Palm Oil — Market Failure and Standard of Living (NYJC 2021 Prelim)

Answers

(a)(i) Identify — [1]

Average prices for palm oil worldwide showed a generally decreasing trend from 2014 to 2019.

(a)(ii) Explain, with a diagram — [4]

This is a simultaneous shift of demand and supply, read off the market-equilibrium model.

• Per Extract 1, demand for palm oil increased as rising disposable income and purchasing power in Asia raised consumption of fats “much of it in the form of palm oil” — demand shifts right. [1m]

• Supply also increased: “favourable weather” and “increased fertilizer use” raised palm tree growth — a positive supply shock that shifts supply right. [1m]

• The increase in supply exceeds the increase in demand: palm trees are “evergreen” (year-round production) and annual production “quadrupled between 1995 and 2015” and is “expected to quadruple again by 2050”. [1m]

• Because supply shifts right by more than demand, at the original price $P_0$ there is a surplus, which exerts downward pressure on price; price falls from $P_0$ to $P_1$. [1m]

(b) Explain — [3]

The demand for palm oil is likely to be price inelastic. [1m] This is because palm oil is difficult to substitute, owing to its “unique physical performance characteristics” (Extract 1). [1m]

Applying the link between PED and total revenue: when demand is price inelastic, a fall in price leads to a less than proportionate increase in quantity demanded, ceteris paribus, so total revenue for palm oil producers falls. [1m]

Common mistake: PED governs the change in quantity demanded, not a change in demand — a fall in price does not “increase demand”.

(c)(i) Explain — [4]

There is a need to intervene because palm oil production generates negative externalities, a source of market failure.

• Palm oil production causes negative production externalities. Per Extract 3, producers “deliberately burn forests”; these fires “burn out of control”, destroying homes and injuring third parties. These external costs borne by society are not incurred by producers or consumers, so a divergence — the marginal external cost — opens between marginal private cost (MPC) and marginal social cost (MSC). [1m define externality / MEC]

• In a free market, producers consider only their MPC and so produce at $Q_m$, above the socially optimal output $Q_s$ where MSC = MSB. [1m social optimum]

• There is therefore an over-allocation of resources to palm oil. [1m] The result is a deadweight welfare loss, the shaded area below. [1m diagram]

(c)(ii) Discuss — [8]

Thesis — ISPO certification is the most effective strategy.

How it works: per Extract 4, producers obtaining ISPO must comply with requirements on “accountability, social responsibility and business practices”. Certified producers enjoy higher demand because large global buyers have “committed to procuring sustainable palm oil”, raising their revenue and profits.

How it corrects the externality: compliant production methods are more sustainable, reducing the negative externalities and hence the marginal external cost of producing palm oil. The MSC curve shifts toward MPC; the divergence narrows. If MSC’ coincides with MPC, the deadweight welfare loss is eliminated and allocative efficiency is restored.

Anti-thesis — a complete ban may be more effective.

Limitations of ISPO: it works only if the government consistently monitors the market to enforce compliance; without monitoring, certified producers may revert to unsustainable methods. Such monitoring is costly and strains the budget. ISPO is also slow to take effect — audits and applications are a long-drawn process — so it may not be the most effective strategy in the short run.

A complete ban: if production is banned, output falls from $Q_m$ to $0$. Relative to the socially efficient output, banning sacrifices the net welfare benefit on units between $0$ and $Q_s$ (area X), but it also removes the deadweight welfare loss from over-production beyond $Q_s$ (area Y). If area X < area Y, the ban produces a net reduction in deadweight loss and society becomes more allocatively efficient.

Limitations of the ban: it backfires if the government lacks information on the true sizes of X and Y — if X > Y, the ban worsens allocative inefficiency. Since the optimal output is not zero, a ban can never reach full allocative efficiency. A ban is also unsustainable without constant enforcement, and may spawn a black market.

Evaluation and judgement. ISPO certification is the more effective strategy. For Indonesia, palm oil has “lifted millions out of poverty” (Extract 2), so a complete ban would cut growth and raise unemployment — too extreme once macroeconomic objectives are weighed. More fundamentally, a ban is a symptomatic, temporary fix that does not address the root cause of the inefficiency — the negative externality — whereas ISPO directly reduces the external cost by regulating production methods, making it the more sustainable long-run policy.

Mark scheme — Content: L2 (4–6) well-developed two-sided response, accurate analysis, contextual evidence; L1 (1–3) one-sided or inaccurate. Evaluation: E2 (2) well-explained, supported judgement; E1 (1) unexplained.

(d) To what extent — [10]

Definition. The standard of living (SOL) covers both the material SOL — the quantity and quality of goods and services available per resident — and the non-material SOL — the intangible quality of life (working hours, stress, pollution).

Scope and stand. Indonesia has experienced an increase in demand for palm oil and a change in industry regulation. On balance these changes raise the SOL of Indonesians.

Thesis — the changes raise SOL.

• Higher palm oil demand. Per Extract 1, demand has risen on palm oil’s ability to “replace less healthy fats” and serve as a versatile input. Indonesia’s aggregate demand rises through higher export revenue and domestic consumption, raising real national income via the multiplier. Higher household disposable income and purchasing power raise the ability to consume more and better goods and services, lifting mSOL.

• ISPO certification. Mandatory ISPO (Extract 4) raises nmSOL: sustainable methods reduce the externalities, so the environmental degradation and air pollution from “burning of forests” fall, raising intangible quality of life.

Anti-thesis — the changes may not raise SOL.

• Demand effect muted. Figure 1 shows palm oil prices falling, and Extract 1 notes no good substitutes, so demand is price inelastic. A falling price then cuts producers’ total revenue, so mSOL may not rise.

• ISPO effect conditional. ISPO reduces externalities only if uptake is high and the government enforces it. If producers resist sustainable methods, pollution and externalities persist, so nmSOL may not rise.

Evaluation and judgement. On balance, the changes raise SOL. Even if palm oil revenue does not rise (inelastic demand), the industry’s expansion attracts investment, including FDI, raising both AD and productive capacity, likely a net rise in mSOL. And although non-compliance is possible, rational producers are unlikely to forgo ISPO, since certification lets them sell to multinationals “committed to procuring only sustainable oil”, raising profits — so nmSOL is likely to rise too.

Mark scheme — Content: L2 (5–7), L1 (1–4). Evaluation: E2 (3), E1 (1–2). Other valid sources of mSOL/nmSOL change are accepted.