Edexcel A-Level Economics (A)

THEME 1
Introduction to Markets and
Market Failure

STUDENT COMPANION

Author: Geoff Riley

Series Editor: Ruth Tarrant

EDITION DATE: SEPTEMBER 2020

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CONTENTS

1.1.1 Economics as a social science ...................................................................................................................................... 3

1.1.2 Positive and Normative Statements ............................................................................................................................ 3
1.1.3 The Economic Problem ................................................................................................................................................ 4
1.1.4 Production Possibility Frontiers (Curves) ..................................................................................................................... 8
1.1.5 Specialisation and the Division of Labour .................................................................................................................. 14
1.1.7 Free market economies, mixed economy and command economy .......................................................................... 16
1.2.1 Rational Decision Making .......................................................................................................................................... 19
1.2.2 Demand ..................................................................................................................................................................... 19
1.2.3 Price, income and cross elasticities of demand ......................................................................................................... 24
1.2.4 Supply ........................................................................................................................................................................ 30
1.2.5 Elasticity of supply ..................................................................................................................................................... 33
1.2.6 Price determination ................................................................................................................................................... 36
1.2.7 Price mechanism ........................................................................................................................................................ 43
1.2.8 Consumer and producer surplus................................................................................................................................ 46
1.2.9 Indirect taxes and subsidies ....................................................................................................................................... 52
1.2.10 Alternative views of consumer behaviour ............................................................................................................... 56
1.3.1 Types of Market Failure ............................................................................................................................................. 61
1.3.2 Externalities ............................................................................................................................................................... 62
1.3.3 Public Goods .............................................................................................................................................................. 70
1.3.4 Information Gaps ....................................................................................................................................................... 74
1.4.1 Government Intervention in Markets ........................................................................................................................ 78
1.4.2 Government failure ................................................................................................................................................... 92
Exam Support – Revision Checklist ..................................................................................................................................... 97

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1.1.1 Economics as a social science
Key specification content:
• Thinking like an economist: the process of developing models in economics, including the need to make assumptions
• The use of the ceteris paribus assumption in building models
• The inability in economics to make scientific experiments

Economics as a social science

Economics is a social science which means it studies society and relationships between people. Economists analyse many
different aspects of human behaviour and decision-making within and between markets, organisations and countries.
Economics is not about money, it is about the decisions that we take in our everyday life – from who to date, whether to
buy a house or which job to apply for. For every choice we make as individuals or as a society, there is a cost and a benefit.

Models in Economics
Economists develop models and theories to help explain the many choices we make in our daily lives. These models are
built on assumptions that can often help to simplify analysis but risk being criticised for not being sufficiently realistic.

What are assumptions?

• Assumptions are initial or prior conditions made before a micro or macroeconomic analysis is built.
• Sometimes assumptions are used for simplification of a theoretical idea or an economic relationship.
What is the ceteris paribus assumption?
To simplify analysis, economists isolate the relationship between two variables by assuming ceteris paribus – i.e. all other
influencing factors are held constant. For example, “an increase in real income will cause an increase in demand, ceteris
paribus.” Here we keep constant all other factors that might lead to a change in demand for a product.

Exam hint:
Try to note down at least one assumption when you are writing analysis points in your exam answers. This then allows you to
critique and evaluate your analysis later in their answer by simply questioning the assumptions that have been made. For example:
“An increase in real income should cause an increase in demand for products, assuming that they are normal goods and have a
positive income elasticity of demand. However, some goods and services are classified as inferior goods and have a negative income
elasticity of demand, so demand for them will fall when household income rises.”

1.1.2 Positive and Normative Statements

Positive Statements
Positive statements are objective statements that can be tested, amended or rejected by referring to the available
evidence. Positive economics deals with objective explanation and the testing and rejection of theories. For example:
• If the government raises the tax on beer, this will then lead to a fall in profits of beer manufacturers.
• A fall in the cost of generating solar energy should cause a contraction of demand for coal and gas.
• A reduction in income tax will improve the incentives of the unemployed to find work.
• A cut in the national minimum wage should reduce the number of people who are willing to work.

Normative Statements
Normative statements are subjective statements – i.e. they carry value judgments. For example:
• High unemployment is more harmful to a country such as the UK than high rates of inflation.
• The retirement age in Britain must be raised to 70 years to combat the effects of an ageing population.
• Scarce resources are best allocated by allowing the price mechanism to work without any intervention.
• The government should enforce a minimum price for beers and lagers sold in supermarkets and off-licences
to help control alcohol consumption and reduce the number of pubs that are closing.

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Exam hint:
Deciding whether a statement is positive or normative is a common multiple-choice question. Examiners may include words such as
‘should’ in statements that are actually positive (this is done to make students think that they are normative). The rule-of-thumb is
that students should always consider whether the statement can be tested. If it can be tested, then it is a positive statement.

1.1.3 The Economic Problem

Key specification content:
• The problem of scarcity – where there are unlimited wants and finite resources
• The distinction between renewable and non-renewable resources
• The importance of opportunity costs to economic agents (consumers, producers and government)

What is microeconomics?
Microeconomics considers the economics of everyday life such as the decisions that we as households take and the
impact of businesses in different and related industries. Economics is essentially all about choices. Hopefully those
choices are those that help to achieve the highest overall benefit for society over time.
What is the economic problem?
It is often said that the main purpose of economic activity is production of goods and services to satisfy our ever-changing
needs and wants. The basic economic problem is about scarcity and choice i.e. economics is about finding efficient and
fair (equitable) ways to meet infinite wants with finite resources. Each society must decide:

• What goods and services to produce? Does the economy use its resources to build more hospitals, roads, schools
or luxury hotels? Can the National Health Service afford to offer free IVF treatment for childless couples or provide
new but expensive cancer treatments? How should we source our growing energy needs in the years to come?
• How best to produce goods and services? What is the best use of our scarce resources? Should government land be
sold off to provide more land for affordable housing? Should we subsidize consumers to help them buy electric
vehicles to reduce carbon emissions from transport?
• Who is to receive goods and services? Who will get hospital treatment - and who might have to join a waiting list?
Which areas get the go-ahead for major transport infrastructure projects such as CrossRail, HS2 and HS3 and which
regions might miss out from government investment? Which schools should get extra funding for new buildings?
Scarcity
• Decision making under scarcity is a common problem because we usually have limited resources available to
meet our objectives.
• We are always uncovering new wants and needs. Because of scarcity, all consumers businesses and
governments must make choices. For example, several million people travel into London each day, they make
decisions about when to travel & whether to use the bus, tube, walk or cycle or work from home.
• Emerging technologies might be changing our perception of scarcity, for example open access to the internet
& freely available services such as Google, Twitter, Instagram & Facebook. These services are free to use but
there is an opportunity cost involved – for example the productive hours lost when people become addicted
to social media and online gaming on a daily basis.
Is use of free internet services an example of the problem of scarcity being overcome?

Total number and the share of population of active social media users in the UK in January 2018

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 Total number of users (in millions) Share of population (%)
66
70
57
60
50 44
38
40
30
20
10
0
Active social media users Active mobile social media users

Factors of Production
Economics is concerned with converting inputs to outputs. Economists call these inputs “factors of production”. The
four main categories of factors of production are land, labour, capital and enterprise (known as entrepreneurship).

Land Labour Capital Enterprise

• Land: The stock of natural factor resources available for production – known as natural capital.
• Labour: The quantity and quality of the human input available for the production process.
• Capital: Man-made goods used to supply other products e.g. drones, vehicles factories, hardware & software.
• Enterprise: Entrepreneurs organise inputs and take risks when seeking to exploit market opportunities.

Working capital Transport Bulky units of Digital platforms Servers for cloud Public good
Infrastructure capital enables such as Instagram computing aspect of air
mass production and WhatsApp networks traffic control
to happen systems
What is automation?
Automation is a production technique that uses capital machinery & new technology to replace or enhance human
labour. Replacing labour is known as capital-labour substitution.

Exam hint: Many students struggle with the concept of ‘capital’ in economics, especially in relation to the term ‘investment’ (which
they will meet in their macroeconomics). Investment, for an economist, is the purchase of capital, or the addition to an economy’s
capital stock. Investment to an economist is not about saving money in a bank or purchasing shares/stocks.

Worldwide spending projection for robotics and drones in 2019 and 2020 (in billion U.S. dollars)

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 Worldwide spending projection for robotics and drones in 2019 and 2020 (in billion U.S. dollars)
120. 112.4
103.4
100.
80.
60. 2019
40. 2020
12.3 16.3
20.
0.
Robotics Drones

Renewable and non-renewable resources

Renewable Resources Finite Resources

What are non-renewable resources?

• Non-renewable resources are finite in supply.
• With crude oil, coal, natural gas and other fossil fuels, no mechanisms exist at present to replenish them.
• The rate of extraction of finite resources depends in part on the current market price. Higher prices give
businesses an incentive to increase the rate of extraction since there is an opportunity to make higher profits.
What are renewable resources?
• Renewables are replaceable if the rate of extraction is less than the natural rate at which a resource renews.
• Examples of renewable resources are solar energy, tidal power, oxygen, biomass, fish stocks and forestry.
• Renewable resources can be exhaustible if they are not managed appropriately because of the length of time
it takes for them to regenerate.
• An important linked issue is the tragedy of the commons and unsustainable use of common pool resources
such as forestry and fish stocks. Over-extraction threatens the long-run supply of renewable inputs.
Renewable electricity generation from 2000 to 2018 in the United Kingdom, by fuel (in gigawatt hours)

Generation of renewable electricity and heat by fuel in the UK from 2000 to 2018 (in gigawatt hours)
40,000

30,000

20,000

10,000

0
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

Bioenergy Wind (onshore) Wind (offshore) Solar photovoltaics

Hydro (large scale) Hydro (small scale) Wave and tidal

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Opportunity Cost
In economics, there is usually no such thing as a free lunch. Even if we are not asked to pay money for something, scarce
resources are used up in production and there is an opportunity cost involved. Opportunity costs describe the
unavoidable trade-offs in the presence of scarcity: satisfying one objective more means achieving other objectives less.
Opportunity cost is defined as the cost of a choice measured by the next best alternative foregone (i.e. given up). Here
are some examples of opportunity cost.

• Work-leisure choices: The opportunity cost of deciding not to work an extra 10 hours is the lost wages foregone. If
you are being paid £8 per hour to work in a shop, if you take a day off, you could lose plenty of income before tax.
• Government spending priorities: The opportunity cost of the government spending nearly £10 billion on
investment in National Health Service might be that £10 billion less is available for spending on education or
improvements to the road and rail transport network.
• Investing today for consumption tomorrow: The opportunity cost of an economy investing resources in capital
goods is the production of consumer goods given up for today (we will explore this when analyzing a PPF).
• Relationships: The opportunity cost of continuing in a relationship might be expressed as sacrificing the
opportunity to go on a date with someone else!
Exam hint:
Students frequently use the concept of opportunity cost as part of their evaluation – but you won’t get much credit for it unless you
give a sensible application of what might have been ‘given up’. For example, it is better to write “Should the government choose to
increase spending on higher education, then the opportunity cost may be that there is less money available to spend on primary or
secondary education, assuming that the government doesn’t borrow more” than writing “Should the government choose to increase
spending on higher education then there might be an opportunity cost”.

Application of opportunity cost in the market – choosing between different products to buy

Application of opportunity cost – the cost of individual health care treatments in the UK
Here is an example of the resource cost of providing health care in the UK. Treatments are often highly expensive and
when government health budgets are limited, we might have to make important choices about who receives care at a
given moment in time. The data in the graphic below is provided by the NHS and is for 2018. The NHS in fact has a
range of over two thousand separate surgeries that they perform across their network, with different hospitals
specialising in different procedures.

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 Heart surgery (very complex) - £22,934

Cardiac arrest (heart attack - complex) - £3,584

Stomach bypass for obesity £4,360

Brain surgery on children (under 18) £40,936

Bilateral cochlear implants £37,904

Knee replacement - £8,325

Assume you run a hospital with a monthly healthcare budget of £200,000. Which combinations of treatments would be
affordable to stay within budget? What is the opportunity cost for example of each and every heart surgery performed?
Opportunity cost would be expressed in terms of other treatments that might have to be foregone. For example, the
opportunity cost of one hip replacement is sacrificing the funds to provide cataract surgery for six people.

1.1.4 Production Possibility Frontiers (Curves)

Key specification content:
• The use of production possibility frontiers to depict:
o The maximum productive potential of an economy & showing opportunity cost (through marginal analysis)
o Economic growth or decline
o Efficient or inefficient allocation of scarce resources
o Possible and unobtainable production
• The distinction between movements along and shifts in production possibility curves, considering the possible causes for
such changes and the distinction between capital and consumer goods

What is a production possibility frontier?

• A PPF shows the maximum potential output combinations of two goods or services that an economy can
achieve when all its resources are fully and efficiently employed.
• We normally draw a PPF as concave to the origin i.e. when we move down along the PPF, as more resources
are allocated towards Good Y, then the extra output gets smaller.
• This is explained by the law of diminishing marginal returns. It occurs because not all factor inputs (such as
land, labour and capital) are equally suited to producing different goods leading to lower productivity.
Exam hint: Explaining the shape of a PPF is a reasonably frequent low-mark or multiple-choice question, but many students struggle
to gain the marks because it is such a small part of the syllabus that they have simply forgotten it!

A micro PPF would look at two specific products such as smartphones and smartwatches. A business might reallocate
their available inputs towards one product i.e. it is specialising in supplying these. This decision involves an opportunity
cost because some output of the alternative good has to be sacrificed.

A macro PPF looks at the choices an economy might have between producing capital goods such as factories and
technology versus supplying consumer goods and services.

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The PPF and economic efficiency
Any point lying on the PPF is an efficient allocation of scarce resources whereas a point inside the PPF is an inefficient
allocation of resources since it is possible to produce more of one good without sacrificing any of the other.

