Thursday, December 25, 2008

Data Response Question: May08; HP3; Q1

This data question was different, interesting, a bit problematic (subquestion c) and had a rather demanding subquestion (d). As such I think that some thoughts on it could prove useful to you guys. If you haven't done it, try doing at least (d) in 20 minutes or less (since you will have already read these thoughts). You'll realize that it is still challenging. Bear in mind that what follows is not the expected 'answer'. There is no such thing (especially in d) as 'the' correct answer. Very many approaches can be considered fine by IB examiners. These are just some thoughts. Please refer to my 'how to' deal with data questions post . Lastly, standard level candidates should be aware that (a1), (c) and (d) could feature in a standard level exam.

May 2008 HP3 Q1 on vines and grapes:
a(i) equilibrium price is that price at which quantity demanded is equal to quantity supplied per period of time

a(ii) allocative efficiency exists if just the right amount of a good is produced from society’s point of view and thus scarce resources are allocated in the best possible way; this occurs if, for the last unit produced, P = MC.

b. Removing an indirect ad valorem tax implies that production costs will be lower so supply will increase, shifting and swiveling to the right from St to S. (i.e. not a parallel shift)

As a result the market price will decrease from P1 to P2 and quantity demanded will in-crease from Q1 to Q2 per period.

c. Since the resources (land, labor, capital and entrepreneurship) available to the Australian economy have not decreased and neither has the available technology changed, potential output (the combinations of goods that the economy can produce if all resources are fully employed given technology) has remained unchanged and thus the PPF has not shifted. Assuming that the economy was originally operating on its PPF (some point A), now that vines are pulled out fewer grapes can be produced in the short run moving to a point inside with fewer grapes (g2) and the same amount of apples produced (point B). When the land is ready for some other good to grow (apples) then there will be a movement to point C with more apples (a2) fewer (g2) grapes than originally. In other words, there has been a reallocation of resources (e.g. land) away from one good (grapes) towards the production of another good (e.g. apples)
Alternatively, if vines are considered a ‘factor’ of production, then a PPF with grapes on one axis and other goods on the other could pivot inward on the side of the grape axis.

d. You are asked to evaluate the role of falling (grape) prices in the reallocation of resources. First, think of the theoretical model: In free, competitive markets, which goods are produced, in what amounts and consequently how resources are allocated is dictated by demand and supply conditions. When market conditions change it is the changes in relative prices that that has ‘signaling power’ and thus leads to changes in the behavior of producers and consumers.

In the specific setup, the market price for grapes is falling as ‘large crops’ coupled with ‘a slower than expected export market for Australian wine’ (paragraph 1). A fall in price signals that too much of the good is available in the market and implies a decrease in profits (‘producers are suffering with falling profit levels’ (paragraph 4); you could visualize here a perfect competitor with his AR (MR, dd) curve falling). Incentives have changed as a result o the price change. Some growers will be making losses and thus exit the industry. Others will be forced to become more efficient: ‘there is a need for grape growers to find substitute products to grow, and for a vine retirement program where unwanted varieties are pulled out and other varieties planted’ (paragraph 3).
Up to this point you are describing the role of a relative price change. Now you should evaluate this role. Can, or do, falling prices on their own do the trick of resource reallocation?
Well, in paragraph 3 the existence of an ‘industry spokesman’ is revealed who is providing information to industry members. This implies a first weakness of relative price changes as a means of reallocating resources. Market participants (farmers) do not possess the ‘perfect information’ the model assumes. They may not be aware of the severity of the problem and of what other market opportunities exist for them to move resources into. Moreover, resources may be geographically or occupationally immobile which would further complicate the process.

Then, in paragraph 5 another issue is revealed: ‘It is estimated that it will take at least another two years to clear the oversupply of wine, with exports, hopefully, growing significantly to achieve a balance between supply and demand’. This information implies that maybe some of the growers should try to survive the current crisis as in 'two years’ the oversupply will clear. Price movements typically reflect current market conditions and often fail to account for future conditions. As a result, perhaps too many vines will be pulled out – more than the situation warrants.

Lastly, the situation now is exacerbated by ‘ appreciating Australian dollar’ which ‘is making it difficult to export more wine’ (paragraph 5). Since the exchange rate system is flexible (as the AUD is ‘appreciating’) and we know that foreign exchange markets exhibit significant volatility the appreciation described may be reversed sooner than expected.

It thus seems that despite the fact that relative price changes are a very powerful and efficient mechanism to allocate and reallocate scarce resources, there are imperfections that relate to scarce information concerning present and future market conditions as well as immobilities that perhaps necessitate the existence of industry and government assistance in the decision making process of the individual producers.

Not a very easy (d) but bear in mind that this question (how are resources allocated in a market economy) shows up very often as a short for the higher level and as a long for the standard level!

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