2026 Cambridge IAL Economics (9708) Practice Paper with Answers

To calculate the current account balance:

1. Calculate the trade in goods balance:
\(\text{Balance on trade in goods} = \text{Exports} - \text{Imports} = 140 - 165 = -25\text{ billion}\)

2. Sum the components of the current account:
\(\text{Current Account Balance} = \text{Balance on goods} + \text{Net services} + \text{Net primary income} + \text{Net secondary income}\)
\(\text{Current Account Balance} = -25 + 18 + (-6) + 3 = -10\text{ billion}\)

Therefore, the current account balance is -$10 billion (or a deficit of $10 billion).

1 mark for correct calculation of the trade in goods balance (-$25 billion) or for showing the correct formula/addition method.
1 mark for the correct final answer: -$10 billion / $10 billion deficit (must include unit: billion or $).
Award 2 marks directly for the correct final answer without working.

1. Calculate the four-firm concentration ratio (\(CR_4\)) by adding the market shares of the four largest firms:
\(CR_4 = 32\% + 24\% + 15\% + 9\% = 80\%\)

2. Identify the market structure:
A concentration ratio of 80% represents a high concentration of market power among a few dominant firms, indicating an oligopoly.

1 mark for correct calculation of \(CR_4 = 80\%\).
1 mark for identifying the market structure as an oligopoly (or oligopolistic market).

Diagram Structure:
- Axes: Vertical axis labelled Price (\(P\)) and horizontal axis labelled Quantity (\(Q\)).
- Curves: Downward-sloping demand curve (\(D\)) and upward-sloping initial supply curve (\(S_1\)), intersecting at original equilibrium price \(P_1\) and quantity \(Q_1\).
- Shift: A rightward/outward shift of the supply curve to \(S_2\), showing a new equilibrium at a lower price \(P_2\) and a higher quantity \(Q_2\).

Explanation:
1. Cause of Shift: Both the direct government subsidy and the technological improvements in silicon refining reduce the marginal/unit production costs for manufacturers. This incentivises producers to increase output at every price level, shifting the market supply curve to the right (\(S_1 \to S_2\)).
2. Market Adjustment and Equilibrium Outcome: At the original price \(P_1\), there is now excess supply (a surplus). To clear this surplus, sellers lower prices. As the price falls from \(P_1\) to \(P_2\), there is a movement along (extension of) the demand curve, leading to a new market equilibrium with a lower equilibrium price (\(P_2\)) and a higher equilibrium quantity (\(Q_2\)).

Diagram (up to 2 marks):
- 1 mark: Correctly labelled axes (Price and Quantity or \(P\) and \(Q\)), demand curve, initial supply curve, and initial equilibrium (\(P_1, Q_1\)).
- 1 mark: Rightward shift of the supply curve (\(S_1 \to S_2\)) with correctly identified new equilibrium price (\(P_2 < P_1\)) and quantity (\(Q_2 > Q_1\)).

Explanation (up to 2 marks):
- 1 mark: Explanation that both the subsidy and technological advances reduce unit/marginal production costs, shifting the supply curve to the right.
- 1 mark: Explanation of the mechanism/outcome: creation of excess supply at \(P_1\) causing price to fall and quantity demanded to extend to the new equilibrium (\(P_2, Q_2\)).

A complete response addresses both instruments and provides a reasoned evaluative conclusion:

1. Analysis of Tradable Pollution Permits:
- Mechanism: The government sets an absolute ceiling (cap) on total emissions consistent with the socially optimum output where \(MSC = MSB\). Permits are allocated or auctioned, allowing firms with low marginal abatement costs to reduce emissions and sell surplus permits to firms with higher abatement costs.
- Advantages for Allocative Efficiency: Guarantees that the physical target for carbon reduction is strictly met. Creates continuous market incentives for innovation in green technology to generate sellable surplus permits.
- Limitations: Permit prices can fluctuate wildly with cyclical demand changes; if the cap is set too high, permit prices collapse (undermining the incentive to abate); enforcement and monitoring require substantial administrative resources.