• Combinations of consumer and capital goods lying inside the PPF happen when there are unemployed resources
or when resources are used inefficiently. This is the case with combinations D and E.
• Combinations beyond the PPF are currently unattainable. A country would require an increase in factor
resources, an increase in productivity and/or an improvement in technology to reach this combination. F is
unattainable by simply producing domestically.
• Specialisation, trade and exchange between countries allows nations to consume beyond their own PPF.
• Producing more of both goods would be an improvement in allocative efficiency.
What is Pareto efficiency?
• In neoclassical economics, a Pareto efficient outcome is an action that harms no one and helps at least one
person.
• A situation is Pareto efficient if the only way to make one person better off is to make another person worse
off.
• The production possibility curve can be used to illustrate the concept of Pareto efficiency and Pareto
improvements in welfare

Pareto efficiency and the PPF

• Pareto efficiency will occur on points that lie on a production possibility frontier / curve

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 • When an economy is operating on a production possibility frontier, it is not possible to increase output of
goods without reducing output of services
• When an economy lies well within the PPF boundary, there is an inefficient use of resources or under-
utilization of resources
• Here it becomes possible for output of two goods or services to increase at the same time

Pareto efficiency and equity

• An outcome may be a Pareto improvement, but it doesn’t always mean this is a satisfactory outcome or fair
• There could still be inequality after a Pareto improvement
• We need to see which groups / people benefit from increased output of goods and services i.e. consider social
welfare
• Showing on a diagram a pareto improvement involves no judgement about the equality of final distribution or
overall social welfare.
The PPF and Opportunity Cost

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 • Reallocating scarce resources from one product to another involves an opportunity cost.
• If we increase our output of cotton (i.e. we move along the PPF from point A to point B) then fewer factor
resources are available to produce wheat, therefore total output of wheat will decline.
• If the law of diminishing returns holds true, the opportunity cost of expanding output of cotton measured in
terms of lost units of wheat must be increasing. I.e. we are giving up more wheat to supply the extra cotton.

Shifts in the PPF

Note: A straight line PPF is an indication of perfect substitutability of labour or capital inputs.

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What causes an outward shift of a country’s production possibility frontier?
The table below provides a summary:

Cause of an outward shift in the PPF Brief comment on the cause of the shift in the PPF
1. Higher productivity / efficiency of factor inputs This increases the output per unit of an input used in production
2. Better management of factor inputs Improved management reduces waste and improves quality

3. Increase in the stock of capital and labour supply e.g. from inward labour migration / increased capital investment

4. Innovation and invention of new products and Improved production processes help to lift efficiency so that we
resources can get more output from given inputs
5. Discovery / extraction of new natural resources Discovery of commercially viable land drives extraction
(land)

Exam hint: Sometimes, PPFs are often drawn with ‘consumer goods’ and ‘capital goods’ on the axes. A movement towards producing
more capital goods requires some consumer goods to be given up in the short run (a movement along the PPF) but in the long run
the increase in capital will cause the entire PPF to shift outwards so that more of both goods can be made.

Coronavirus update: Impact on the PPF in the short and medium term
Public health measures brought in to control the coronavirus have had the effect of greatly restricting consumption and production in
many countries including the UK. The result has been a sharp fall in demand for goods and services and a severe contraction of GDP.
In the short-term, this means that we move away from the production possibility frontier which implies a higher level of spare capacity.

There are some fears that the downturn may turn out to be longer-lasting, especially if there is a second wave of infections and an
effective vaccine is delayed. In this case, there might be some ‘economic scarring’ effects which could lead to an inward shift of the
production possibility frontier. This might happen for example if many of those made unemployed become economically inactive
and/or if a large number of businesses who were viable in normal times, fall in bankruptcy and have to close.

Can a production possibility frontier shift inward?

Yes it can, and if this happened, then the productive potential of a country might have suffered perhaps due to:
1. The damaging effects of severe natural disasters such as a tsunami, floods, persistent drought and other
extreme weather events.
2. The destruction caused by war and other types of conflict.
3. Large scale net migration of people out of a country e.g. when there is high unemployment or a depression.
4. A long-term fall in productivity of labour.

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 Human Capital Flight Capital Scrapping Natural Disasters Deforestation

Resource depletion
This is a decline in the total stock of resources available, for example arising from the effects of de-population, climate
change and low rates of investment in new capital goods. Extensive deforestation and industrial fishing beyond the
sustainable yield can lead to a significant decline in the stock of a country’s natural capital.

Machinery Skills Decline Buildings Basic Infrastructure

Resource depreciation
This is when the efficiency of resources diminishes with age and with repeated use during production.

Exam hint: Questions relating to the short-run and long-run impacts on PPFs of an economy producing more capital goods are
reasonably common. In the short run, there will be a movement along the PPF so that more capital goods are produced and fewer
consumer goods are given up. However, in the long-run, the economy now has more capital goods available and so can produce
more of everything – this then causes a shift outwards of the PPF. In some countries such as China, the level of capital investment
measured as a share of their GDP is very high up to 40% of their annual GDP. When investment rates are high and provided this
investment is productive, we expect to see significant outward shifts in the production possibility frontier.

Deforestation and Resource Depletion

Deforestation causes significant economic and social/human costs, and this is one of the most critical environmental
issues of the age. In Brazil for example, between August 2017 and July 2018, approximately 7,900 square kilometres
(3,050 square miles) of rainforest was destroyed - that's an area five times the size of London. Up to one-fifth of Brazil's
soya exports to the European Union may have been contaminated by illegal deforestation according to a report
published in 2020.

Key causes / drivers of deforestation:

• Expansion of industrial cattle / soy / palm oil farming especially in countries such as Brazil
• Expansion of (often illegal) gold mining
• Expansion of hydro-electric dams requiring land clearance
• Urban development / urban sprawl
• Illegal logging / land grabbing alongside weak legal / institutional protections

Economic and social costs of deforestation:

• Threat to livelihoods of millions in indigenous populations
• Environmental impact – loss of a vital carbon store
• Threat to eco-systems – permanent loss of natural capital
• Consequences for water supplies in other countries and continents
• Huge threat to potential for a country to achieve sustainable development

What policies / government interventions might successfully reduce rates of deforestation?

1. Increase in overseas aid programmes e.g. husbandry payments to local farmers
2. Investment to make farming more sustainable (requires appropriate capital inputs)
3. Linking trade agreements to improved environmental and farming policies

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 4. Using satellite technology to monitor and track rates of deforestation
5. Investment in reforestation via government spending.

Reforestation
In some countries, reforestation has become an important part of government economic policy. From 2000 to 2019, a
total of 27 million hectares of forest area has been restored around the globe. However, the annual State of the
World's Forests report found that an estimated 10 million hectares were lost each year between 2015 and 2020 due to
deforestation. The key to controlling deforestation in the long run is to show that the conservation of land can be both
economically profitable and environmentally valuable to the communities most closely connected to the land.

1.1.5 Specialisation and the Division of Labour

Key specification content:
• Specialisation and the division of labour: (including reference to Adam Smith)
• Advantages and disadvantages of specialisation and the division of labour in organising production
• Advantages and disadvantages of specialising in the production of goods and services to trade
• Functions of money

Learning by doing helps to Many businesses employ

increase productivity and the specialist managers in the
quality of supply production process

What is specialisation?
Specialisation is when we concentrate our resources on a specific product or task. It happens in all economic activities:
1. Specialisation of tasks within extended families in many of the world’s poorer countries.
2. Within businesses and organizations – e.g. specialist buyers & managers employed by supermarkets.
3. In a country – Bangladesh is a major producer and exporter of textiles; Norway is a leading oil and gas exporter.
And Ghana is one of the biggest global producers of cocoa. Morocco is now specialising in renewable energy.
The UK economy tends to specialise in many service industries such as finance, arts, and tourism.
4. In a region of a country – for many years the West Midlands has been a major centre for motor car assembly.
What are the possible gains from specialisation?
By concentrating on what people and businesses do best rather than relying on self-sufficiency we may experience:
• Higher output: Total production is raised, and quality can be improved. Division of labour means a task is
divided up into sections so that workers can complete their task accurately in less time. This means that
specialisation can lead to increased productivity / efficiency.
• Variety: Consumers have access to a greater variety of higher-quality products in different markets.
• A bigger market and economies of scale: Specialisation and an expansion of global trade increases the size
of the market offering opportunities for economies of scale to be exploited, which then leads to lower unit
costs and lower prices for consumers.

Key Exam Point: For specialisation to be used, there needs to be a medium of exchange so that trade can be successful.

Potential drawbacks from specialisation

1. Some workers receive little training and may not be able to find alternative jobs when out of work – they then
suffer structural unemployment arising from occupational immobility.
2. Mass-produced standardized goods may lack variety which damages consumer welfare.

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 3. There are dangers from over-specialisation. Farmers may become too reliant on one crop. At a
macroeconomic level, a country may over-specialise in the supply of just a few products which makes them
vulnerable to shocks in global demand. A good example is a country that specializes heavily in a natural
resource such as copper or cocoa and there is a fall in demand and prices paid for their output.

Division of labour
• The division of labour occurs where the production process is broken down into many separate tasks.
• Division of labour can raise output per person (productivity) as people become proficient through repetition of
a task. This is called learning by doing.
• This gain in labour productivity then helps to lower the supply cost per unit for a business.
• Reduced supply costs in theory will lead to lower market prices for consumers of goods and services causing
gains in economic welfare e.g. through an increase in consumer surplus (see theme 1.2.8)

Potential drawbacks from the division of labour

1. Unrewarding, repetitive work can lower motivation causing lower labour productivity.
2. Workers may take less pride in work and therefore the quality of a good or service suffers.
3. Dissatisfied workers cause absenteeism to increase which increases costs for businesses.
4. People move to less boring jobs creating high worker turnover and increased hiring/training costs.
5. Increased risk of repetitive strain injuries at work – adding to the burdens facing the health service.

Adam Smith and the Division of Labour

Adam Smith famously wrote about the division of labour in his book, The Wealth of Nations, published in 1776. Smith considered
the impact of using division of labour in a pin factory in Glasgow. He claimed that by separating the production process of pins into
18 different parts, then just 10 workers would be able to produce 48 000 pins in one day, a significant increase on the number that
could be produced if each worker made a pin in its entirety from start to finish.

Smith realised that the increase in productivity stemmed from workers being able to focus on just one task, gaining large increases
in dexterity, being able to use specialist tools to get the job done, and wasting less time moving from task to task. He did note,
however, that this could cause significant boredom.

Looking beyond some of the benefits of specialisation, many countries are seeking to diversify their economies with a
wider range of industries so that they are less exposed to external economic shocks.

Characteristics and functions of money

In any economic system in which there is specialisation, there is a need for money. Prior to specialisation, when
households made products / services in their entirety, they could simply barter (i.e. swapping home-grown herbs for, say,
a loaf of bread), provided that they could find someone to engage in this double coincidence of wants. However, because
specialisation leads to households simply producing part of a good/service, this leads to them having nothing with which
to barter. For an economist, money is anything that is generally acceptable in the settlement of a debt. For most
economies, this now includes notes, coins and electronic money. For many people in the past, it could be anything –
shark teeth, shells, and even rice.

Standard of
Medium of Store of Unit of
deferred
exchange value account
payment

What are the main functions of money?

1. A medium of exchange - Money is any asset acceptable as a medium of exchange. It facilitates transactions
between buyer & seller. Specialisation and the division of labour require a means of exchange.
2. A store of value - An asset that holds its value over time (high inflation reduces cash as a store of value).

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 3. A unit of account – money is a unit of measure used to value and cost products, assets (e.g. houses), debts,
incomes and spending.
4. A standard of deferred payment - the accepted way, in a given market, to settle a debt.
Forecasted number of cash transactions in the United Kingdom from 2006 to 2026, by denomination (in billions)

< £1 < £5 < £10

20
Number of transactions in

15

10
billions

0
2006 2016 2026*

What are the key characteristics of money?

Acceptable when
Hard to counterfeit Durable and Portable Holds value over time
making transactions

1. Durability i.e. it needs to last

2. Portable i.e. easy to carry around, convenient, easy to use
3. Divisible i.e. money can be broken down into smaller denominations to facilitate purchases
4. Hard to counterfeit - i.e. it cannot easily be faked or copied by currency fraudsters
5. Accepted i.e. money must be accepted as legal tender – there must be sufficient trust in money
6. Valuable – i.e. it generally holds value over time and is not destroyed by the effects of rapid / hyper-inflation
Cash is legal tender and is durable, portable, divisible.

1.1.7 Free market economies, mixed economy and command economy

Key specification content:
• Distinction between free market, mixed & command economies: reference to Adam Smith, Friedrich Hayek and Karl Marx
• Advantages and disadvantages of a free market economy and a command economy
• Role of the state in a mixed economy

Economic systems

Free Market System Mixed Economy Transition Economy Socialist Planning

An economic system is a network of organisations used to resolve what, how much, how and for whom to produce i.e.
a way of addressing the basic economic problem.

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 1. Free market economy: Markets allocate scarce resources through the price mechanism. An increase in demand
raises price and this encourages businesses to bring more resources into production. The quantity of products
consumed by people depends on their income which itself depends on the market value of an individual’s work.
In a free market system, there is a limited role for the government, indeed in a pure free market system, the
government restricts itself to protecting property rights of people and businesses using the legal system and
protecting the real value of money by maintaining a low rate of inflation.
2. Planned or command economy: in a planned or command system associated with a socialist or communist
system, the government owns scarce resources. The state allocates resources and sets production targets and
growth rates according to its own (subjective) view of people's wants. Market prices play little or no active part
in informing resource allocation decisions and often, queuing rations scarce goods.
3. Mixed economy: In a mixed system, some resources are owned by the public sector (i.e. the government) and
some are owned by the private sector. The public (or state) sector typically supplies public, quasi-public and
merit goods and intervenes in markets to correct market failures. Nearly all economies in the world are mixed
(including the UK) although that mix changes over time for example as some industries are privatised (sold to
the private sector) or nationalised (taken back into state ownership).

What are markets?

A market is anywhere where buyers and sellers come together to transact. The buyer and seller don't have to be in the
same place in order to conduct transactions with each other – many businesses now operate on digital platforms such
as Amazon marketplace and eBay. The twin forces of supply and demand in markets such as agricultural products are
crucial in establishing prices and perhaps reaching an equilibrium i.e. a market-clearing price where supply = demand.

What are submarkets?

The market for most goods and services can be broken down into sub-markets which tailor to the different needs and
wants of groups of consumers. For example, the market for new cars could be segmented into the market for electric
and hybrid vehicles as well as petrol and diesel-powered cars. In the housing market we can distinguish between
residential and commercial property. A pharmaceutical company might consider sales in each submarket by country.

What are the key aspects of a free-market economic system?

1. Light touch regulation of labour, product and financial markets
2. Legal system focuses on protecting property rights
3. Freedom to trade internationally and promote free movement of capital and labour
4. Limited market intervention (e.g. indirect taxes, subsidies, maximum and minimum prices)
5. Small size of government (including a small size/scope of welfare benefits)
6. Low tax environment / focus on “ease of doing business”
7. Consumer preferences determine allocation of resources

What are some of the main advantages of free-market competition?

