FA_p24-31 Vol4-5 Essays

SKILLS FEATURE

Q

1

ESSAYS

ARTICLES

Let’s break the dominance of the big five banks. Let’s turn five into at least seven so there is proper choice for the consumer (a) What type of market structure would the banking industry be classified under? Explain. [10] (b) Examine whether there is a need for governments to intervene in the banking industry? [15]

PART A

enjoyed by incumbent firms are a major natural barrier to entry.

A new bank considering entering the market will have fewer customers (Q) compared to an existing bank with a larger number of customers (Q2). Hence, the new entrant will face a higher average cost of production compared to the existing firm.

This higher average cost serves as a natural barrier to entry.

Besides the market structure of banking industry being oligopolistic due to high natural barriers to entry, there are also significant artificial or created barriers that restrict competition, resulting in a few large players dominating the market. Banks differentiate themselves by building brands to distinguish themselves from their competitors. By spending large sums of money on advertising and on renovating outlets in unique ways, banks

FIGURE 1 Internal economies of scale as a natural barrier to entry

T

he banking industry should be classified under market structure of oligopoly. The characteristics of the industry determine the behavior of firms in the industry, which further determines the type of market structure those firms are classified under.

A feature of the banking industry is the presence of a small number of big firms. As given in the prompt, five banks share the entire market, which gives each bank a substantial market share and customer basis. The industry of banking is dominated by a few large firms—a key feature of oligopoly.

Another feature of oligopolistic firms is that firms are price setters, since they dominate the market and sell differentiated products or services. Each firm faces a downward sloping demand curve for its products and services.

Banks are price setters, since different banks can charge different prices for loans, since the terms and conditions of the various loan types differ. Different prices are also seen from the differing deposit rates offered between banks as they differentiate between the types of loans and the service as well as credibility of banks. Banks are also differentiated in terms of the location of the banking outlets, the network of ATMs, and the types of privileges offered to various types of credit cards. This feature of a

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selling firm being a price setter makes the market structure one that is imperfectly competitive.

Another feature of the banking industry that makes it an oligopolistic one is the presence of high or significant barriers to entry. Barriers to entry serve to deter or to make it difficult for new firms to enter and exist in various forms—categorized broadly into natural and created barriers to entry. Due to the high financial capital required in setting up a bank, for rental of branches and for the cost of setting up branches, this serves as a significant form of barrier to entry for new firms looking to enter as they need as much financial capital. Because of the higher setup cost, there are significant internal economies of scale to be reaped.

Greater internal economies of scale

It’s important to occasionally

bring in key linking

sentences to relate back to the key part of the question, which is reasons for the categorization of a particular industry as a certain market structure.

MICRO

ECONOMICS

build brands that serve as an artificial barrier to entry.

Given that a country’s banking industry is regulated by the central bank of the country, an important barrier to entry is the need to obtain banking licenses from the government. This limits the number of firms in the industry and makes the industry oligopolistic.

Existing banks with large financial resources and accumulated profits may exploit strategic deterrence actions by practicing limiting pricing or predatory pricing, selling their products at prices lower than those of newcomers. This is also another form of created barriers to entry.

The above barriers discourage new firms without lower cost of production or large financial capital from setting up from entering, as the actions of the existing firms have raised the barriers to entry, thus limiting the number of firms in the industry.

Lastly, behavior of banking firms also reveals their market structure. Banks

SUCH INTERACTION AMONG BANKING FIRMS IS MADE NECESSARY BY THE FACT THAT THERE ARE ONLY A FEW BANKS IN THE MARKET, SO ONE PARTY’S ACTIONS WILL HAVE A SIGNIFICANT IMPACT ON OTHERS. are always watching each other’s actions closely. For example, the banks in Singapore are constantly upgrading their services and financial products. They have intense competition with each other in terms of price, product quality, and service reputation. Such interaction among banking firms is made necessary by the fact that there are only a few banks in the market, so one party’s actions will have a significant impact on others. Rivalry is a proof that banks belong to the oligopoly market structure.

PART B

G

overnment intervention is often advocated when the free market on its own fails to achieve the goals of equity and efficiency.

This means that the free market forces of demand and supply do not achieve maximum society welfare. Free market outcomes instead lead to welfare losses as the conditions of allocative and productive efficiency are not attained.

THE DEBT ISSUE

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SKILLS FEATURE

Allocative efficiency occurs when output is produced where price exactly equals marginal costs, while productive efficiency occurs when a given level of output is produced using the least cost method and cost of production incurred is at the minimum point of the long run average cost curve.

