Data Response Exam Preparation: HL P3 Q2 M08

IB Economics - Higher Level - Data Response Question - May 2008, Paper 3, Question 2
(What follows can be found as a file including the diagrams at our wikispace here)

We've done this one in class but as May approaches I'm posting some of our thoughts for you to have. Here it goes (May08, HP3, Q2):

You are asked in (a) to define ‘structural unemployment’ and ‘average costs’. Remember that definitions are worth 2 points each; it follows that you should try to be very precise and concise. No reason to explain at length – only to define. You only have 40 minutes for each data question. Never allocate more than 2-3 minutes to definitions!

(a)(i) The unemployment that results when there is a mismatch between the skills available by the unemployed and the skills demanded by firms in the labor market. (no reason to explain why there may be a mismatch of skills or how policymakers may deal with structural unemployment)
(a) (ii) Costs per unit of output; average costs are thus total costs divided by the number of units produced (no reason to explain the typical behavior of average costs; note though that if you felt insecure about your definition you could sketch a U-shaped average cost curve with Q on the horizontal and ATC on the vertical)

In (b) and (c) remember that if the question asks you to explain something using a diagram you earn 2 points for the diagram and 2 for the explanation. It follows that in such a case your explanation does not need to be extensive and should use the diagram you draw.

(b) This question asks you to explain how increased unemployment could lead to a fall in the output of a nation using a production possibility curve (PPC) diagram.
A production possibilities curve shows that maximum output combinations an economy can at the most produce if it fully utilizes its scarce resources (labor, capital etc) using available technology. The existence of unemployment implies that the economy is operat-ing at a point (a combination of goods X and Y) inside the PPF, such as point A in the diagram. If unemployment increases it means that the economy has moved to a new point (such as B) further away from the curve and closer to the origin (in a south-west direction). The reason is that higher unemployment typically implies lower output. (Your graph has a typical concave PPF with (units of) good X on the horizontal and (units of) good Y on the vertical. Choose two points inside the PPF, A and B, with B closer to the origin so that it reflects fewer units of both X and Y)

(c) This question asks you to explain why average costs in Canadian timber firms might fall in the long-run using an appropriate diagram. Since the question is about average costs in the long run that are falling you should recognize that we’re dealing with a case of economies of scale. The diagram would thus illustrate a (long run) average cost curve that is falling (perhaps you could show it rising after some level of output but it is not necessary). The relevant info from the extract is this sentence: ‘With production now concen-trated at the larger, more efficient timber firms, the industry’s average costs have fallen significantly’. Thus:

Average costs have decreased because the Canadian timber firms are enjoying economies of scale. Economies of scale refer to lower average costs that are a result of bigger size. The extract mentions that now production of timber in Canada is concentrated ‘at the larger, more efficient timber firms’. In the diagram, the typical firm has grown in size from SAC1 to SAC2 for which average costs are lower as illustrated by the downward sloping LAC curve. The larger size may permit these firms to buy inputs in bulk achieving better prices from suppliers or to use specialized machinery that was not available for smaller size firms.

(d) This question asks you to evaluate the effects of the removal of US timber tariffs on US consumers, US producers and the US government (using information from the text and your knowledge of economics, as usual). First note exactly what you are asked to evaluate: the effects of removing a specific tariff on 3 specific entities: US consumers, US producers and the US Government. Note one very important issue present in all such 'evaluation’ questions: you are not asked to simply mention the effects but to evaluate these. Evaluation in data questions is an informed, theory-backed and issue-specific judgment.

Next, carefully read the extract noting the specific phrases / sentences / points that you could use in your answer (a great answer in a ‘vat’ i.e. without reference to the specifics of the question can not earn you more that 5 of 8 points).

The points that may be used in your answer include
-- that the ‘US and Canada have ended a long-standing and bitter $4.5 billion trade row’ (paragraph 1). Frictionless international relations between countries decrease risks of trade wars and provide a conducive environment for more welfare enhancing trade to take place; this is a most important effect of removing the timber tariffs.

-- that ‘Canadian timber mills have been forced to close or cut their output because the demand for Canadian timber from the US has fallen. This has created an increase in struc-tural unemployment in Canada and a consequent fall in income, expenditure and output’ (paragraph 3). This point can be used when explaining that the removal of the tariff by the US government will create symmetric (short term at least) costs to US timber firms and to the workers it employs. If you draw the standard tariff diagram (remembering that here the tariff is removed and not imposed) the effect on US (domestic) timber firms is that production will decrease (and unemployment {structural} may increase. This definitely makes US timber firms worse off as they will witness lower profits and some may be forced to exit the market. Specialized US labor employed in the timber industry will also be hard hit. The US government may have to spend on training and re-training to lower the adjustment costs. On the other hand other US firms that use timber as an input (hous-ing construction, furniture makers etc) will be better off as the price of timber will de-crease. This means lower production costs. They may expand their output and increase their employment. The net overall US employment effect is thus not necessarily negative as a result of the tariff removal.

-- ‘However, despite this, the Canadian timber industry has emerged more competitive than before. With production now concentrated at the larger, more efficient timber firms, the industry’s average costs have fallen significantly’ (paragraph 3). This is perhaps the most important expected effect on the US timber industry of removing the tariff. US tim-ber firms will be forced to become more efficient. The least efficient will exit or be taken over by the more efficient firms so the average size of US firms will probably increase so that they too will probably benefit from scale economies.

-- ‘The removal of tariffs is bound to affect consumer welfare, producer efficiency and the ability of government to achieve its macroeconomic objectives’ (paragraph 5). As men-tioned earlier the buyers of timber are typically other firms using timber as an input. They will enjoy a larger consumer surplus (plus areas 1,2,3,4 in the typical tariff diagram) as price of timber will be lower. All US (household) consumers will be better off as lower prices may result for all wood using firms. Houses may become somewhat cheaper, boats (cruisers), furniture etc. Greater demand may thus be expressed for a variety of products even though the effect on US aggregate demand will probably by small. In this sense the macro objectives of growth, price stability and employment will probably be small. In ad-dition the US government will not be collecting anymore tariff revenues (area 3 in the standard tariff diagram) but this does not mean the overall tax revenues will be negatively affected as the increased economic activity in the timber using industries and the resulting profit and indirect taxes collected may more than offset this loss.

Bear in mind that you do not have to include all of the above points from the extract. You may include additional evaluation points for which there is no direct reference in the extract but please make sure that even then you refer to the issue at hand (i.e. the US timber industry stakeholders).

If you do draw a standard tariff diagram refer to it in your answer.

These are not 'model answers'! The whole idea of 'model answers' is counterproductive. The aim is to help you realize what examiners expect in paper 3 (and Standard P2). Rem.: HP3 is 40% of your grade and SP2 is a whopping 50%!