1. An efficient allocation of scarce resources – factor resources tend to go where the expected profit is highest.
2. Competitive prices for consumers as suppliers look to increase and then protect their market share.
3. Innovative dynamism provides major benefits to consumers by bringing them new goods and new processes.
4. The profit motive stimulates investment which encourages economies of scale arising from big-scale
production and ultimately lower prices for consumers.
5. Competition through trade helps to reduce monopoly power and increases choice whilst lowering prices.
What are some of the potential drawbacks / disadvantages from a free market economic system?
1. Free market activity can lead to a rise in income and wealth inequality as shown by rise in the Gini coefficient
2. Businesses can develop monopoly power which leads to higher prices and damage to consumer welfare
3. Under or non-provision of pure public goods (e.g. defence – goods which are non-rival and non-excludable)
4. Under-provision of merit goods such as health and education – which many cannot afford – leading to lower
social welfare

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 5. Free markets may fail to address negative externalities from production and consumption leading to
unsustainable economic growth
6. Deregulated financial markets often prone to bouts of instability – the fallout from which affects millions not
directly involved
What are some of the problems associated with central planning?
1. Bureaucratic costs of central planning of resources – petty officialdom can lead to wasteful inefficiencies and
therefore higher costs.
2. Problems in fixing prices of goods and services – government planners are unlikely to be as accurate as the
market in determining suitable prices leading to numerous shortages and surpluses.
3. Absence of incentives for both workers and businesses can damage productivity and lead to large levels of
over-employment / hidden unemployment and, ultimately, lower living standards.
4. Low productivity and weak incentives can lead to rising losses for many state-owned enterprises. The
incentive to innovate is limited leading to a less dynamic economy.
5. Changing consumer needs and wants are not expressed as preferences in markets – the state is often slow to
react to these.
6. The state can suffer from information failures and endemic corruption with elites drawing most of the wealth.
7. State-run economies are at higher risk of mal investment driven by political motivations. Projects might be
driven by vanity rather than objective cost-benefit analysis.
Adam Smith on economic systems

In his 1776 book ‘Wealth of Nations’, Adam Smith wrote about the ‘invisible hand’ of resource allocation, and the role of ‘self-
interest’, in an early reference to free-market economies. The key quotes from Wealth of Nations on this topic are:

“[Every individual] generally, indeed, neither intends to promote the public interest, nor knows how much he is promoting it. By
preferring the support of domestic to that of foreign industry, he intends only his own security; and by directing that industry in such
a manner as its produce may be of the greatest value, he intends only his own gain, and he is in this, as in many other cases, led by
an invisible hand to promote an end which was no part of his intention. Nor is it always the worse for the society that it was no part
of it. By pursuing his own interest, he frequently promotes that of the society more effectually than when he really intends to
promote it. I have never known much good done by those who affected to trade for the public good.”

“It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their
own interest. We address ourselves, not to their humanity but to their self-love, and never talk to them of our own necessities but of
their advantages.”

At the same time, however, Adam Smith warned that we should be wary of businesses that become too large (i.e. monopolies)
because of their tendency to raise prices. He recognised that the government should keep an eye on their activities, but believed it
was dangerous for large businesses to influence politics and legislation. Smith recognised that in a free market economy, some
people would be rich ‘property owners’ i.e. owners of the factors of production, and there would be far fewer of these people than
labourers. He said that one important role of government in this type of economic system would be to maintain law and order,
because the many poor would want to take over the property of the rich.

Other roles for the government, identified by Smith, include the issuing of patents and copyright (to protect invention), providing
national defence, regulating the banking sector, building infrastructure, and public goods. Smith is now regarded as the founder of
free market (or laissez-faire) economics, despite recognising the need for some government intervention.

Karl Marx and economic systems

Marx developed many of Adam Smith’s ideas on capitalism / free-market economics, but mostly considered the negative
consequences. He agreed that free markets would lead to large increases in productivity and output but thought that the impact on
labourers would be terrible. Marx believed that the drive for profit by business owners in the capitalist system would push worker
wages to ‘subsistence’ levels and that they would be exploited. He said that, ultimately, exploited workers would work together and
overthrow capitalism in a revolution. Capitalism would be replaced by socialism. In this system, production would be coordinated
centrally, and distribution of the goods made would be “to each according to his contribution”. Beyond this, Marx gave very little
indication of how a centrally planned command economy would operate in practice.

Friedrich Hayek and economic systems

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Hayek is probably the best-known member of what is known as the Austrian School of economics, in which there is a strong belief in
the role and importance of the individual in the economy, rather than any collective group or government. During the 1930s, he
engaged in lively debate with the economist Keynes – Keynes supported significant government intervention in the economy to
stimulate growth whereas Hayek did not.

Whereas Adam Smith saw a role for government intervention in money markets and financial markets, Hayek disagreed, arguing that
intervention in money markets was one of the main causes of economic instability (the pattern of booms and recessions). In other
words, Hayek saw less of a role for governments in an economy than even Smith. For Hayek, the only possible role for a government
was to maintain law and order. Later in life, he did suggest that the state could provide a small ‘safety net’ for those who found
themselves unable to work.

Hayek argued strongly against command economies, noting that a small group of individuals would be entirely responsible for
determining the allocation and distribution of resources; in his view, it would be completely impossible for them to ever have
enough information to do this properly to meet people’s needs. Hayek believed that markets alone would have the information
needed to make these decisions, because markets coordinate the views and information held by everyone, in a ‘spontaneous’ way.

1.2.1 Rational Decision Making

Key specification content:
• The underlying assumptions of rational economic decision making:
o Consumers aim to maximise utility
o Firms aim to maximise profits

Rational decision making

Rational consumers make their choices with the aim of maximising utility (i.e. their satisfaction or benefit) from
purchasing and consuming goods and services using a limited budget. The assumption of people acting rationally has
dominated standard economic theory for decades: The rational choice model assumes the following:
• Consumers choose independently (i.e. my preferences do not affect in any way your choices).
• A consumer has consistent tastes and preferences; so, if product A is preferred to product B and B is preferred
to C, then A is preferred to C (technically, this is called transitive preferences).
• They gather complete (full) information on the alternatives.
• They always make an optimal choice given their preferences.
The rational rule is that you should continue doing something e.g. eating more slices of pizza until the marginal benefit
equals the marginal cost. Marginal (in economics) means a little more or less of something. This model of rational
choice has been challenged in recent times by growing academic interest in behavioural economics and the
widespread use of behavioural nudges designed to change people’s decisions.

Summary of some key concepts

Bounded rationality When consumers have limited attention, knowledge and ability to understand complex decisions
Information gaps When consumers have insufficient knowledge to make an optimal decision
Irrational behaviour Any decision that goes against or counter to logic
Marginal private cost Internal cost to the consumer of buying another unit
Marginal utility Change in total utility from consuming the next unit
Maximum utility When marginal utility is zero
Rationality Using all information to make optimal choices

1.2.2 Demand
Key specification content:
• Distinction between movements along a demand curve and shifts of a demand curve
• Factors that may cause a shift in the demand curve (the conditions of demand)
• Concept of diminishing marginal utility and how this influences the shape of the demand curve

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What is meant by demand?
• Demand is the quantity of a good or service that consumers are willing and able to buy at a given price in a
given time period.
Effective Demand
• Effective demand is when a desire to buy a product is backed up by having an ability to pay in other words,
consumers have sufficient income in their budget to make purchases.
Derived Demand
• Derived demand is the demand for a factor of production used to produce another good or service.
• Example: Steel - The demand for steel is linked to market demand for cars and construction of new buildings.
• Example: Cloud computing infrastructure - Growth in the cloud infrastructure service space is being driven by
increasing demand for information and data storage among businesses and households across the world for
example, the surge in demand for online video streaming and online gaming.
• Example: Transport - A fall in demand for commuting during the pandemic led to a steep decline in the demand
for public transport.
• Example: Cobalt - 50% of all cobalt demand is for battery use e.g. for smartphones and electric vehicles
• Example: Logistics - A consequence of falls in demand for, and production of new cars is reduced demand for
logistics services provided by companies such as DHL. On the other hand, Tesco announced that it planned to
create 16,000 new jobs in response to what is expected is a permanent shift towards online grocery retail

New homes increases the Take up of e-cars increases Internet of Things increases
Labour is a derived demand
demand for steel demand for charging stations demand for cloud servers

What is the basic law of demand?

• There is usually an inverse relationship between the price of a good and demand. As prices fall, we see an
expansion/extension of demand. If price rises, there will be a contraction of demand.
• When drawing a demand curve, economists assume all factors are held constant except one – the price of the
product itself. Ceteris paribus allows us to isolate the effect of one variable on another variable.
Explaining the Demand Curve
A demand curve shows the relationship between the price of an item and quantity demanded over a period of time.
There are two reasons why more is demanded as price falls:
1. The Income Effect: When the price of a good falls, the consumer can maintain the same consumption for less
spending. Provided that the good is normal, some of the increase in real income is used to buy more.
2. The Substitution Effect: When the price of a good falls, ceteris paribus, the product is now relatively cheaper
than an alternative and some consumers will switch their spending from an alternative good or service. The
more substitutes there are in the market and the lower the cost and inconvenience of switching, the bigger the
substitution effect is likely to be.
Diminishing marginal utility and the demand curve
We can think about how the Law of Diminishing Marginal Utility can help to explain the inverse relationship between
price and quantity demanded. As more of a good is consumed, the additional utility (satisfaction) from each extra unit
consumed will fall. Because consumers are assumed to be rational, they will not pay more for a good than the additional
utility it provides. Therefore, price and quantity demanded are inversely related.

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 • As price falls, a person switches away from rival products towards the product.
• As price falls, a person’s willingness and ability to buy the product increases.
• As price falls, a person’s opportunity cost of purchasing the product falls.
• Note: Many demand curves are drawn as straight lines, this is to make the diagrams easier to interpret.
Exam hint: You need to be able to explain the shape of the downwards sloping demand curve using the concepts of income and
substitution effects.

Changes in Conditions of Demand – shifts in the demand curve are due to changes in non-price factors:
• Changing prices of a substitute goods or services i.e. products in competitive demand.
• Changing price of complements – i.e. products in joint demand.
• Changes in the real income of consumers:
o When real income goes up, our ability to purchase goods and services increases, and this causes an
outward shift in the demand curve for normal goods.
o But when incomes fall there will be a decrease in demand, except for inferior goods (i.e. those with a
negative income elasticity of demand).
• Changes in the distribution of income - a more equal distribution of income can increase total demand because
relatively poorer consumers tend to spend a higher proportion of their income.
• Changes in consumer tastes and preferences – brought about for example by the effects of advertising and
marketing and the impact of behavioural factors such as peer pressure and herd behaviour. Social influencers
might also have an impact on the preferences of consumers.
• Interest rates (e.g. affecting the cost of credit for big ticket items such as a new car or home improvements).
• Changes in both the size and age structure of a population in a country. Rapid population growth often leads to
a significant increase in demand for many different goods and services.
• Seasonal factors for some goods and services e.g. holidays, sporting equipment.
• Social and emotional factors affecting demand.

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Exam hint: One of the most frequently seen errors by examiners is students wanting to shift the demand curve when there is a
change in the price. It is vital that students understand that a change in the price causes a movement along the demand curve. A
useful tip is to be careful with your language. For example, a fall in the price leads to an increase in the quantity demanded i.e. an
extension along the curve, whereas an increase in income leads to an increase in demand at each and every price i.e. a right shift.

A good example of declining demand is the market demand for diesel vehicles in the UK.

Market share of fuel types in newly registered cars in the United Kingdom
Alternative fuel Petrol Diesel
2014 2.1 47.8 50.1
2015 2.8 48.8 48.5
2016 3.3 49.0 47.7
2017 4.6 53.4 42.0
2018 6.0 62.3 31.7

In contrast, market demand for electric vehicles in the UK and in many other countries is rising.

Factors influencing demand for electric vehicles include:

1. Retail prices of electric vehicles
2. Prices of and availability of car charging points
3. Prices of substitutes such as diesel / petrol cars, rail travel
4. Government intervention in markets e.g. ban on sales of petrol and diesel cars in the UK from 2035

Quarterly sales volume of battery electric (BEV) and plug-in hybrid electric vehicles (PHEV) in Europe from Q1 2014 to Q2 2019

Sales volume of electric vehicles in Europe 2014-2019

140,000
120,000
100,000
80,000
60,000
40,000
20,000
0
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2
'14 '14 '14 '14 '15 '15 '15 '15 '16 '16 '16 '16 '17 '17 '17 '17 '18 '18 '18 '18 '19 '19

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Joint demand

Fish and chips Smartphones and apps Solar panels & batteries Flights and taxi services

Pasta and pasta

Shoes and polish
sauces
• Joint demand is when demand for one product is positively related to demand for a related good or service.
• Two complements are said to be in joint demand.
• The cross-price elasticity of demand for two complements is negative.
• Examples of joint demand include fish and chips, iron ore and steel, apps for smartphones and smart TVs.
Composite demand
• Composite demand is where a product has more than one use.
• An increase in demand for one product leads to a fall in supply of the other.
• An example is milk which can be used for cheese, yoghurts butter and other products including fertilizer.
• An example is land – e.g. farmland can be developed in many different ways, urban land has different uses.

Coronavirus update: Changing market demand for different goods and services
Demand for some products surged during the early stages of the coronavirus pandemic and lock-down. Good examples include hand
sanitisers, face masks, household cleaning products, digital hardware as millions more worked from home and staple items of
consumption such as dried long-life food, toilet rolls and children’s medicines. However the public health crisis inevitably led to a
large decline in market demand for meals out, takeaway food including sandwiches and coffees because of the collapse in the daily
number of people travelling to and working in offices. Demand for online streaming services surged and so too delivery services but
spending on visits to theatres and cinemas fell away to almost zero within the space of a few days.

Utility and demand

Utility measures the satisfaction we get from purchasing and consuming a product:
• Total utility: The total satisfaction from a given level of consumption.
• Marginal utility: The change in satisfaction from consuming an extra unit.
• Diminishing marginal utility: Standard theory believes in the assumption of diminishing returns i.e. the marginal
utility of extra units decline as more is consumed. In other words, suppose that you buy a packet of crisps –
eating the crisps gives you a certain amount of satisfaction, or utility. Suppose you now buy a second bag –
eating the crisps still gives you some utility, but not as much as the first bag gave you.
An example of diminishing marginal utility is shown in the next table:

Quantity Consumed (units) Total Utility (TU) Marginal Utility (MU)

1 10 10
2 24 14
3 40 16
4 52 12
5 61 9

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 6 68 7
7 72 4
8 72 0

• Marginal utility is the change in satisfaction from consuming an extra unit of a good or service
• Beyond a certain point, marginal utility may start to fall (i.e. diminish)
• This happens with the 4th unit where marginal utility falls to 12
• The 8th unit carries zero marginal utility i.e. total utility is constant
• If marginal utility is falling, then consumers may only be prepared to pay a lower price
• This helps to explain downward sloping demand curve for a good or service

Note: Rational choice theory assumes that consumers always behave rationally in allocating their limited budget between different
products to maximise total satisfaction from their purchases. Behavioural economists challenge this assumption of pure rationality in
people’s everyday decisions.