In this case of the banking sector, being an oligopolistic market dominated by only five large firms gives rise to deadweight losses from prices charged by banks that are above the marginal costs of production, as seen in Figure 2.

Each bank charges a price that maximizes the firm’s profits (where MC=MR). In Figure 2, the firm charges a price P1 at profit maximizing level of output Q1.

Though this level of output ensures maximum profits for firms, it is not in the interest of society. The shaded area is the deadweight loss to society before government intervention. Quantity Q1 to Q2 are not produced due to the higher price set by oligopolistic firms so that consumers are buying less quantity than they would otherwise. The welfare loss is from units that confer net benefit to society that is not produced.

Hence, government intervention is based on improved efficiency.

Governments intervene with policies to improve

Such clear statements

specifically identifying the

grounds for intervention or the basis of government intervention is important.

the allocative efficiency of the industry by encouraging levels of output beyond Q1. At Q2, which shows the equilibrium of a perfectively competitive industry, society welfare is maximized. So as the government intervenes and the market power of a firms gets reduced, output is reaching Q2 while price is reaching P2. As a result, the shaded area gets reduced

For such a question asking for

the reasons for government

intervention, you need to also include the end objective of the government’s intervention in order to fully explain the purpose or reasons for the government to step in, which in this case is to bring prices down and output up.

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CONTENT BUSTER

ESSAYS

ARTICLES

This results in firms earning supernormal profits at the expense of consumers.

Governments intervene to prevent further excessive profits by preventing collusive actions of price fixing amongst banks or by preventing further gains in market power through mergers and acquisitions.

Government intervention through prevention of anticompetitive acts is along the way and welfare loss is reduced. meant to prevent further inequity.

This can be done through restricting However, by breaking up firms into further accumulation of market power smaller ones, governments create and deregulating the industry to prevent new problems. As with any form of firms with high market power from government intervention, there are costs raising prices even more and causing P to as well as benefits. Let us first look at the be much greater than MC and worsening benefits of intervention. the market failure.

If the government turns five firms into seven, the market power of each firm

Though there is no need to will be reduced. Customers have more

explain the policy options substitutes to turn to, so firms are going

the government can use to to lose customers if they charge higher deal with the problem, there is a need to prices, as the firm’s demand is now spend sufficient effort in explaining the more price elastic. The competition for purpose or reason for the government customers becomes more intense. To intervention. attract customers, the cost of borrowing Market power arising from an set by firms will be reduced and banks oligopolistic market structure is a form of will be more eager to give out loans. market failure, as such there is a strong Various improvements in service will ensue with more choices for savers.

Putting in descriptive words Governments intervene for these benefits

like “strong” and “most to be realized.

important” helps improve the Besides benefitting consumers, quality of the answer. government intervention to prevent the basis for government intervention to domination of a few large banks has prevent further welfare loss. wider social effects, such as encouraging entrepreneurship and encouraging

One evaluative point that can the growth of other sectors. Increasing

be added here is that since competition makes loans more easily

oligopolies with only a accessible to startups. Also, the few large players can easily collude, so lower interest rate makes loans more governments need to be especially alert affordable to firms, especially small and and prevent any collusive behaviour that can further worsen the welfare of medium enterprises. The expected rate consumers. So, another basis for of return on investment will rise, ceteris intervention is to prevent collusion. paribus. Hence, firms will be more likely to buy capital goods, which enlarge the Besides efficiency, governments also productive capacity of the economy. PPC intervene when equity issue becomes will shift outward in the long run and prominent. An oligopoly market is economic growth will be achieved. likely to create equity problems due Lastly, reducing market power prevents to the price setting ability of firms. the fear of having big banks collapse, FIGURE 2 WELFARE LOSSES FROM MARKET POWER

MICRO

ECONOMICS

since being extremely large means many jobs will be lost. If a bank is extremely large, it may become complacent and will be less careful in its investment and planning. It may engage in more risky operations, thinking that the government will rescue it if it one day goes bankrupt to avoid massive unemployment and financial disaster. If the size of a firm is reduced, the impact of its bankruptcy is reduced, too. The government may not protect it from ruin, given plenty of alternative banks to support the function of the entire economy. This forces banks to be more responsible in using customer money. Informed investment activities are beneficial to the nation as a whole.

