2021 H2 Economics Paper 1 Case Study 1: Suggested Answers

Salmon and cod are substitute goods. When the price of salmon rises, consumers seeking an alternative shift their demand towards cod. On a demand and supply diagram this is a rightward shift of the demand curve for cod, from DD0 to DD1. At the original price P0 the increase in demand creates a shortage, as quantity demanded exceeds quantity supplied. This shortage puts upward pressure on price, and the market settles at a new equilibrium where the price of cod has risen to P1.

The disagreement left fishing boats idle for an extended period, reducing the production of cod. On a demand and supply diagram this is a leftward shift of the supply curve for cod, from SS0 to SS1. At the original price P0 there is now a shortage, as the quantity supplied falls short of the quantity demanded. The market adjusts upward to a new equilibrium where the price of cod has risen to P1 and the quantity traded has fallen.

For a maximum price to have any effect it must be set below the equilibrium price. While the equilibrium price of Iceland cod stayed below the ceiling, the maximum price would not bind and the market would function as if no ceiling existed.

Once the equilibrium price rose above the ceiling, the maximum price would become binding. Quantity supplied would then be less than quantity demanded at the capped price, creating a shortage, as consumers want to buy more cod at the ceiling price than producers are willing to supply.

Stockpiling stabilises prices by adjusting demand and supply in the cod market. When prices are low, the authority buys cod and adds it to the stockpile, raising demand from DD0 to DD1 and preventing the price from falling further. When prices are high, it releases cod from the stockpile, raising supply from SS0 to SS1 and pushing the price back down. By buying in gluts and selling in shortages the scheme keeps the price within a narrower band.

Difficulty 1. Frozen cod has a limited shelf life. Its quality, or its perceived quality, deteriorates over time, which reduces the saleability of the stockpiles.

Difficulty 2. Stockpiling is costly. Warehousing and temperature control to maintain sub zero conditions are expensive, and the longer the stock is held the higher these costs, which can make long term stockpiling economically unfeasible.

The decision is explained by the shutdown condition, where average revenue falls below average variable cost. With shrimp sold at only about 10 per cent of the usual price, average revenue was likely insufficient to cover average variable cost, which includes the cost of the shrimp larvae and the electricity for cold storage. Continuing to produce would have meant losses larger than the fixed costs, so it was rational to shut down in the short run.