1.2.3 Price, income and cross elasticities of demand

Key specification content:
• Understanding of price, income and cross elasticities of demand
• Use formulae to calculate price, income and cross elasticities of demand
• Interpret numerical values of
o Price elasticity of demand unitary elastic, perfectly and relatively elastic, and perfectly and relatively inelastic
o Income elasticity of demand: inferior, normal and luxury goods; relatively elastic and relatively inelastic
o Cross elasticity of demand: substitutes, complementary and unrelated goods
• Factors influencing elasticities of demand
• Significance of elasticities of demand to firms and government in terms of:
o The imposition of indirect taxes and subsidies
o Changes in real income and changes in the prices of substitute and complementary goods
o The relationship between price elasticity of demand and total revenue (including calculation)

Price elasticity of demand

What is price elasticity of demand?
• Price elasticity of demand (PED) measures responsiveness of quantity demanded for a product after a change
in the good’s own price.
• The formula for calculating the co-efficient of price elasticity of demand is:
• Percentage change in quantity demanded divided by the percentage change in price
• All normal goods with downward sloping demand curves will have a negative coefficient of PED.
What are the key values for the coefficient of price elasticity of demand?
1. If Ped = 0, demand is perfectly inelastic – i.e. demand does not change at all when the price changes – the
demand curve is drawn as vertical.
2. If Ped is between 0 and -1 (% change in quantity demanded from A to B is smaller than the percentage change
in price), demand is price inelastic.
3. If Ped = -1 (the % change in quantity demanded is exactly the same as the % change in price), demand is unit
price elastic. A 15% rise in price would lead to a 15% contraction in demand leaving total spending the same).
4. If Ped is between -1 and -∞, quantity demanded responds more than proportionately to a change in price i.e.
demand is price elastic. For example, if a 10% increase in the price of a good leads to a 30% drop in quantity
demanded. The price elasticity of demand for this price change is –3.

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 5. If Ped = ∞ then demand is perfectly elastic – quantity demanded will fall to zero if the price rises – the demand
curve will be drawn as horizontal.

What are the main factors that influence the coefficient of price elasticity of demand for a product?

Availability of close Cost of switching Breadth of Degree of necessity Time frame when
substitutes suppliers definition of product making a choice

Brand loyalty Percentage of Habitual demand

income spent on a
product

1. Number of close substitutes – the more substitutes there are in the market, the more price elastic is demand
because consumers can easily switch. E.g. Air travel and train travel are weak substitutes for inter-continental
flights but are closer substitutes for journeys between major cities.
2. Cost of switching between products – there may be expense involved in switching. In this case, demand tends
to be inelastic. For example, mobile phone service providers or gyms may require a contract which has the effect
of locking-in some consumers once a purchase has been made.
3. Degree of necessity or whether the good is a luxury – necessities tend to have a price inelastic demand whereas
luxuries tend to have a more price elastic demand. An example of a necessity is rare-earth metals that are an
essential raw material in the manufacture of solar cells and batteries.
4. Proportion of a consumer’s income allocated to spending on the good – products that take up a high
percentage of income will have a more price elastic demand.
5. Time period allowed following a price change – demand is more price elastic, the longer that consumers have
to respond to a price change. They have extra time to search for relatively cheaper substitutes in the market.
6. Whether the product is subject to habitual consumption – consumers become less sensitive to the price of the
good of they buy something out of habit (it has become their default choice).
7. Peak and off-peak demand - demand tends to be price inelastic at peak times and more elastic at off-peak times
– this is the case for transport services including rail, airlines and taxi companies such as Uber and Lyft.
8. Breadth of definition of a good or service – if a good is broadly defined, i.e. the demand for petrol or meat,
demand is often price inelastic. Individual brands of petrol or beef are likely to be price elastic.
9. Method of payment - people tend to notice price changes more when they pay in cash rather than card, or
direct debit.

Exam hint: The best candidates use economic language and terminology with high accuracy. It is more effective for students to write
that a product has price elastic demand rather than simply writing that the product has elastic demand (because there are different
types of demand elasticity). Students should definitely avoid writing phrases such as “petrol is inelastic”.

Price elasticity of demand and total revenue

The relationship between elasticity of demand and a firm’s total revenue is an important one often tested in exams:
• When demand is price inelastic, a rise in price leads to a rise in total revenue – for example, 20% rise in price
might cause demand to contract by only 5% (i.e. PED = -0.25).

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 • When demand is price elastic, a fall in price leads to a rise in total revenue - for example, a 10% fall in price
might cause demand to expand by 25% (i.e. PED = +2.5).
• When demand is perfectly inelastic (PED=0), a given price change will result in the same revenue change, for
example, a 5 % increase in a firm’s prices results in a 5 % increase in its total revenue since demand is unchanged.
• When demand is unit elastic (i.e. PED = -1) a change in the price leads to no change at all in total revenue.
Price elasticity of demand and total revenue
The table below gives an example of the relationships between prices; quantity demanded and total revenue.

Price Quantity Total Revenue Marginal Revenue

£ Per Unit Units £ £
20 200 4000
18 280 5040 13
16 360 5760 9
14 440 6160 5
12 520 6240 1
10 600 6000 -3
8 680 5440 -7

• Consider the price elasticity of demand of a price change from £20 per unit to £18 per unit.
• The % change in demand is 40% after a 10% change in price – giving a PED of -4 (i.e. highly price elastic).
• In this situation when PED>1, a fall in price leads to higher total consumer spending / producer revenue.
• Consider a price change further down the estimated demand curve – from £10 per unit to £8 per unit.
• The % change in demand = 13.3% following a 20% fall in price – giving a co-efficient of – 0.665 (i.e. price inelastic).
• A fall in price when demand is price inelastic leads to a reduction in total revenue.

Exam hint: Make sure that you can explain the relationships stated above, rather than merely repeat the relationships – this will help
you to pick up analysis (AO3) marks and not just knowledge (AO1) marks.

Exam hint: Students often really struggle to grasp the idea that PED changes along a demand curve – this occurs because PED is
calculated using proportionate changes not absolute changes.

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 CHANGE IN THE MARKET WHAT HAPPENS TO TOTAL REVENUE?
Ped is price inelastic (<1) and a firm raises its price. Total revenue increases
Ped is price elastic (>1) and a firm lowers its price. Total revenue increases
Ped is price elastic (>1) and a firm raises price Total revenue decreases
Ped is unit elastic (PED=1) and a firm raises price Total revenue remains the same
Ped is -1.5 (price elastic) and the firm raises price by 4% Total revenue decreases
Ped is -0.4 (price inelastic) and the firm raises price by 30% Total revenue increases
Ped is -0.2 (price inelastic) and the firm lowers price by 20% Total revenue decreases

Ped is -4.0 (price elastic) and the firm lowers price by 15% Total revenue increases

Price elasticity of demand along the demand curve

The coefficient of price elasticity of demand changes along the demand curve. As we move from left to right along the
demand curve, PED becomes increasingly price inelastic. This is because we are looking at proportional changes and
not absolute changes. This is illustrated in the diagram below, which illustrates how we represent total revenue on a
demand curve:

Usefulness of Price Elasticity of Demand for Producers

Firms can use PED estimates to predict:
• Effect of a change in price on their total revenue. (Total revenue = price per unit x quantity sold)
• Price volatility in a market following changes in supply – this is important for farmers and other commodity producers
who frequently suffer big price and revenue shifts from one time period to another. A good example is the coffee
industry. Globally, over 21 million families make a living from coffee but farmers typically only received around 2
percent of the profits from each cup of coffee sold at retail level.
• Effect of a change in an indirect tax on price and quantity demanded and whether the business is able to pass on
some or all of the tax onto the consumer.
• Information on the PED can be used by a business for price discrimination. This is where a supplier decides to charge
different prices for the same product to different segments of the market e.g. peak and off-peak rail travel or prices
charged by many of our domestic and international airlines.
• Usually a business will charge a higher price to consumers whose demand is price inelastic (Ped<1).
In reality, it is really difficult for businesses to estimate the PED for their goods – this is because we can only calculate it
assuming that ‘ceteris paribus’ holds. In reality, many factors affect the amount of a good or service bought, and it is
difficult to ‘isolate’ the effect of a price change alone.

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Income elasticity of demand
What is income elasticity of demand?
• Income elasticity of demand (YED) measures the relationship between a change in demand following a change
in the real income of consumers.
• The formula for calculating income elasticity of demand is: Percentage change in demand divided by the
percentage change in income.
Normal and inferior goods
1. Normal Goods
• Normal goods have a positive income elasticity of demand so as consumers’ income rises, more is
demanded at each price i.e. there is an outward shift of the demand curve.
• Normal necessities have an income elasticity of demand between 0 and +1 for example, if income increases
by 10% and demand for fresh fruit increases by 4%, income elasticity is +0.4. Demand is rising less than
proportionately to income – demand is income inelastic.
• Luxury goods and services have an income elasticity of demand > +1 i.e. demand rises more than
proportionate to a change in income – for example an 8% increase in income might lead to a 10% rise in
demand for new kitchens. Income elasticity of demand in this example is +1.25 - demand is income elastic.
2. Inferior Goods
• Inferior goods have a negative income elasticity of demand meaning that demand falls as income rises.
• Typically, inferior goods or services exist where superior goods are available if a consumer has money to
be able to buy it.
• Examples include demand for cigarettes, economy own label foods in supermarkets and demand for
council-owned rented housing. In the aftermath of the 2009 recession experienced in the UK, there was
some evidence of the goods that came to be regarded as inferior. For example, as national income fell, there
was a large increase in demand for home-delivered pizza (a substitute for eating out in restaurants) and
lipstick (as many women swapped more expensive spa treatments for a little ‘pick-me-up’).
Product ranges, income elasticity and long-term trends
• Income elasticity of demand will vary within a product range. For example, YED for own-label foods in
supermarkets is usually less than for their higher-value “finest” food ranges.
• There is a general downward trend in income elasticity of demand for many basic products, particularly
foodstuffs. One reason is that as a society becomes richer, there are changes in tastes and preferences. What
might have been considered a luxury good several years ago might now be regarded as a necessity.
• Extending the product range can be a way of shifting demand towards items with a higher income elasticity. A
good example is the biscuit manufacturer McVite’s which in 2020 repositioning the standard digestive with 3
premium flavours: Classic Caramel Bliss, Heavenly Chocolate Hazelnut & Luscious Blood Orange.

Inferior goods

Own label discounters Urban bus transport Cigarettes

Economy class travel Own-label cereals Economy Foodstuffs

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How do businesses make use of estimates of income elasticity of demand?
Knowledge of income elasticity of demand helps firms predict the effect of an economic cycle on sales. For example,
luxury products with high-income elasticity see greater sales volatility over a business cycle than necessities where
demand from consumers is less sensitive to changes in the cycle.

Income elasticity and the pattern of consumer demand

As we become better off, we can afford to increase our spending on different goods and services. Income elasticity of
demand will affect the pattern of demand over time.
• For normal luxury goods - income elasticity of demand >+1, so as incomes rise, the proportion of a consumer’s
income spent on that product will go up.
• For normal necessities (income elasticity of demand is positive but less than +1, as income rises, the share or
proportion of their budget on these products will fall.
• For inferior goods as income rise, demand declines and so too will the share of income have spent on inferior
products. A good example of a product with a negative income elasticity of demand is tobacco. Many factors
affect demand for cigarettes and related products including indirect tax placed on them by the government and
the effects of health campaigns and bans on smoking in public places.

Exam hint: Just because an economist might categorise a particular good or service as ‘inferior’ does not necessarily mean that the
good/service is poor quality – it is just less desirable than other alternatives. You must refer to negative income elasticity of demand
as the main feature of inferior goods.

Restaurant and café spending appear to have a positive income elasticity of demand given the data below on the
average level of spending by income decile group.

Average weekly household expenditure on restaurant and cafe meals in the UK in 2018, by gross income decile group, £s
Lowest ten percent 6.00
Second decile group 7.40
Third decile group 9.80
Fourth decile group 11.80
Fifth decile group 15.70
Sixth decile group 17.90
Seventh decile group 18.70
Eighth decile group 24.60
Ninth decile group 30.80
Highest ten percent 43.30

A different picture emerges if we look at the percentage of weekly household expenditure going on gambling payments
in the UK in 2018, by disposable income decile group.
Percentage of weekly household expenditure going on gambling payments in the United Kingdom (UK)
in 2018, by disposable income decile group
1. 0.9

0.8
0.6 0.6
0.6 0.5 0.5 0.5
0.4 0.4 0.4
0.4 0.3

0.2
0.
Lowest ten Second decile Third decile Fourth decile Fifth decile Sixth decile Seventh Eighth decile Ninth decile Highest ten
percent group group group group group decile group group group percent

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Cross price elasticity of demand

Substitutes Complements

What is cross-price elasticity of demand?

• Cross-price elasticity of demand (XED) measures the responsiveness of demand for good X following a change
in the price of good Y (where Y is a related good).
• With cross-price elasticity, we make an important distinction between substitute and complementary goods.
Substitutes:
Substitutes have a positive cross price elasticity of demand. (I.e. XED > 0) which means that an increase in the price of
one product will lead to a rise in demand for its substitute. A high +ve value suggests both products are close substitutes.

Complements:
When there is a strong complementary relationship, cross elasticity of demand (XED) will be negative. An increase in the
price of Good T will lead to a contraction in demand for T and a fall in demand for a complement, good S.

The business relevance of cross price elasticity of demand

• Businesses may want to consider supplying complementary goods together in a ‘bundle’ or ensuring that they
are positioned close to each other in shops.
• They may want to take advantage of what is often called the ‘razor and blades’ model – razors are generally
available to buy quite cheaply, but the accompanying blades (sold separately) are expensive. We see this being
used by printer companies, which sell printers quite cheaply but then charge a high mark-up on ink cartridges.
• With substitute products, we often find that different brands are owned by the same company (“brand
proliferation”) e.g. Unilever, and Procter and Gamble, own many different cleaning product and toiletries
products each.

1.2.4 Supply
Key specification content:
• Distinction between movements along a supply curve and shifts of a supply curve
• Factors that may cause a shift in the supply curve (the conditions of supply)

Definition of Supply
• Supply is the quantity of a good or service that producers are willing and able to supply at a given price in a given
time period.
• The law of supply is that as price rises, so businesses expand supply. This is because higher prices provide a
profit incentive for firms to expand production to meet growing demand.
• A supply curve shows a relationship between market price and how much a firm is willing and able to sell.
• Supply is not necessarily the amount sold, if consumers do not wish to buy the product, it will remain unsold.

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Market supply
Market supply is total supply brought to market by all producers at each price. To calculate, we sum the individual supply
schedules for each producer. An example of calculating market supply is shown in the table below.

