increased from 4.9% to 6.5% of GDP. If the money came from taxation, there would be psychological implications on workers as incentives to work decrease when taxes increase.

Furthermore, many critics of government spending say that resources are misallocated and used inefficiently. This is because governments tend to spend money on politically motivated projects and government enterprises do not have the pressure of competition or profit to make them efficient. For example, the subsidies on cotton to support farmers and make clothing cheaper may be done to attract the votes of those who benefit.  Furthermore, there are bureaucratic problems whereby government struggle to operate efficiently and effectively at a micro level due to diseconomies of scale.

Although there are problems with the interventionist approach it does seem the most appropriate way to create greater equity in Country Y.

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