However, there are drawbacks of government intervention. First, the extent of internal economies of scale enjoyed

This section of balancing

the need for intervention

(benefits of intervention) against the costs of intervention is crucial, as it helps evaluate the need for intervening.

by local firms is reduced as local firms are less cost competitive compared to international counterparts. This poses difficulty for local banks to venture overseas and makes them less likely

to survive if international giants set up local branches. Government intervention becomes all the more harmful if a nation, like Singapore, aims to be an international financial centre. Without a strong local banking industry, a nation will not internationalize its banking industry extensively, hampering long-run economic growth brought about by FDI and flow of funds.

Breaking up big firms leads to erosion of supernormal profits. Firms have less profit for innovation and upgrading of services. The slower expansion and growth of banks may ultimately hurt customers who may have enjoyed better service. In severe cases, banks may collapse if the cost of operation can no longer be covered. This harms customers who cannot get their money back, and society in general through lower investment confidence.

Lastly, government intervention will incur inefficiency from the process itself.

Firms facing the prospect of being divided may lobby governments for favorable treatment. Such rent-seeking behavior may defeat the purpose of breaking up big firms, as firms receiving preferential treatment may still retain great market power that lowers the effectiveness of government intervention. Moreover,

breaking up firms may create internal inefficiency. The conflicts between new departments, the division of labor, and the discrepancy of corporate culture and philosophy are all instances of inefficiency. This lowers the cost competitiveness and standard of service of new banks.

Ultimately, whether a government should intervene depends on the aim of the economy. If the government thinks that building the nation into an international financial centre is a priority, the breaking up of local firms is undesirable, as local firms are unable to reap the benefits of internationalization due to small size. If internationalization is not an urgent issue, the government can put more attention locally by forcing firms to upgrade their services under more intense competition.

Moreover, whether to intervene also depends on the nature of the product. It is a trade-off between price and choice.

If the product is an essential good, the government must ensure an affordable price. If the product isn’t essential, enhancing variety can greatly improve the welfare of consumers. In this case, improving variety in banking industry is more important.

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27

SKILLS FEATURE

Q

2

CONTENT BUSTER

ESSAYS

ARTICLES

(a) Explain the relationship between the business cycle and the government’s budget. [12] (b) Examine the view that a budget deficit is not harmful as it is a countercyclical tool. [13]

PART A

A

government’s budget consists of two elements: government revenues and government expenses. The bulk of government revenue comes from taxes of various forms, such as corporate tax, personal income tax, and value-added taxes. Other forms of revenues to fund government expenditures include payments for licenses and administrative charges levied by government agencies.

Expenses of the government are for services or goods purchased by the government, such as the cost of investment projects or transfer payments for nonproductive work done.

Government expenditure can be divided into three categories: expenditure on capital goods, expenditure on goods for current consumption, and transfer payments. Government expenditure is based on meeting several needs for managing the economy. The government’s expenses are for the provision of merit goods, such as education and healthcare (microeconomic goals), as well as macroeconomic goals of stabilizing growth (through the conduct of fiscal policy).

As one primary tool for stabilizing the growth of the economy is through fiscal policy, government budget, which is dependent on the stance of the fiscal policy, will vary according to the business cycle. There are two forms of fiscal policy, one being automatic stabilizers and the revenue, the government is said other being discretionary fiscal policy. to be running a budget deficit The automatic stabilizing feature of fiscal for that year. On the contrary, policy refers to the in-built automatic when a government’s revenue mechanisms of a progressive income exceeds the spending for a tax system and unemployment benefits. particular year, it runs a budget Discretionary fiscal policy refers to surplus for that fiscal year. deliberate changes to either government A business cycle is made up spending or taxes (or both) in order of a peak, trough, upturn, and for a government to use fiscal policy downturn, and due to changes in national as a countercyclical tool to stabilize the income level it will affect a government’s economy. budget through both the automatic The government’s budget is rounded stabilizing as well as the discretionary up in each fiscal year. For a particular fiscal policy, affecting the government’s year, if government expenses exceed budget.

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During the peak of the economy, aggregate demand is rising fast.

General price levels are also rising fast as increases in aggregate

Since the question is about

the relationship between

government budget and the business cycle, the student needs to clearly state the relationship before explaining it. During an economic downturn, the government’s budget tends to go into deficit. While during an economic upturn, the government’s budget tends to go into surplus.