Price (£) Firm A’s supply + Firm B’s supply + Firm C’s supply + = Market Supply
10 30 0 5 35
20 45 10 15 70
30 65 20 40 125
40 100 30 70 200

Supply Curve
• A supply curve is drawn assuming ceteris paribus so that if market price varies, we move along a supply curve.
• In the diagram below, as price rises from P1 to P2, there is an expansion / extension of supply.
• If market price falls from P1 to P3, there is a contraction of supply.
• Businesses are responding to market price signals when making their output decisions.

Explaining the law of supply

There are three key reasons why supply curves are drawn as sloping upwards from left to right giving a positive
relationship between market price and quantity supplied:
1. Profit motive: When market price rises following an increase in demand, it then becomes more profitable for
businesses to increase their output.
2. Production and costs: When output expands, a firm’s production costs tend to rise; therefore, a higher price is
needed to cover these extra costs. This may be due to diminishing returns as more factors of production are
added to production, but each extra input is less productive than the one before.
3. New entrants into the market: Higher prices create an incentive for other businesses to enter the market leading
to an expansion of supply. (note – if businesses enter the market for any reason other than an increase in the
price of the product, then the supply curve will shift to the right, rather than there being a movement along it)

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Shifts in supply

• If supply shifts to the right (from S1 to S2) this is an increase in supply i.e. more is provided for sale at each price.
• If supply moves inwards from S1 to S3, there is a decrease in supply i.e. less will be supplied at each price.
Here are the key factors that can cause a shift in the supply curve:
1. Changes in production costs
a. Lower costs mean that a business can supply more at each price. For example, a magazine publisher
might see a reduction in the cost of imported paper and inks. These cost savings can be passed through
the supply chain to retailers and may eventually result in lower prices for consumers.
b. If costs increase, for example following a rise in price of raw materials or higher wages, then businesses
cannot supply as much at the same price and this will cause an inward shift of the supply curve.
c. A fall in the exchange rate causes an increase in prices of imported components and raw materials and
will lead to a decrease in supply. For example, if the pound falls 10% against the Euro, it becomes more
expensive for British car manufacturers to import rubber, glass, steel and paint from overseas suppliers.
2. Changes in technology
a. Improvements in production technology normally bring about lower costs and increased supply. For
example, the latest renewable energy technologies are significantly more efficient than a decade ago.
3. Government taxes and subsidies and regulations
a. Indirect taxes cause an increase in production costs – leading to an inward shift of supply.
b. Government subsidies bring about a fall in supply costs – leading to an outward shift of supply.
c. Regulations typically increase production costs – leading to an inward shift of supply.
4. Changes in climate in agricultural industries
• For commodities such as coffee, cocoa and wheat, climatic conditions have a big influence on supply.
• Favourable weather will produce a bumper harvest and will increase supply. (An outward shift).
• Unfavourable weather conditions including the effects of drought and disease will lead to a poorer harvest,
lower yields and therefore a decrease in supply. (An inward shift).
• Because commodities are often used as ingredients in the production of other products, a change in the supply
of one can affect supply and price of another product. Higher global coffee bean prices for example can lead to
an increase in price of coffee-flavoured cakes.

5. Change in prices of a substitute in production

• A substitute in production is a product that could have been supplied using the same resources. If cocoa prices
rise for example, this may cause some farmers to switch from other crops and invest money in new cocoa
plantations. An increased supply of cocoa may cause an inward shift in supply of a substitute in production.

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 6. The number of producers in the market and their objectives
• The number of sellers in an industry and their objectives affects market supply.
• When new businesses enter an industry, market supply increases causing downward pressure on price.
• If existing businesses decide to move away from maximising their profits towards seeking a higher share of the
market, total supply available at each price will increase.
What are supply shocks?
• A supply shock occurs when an outside event has an impact on the ability of producers to supply goods and
services to a market. Many supply shocks are negative. For example, unexpected flooding or periods of drought
might lead to farm yields (output) being much lower than forecast. Production might be halted by a major public
health crisis as we saw during the coronavirus pandemic which led to a large number of factory closures.
• In East Africa in 2020, a huge plague of locusts threatened production for thousands of small-scale farmers with
little or no resources to battle the threat. In Europe in 2020, a virus affecting olive trees spread across Italy,
dramatically reducing the supply of olives and, by definition, olive oil. Reduced supply for a given level of demand
normally causes prices to rise.
What is competitive supply?
• Goods and services in competitive supply are alternative products that a business could make with its factor
resources of land, labour and capital. An example is the diversion of land used in supplying food to producing
biofuels and the impact this has had on global food prices.
What is joint supply?
• Joint supply is where an increase or decrease in the supply of one good leads to an increase or decrease in
supply of a by-product.

Cotton and cotton

Beef and hide Lamb and wool Wheat and straw
seed

• Examples of joint supply:

o An expansion in beef production will lead to a rising market supply of beef hides.
o A contraction in the market supply of lamb will reduce the supply of wool.
o Another example of joint supply is wheat and straw.
o There are several by-products of ethanol production using sugar cane.
Exam hint: As with demand, it is vital to use language / terminology appropriately and correctly. So, a change in the price of a
product leads to an extension or contraction along the supply curve i.e. a change in the price leads to a change in the quantity
supplied. A change in any non-price factor leads to a change in supply at each and every price (i.e. a shift in the supply curve)

1.2.5 Elasticity of supply

Key specification content:
• Understanding of price elasticity of supply
• Use formula to calculate price elasticity of supply
• Interpret numerical values of price elasticity of supply: perfectly and relatively elastic, and perfectly and relatively inelastic
• Factors that influence price elasticity of supply
• The distinction between short run and long run in economics and its significance for elasticity of supply

What is price elasticity of supply?

Price elasticity of supply (PES) measures the relationship between change in quantity supplied and a change in price.

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Elastic and inelastic supply
• If supply is price elastic, producers can increase their output without a rise in cost or a time delay.
• If supply is price inelastic, then firms find it hard to change their production in a given time period.
Formula for price elasticity of supply
The formula for price elasticity of supply is: (% change in quantity supplied divided by the % change in price).

Values of the coefficient of price elasticity of supply

• When PES > +1, supply is price elastic.
• When PES < 1, supply is price inelastic.
• When PES = 0, supply is perfectly inelastic (and the supply curve is drawn vertically).
• When PES = infinity, supply is perfectly elastic (and the supply curve is drawn horizontally).

Factors that affect price elasticity of supply

• Spare production capacity: If there is plenty of spare capacity, then a business can increase output without a
rise in costs and supply will be price elastic in response to a change in consumer demand.
• Stocks of finished products and components: If stocks of raw materials and finished products are at a high level,
a firm is able to respond easily and quickly to a change in demand - supply will be elastic. Perishable goods such
as fresh foods are often harder/more expensive to store compared to manufactured products.
• Ease and cost of factor substitution/factor mobility: If capital and labour factor inputs are occupationally
mobile, the price elasticity of supply for a product is likely to be higher as extra resources can be mobilized to
supply the desired increase in output e.g. the reallocation of workers to new tasks is straightforward. In this way,
having a flexible labour market can help to increase the price elasticity of supply in many industries.
• Time period and production speed: Supply is more price elastic the longer the time that a firm is allowed to
adjust its production levels. In the momentary period, there is insufficient time for supply to adjust to any
change in demand and hence the supply curve in the momentary period is drawn as vertical (i.e. PES = zero).
The capacity of sports stadia and other venues is a good example of a fixed supply in the short run where supply cannot
respond to changes in market demand.

Example of short-term fixed supply: Premier League teams ranked by stadium capacity in the 2019-20 season

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 Capacity of Premier League stadiums 2019/20

AFC Bournemouth (Vitality Stadium) 11,364

Burnley FC (Turf Moor) 21,944
Watford (Vicerage Road Stadium) 22,200
Crystal Palace (Selhurst Park Stadium) 25,486
Norwich City (Carrow Road) 27,359
Brighton & Hove Albion (The American Express Community Stadium) 30,750
Wolverhampton Wanderers (Molineux Stadium) 32,050
Sheffield United (Bramall Lane) 32,125
Leicester City (King Power Stadium) 32,261
Southampton FC (St Mary's Stadium) 32,384
Everton FC (Goodison Park) 39,414
Chelsea FC (Stamford Bridge) 40,834
Aston Villa (Villa Park) 42,095
Newcastle United (St James' Park) 52,305
Liverpool FC (Anfield Road) 53,394
Manchester City (Etihad Stadium) 55,017
West Ham United (Queen Elizabeth Olympic Park) 60,000
Arsenal FC (Emirates Stadium) 60,704
Tottenham Hotspur (Tottenham Hotspur Stadium) 62,062
Manchester United (Old Trafford) 74,879

0 10,000 20,000 30,000 40,000 50,000 60,000 70,000 80,000

Analysis diagrams: Supply curves with different price elasticity

Exam Technique:
Question: Evaluate two factors which determine the degree of price elasticity of supply

Point 1:
One factor that determines the degree of price elasticity of supply is the amount of spare capacity that a business has. For example,
in the building industry after an economic recession, it is likely that house builders will be able to hire plenty of extra workers if they
want to expand the number of new homes being constructed. This is because of a high rate of cyclical unemployment.

However, there might have been a drop of net inward migration of skilled construction workers from EU and non-EU countries which
could lead to labour shortages. Furthermore, even if skilled labour might be available, there could be low stocks of building materials
or construction equipment.

Point 2:
Another factor affecting price elasticity of supply is the length of the production period. In farming for example, the growing period
for arable crops means that there is usually a time delay between crops being planted and harvested. Unless surplus crops can be
stored and maintain their quality, then supply of some crops will be price inelastic.

A counter point is that, advances in farming technology and the impact of climate change is meaning that many crops in countries
such as the UK can now be grown for nearly all months and year and globalisation has increased the supply capacity of imported
foodstuffs to meet changing demand. This helps to increase supply elasticity.

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1.2.6 Price determination
Key specification content:
• Equilibrium price and quantity and how they are determined
• The use of supply and demand diagrams to depict excess supply and excess demand
• The operation of market forces to eliminate excess demand and excess supply
• The use of supply and demand diagrams to show how shifts in demand and supply curves cause the equilibrium price and
quantity to change in real-world situations

What is meant by market equilibrium?

• Equilibrium means a state of equality or balance between market demand and supply.
• Equilibrium price represents a trade-off for buyer and seller – higher prices are good for the producer (they
mean higher revenues and profits) but they make the product more expensive for the buyer. Prices where
demand and supply are out of balance are called points of disequilibrium.
• Most exam questions present the student with an event(s) that causes either the demand or supply curve (or
both) to shift. The student is expected to find and analyse the new equilibrium price and quantity.
Exam hint: Frequently, there may be two changes on a demand and supply diagram (one affecting demand and one affecting
supply). Many students fail to gain full marks because they only shift one curve. Remember to explain each shift in a diagram!

Example of equilibrium price and quantity

A football club has a fixed stadium capacity of 8,000 seats and has estimated demand at each ticket price as follows:

Price Quantity demanded Quantity supplied

£20 6,000 8,000
£18 7,000 8,000
£16 8,000 8,000
£14 9,000 8,000
£12 10,000 8,000

The equilibrium price in this situation is £16 where quantity demanded and supplied = 8,000 tickets. Supply & demand
are in balance at this number of tickets sold.

Exam hint: For exam questions that specifically state that a diagram is required as part of the answer, then there are specific marks
available for that diagram. Those marks will only be awarded if the diagram is ACE, that is, includes labelling for all Axes, Curves and
Equilibrium points.

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Summary of changes in equilibrium price:

Shift (assuming ceteris paribus) Movement in the Equilibrium Price Movement in the Equilibrium Quantity

Demand increases Higher Higher

Demand decreases Lower Lower
Supply increases Lower Higher
Supply decreases Higher Lower

Change in market supply

Demand for and supply of cocoa beans is shown in the table below. The original equilibrium price is $30. If market supply
increases by 900 tonnes at each price, the new equilibrium price will be £25 with 3,500 tonnes bought & sold.

Price per kg Quantity demanded (1) Quantity supplied Quantity Supplied (2)

$40 2,000 3,800 4,700

$35 2,500 3,400 4,300
$30 3,000 3,000 3,900
$25 3,500 2,600 3,500
$20 4,000 2,200 3,100
$15 4,500 1,800 2,700
Change in market demand
Demand for and supply of fresh fish in a market is shown in the table below. The original equilibrium price is £6 per kg
If market demand rises by 140kg at each price, the new equilibrium price will be £8 with 300kg bought and sold.

Price per kg Quantity demanded (1) Quantity supplied Quantity demanded (2)

£10 100 380 240

£9 130 340 270
£8 160 300 300
£7 190 260 330
£6 220 220 360
£5 250 180 390

Inward shift of market supply

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Outward shift of market demand

Exam hint:
Much of the economics A-Level is assessed in terms of levels of response. This means that answers are judged in terms of their
quality. Generally speaking, the quality of analysis is enhanced if there are longer chains of analytical reasoning providing a deeper
explanation as to why certain results have occurred. One way to strengthen these analytical chains in questions relating to market
diagrams is to provide an explanation of how a new equilibrium is reached – it does not happen immediately or by magic! The so-
called invisible hand (a phrase coined by Adam Smith) must be explained. This is explained below.

Moving from one market equilibrium to another

• Changes in equilibrium prices and quantities do not happen instantaneously! The shifts in supply and demand
outlined in the diagrams before are reflective of changes in conditions in the market.
• So, an outward shift of demand (depending upon supply conditions) initially leads to a shortage at the existing
market price (i.e. there will be excess demand).
• This then leads to a short-term rise in price and a fall in available stocks. This acts as a signal to suppliers.
• The higher price is then an incentive for suppliers to raise their output (termed as an expansion of supply)
causing a movement along the supply curve towards a new equilibrium point.
Disequilibrium – excess demand
• Excess demand occurs when quantity demanded exceeds available supply
• Excess demand happens when the current market price is set below the equilibrium price.
• This will result in queuing and an upward pressure on price.
• Higher prices ration demand to those consumers with effective demand.
• Higher prices – in theory – stimulate an expansion of supply as producers respond to higher profits.

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Disequilibrium – excess supply
• Excess supply is a state of disequilibrium in a market.
• When supply is greater than demand and there are unsold goods in the market, there is excess supply.
• Surpluses put downward pressure on the market price.
• As prices fall, there is an extension of demand which cuts the surplus and takes a market towards equilibrium.