2. Analysis of a Specific Carbon Tax:
- Mechanism: Imposes an indirect tax equal to the marginal external cost (\(MEC\)) at the optimum, shifting the marginal private cost (\(MPC\)) up to internalise the negative externality (\(MPC + tax = MSC\)).
- Advantages for Allocative Efficiency: Gives firms predictable, stable price signals for long-term investment planning; generates government tax revenue that can be hypothecated towards clean energy infrastructure or R&D subsidies.
- Limitations: The government may face imperfect information when calculating the exact \(MEC\), risking under-taxation or over-taxation; if demand for carbon-intensive energy is price-inelastic, emissions may not fall to the targeted level.

3. Evaluation and Synthesis:
- Relative effectiveness depends on government priorities and market stability. If ecological certainty (preventing irreversible environmental tipping points) is paramount, permits are superior because quantity is fixed. If investment predictability and revenue generation are priorities, a carbon tax is more reliable.
- A hybrid scheme (e.g., a cap-and-trade system with price floors and ceilings) may offer the most effective path to allocative efficiency.

Mark Allocation: AO1/AO2 (Analysis) = max 4 marks; AO3 (Evaluation) = max 2 marks.

- Analysis of Tradable Permits (up to 2 marks):
- 1 mark for explaining the mechanism (setting an absolute cap and internalising externalities via trading permits at equilibrium price).
- 1 mark for analytical development regarding cost-effective abatement / incentivising technological innovation.

- Analysis of Carbon Tax (up to 2 marks):
- 1 mark for explaining internalisation of negative externality (tax equal to marginal external cost \(MEC\), shifting \(MPC\) towards \(MSC\)).
- 1 mark for analytical development (e.g., price certainty for investment, tax revenue generation).

- Evaluation / AO3 (up to 2 marks):
- 1 mark for identifying limitations/trade-offs of both policies (e.g., price volatility in permit markets vs difficulty in estimating correct tax rate / inelastic demand).
- 1 mark for a well-reasoned, balanced concluding judgement on which policy is more effective under specific conditions (e.g., ecological threshold certainty vs long-term investment predictability).

A complete response examines the mechanisms of expenditure switching alongside the specific structural constraints presented in the context:

1. Theoretical Mechanism of Currency Depreciation (Expenditure-Switching):
- Depreciation lowers the foreign currency price of domestic exports (making exports more price-competitive abroad) and raises the domestic currency price of imports (encouraging domestic substitution).
- If the Marshall-Lerner condition holds (\(|PED_x + PED_m| > 1\)), the trade balance will improve over time as net export volumes expand (\(X - M\) increases).

2. Application to Oakhaven's Economic Context:
- Import Inelasticity: Oakhaven imports essential goods (crude oil, staple foods, capital machinery) with few domestic substitutes, meaning \(PED_m\) is highly inelastic (\(PED_m \approx 0\)). The total import expenditure in domestic currency will rise significantly, worsening the current account balance.
- Supply Constraints: Domestic manufacturing faces capacity bottlenecks and skilled labour shortages. Even if foreign demand for Oakhaven's exports rises, domestic firms cannot expand output rapidly (price elasticity of supply for exports, \(PES_x\), is very low).
- Inflationary Pressures: Higher import costs increase production costs (cost-push inflation), which erodes initial price-competitiveness gains.
- J-Curve Effect: In the short run, trade contracts are fixed; thus, the trade deficit deepens before any potential long-run volume adjustment occurs.

3. Evaluation and Supported Conclusion:
- In Oakhaven's context, currency depreciation alone will be largely ineffective and may even worsen the current account deficit due to inelastic import demand and supply-side constraints.
- To be effective, exchange rate policy must be accompanied by supply-side reforms (retraining workers, infrastructure investment to ease bottlenecks) and expenditure-reducing policies to dampen domestic inflationary pressures.

Mark Allocation: AO1/AO2 (Analysis) = max 4 marks; AO3 (Evaluation) = max 2 marks.

- Analysis of Depreciation Mechanism & Marshall-Lerner Condition (up to 2 marks):
- 1 mark for explaining expenditure-switching (cheaper exports in foreign currency, dearer imports domestically).
- 1 mark for referencing the Marshall-Lerner condition / elasticity requirements for balance of payments improvement.

