2019 H2 Economics Paper 1 Case Study 1: Suggested Answers

Fracking, as mentioned in Extract 1, is a key demand factor affecting the coal market in the US. The process of fracking has led to the production of cheaper natural gas, which is a substitute for coal. When the price of a substitute, in this case natural gas, falls, the demand for the original product, coal, typically falls, because consumers and businesses switch to the cheaper alternative. Therefore the advent of fracking and the resulting fall in the price of natural gas have reduced the demand for coal in the US.

Cross elasticity of demand (XED) measures the responsiveness of the demand for one good to a change in the price of another good. In China, as detailed in Extract 1, the XED between coal and renewable energy is positive. This is drawn from the evidence of a decline in coal consumption following a fall in renewable energy prices.

A positive XED indicates that coal and renewable energy are substitute goods in China. As the price of renewable energy falls, people shift their preference towards it, reducing the demand for coal.

Initially the UK government set a minimum price for coal (Pmin1) above the equilibrium price (Pe). This led to a fall in quantity demanded, from Qe to Qd, as consumers were less willing to buy coal at a higher price, while quantity supplied increased, from Qe to Qs, as producers were more inclined to sell at the higher price. This resulted in a surplus of QdQs and a deadweight loss shown by the area ABC.

In 2016 the government further increased the minimum price to Pmin2. This caused a further fall in quantity demanded, from Qd to Qd2, and a further rise in quantity supplied, from Qs to Qs2. The surplus widened to Qd2Qs2 and the deadweight loss increased to the area ADE.

This illustrates how price controls can lead to market inefficiency, surplus and a loss of social welfare. By setting the price above the market equilibrium, the intervention distorts resource allocation and reduces total economic welfare. A supply and demand diagram with the two horizontal price floors above Pe, and the widening surplus and deadweight loss areas ABC and ADE, would support this.

Negative externalities are the costs imposed on third parties not directly involved in the production or consumption of coal, here including local communities, future generations and the global population. The external costs are mainly health and environmental: coal burning causes air pollution and respiratory and cardiovascular illness, while greenhouse gas emissions contribute to climate change.

In the unregulated market, equilibrium is where Marginal Private Cost (MPC) equals Marginal Private Benefit (MPB), giving quantity Qm. This ignores the external costs on third parties. The socially optimal quantity Qs is lower and occurs where Marginal Social Cost (MSC) equals Marginal Social Benefit (MSB). The gap between Qm and Qs is the overproduction of coal, and the area ABC is the initial deadweight loss from this market failure.

As demand for coal increases, shown by a rightward shift of the demand curve from DD0 to DD1, the quantity produced and consumed rises. This worsens the negative externality, with more severe health problems and environmental damage for third parties. The new market quantity Q1 is still above the socially optimal level, and the deadweight loss enlarges to the area DEF. A negative externality diagram with MSC above MPC and demand shifting from DD0 to DD1 would illustrate this.