Market Prices in Action: Global Steel Supply and Demand

World crude steel production from 2012 to 2019

World crude steel production from 2012 to 2019 (in million metric tons)
1,870
1,900
1,808
1,800 1,732
1,650 1,671
1,700 1,621 1,629
1,600 1,560

1,500
1,400
2012 2013 2014 2015 2016 2017 2018 2019

Factors that affect the market supply of steel in the UK market:

• Prices of key steel-making inputs such as iron ore
• Exchange rate (£ v US dollar) – a weaker exchange rate increases the £ price of imported steel
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 • Trade tariffs
• Productivity in the steel industry
• Economies of scale in the long run
• Process innovation in steel production

Factors that affect the market demand for steel in the UK market:
Steel has a derived demand; this means it is an important input into the supply of other goods and services:
• Housebuilding and other residential / commercial construction projects
• Vehicle manufacturing
• Infrastructure projects including new rail lines, power supply and bridges
• Household appliances
• Logistics industries e.g. steel containers

Other important demand factors:

• Cyclical demand (GDP growth) – There is a cyclical demand for steel meaning that the demand for steel in the
UK is affected by where the economy is in the economic (business) cycle:
• Government spending plans (fiscal policy)
• Scale of new housebuilding
• Prices of steel substitutes

Impact on market equilibrium is there is an increase in government infrastructure spending:

Impact on market equilibrium of an increase in the price of iron ore – which is an input used in manufacturing steel.

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Market Prices in Action: The Global Cocoa Market

Some demand factors in the market for cocoa beans

• Per capita incomes – chocolate usually has a positive income elasticity of demand
• Relative prices of cocoa substitutes e.g. fruit, protein bars, coffee-based cakes
• Changing consumer tastes and preferences – e.g. health awareness / lifestyle choices
• Derived demand – cocoa used in manufacturing a wide range of consumer products
• Speculative demand – cocoa is a soft commodity subject to speculative buying at key times

Some supply factors in the market for cocoa beans

• Impact of weather conditions – affecting cocoa yields
• Impact of climate change including rainfall, soil fertility
• Rate of capital investment in cocoa farming including investment in storage
• Productivity of cocoa plantations – many of which are small with limited opportunity for economies of scale
• Impact of innovation in cocoa growing to improve yields
• Prices / potential profits from growing alternative crops (land is in competitive supply)

The Cocoa Supply Chain

Cocoa Farmer / Grower

Export Company

Cocoa Bean Grading Company

Shipping Business

Cocoa Processor

Manufacturer e.g. confectioner

Retailer of cocoa based products

The importance of cocoa to developing country producers cannot be overestimated - more than two million farmers in
Africa alone depend on cocoa for a major part of their income. It is imperative for producers to move up the value
chain into manufacturing, marketing and sales, as countries can capture more income from their participation in the
chocolate industry. Typically the price that a small-scale cocoa farmer gets for their raw product is a tiny percentage of
the price that consumers pay for their hot chocolates in a store or for their chocolate bars from a supermarket. Cocoa
producer cooperatives seek to increase the selling power of cocoa farmers to get a better price for their output.

Exam Technique: Chains of Reasoning on Causes of Changing Market Prices

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 Average price of diesel fuel in the United Kingdom from June 2015 to June 2020 (in pence per litre)
140
130
120
110
100
90
80
Oct 15

Apr 16

Oct 16

Apr 17

Oct 17

Apr 18

Oct 18

Apr 19

Oct 19

Apr 20
Aug 15

Dec 15

Aug 16

Dec 16

Aug 17

Dec 17
Jun 15

Feb 16

Jun 16

Feb 17

Jun 17

Feb 18

Aug 18

Dec 18

Dec 19
Jun 18

Feb 19

Aug 19
Jun 19

Feb 20

Jun 20
Examine two factors that might have caused an increase in the retail price of diesel fuel in the UK

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Here are some chains of reasoning to this question:

Chain of reasoning 1

Second chain of reasoning:

1.2.7 Price mechanism

Key specification content:
• Functions of the price mechanism to allocate resources:
o Rationing
o Incentive
o Signalling
• The price mechanism in the context of different types of markets, including local, national and global markets

What is the price mechanism?

Changes in market price act as a signal about how scarce resources should be allocated. A rise in price encourages
producers to switch into making that good but encourages consumers to use an alternative substitute product
(therefore rationing the product). A fall in price leads to an extension of demand but makes it less profitable for a
business to supply the good or service affected.

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Adam Smith’s Invisible Hand
• Adam Smith described the invisible hand of the price mechanism in which the hidden
hand of the market operating through the pursuit of self-interest allocated resources
in society’s best interest.
• This remains a view held today by free-market economists who believe in the virtues
of an economy with minimal government intervention.
• The price mechanism describes how decisions taken by consumers and businesses
interact to determine the allocation of scarce resources between competing uses. The
price mechanism plays three important functions:
What are the main functions of the price mechanism?

1/ Signalling function
• Prices perform a signalling function – i.e. they adjust to demonstrate where resources are required.
• Prices rise and fall to reflect scarcities and surpluses.
o If prices are rising because of high demand from consumers, this is a signal to suppliers to expand
production to meet the higher demand.
o If there is excess supply in a market, the price mechanism will help to eliminate a surplus of a good by
allowing the market price to fall.
2/ Incentives function
• Through choices consumers send information to producers about their changing nature of needs and wants.
o Higher prices act as an incentive to raise output because suppliers stand to make a better profit.
o When demand is weaker in a recession, supply contracts as producers cut back on output.
One important feature of a free-market system is that decision-making is decentralised, i.e. there is no single body
responsible for deciding what to produce and in what quantities. This is in contrast to a planned (state-controlled)
economic system where there is significant intervention in market prices and state-ownership of key industries.

3/ Rationing function
• Prices ration scarce resources when demand outstrips supply.
• When there is a shortage, price is bid up – leaving only those with willingness and ability to pay to buy.
Prices and incentives
• Incentives matter! For competitive markets to work efficiently, all agents (consumers and producers) must
respond to appropriate price signals in the market.
• Market failure occurs when signalling and incentive functions fail to operate optimally leading to a loss of
economic and social welfare. For example, a market may fail to consider external costs and benefits from
production and consumption. Consumer preferences for goods and services may be based on imperfect
information on costs and benefits of a decision to buy and consume a product.
Secondary markets
• Secondary markets occur when buyers and sellers are prepared to use an alternative market to re-sell items that
have already been purchased.
• Perhaps the best example is the secondary market in tickets for concerts and sporting-events.
Government intervention in the market mechanism
• The incentives that consumers and producers have are changed by government intervention.
• For example, changes in relative prices brought about by subsidies and indirect taxation.
• The government might intervene through imposing maximum and minimum prices.
• The law of unintended consequences encapsulates the idea that government intervention can often be
misguided and lead to extra problems in society.

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Price mechanism and examples of inter-relationships between markets
All markets are inter-connected in some shape or form. Supply and demand analysis can help to explain and inter-
relationships between different markets and industries. When showing inter-related markets, it is good to make use of
a double diagram to help analyse how a change in demand/supply conditions in one market can influence
demand/supply in a related market. Here are two examples:

How an increase in supply in one market may impact upon other markets
Consider the changes in the market supply of solar energy and the possible impact on the market price of coal.

How a decrease in demand in one market may impact upon other markets
Consider changing market demand for new homes and the related (derived) demand for bricks used in construction.

An inward shift in demand for new housing will lead to a contraction in housebuilding in the construction industry. As a
result average prices of new housing might start to fall. A drop in new homes being built will lead to an inward shift in
demand for inputs such as bricks, concrete and steel used in the building industry. Stocks of these unsold inputs will
tend to rise, and the theory of the price mechanism would suggest that prices of these inputs too will fall.

Summary of key price mechanism concepts

Asking price Minimum price at which a security, commodity or currency is offered for sale on a market
Black market An illegal market in which the market price is higher than a legally imposed price ceiling
Cyclical Demand that varies depending on the stage of the trade/business cycle an economy is in
demand
Excess demand Difference between the quantity supplied and the higher quantity demanded when the price is set below the
equilibrium price
Excess supply When there are unsold goods at the current market price
Inventories Unsold products, finished and unfinished, and the raw materials used to make them.

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 Market Signals that motivate actors to change their behaviour perhaps in the direction of greater efficiency or profit
incentives
Rationing A way of allocating scarce goods and services when market demand exceeds available supply
function
Signalling When a changing price in a market sends important information to BOTH producers and consumers.
function
Utility A measure of the satisfaction that we get from purchasing and consuming a good or service.

1.2.8 Consumer and producer surplus

Key specification content:
• Distinction between consumer and producer surplus
• Use of supply and demand diagrams to illustrate consumer and producer surplus
• How changes in supply and demand might affect consumer and producer surplus

Consumer surplus
• Consumer surplus is a measure of the welfare that people gain from buying & consuming goods and services.
• Consumer surplus is the difference between the price that consumers are willing and able to pay for a good or
service and the total amount that they actually do pay (i.e. the market price x the quantity bought).
• The area underneath the demand curve and above the market price shows consumer surplus.
• Consumer surplus rises or falls as the market price for a good or service changes.
Simple example of consumer surplus
The table shows the maximum price a consumer would be willing to pay for extra cans of a sports drink. Assume that
the market price is constant at £1 per bottle and that the consumer will only consume an extra can if the price is less
than or equal to their willingness to pay.

Cans 1st 2nd 3rd 4th 5th

Price (£) £2 £1.80 £1.50 £1.10 80p

Consumer surplus £1 £0.80 £0.50 £0.10 Not consumed

Total consumer surplus if this person buys 4 cans will be £2.40 from a total spending of £4.

Consumer surplus and price elasticity of demand

1. When demand for a good or service is perfectly price elastic, consumer surplus is zero. This is because the
price that people pay always matches what they are willing to pay.
2. In contrast, when demand is perfectly price inelastic, consumer surplus is infinite. Demand does not respond
to price changes. Whatever the price, quantity demanded remains the same (likely with an absolute necessity)
3. The majority of demand curves are downward sloping. When demand is inelastic, there is a greater potential
consumer surplus because there are some buyers willing to pay a high price to consume the product.

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Price discrimination and consumer surplus
• Producers often take advantage of consumer surplus when setting their prices.
• If a business can identify groups of consumers within their market who are willing and able to pay different
prices for the same products, sellers use price discrimination – this is a way of turning consumer surplus into
producer surplus, put simply to make higher revenues and profits.
• Airlines and train companies are expert at this, extracting from consumers the price they are willing and able to
pay for flying to different destinations are various times of the day, and exploiting variations in elasticity of
demand for different types of passenger service.
• You will always get a better deal with airlines such as EasyJet and Ryan Air if you are prepared to book in advance.
The airlines are happy to sell tickets more cheaply because they get the benefit of cash flow together with the
guarantee of a seat being filled. The nearer the time to take-off, the higher the price.
• If someone is desperate to fly from Newcastle to Paris in 24 hours’ time, his or her demand is said to be price
inelastic and the corresponding price for the ticket will be much higher.
Changes in supply and demand, market price and consumer surplus
Consumer surplus rises or falls as the market price for a good or service changes – here are two examples:

Exam technique: Building a chain of analysis and evaluation:

Question: Evaluate the impact of changes in price on consumer surplus

Consumer surplus measures the difference between what a consumer is willing and able to pay for a product and the price that
he/she actually pays. Price changes can come about because of changes in the conditions of demand and supply. But they can arise
from government interventions in markets and changes in prices brought about by adjustments in business objectives. Some factors
increase consumer surplus, whereas other factors may cause consumer surplus to fall.

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However, falling prices does not necessarily mean that consumer surplus will increase. For example, there might have been an
inward shift in the demand curve perhaps caused by a fall in real disposable income. This is shown in the diagram with demand
shifting inwards from D1 to D2 which leads to a fall in both equilibrium price and quantity. The area of consumer surplus drops from
AP1B to EP2D.

Changes in price can be caused by government interventions in a market. For example, the UK government recently brought in the
Sugar Levy which taxes manufacturers of drinks with high sugar content. A tax causes an inward shift of supply and leads to higher
prices and – in theory – a fall in consumer surplus. But this depends on whether retailers pass on the tax to consumers which
depends on both the price elasticity of demand and the strategic objectives of firms. When demand is price inelastic, the level of
consumer surplus is high, and a tax can cause a large transfer of consumer surplus to the government.

The table below shows the most expensive season ticket for Premier League clubs in the 2019-20 season. What factors
will influence the consumer surplus that fans might experience if they decide to buy a season ticket?

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Teams of the Premier League ranked by most expensive season ticket in 2019/20 (in £s)

Tottenham 1995
Arsenal 1768
Chelsea 1250
West Ham United 975
Manchester United 950
Manchester City 950
Liverpool 865
Southampton 855
Brighton 845
Newcastle United 811
Crystal Palace 810
Bournemouth 760
Watford 722
Aston Villa 684
Leicester City 660
Norwich City 631
Wolves 628
Burnley 580
Everton 565
Sheffield United 514

Producer Surplus
• Producer surplus is the difference between the price producers are willing and able to supply a product for and
the price they actually receive in the market.
• Producer surplus is shown by the area above the supply curve and below the market price (assuming that the
firm receives the same price for each unit sold.)
• Higher prices provide an incentive to for businesses to expand supply. This is due to the profit motive and is an
important aspect of the price mechanism.
Changes in demand and supply, market price and producer surplus
Here are two examples of how shifts in demand and supply can lead to changes in the level of producer surplus:

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Exam technique: Building a chain of analysis and evaluation:
Question: Evaluate the impact of changes in price on producer surplus

Producer surplus is a measure of the profit that a supplier can earn from supplying goods and services. It is shown by the difference
between the market price received and the minimum supply price that a firm such as a grower or manufacturer requires. One cause
of an increase in producer surplus is an outward shift of supply for example caused by a fall in the cost of inputs. Price falls from P1
to P2 and quantity supplied expands to Q2. Producer surplus grows from area P1AB to P2BC. Although the market price has fallen
(i.e. the supplier is getting less per unit) there has been a reduction in costs and extra profit to be made from selling a greater
quantity.

However, higher prices do not always mean that producer surplus will increase. Consider a tax imposed on producers by the
government. In the diagram, we see the impact of a tax when demand is price sensitive (i.e. the coefficient of PED>1). This means
that the producer only has a limited ability to pass on a tax to consumers in the form of higher prices. As a result, the market price
rises by only a fraction of the tax per unit and the post-tax price received by the producer is much lower. We can see in this diagram
that although the retail price has increased, the amount of producer surplus has fallen by especially because of a contraction in
demand. PS has dropped from P1EA to P3FA.

Price elasticity of supply and producer surplus

Another term for producer surplus, that you will use later in the course in Theme 3 micro, is “supernormal profit”.
Community surplus
• Community surplus is also known as social or society surplus.
• It is the sum of consumer and producer surplus at a given price and quantity in a market.
• At a free market equilibrium price, the level of consumer and producer surplus is maximised.
• This is also known as the point of allocative efficiency.
• In the absence of a change (shift) in demand and/or supply there is no other price and output combination
that could increase community surplus.

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 • When community surplus is maximised, an optimum allocation of scarce resource has been achieved.