- Application to Case Constraints (up to 2 marks):
- 1 mark for explaining why import spending rises due to inelastic demand for essential imports (crude oil, machinery, food).
- 1 mark for explaining how capacity bottlenecks and skilled labour shortages limit export supply responsiveness (low \(PES\)) or induce cost-push inflation.

- Evaluation / AO3 (up to 2 marks):
- 1 mark for analytical synthesis of short-run vs long-run effects (e.g., J-curve deterioration).
- 1 mark for a justified conclusion assessing that depreciation alone is insufficient without complementary supply-side or expenditure-reducing policies.

### Definitions and Conceptual Distinctions

1. Public Goods:
- Non-excludability: Once provided, it is impossible (or prohibitively costly) to prevent non-payers from consuming the good.
- Non-rivalry (non-diminishability): Consumption of the good by one individual does not reduce the quantity or quality available for others.
- Examples: Street lighting, national defence, flood defence barriers.

2. Merit Goods:
- Goods that are more beneficial to consumers than they realise due to imperfect information (information failure).
- They are excludable and rivalrous in consumption (i.e. private goods in nature).
- They often generate positive externalities in consumption, where the Marginal Social Benefit exceeds the Marginal Private Benefit (\(MSB > MPB\)).
- Examples: Healthcare, education, vaccinations.

---

### Analysis of Market Failure

1. Market Failure in Public Goods (Missing Market / Complete Market Failure):
- Because public goods are non-excludable, individuals have no incentive to pay for them, hoping that others will bear the cost while they consume them freely. This is known as the free-rider problem.
- Since private firms are motivated by profit and cannot charge a price to exclude non-payers, they cannot generate revenue (\(TR = 0\)).
- Consequently, private profit-maximising firms will not produce the good at all, resulting in a missing market (complete market failure).

2. Market Failure in Merit Goods (Underprovision / Partial Market Failure):
- Because merit goods are excludable and rival, private firms can charge a price and will supply them in a market.
- However, consumers suffer from an information gap (short-termism or lack of awareness regarding the full long-term personal benefits), meaning they undervalue the good and demand less than the socially optimal amount (\(MPB < MSB\)).
- In addition, consumers ignore the external benefits conferred on third parties (positive externalities).
- As a result, market demand reflects only \(MPB\), leading to an equilibrium output (\(Q_m\)) that is strictly below the socially efficient output (\(Q_s\) where \(MSB = MSC\)). This causes a welfare loss and partial market failure (underconsumption and underprovision).

### Levels of Response Mark Scheme (AO1: 3 marks, AO2: 5 marks)

- Level 3 (6–8 marks):
- Clear, accurate definitions and explicit distinctions between public goods (non-excludable and non-rival) and merit goods (excludable, rival, imperfect information/externalities).
- Sound, coherent analytical chains explaining why the free market fails in each case: explains the free-rider problem causing zero provision for public goods, and information failure / divergence between MPB and MSB causing underprovision for merit goods.

- Level 2 (3–5 marks):
- Defines/explains both types of goods but distinction may lack precision, OR provides a strong analysis of market failure for one type of good while the other is only briefly touched upon.
- Minor errors or omissions in the analytical links (e.g. mentions the free-rider problem but does not link it clearly to non-excludability and zero profit).

- Level 1 (1–2 marks):
- Fragmented or descriptive answer with basic knowledge of public and/or merit goods (e.g. giving examples without explaining characteristics).
- Identification of market failure with no analytical explanation.

- Level 0 (0 marks):
- No creditworthy response.