MICRO

ECONOMICS demand cannot be met by corresponding increase in aggregate supply, posing the risk of demand pull inflation. Hence, the government wants to avert inflation. To do that, the government has to reduce expenses so that AD does not rise as quickly as the cutback in G helps to offset the rise in AD due to other components, such as consumption and investment by firms. At the same time, the government prevents further increases in AD by raising direct taxes, such as corporate and personal income taxes. This causes the government to see rising tax revenues, especially since taxes are the main form of revenue.

These two deliberate changes to government spending and taxes will cause a government to deliberately run a budget surplus during a boom. Besides deliberately running a budget surplus, the budget tends to go into a surplus automatically, due to the features of the automatic stabilizers. During an economic boom, as national income increases and employment levels are high, the government will see a fall in its spending due to fewer unemployed citizens claiming unemployment benefits. This decreases payouts and lessens government expenditure. As the income of individuals rises, profits of firms will cause individuals and firms to pay a higher absolute amount of taxes.

Lower levels of unemployment cause an increased tax base as more people contribute to tax revenue.

Furthermore, with increases

in salary, individuals get

pushed into higher tax brackets, which causes tax revenue to increase further.

At the same time, the automatic features of more unemployment benefit payouts as unemployment numbers climb and reduced taxes from falling incomes will cause profits to fall, causing spending to exceed revenue.

During an economic boom, countries see their budget positions improve and generally record budget surpluses.

During economic recessions, the budget position worsens and the government records budget deficits.

PART B

T

his essay will examine the consequences of a budget deficit and whether or not it is harmful.

Whether or not a budget deficit is harmful depends on several factors, such as the circumstances leading to the deficit and the extent of the problem, as well as whether it is a one off deficit or prolonged and the amount of budget deficit incurred.

Though the points here are

valid in considering whether

or not a budget deficit is harmful, however, this discussion is not an exact interpretation of the question.

The question requires a discussion of the view that running budget deficits with the intent of stabilizing the economy through expansionary fiscal policy is not harmful.

There are many reasons for a government to run a budget deficit.

One is from the use of fiscal policy as a countercyclical tool. Given that the purpose behind the budget deficit is

to prevent the economy from sinking deeper into recession, the deficit poses less of a problem since the budget deficit has countercyclical effects. During a recession, the aggregate demand of the economy is weak. Households do not wish to consume and firms do not wish to invest due to an uncertain and pessimistic outlook. To boost economic activity, a government has to increase its spending on building bridges and hospitals or transfer grants to lower income households. This additional spending will help increase the aggregate demand from AD to AD1 and prevent aggregate demand from falling further.

A government will also reduce taxes, such as the corporate tax, to encourage investment from firms by allowing more post-tax profits to be retained and personal income tax to encourage consumption by raising the disposable income of households, thereby boosting aggregate demand. As increased consumption and investment flows into the economy, it encourages further rounds of increases in income and expenditure. The multiplier effect will bring about an increase in national income that is higher than the initial increase in government expenditure or tax cuts. As the level of economic activity increases, this also helps create jobs in an environment of job losses.

The large amount of government expenditure pumped in will also enhance confidence of investors, both locally and from abroad, encouraging investment by lifting economic gloom through the expansionary fiscal policy. Hence, running

FIGURE 3 POSITIVE EFFECTS OF A BUDGET DEFICIT

During a recession or economic downturn, a government’s budget tends to move into deficit, due to both the automatic stabilizing effect and deliberate fiscal stimulus enacted to counter the recession.

During an economic recession, the reverse happens. Countries tend to suffer budget deficits. Given that AD tends to fall rapidly, a government will adopt a deliberate expansionary fiscal policy of increasing government expenditure and/ or fall in taxes. Increased spending, along with reduced tax revenues collected due to tax cuts to spur more consumption and investment, will cause the budget to go into deficit.

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SKILLS FEATURE

a budget deficit is not harmful, as it helps stabilize economic growth and prevent further job losses.

However, such a way of managing an economy has its drawbacks. If conducting expansionary fiscal policy results in a one off budget deficit, it is not harmful. But

Here, it will be good to see

the problems of running

a budget deficit due to the conduct of expansionary fiscal policy to be grouped under (i) problems or limitations of fiscal policy that cause other macro problems in the short term and (ii) problems of a budget deficit in the longer run.