Loss of community surplus from higher prices

Market changes and consumer / producer surplus

The table below summarises some of the effects on consumer and producer surplus from changes in the conditions of
market demand and supply and/or intervention by the government:

Market change What happens to consumer surplus? What happens to producer surplus?

Outward shift of demand Increase Increase

Government subsidy to producers Increase Increase

Cost-reducing innovation Increase Increase

Minimum price for consumers Fall Uncertain

Indirect tax on producers Fall Fall

Inward shift of market demand Fall Fall

Maximum price for consumers Uncertain Fall

Exam hint:
Applying the concepts of consumer and producer surplus (and community or social surplus) is an excellent way of achieving higher
marks for your analysis. For example, show the impact on economic welfare of an increase in an indirect tax on both consumers and
producers, or the effects of technological advances including innovation on price, quantity and overall consumer and producer
surplus. Whenever you get a question on one or more forms of government intervention, try to bring consumer and producer
surplus into your answer and into developed diagrams.

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1.2.9 Indirect taxes and subsidies
Key specification content:
• The impact of indirect taxes on consumers, producers and government
• The incidence of indirect taxes on consumers and producers
• The impact of subsidies on consumers, producers and government
• The area that represents the producer subsidy and consumer subsidy

Indirect taxes

Value Added Tax Plastic Bag Fuel Duties Alcohol Duties Tobacco Duties Sugar Tax
Charge
What is an indirect tax?
• An indirect tax is a tax imposed by the government that increases the supply costs faced by producers.
• The amount of the tax is always shown by the vertical distance between the two supply curves.
• Because of the tax, less can be supplied at each price level.
• An indirect tax will increase the price of a product reducing the quantity demanded (but importantly the
demand curve DOES NOT SHIFT); the impact of a tax depends upon the price elasticity of demand
• An indirect tax on suppliers will have no effect on market price if demand is perfectly elastic
• An indirect tax on suppliers will be passed onto consumers in full if demand is perfectly price inelastic
• An indirect tax on suppliers will be passed onto consumers in full if supply is perfectly elastic
o A specific tax is a set tax per unit e.g. a £5 tax per unit– this causes a parallel shift in the supply curve
o An ad valorem tax is a percentage tax e.g. 20% on the unit price – this causes a pivot shift in the
supply curve
Analysis of an indirect tax for different PED
• If co-efficient of price elasticity of demand >1, most of an indirect tax will be absorbed by the supplier.
• If co-efficient of price elasticity of demand <1, most of an indirect tax can be passed on to the consumer.

Perfectly inelastic and perfectly elastic demand and the burden of a tax
• Perfectly inelastic demand: All of the tax is paid by the consumer (left hand diagram below)
• Perfectly elastic supply: All of the tax is paid by the consumer (right hand diagram below)

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Ad-valorem taxes
An ad-valorem tax is an indirect tax based on a percentage of the sales price of a good or service. An increase in an ad-
valorem tax causes an inward shift in the supply curve.
• The effect of an ad valorem tax is to cause a pivotal shift in the supply curve.
• This is because the tax is a percentage of the unit cost of supplying the product.
• So, a good that could be supplied for a cost of £50 will now cost £60 when VAT of 20% is applied.
• A different good that costs £400 to supply will now cost £470 when the same rate of VAT is applied.
• The absolute amount of the tax paid will go up as the market price increases.

Exam hints:
A significant number of students shift the demand curve as a result of the imposition of an indirect tax because, they argue, a tax
causes people to buy less. However, they have forgotten that a change in the price causes a movement along the curve. The supply
curve shifts, and the new equilibrium point shows a fall in the quantity demanded i.e. a movement along rather than a shift. Think
about the type of tax imposed if you are drawing a diagram to illustrate the shift. A unit tax causes a parallel shift and an ad valorem
tax causes a pivot shift.

Students sometimes get confused between direct and indirect taxes. This is a topic that they will meet in their macroeconomics.
Direct taxes are taxes that are taken straight from income (e.g. income tax). A rise in direct tax i.e. an increase in the rate of income
tax, is likely to shift the demand curve left for normal goods. Indirect taxes will always shift the supply curve.

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Subsidies

Biofuel subsidies Solar Panel “Feed- Apprenticeship Aid to businesses Subsidies for wind
for farmers In Tariffs” Schemes making losses farm investment

Food / fuel Child Care for Subsidies to the

subsidies for working families rail industry
consumers
What is a subsidy?
A subsidy is any form of government support—financial or otherwise—offered to producers and (occasionally)
consumers. It does not have to be repaid. A subsidy paid to producers causes an outward shift of the supply curve
leading to a lower equilibrium price and an increase in the quantity traded. This is because it is intended to lower
production costs.

Coronavirus update: Is there a case for the government to subsidise healthy foods?
Subsidies for healthy food, plain packaging for unhealthy food, and more research into meat alternatives could help the UK's obesity
crisis, according to a new report from think-tank Demos. Their research found that too many people face "significant barriers to
eating healthy diets". The report recommended a government fund for the development of lab-grown meat or meat alternatives and
offering consumer subsidies for healthy foods such as tinned tomatoes, carrots, and frozen vegetables to make healthy options
much cheaper. Around two-thirds of UK adults are above a healthy weight, with 36% overweight and 28% obese.

Analysis of government subsidy (to producers)

Total government spending on the subsidy equals the subsidy per unit multiplied by output.

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Exam hint: Students typically find it difficult to correctly identify the total amount spent by a government on a subsidy. Ensure you
practice the subsidy diagram properly before taking the exam!

Economic and social justifications for a subsidy

Justifications for government subsidies include:
• Helping poorer families with food and child-care costs – to relieve persistent poverty and improve work
incentives in the labour market.
• Encourage output and investment in fledgling sectors such as renewable energy.
• Protect jobs in loss-making industries hit by recession such as steel and farming. UK farmers receive around €4
billion per year under the EU's Common Agricultural Policy (CAP).
• Make some key health care treatments more affordable to families on lower incomes.
• Reduce the cost of training & employing workers to help improve human capital.
• Achieve a more equitable distribution of income.
• Reduce some of the external costs of mass transport.
• Encourage the arts and other cultural services – many of which have positive externalities from consumption.

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 Help poorer families e.g. food Encourage output and Protect jobs in loss-making Make some health care
and child care costs investment in fledgling sectors industries e.g. hit by a treatments more affordable
recession

Reduce the cost of training & Achieve a more equitable Reduce some of the external Encourage arts and other
employing workers income distribution costs of transport cultural services

Analysis of a subsidy – the effect of price elasticity of demand

A subsidy causes an outward shift of supply and – other factors remaining constant – will lead to a lower market price
and an expansion of quantity demanded. Both consumer and producer surplus will increase following a subsidy.

1.2.10 Alternative views of consumer behaviour

Key specification content:
The reasons why consumers may not behave rationally:
• Consideration of the influence of other people's behaviour
• Importance of habitual behaviour
• Consumer weakness at computation

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 Use all information when People seek to maximise
making choices satisfaction

The assumption of rational behaviour:

The assumption of rationality has dominated standard economic thinking and orthodox theory for decades:
Key assumptions are as follows:
1. Agents choose independently of one another.
2. An agent has fixed and stable tastes and preferences.
3. An agent gathers complete information on all alternatives.
4. Always makes an optimal choice with given preferences.
The key assumption is that people make choices in order to maximise the satisfaction (or utility) they get from spending
a limited budget. However, there are many reasons why individuals may not necessarily always act in a rational way:

Limited ability to Importance of social

Emotion overtakes logic
calculate networks

Altruism v pure self Desire for instant People stick to default

interest rewards choices

Economic agents:
• Have limited capacity to calculate all costs and benefits (they have bounded rationality)
• Are influenced by other people in their own social networks
• Often act reciprocally rather than in pure self interest
• Lack self-control and seek immediate satisfaction (they have bounded control)
• They are loss averse (losses matter more than gains)
• They make different choices in cold & emotional states
• Often fall back on simple rules of thumb when choosing – they satisfice rather than maximise
• Have a strong default to maintain the status quo – i.e. they rarely change their default behaviour
Social norms
Our day-to-day behaviour in markets is often strongly influenced by prevailing social norms or social customs

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 Social norms at the pub such
Respecting seat belt laws Social norms when queuing Not smoking in public places
as buying a round of drinks

Examples of social norms:

• Changing the social stigma of drink-driving and speeding
• Queuing behaviour in shops
• Impact on behaviour of smoking bans in all public places
• Making seat-belts compulsory – these created conventions which then became largely self-sustaining
Exam hint: Questioning the assumptions made in analysis is a highly effective way to evaluate. Using behavioural economic ideas to
critique the assumption that economic agents are rational and have perfect information is therefore a fairly fail-safe way to evaluate.
Behavioural economics can perhaps be summarised in one sentence:
Systematic and persistent deviations from rational choice are an important feature of the real world.

Habitual behaviour

Most of us choose the Our menu choices are A default opt-in (or auto
same breakfast! predictable enrollment) e.g. for
pensions organ donations
can have a powerful effect
• Most people carry on behaving as they have always done.
• Repeat choices / purchases often become automatic because default choices don’t involve mental effort
• To get people to change their behaviour may require compelling incentives or introducing a form of mandated
choice (known as a default rule)
• Examples of habitual behaviour:
o Your choice of daily breakfast cereal / razor / sandwich preference
o Many consumers of energy, broadband stay with the same provider
Bounded rationality

Choice does not always Search costs in finding the Rules of thumb might
Pensions are complex
help best price replace pure rationality

• Most consumers and businesses do not have sufficient information to make fully informed judgements when
making their decisions in markets
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 • The increasing complexity of products makes life difficult
• People have limited attention spans especially when faced with difficult and costly decisions
• Many consumers and businesses opt to satisfice rather than maximise
• They will use rules of thumb (heuristics) and approximations when making their choices
Bounded control
• Bounded control helps explain why people carry on consuming even when it makes sense to stop
• It is linked to the idea of hyperbolic discounting – i.e. we value the present much more than the future
• There is a desire for instant and immediate gratification and a reluctance to hold back for longer term rewards
Herd Behaviour
• We are herd animals and we often make decisions based on who is around us plus the choices they make
• Examples:
o Choosing items off a menu in a restaurant
o Herd behaviour in financial markets – investors often act in herds – following the crowd
o Binge drinkers going on holiday with each other

Herd behaviour is often seen Amazon Prime – people don’t Ratings systems for hotels,
in financial markets want to miss out on a deal books, general products

Anchoring
Value is often set by anchors or imprints in our minds we use as mental reference points.
• Some anchors establish in our mind a low price, others help to cement a higher basic price that we might be
prepared to pay
• Examples:
o Refereeing decisions might be anchored by the size (and noise!) of home crowd
o Price anchors used in menus at restaurants and in coffee shops

Offer price for Pricing of new McDonalds has a

houses on sale is an products such as the lower anchor price
anchor for potential Apple Watch than Starbucks
buyers
Priming
• Our behaviour by cues that work subconsciously and prime us to behave and choose in certain ways
• Examples:
o Playing of certain types of music in a shopping mall
o Subliminal cues in films / TV adverts
o Students signing an honour-code at university before taking an exam

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 How effective is Labelling a Is there less
subliminal product as plagiarism with an
advertising? premium affects honour code at
our expectations! university?
Framing
• Framing a question or offering in a different way often generates a new response by changing the comparison
set it is viewed in
• Examples:
o Framing of privacy settings on social networks
o Presumed consent for human organ donations (now brought into force in England, Scotland & Wales)
• Asymmetric framing
• Involves including an obviously inferior 3rd choice or a hyper-expensive 3rd option rather than a simple
expensive/cheap choice can guide consumers to more expensively priced items
Summary of key ideas and concepts in behavioural economics

Altruism Willingness to bear a cost in order to benefit somebody else

Anchoring When we are influenced in an exaggerated way by the first piece of information received.
Availability heuristic Mental shortcut that relies on immediate examples that come to mind
Behavioural Applying psychological insights into human behaviour
economics
Bounded rationality Decisions that flow from limited decision-making capacity or lack of information
Butterfly effect When small details make big differences to choices, we make
Choice architecture Careful design of how options are presented can influence decisions
Choice overload When there are too many options to make a fully informed rational decision
Commitment When someone voluntarily loses money if they do not engage in a future behaviour to which they have
contract committed
Compromise effect Options chosen more often when they are the compromise option in a choice set
Confirmation bias Seeking out information in a way that fits with our existing preconceptions
Default choice Option selected if a consumer does nothing
Endowment effect When we value things that we own more than the things we do not own
Framing When a decision is based on how information and data is presented to us
Gambler's Fallacy Belief that future probabilities are altered by past events when in fact they are independent
Herd behaviour When individuals act collectively as part of a group
Heuristic When people use a rule of thumb to make a decision
Hyperbolic Valuing immediate benefit or cost more than any future impact
discounting
IKEA effect Placing a disproportionately high value on objects we have partially assembled ourselves
Intention-action gap When people often don't accomplish what they would like to do
Loss aversion When a loss is more painful than an equivalent gain is rewarding
Mental accounting Idea that the manner in which money is categorised influences how it is spent
Nudge Minimal change to the environment to alter behaviour in an easy, timely, social way
Priming Subconscious influence of small cues such as bad smells, dirty shop floors

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 Psychological bias Any systematic deviation from a rational choice
Scarcity bias We value things that more limited in number or are only available for a short time
Social image Humans present themselves to look good to others to produce positive rewards
Social norms Day-to-day behaviour influenced by prevailing customs
Social proof When an individual looks to the behaviour of their peers to inform their decision-making
Status quo bias Preference to keep things the way they are
Sunk cost effect People tend to consume what they have prepaid for even if does not make sense to do so.
System 1 Thinking Decisions made on autopilot
System 2 thinking Slower, careful, effortful decision-making

1.3.1 Types of Market Failure

Key specification content:
• Understanding of market failure
• Types of market failure
o Externalities
o Under-provision of public goods
o Information gaps

Negative Positive Public goods and Information Monopolies / Immobility and

(production) (consumption) quasi public failures (including market power inequality of
externalities externalities goods merit & demerit income and
goods) wealth
What is market failure?
• The main role of the price mechanism in a free-market economy is to allocate scarce resources efficiently.
• Market failure exists when the competitive outcome of markets is not efficient and/or equitable from the
point of view of society as a whole.
• This is usually because the private (or internal) benefits that the market confers on individuals or businesses
carrying out a particular activity diverge from the benefits to society.
• And when private costs diverge from social costs in the case of negative externalities.
• An inequitable allocation of resources / unequal factor incomes arising from the free market mechanism is
regarded by many (but not all economists) as a key cause of market failure.