### Indicative Content

#### Knowledge, Understanding and Analysis (AO1 & AO2)
- Negative Externalities of Production: Industrial production often generates negative externalities (e.g. air/water pollution, greenhouse gas emissions), creating a divergence where Marginal Social Cost (MSC) exceeds Marginal Private Cost (MPC) by the Marginal External Cost (MEC). In an unregulated free market, firms produce at the private equilibrium where \(MPB = MPC\), resulting in overproduction and a deadweight welfare loss compared to the socially optimum output where \(MSB = MSC\).
- Mechanism of Indirect / Pigouvian Taxes:
- An indirect tax placed per unit of pollution or output shifts the firm's \(MPC\) curve upwards towards \(MSC\).
- If set exactly equal to \(MEC\) at the social optimum, it internalises the externality, eliminating deadweight welfare loss.
- Generates tax revenue for the government which can be hypothecated towards green infrastructure or R&D.
- Mechanism of Tradeable Pollution Permits (Cap-and-Trade):
- The government sets an absolute legal cap on total permitted emissions and issues or auctions permits corresponding to this quantity.
- Firms with high abatement costs buy permits; firms with low abatement costs reduce emissions and sell surplus permits.
- Market forces establish the equilibrium price of permits, incentivising cost-effective pollution abatement across the entire economy.

#### Evaluation (AO3)
- Certainty of Output/Emissions vs Price Certainty:
- Permits: Provide absolute certainty over the quantity of pollution reduction (the cap is fixed), which is critical when dealing with dangerous ecological thresholds.
- Taxes: Fix the price of polluting, but the resulting reduction in pollution depends on the price elasticity of demand (PED) and price elasticity of supply (PES). If demand is highly inelastic, emissions may not fall sufficiently.
- Cost Information & Imperfect Information:
- Setting the correct tax requires precise knowledge of the monetary value of external costs, which is difficult to estimate in practice.
- Setting a permit cap requires estimating the optimal pollution level, but the market determines the price dynamically.
- Incentives for Innovation:
- Both create market incentives for dynamic efficiency and developing cleaner technology.
- With permits, as cleaner technology is adopted, the demand for permits falls, lowering permit prices and reducing ongoing abatement incentives unless the government ratchets down the cap.
- With taxes, the continuous tax per unit guarantees a perpetual incentive to reduce emissions to minimise tax liability.
- Administrative Feasibility and Potential Failures:
- Permits require sophisticated monitoring, verification, and liquid trading platforms; risk of price volatility or lobbying leading to an over-allocation of initial allowances.
- Taxes are simpler to collect using existing fiscal machinery, but may face political resistance and risk hurting international competitiveness.

#### Conclusion / Judgement
- Neither policy is strictly superior in all contexts. Tradeable permits are generally more effective when achieving a strict emissions target is paramount (e.g., climate change targets), whereas indirect taxes are more effective for broad-based application where price stability and simplicity of administration are prioritised.

### Level Descriptors for Section B (12 marks)

#### AO1 Knowledge & Understanding and AO2 Analysis (Max 8 marks)
- Level 3 (6–8 marks): Detailed and accurate knowledge and understanding of both tradeable permits and indirect taxes. Rigorous economic analysis explaining how each policy addresses negative production externalities (divergence of MSC and MPC, internalization of external costs, price/quantity mechanisms). Clear and relevant diagrammatic analysis can be used to support the explanation.
- Level 2 (3–5 marks): Sound understanding of at least one policy, or partial/descriptive explanation of both policies. Chains of analytical reasoning are present but may have gaps or lack clarity regarding how market failure is corrected.
- Level 1 (1–2 marks): Basic or fragmented knowledge. Shows limited understanding of negative externalities, taxes, or permits, with minimal analytical depth.
- 0 marks: No creditworthy response.

#### AO3 Evaluation (Max 4 marks)
- Level 2 (3–4 marks): Balanced, developed evaluation comparing the relative merits and drawbacks of permits versus indirect taxes (e.g. quantity certainty vs price certainty, administrative complexity, information failure, dynamic efficiency). Contains a well-reasoned, justified conclusion based on the preceding analysis.
- Level 1 (1–2 marks): Generalized or one-sided evaluative comments with limited justification or unsupported assertions.
- 0 marks: No evaluative commentary present.