Hence, the problem of crowding out of private investment can be considered a short-term problem along with the problem of budget deficits taking a long time to start helping the economy (long time lags) such that by the time the policy takes effect, the economy may have already recovered on its own, causing the economy to over-expand instead. This causes growth to be more unstable.

if continuous conduct of expansionary fiscal policies results in prolonged budget deficits and accumulated debt, despite the benefits of stabilizing growth, it is creating harmful effects on the economy.

The US economy is facing such a situation now. To pay off accumulated debt, the government has to find ways to pay for expenditures not covered by government revenues. One way is to borrow. Under the condition of limited loans in the funds market, the large amount of borrowing from the government increases demand for loans, thus forcing interest rates to rise, forcing private individual loan-seekers who cannot afford the higher interest rate to leave the market. The crowding-out effect discourages investment by private firms.

The decrease in private investment may even outweigh the injection of spending from the government. As a result, the effectiveness of the government’s policy to get the economy out of recession is limited. If private investment is discouraged, the amount of taxes a government can collect from firms is also limited, further worsening the deficit for that year.

Another consequence of government deficit is the need to raise taxes in the long run. Both personal income tax and

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CONTENT BUSTER

corporate tax will need to increase in the long run to be able to pay off government debt incurred from expansionary fiscal policies. Households expecting such tax increases are less willing to consume, even if disposable income has risen due to tax cuts. Hence, any current expansionary policies will not be as effective as households and firms are curbing spending while government debt mounts. Rising taxes in the long run also lowers people’s standard of living as well as the long-term economic growth achieved by investment.

The lowered SOL also comes

from the need for GDP

to be spent on repaying the loan and interest payments and not for improving infrastructure or provision of merit goods, such as healthcare and education.

Moreover, chronic budget deficits affects a nation’s financial reputation if the problem persists. Recent examples can be seen in EU countries plagued by prolonged adversity policies or austerity measures, which include increased income tax and reduced welfare benefits.

Such countries also suffer from lower financial credit. That further limits their borrowing liberty while sending a

Here, it is important to look

at the source of loans to the

government running a debt.

Usually when loans are internal, meaning borrowed from savings within the country, it is considered less harmful. This is the case of Japan, whereby despite a large debt amount, it is of now not considered to be at large default risks, since the huge supply of loans domestically allows the government to borrow at a lower interest cost. Furthermore, an internal loan is also safer, since it does not involve foreign exchange risks. Loans borrowed from overseas will run the risk of foreign exchange risks. When borrowing in a foreign currency and the domestic currency depreciates, the loan amount balloons in domestic currency terms. This makes repayment of debt even more difficult.

It is good that the student

writes clearly to distinguish

the fact that budget deficits are for a particular fiscal year while debt is a stock concept that is determined from many years of budget surpluses vs. budget deficits.

ESSAYS

ARTICLES

BOTH PERSONAL INCOME TAX AND CORPORATE TAX WILL NEED TO INCREASE IN THE LONG RUN TO BE ABLE TO PAY OFF GOVERNMENT DEBT INCURRED FROM EXPANSIONARY FISCAL POLICIES. negative signal to investors who may be afraid the government will resort to “default” so they won’t be able to get their money back, thereby preventing those countries from taking on fresh loans to service interest payments on debts already incurred. Countries will be seen to be at risk of defaulting, since the cost of interest repayments take up a larger and larger portion of their GDP. A pessimistic mood discourages both consumption and investment and nations continue to be mired in recession.

During extreme cases, a government may choose to print a lot more money to pay the debt. Excessive circulation of money, according to the monetary theory, leads to monetary inflation. Desperate printing of money, like what was done in Germany, leads to hyperinflation.

The general price level skyrockets and the economy become highly unstable, causing a fall in export competitiveness and the loss of investors as the country becomes uncompetitive.

In conclusion, using budget deficit as a way of stabilizing economy has its shortterm efficacy ,provided a budget deficit is only for the short term and best financed by subsequent years of budget surplus.

The benefits of a budget deficit are that it helps stabilize growth and employment in an economy. However, when used as a countercyclical tool and if it leads to prolonged deficit, such a process can be harmful, as it means that a country is accumulating debt, which will cause longterm macro-instability for the economy.

MICRO

ECONOMICS

NO Are budget deficits harmful? (Are expansionary fiscal policies harmful?)

Countercyclical tool to stabilise the growth of economy Budget deficit is one - off or does not lead to long term debt

Leads to long term debt problems

YES

Short term problems of debt deficit

Austerity policies causing further contraction of economy Fear of collapse of economy and pessimism

Crowding out effect

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