### Key Distinctions between GDP and GNI
- Gross Domestic Product (GDP): Measures the total monetary value of all final goods and services produced within the geographic boundaries of a country over a specific period, regardless of the nationality of the resource owners.
- Gross National Income (GNI): Measures the total income earned by a country's permanent residents and domestic factors of production, regardless of where that production takes place.
- Relationship: \(\text{GNI} = \text{GDP} + \text{Net Primary Income from abroad}\) (where Net Primary Income = factor income received from abroad by domestic citizens minus factor income paid to foreign owners of domestic assets, such as repatriated profits, dividends, and wages).

### Need for Purchasing Power Parity (PPP) Adjustments
1. Distortions of Market Exchange Rates: When comparing GNI per capita internationally, figures are usually converted into a common currency (e.g. US dollars) at prevailing market exchange rates. However, market exchange rates are determined primarily by international trade flows, interest rate differentials, and speculation, rather than domestic price levels.
2. Non-Traded Goods and Services: Non-tradable goods (e.g. haircuts, healthcare, local transport, domestic housing) are significantly cheaper in developing nations due to lower domestic wages. Standard exchange rates undervalue the purchasing power of low-income nations because domestic currencies can purchase more local goods and services than market exchange rates suggest.
3. Equalising Purchasing Power: PPP uses the rate of currency conversion that equalises the purchasing power of different currencies by eliminating the differences in price levels between countries based on an identical basket of goods and services (the Law of One Price). This provides a more realistic and accurate comparison of real output, actual consumption possibilities, and material living standards across nations.

Table A: AO1 Knowledge & Understanding and AO2 Analysis (8 marks)

- Level 3 (7–8 marks):
- Accurate, clear explanations and definitions of GDP and GNI, clearly stating the role of net property/primary income from abroad.
- Detailed, coherent analysis of why market exchange rates give a misleading comparison of living standards (e.g. non-traded goods, price level variations) and how PPP adjusts for differences in local price levels to reflect true purchasing power.

- Level 2 (4–6 marks):
- Sound explanation of the difference between GDP and GNI, but with minor omissions or lack of full precision.
- Explains the purpose of PPP, but the analytical chain explaining price-level differences / non-traded goods is partial or descriptive.

- Level 1 (1–3 marks):
- Shows basic awareness of GDP, GNI, or PPP.
- Fragmented points with superficial or purely descriptive analysis.

- Level 0 (0 marks):
- No creditworthy response.

An effective response should address the following key points: 1. Definition and Mechanisms of Supply-Side Policies: - Supply-side policies aim to increase an economy's productive capacity by improving the quantity, quality, and efficiency of factors of production. - Examples of interventionist policies include government expenditure on transport/digital infrastructure, education and workforce retraining, and subsidies for research and development (R&D). - Examples of market-oriented policies include deregulation, reduction in direct taxes (e.g. corporate and income tax cuts), privatisation, and labour market reforms (reducing trade union power, lowering minimum wages). - In an AD/AS diagram, successful supply-side policies shift the Long-Run Aggregate Supply (LRAS) curve outward to the right (from LRAS_1 to LRAS_2). This increases real output from Y_1 to Y_2 while placing downward pressure on the general price level (reducing it from P_1 to P_2 or mitigating demand-pull inflation), thus achieving non-inflationary economic growth. 2. Arguments that Supply-Side Policies are the Most Effective: - Unlike expansionary fiscal or monetary policies, which shift Aggregate Demand (AD) to the right and often cause demand-pull inflation and worsening current account balances when the economy approaches full employment, supply-side policies expand the production possibility frontier. - By improving factor productivity (e.g. through education and technology), unit labour costs decrease, reducing cost-push inflationary pressure and improving international competitiveness. 3. Limitations and Counter-Arguments: - Time Lags: Infrastructure projects, education reforms, and R&D take years or even decades to yield measurable increases in productive capacity. They are ineffective for short-run stabilization. - Opportunity Cost and Fiscal Burden: Interventionist supply-side measures require substantial government borrowing and capital expenditure, which can increase national debt and cause budget deficits. - Ineffectiveness in a Demand-Deficient Recession: If aggregate demand is weak, increasing productive potential alone will result in spare capacity rather than actual economic growth. Firms will not invest if there is no consumer demand. - Market-oriented policies (e.g. cutting top income tax rates, deregulation) can exacerbate income and wealth inequality or lead to market failure (e.g. environmental degradation). 4. Evaluative Synthesis & Conclusion: - Supply-side policies are essential for sustained long-run economic growth without inflation because demand-side policies alone eventually hit capacity constraints. - However, whether they are the 'most effective' depends on the macroeconomic context: in the short run during a downturn, expansionary monetary/fiscal policy is needed to stimulate AD; in the long run, supply-side measures must accompany demand management to ensure capacity expands in line with spending.

Assessment is based on Cambridge Levels of Response marking grid for 12-mark questions: AO1 Knowledge and Understanding & AO2 Analysis (max 8 marks): - Level 3 (6-8 marks): Detailed and accurate knowledge of both interventionist and market-based supply-side policies. Rigorous and clearly explained AD/AS analytical chains demonstrating how LRAS shifts lead to higher real output and lower or stable price levels. Analysis of why demand-side policies might cause inflation when generating growth. - Level 2 (3-5 marks): Sound explanation of supply-side policies and their effect on output and prices with minor gaps in analysis or incomplete diagrammatic support. - Level 1 (1-2 marks): Descriptive account of supply-side measures with limited economic reasoning linking to growth or price stability. AO3 Evaluation (max 4 marks): - Level 2 (3-4 marks): Developed, balanced evaluation assessing the limitations of supply-side policies (e.g. time lags, government fiscal costs, demand deficiency, inequality) versus alternative policies, leading to a reasoned and justified final judgement. - Level 1 (1-2 marks): Generalized or one-sided evaluative assertions (e.g. simply stating policies take a long time without explaining the economic consequences).

An effective response should address the following key points: 1. Mechanism of Currency Depreciation (Expenditure-Switching): A depreciation of the nominal exchange rate lowers the foreign price of domestic exports and raises the domestic price of imports. If price elasticities of demand are sufficient, export volumes rise and import volumes fall, shifting domestic and foreign expenditure toward domestically produced goods and services, thereby improving the balance of trade in goods and services. 2. Conditions for Effectiveness: - Marshall-Lerner Condition: The current account will improve only if the sum of price elasticities of demand for exports and imports exceeds 1 in absolute terms (|PED_x + PED_m| > 1). - Spare Capacity: Domestic exporters must possess spare capacity and supply elasticity to meet higher foreign demand without bidding up domestic costs. 3. Limitations and Counter-Arguments: - The J-Curve Effect: In the short run, contracts are fixed and PED is low (|PED_x + PED_m| < 1), worsening the current account deficit before it improves. - Cost-Push Inflation: Higher import prices increase the costs of imported raw materials and consumer goods, causing imported inflation and real wage erosion. - Retaliation / Competitive Devaluation: Trading partners may retaliate with tariffs or devaluations. 4. Alternative Policies: - Expenditure-reducing policies (contractionary fiscal or monetary policy) directly reduce domestic demand for imports (M), though at the cost of lower economic growth and higher unemployment. - Supply-side policies improve domestic productivity, quality, and non-price competitiveness, addressing structural causes of current account deficits over the long term without generating inflation. 5. Evaluative Synthesis & Conclusion: Currency depreciation is an effective short-to-medium-term expenditure-switching tool if demand is elastic and inflation is contained. However, if the persistent deficit stems from structural inefficiencies, low productivity, or poor product quality, supply-side policies are more effective in achieving long-run current account sustainability.

AO1 & AO2 (max 8 marks): Level 3 (6-8 marks) for clear, rigorous analysis of how currency depreciation affects export and import prices/volumes, including the Marshall-Lerner condition and J-curve analysis. Level 2 (3-5 marks) for sound analysis of expenditure-switching effects with minor omissions. Level 1 (1-2 marks) for basic descriptive points. AO3 (max 4 marks): Level 2 (3-4 marks) for balanced evaluation contrasting depreciation with alternative policies (e.g. expenditure-reducing, supply-side) and arriving at a reasoned conclusion. Level 1 (1-2 marks) for generic evaluative comments.