Partial and complete market failure

Complete market failure happens when the market does not supply products at all. Example: Pure public goods which
the market won’t provide as they are non-excludable. There is a missing market in the provision of public goods such as
national defence systems.
Partial market failure happens when the market functions, but it supplies either the wrong quantity of a product or at
the wrong price
• Example: Negative externalities such as pollution arising from production and/or consumption
• Most market failures covered in A level Economics are partial - involving a deadweight loss of social welfare

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Importance of Property Rights
Why are property rights important in an economic system?
• Property rights confer legal control or ownership
• Private property is a key requirement for a market system. If something is to be bought and sold, then it must
be possible to claim the right to own it.
• For markets to operate efficiently, property rights must be protected – perhaps through state regulation
• Put another way, if an asset is un-owned, no one has an incentive to protect it from abuse. The right to own
property is widely regarded as essential in a market-based system
• Failure to protect property rights may lead to what is known as the Tragedy of the Commons - examples include
the overuse of common land and the long-term decline of fish stocks caused by over-fishing which leads to a
long-term permanent damage to the stock of natural resources.

1.3.2 Externalities
Key specification content:
• Distinction between private costs, external costs and social costs
• Distinction between private benefits, external benefits and social benefits
• Use of a diagram to illustrate:
o External costs of production using marginal analysis
o Distinction between market equilibrium and social optimum position
o Identification of welfare loss area, use of a diagram to illustrate:
o External benefits of consumption using marginal analysis
o Distinction between market equilibrium and social optimum position
o Identification of welfare gain area from positive externalities
o Impact on economic agents of externalities and government intervention in various markets

What are externalities?

• Externalities are defined as spill-over effects from production and/or consumption for which no appropriate
compensation is paid to one or more third parties affected.
• Externalities lie outside the initial market transaction / and are not reflected in the market price.
• Externalities cause market failure if the price mechanism does not take account of the social costs and
benefits of production and consumption.
• Externalities can be positive and/or negative.
• It may be hard to accurately measure the extent of externalities and put a value on their impact
Private costs, external costs and social costs
• Private costs are the costs faced by the producer or consumer directly involved in a transaction.
• When negative externalities exist then social costs exceed private cost.
• External costs occur when the activity of one agent has a negative effect on the wellbeing of a third party.
• External costs damage third parties, but the consumer and producer don’t have to pay, meaning that output
will be too high. In the case of production externalities, the market price will therefore be too low.
Exam hint:
It is easy for students to confuse social cost with external cost. Multiple choice questions on this topic consider this common error,
so be careful! Social cost = private cost + external cost.
Valuing Externalities
A key aspect of all externalities is the difficulty of assigning values:
1. Shadow pricing: e.g. the external cost of road congestion can be calculated by multiplying the number of hours
lost by the average wage e.g. 1m lost working hours x £12 average hourly wage = £12m
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 2. Compensation: estimate the cost of putting right an externality e.g. includes the cost of installing double-glazing
in houses affected by increased road noise from a new motorway. If 200 houses are affected each with £5,000
double glazing cost, increased road noise is estimated at £1m
3. Revealed preference: how much people are willing to pay to avoid an externality e.g. if 200 householders are
willing to pay £2,000 each to avoid noise, the externality is valued at £0.4m
Exam hint:
Noting that it is virtually impossible to put a price on externalities helps with evaluation of the effectiveness of policies to tackle
externalities. For example, governments may decide to use an indirect tax to reduce production to the socially optimal level, but this
requires them to set the indirect tax equal to the value of the external cost – this is not possible if we cannot value the external cost,
so as a result the government intervention may be ineffective and might be a cause of government failure.

Key externalities definitions:

When drawing diagrams and carrying out detailed analysis of externalities, economists work “at the margin” i.e.
considering the impact of one more unit of consumption / production. Hence, we look at these concepts:
• Marginal private cost (MPC)
o Cost to the producing firm of producing an additional unit of output or costs to an individual of any
economic action. Private costs are internal costs.
• Marginal external cost (MEC)
o Cost to third parties from the production/consumption of an additional unit of output
• Marginal social cost (MSC)
o Total cost to society of producing an extra unit of output.
o MSC = MPC + MEC
• Marginal external benefit (MEB)
o The benefit to a third party from the production/consumption of an additional unit of something
• Marginal social benefit (MSB)
o Total benefit to society from consuming an extra unit.
o MSB = MPB + Marginal External Benefit (MEB)

Calculating Social Costs and Benefits – A Worked Example

A government is considering four investment projects. It has the resources to finance only one of these projects. Consider
the data shown in the table below:

New city motorway New schools Airport extension New hospitals

Private benefits 50 135 130 90
Private costs 120 80 100 65
Positive externalities 90 55 35 120
Negative externalities 60 20 60 45
Net private benefit -70 +55 +30 +35
Net social benefit -40 +90 +5 +100

In this example, the largest net social benefit is highest for building new hospitals. Net social benefit may be considered
by a government when deciding which project offers the best expected return for society.

Negative externalities
• When negative externalities exist, social costs exceed private cost
• External costs occur when the activity of one agent has a negative effect on the wellbeing of a third party.

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 • External costs damage third parties, but the consumer and producer don’t have to pay, meaning that market
output will be too high. In the case of production externalities, the market price will therefore be too low.
Examples of negative externalities from production
Production externalities are generated and received in supplying goods and services - examples include noise and
atmospheric pollution from factories and discharges of waste.

Air pollution from factories Pollution from fertilizers Industrial waste

Noise pollution Collapsing fish stocks Methane emissions

Market failure analysis diagram with negative externalities from production

• If there are negative externalities, then we must add the external costs to the firm’s supply curve to find the
marginal social cost curve (MSC).
• If the market fails to include these external costs, the private equilibrium output is Q1 and the price P1 where
marginal private cost = marginal private benefit.
• The socially efficient output is Q2 with a higher price P2.
• At this price level, the external costs have been considered.
• At price P2and output Q2, we have not eliminated the pollution – but at least the market has recognised them and
priced them into the price of the product.
• For economists, it is rarely the case that products generating external costs should have production levels of zero –
we recognise that there are usually some benefits to these products being provided.
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Showing the welfare loss from negative externalities

Common exam error:

Students frequently draw the welfare loss triangle in the wrong place! One piece of advice is to put their pencil on the free market
equilibrium and then draw a vertical line in whichever direction they can to create a triangle. A second piece of advice is that the
triangle always creates an ‘arrow’ that points towards the desired socially optimal equilibrium.

Exam hint:
What is the essential point about externalities and market failure? The key problem is that often, economic agents do not take
account of the costs their decisions impose on others. The market fails to price negative and positive externalities properly.

Negative externalities from consumption

Particulates from Household waste Noise pollution from Air pollution from Traffic congestion
vehicle pollution neighbours smokers

Impact of addiction Litter from tourists Spillover costs from

on families rising levels of
obesity
Negative consumption externalities are spill-over costs generated and received from the consumption of goods and
services that affect third parties not involved in the transaction.

A good example is fast fashion. Fashion accounts for 10% of global CO2 emissions.

Exam hint:
It is an excellent idea when answering exam questions on externalities to make sure that you carefully identify who the third party
is that is being affected by the market. For example, suppose you are given a scenario of a production process creating atmospheric
pollution; instead of just writing that “pollution is a negative externality” you would be better to write that “people living close to the

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factory may be inhaling air containing particles that are likely to make them ill, which may result in them taking time off work and
losing income as a result”.

Positive externalities
• Positive externalities exist when third parties benefit from the spill-over effects of production/consumption e.g.
the social returns from investment in training or the positive benefits from health care/medical research.
• Private benefits are the benefits faced by the producer or consumer directly involved in a transaction
• External benefits are the benefits enjoyed by third parties as a result of a transaction that they are not directly
involved in (note - "external benefits" is a synonym for positive externalities)
• Social benefit = private benefits plus external benefits
• Marginal social benefit (MSB) = marginal private benefit (MPB) + marginal external benefit (MEB)
• The market equilibrium only considers private costs and benefits
• Social benefits include the positive externalities in consumption
Analysis diagram of positive externalities from consumption
• If there are positive externalities, then we must add the external benefits to the demand curve (i.e. the marginal
private benefit (MPB) curve) to find the marginal social benefit curve (MSB).
• If the market fails to consider these external benefits, the private equilibrium output is Q1 and the price P1
where marginal private cost = marginal private benefit.
• In a free market, there is therefore under-consumption of this good or service leading to market failure.
• The socially efficient output would be Q2 with a higher price P2. At this output level, the external benefits have
been considered, and marginal social cost is equal to marginal social benefit.

• Marginal private benefit (MPB): benefit to the consumer of consuming an additional unit of output
• Marginal external benefit (MEB): benefit to third parties from the consumption of an additional unit of output
• Marginal social benefit (MSB): total benefit to society of consuming an extra unit of output. MSB = MPB + MEB
• With positive (consumption) externalities, marginal social benefit is higher than marginal private benefit

Examples of positive consumption externalities

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 Health Early years Subsidised Bike Public libraries / Museums and Free school
programmes e.g. education e.g. Schemes in community Galleries meals /
NHS services nursery provision urban areas spaces nutritional
advice
Positive externalities from production
It is possible to consider positive externalities in production (rather than consumption, as we’ve done so far), although
this is not required for Edexcel A level Economics.

Open Source Software Positive spillover effects

made freely available to from research and
users development
When there are positive externalities in production, the marginal social cost of production is less than the marginal
private cost of production. A good example arises from universities making their research available as a public good.
Positive production externalities shift the supply curve to the right.

Mixed externalities: Net social welfare loss or social welfare gain

Consider the diagram below. There are net social costs in this market i.e. it is costing society more to produce these
units than society is valuing these units. As a result, the social optimum output is lower than the free market
equilibrium output.

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In the next diagram, there are net social benefits from producing and consuming the product. This is because there are
substantial external benefits from consumption. The free market mechanism might under-provide this product again
leading to market failure.

Exam Technique: Question: How might a tax on plastic bottles change behaviour?

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Coronavirus update: Externalities of pandemics
A pandemic is a disease epidemic that has spread across a large region, for instance multiple continents, or worldwide. We have seen
numerous instances of externalities in recent months as the coronavirus pandemic has spread. Externalities flow from the choices that
people and businesses make within civil society and markets. Government policy interventions such as epidemic mitigation also create
externalities and unintended consequences.

Negative externalities from the pandemic have included:

Macroeconomic fall-out – including hundreds of thousands of lost jobs, falling incomes and higher tax burdens in the future as
government debt rises following an increase in borrowing
Risk of a permanent loss of output / productive capacity which lowers per capita living standards
Social behaviours that risk spreading infection (these behaviours have a low private cost and high private benefit + high social cost) –
some behaviours stemming from ignorance
Panic buying in supermarkets – food supplies are rival in the immediate period one person’s extra demand reduces supply for others
e.g. key workers when supply chains are unable to respond.
Externalities from the mental health impact of sustained periods of lockdown
Impact on inequality (at local, national and global levels) – most economists believe that inequality will have increased as a result of
pandemic not least because many people in lower-skilled, lower-paid work have been at higher risk of infection

Positive externalities
By contrast, many interventions and changing behaviours can have significant positive externalities:
Social distancing behaviour (this behaviour has a high private cost + external benefit)
Self-quarantine (self-isolation) (again – a behaviour with high private cost + external benefit)
Reduced pollution including lower C02 and N02 emissions, cleaner oceans and rivers, reduced noise pollution as air travel has dropped
away. Evidence of the benefits of grasslands being turned into wild meadows
Increased community engagement has also been evident along with plenty of examples of enhanced corporate social responsibility

Summary of key concepts linked to externalities

Carbon trading Market which buys and settles permits to emit carbon from one/more industries
Marginal social benefit Marginal private benefit + marginal external benefit
Marginal social cost Marginal private cost + marginal external cost
Negative consumption externality (Example) Litter dropped by people in a town centre
Negative production externality (Example) Pollution from fertilisers used in farming
Net social benefits When external benefits from production / consumption outweigh external costs
Net social costs When it costs society more to produce/consume than society values these units
Nudges Incentives to make it easier to choose less costly environmental choices.
Pigouvian Tax Charge on goods & services with external costs
Positive consumption externality (Example) School meals and nutritional advice to pupils
Positive production externality (Example) Open source software made freely available to other developers
Private optimum consumption Where marginal private benefit = marginal private cost
Social optimum consumption Where marginal social benefit = marginal social cost
Third party Agent not directly involved in act of production or consumption

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1.3.3 Public Goods
Key specification content:
• Distinction between public and private goods using the concepts of non-rivalry and non-excludability
• Why public goods may not be provided by the private sector: understanding the free rider problem

What are public goods?

Sanitation Flood defence Crime control for Reduced risk of Freely available Public service
infrastructure projects a community disease from knowledge e.g. broadcasting
vaccinations online learning
Public goods cause market failure due to the problem of missing markets. Pure public goods are sometimes referred to
as collective consumption goods.

Private Goods
A private good or service has three main characteristics:
1. Excludable: A ticket to the theatre or pay-per-view sporting events are private goods because buyers can be
excluded from enjoying the product if they are not willing and able to pay for it. Excludability gives the seller the
chance to make a profit. When goods are excludable, the owners can exercise property rights.
2. Rival in consumption: If you enjoy a takeaway pizza from Dominos, that pizza is no longer available to someone
else. Likewise driving a car on a road uses up road space that is not available at that time to another motorist.
With a private good, one person's consumption of a product reduces the amount left for others to consume and
benefit from - because scarce resources are used up in supplying the product.
3. Rejectable: If you don't like the soup on the school menu, you can use your money to buy something else! You
can choose not to travel on Virgin Rail and go instead by coach, or you can choose not to buy a season ticket for
your local soccer club and instead use the money to finance a subscription to a health club. The consumer can
reject private goods and services if their needs and preferences or their budget changes.

What are the key features of pure public goods?

The characteristics of pure public goods are the opposite of private goods:
1. Non-excludability: The benefits derived from pure public goods cannot be confined solely to those who have
paid for it. Non-payers can enjoy the benefits of consumption at no financial cost – economists call this the free-
rider problem. No price can be charged for a pure public good and hence the market will not supply for a profit.
2. Non-rival consumption: Consumption by one consumer does not restrict consumption by other consumers – in
other words the marginal cost of supplying a public good to an extra person is zero. If it is supplied to one
person, then it is available to al – the quantity available to consume does not fall if someone uses it.
3. Non-rejectable: The collective supply of a public good for all means that people cannot reject it, a good example
is a nuclear defence system or major flood defence projects affecting an entire community.

Rival or non-rival Excludable or non-excludable

A large expanse of public beach Non rival (off-peak) Non-excludable
A monthly subscription to BT Sports Channel Non-rival Excludable via encryption
Free Economics lecture streamed on You Tube Non-rival Non-excludable
Access to a road bridge through a tolling system Non-rival Excludable
Natural drainage systems installed in the hills to lower the Non-rival Non-excludable
risk of town/city flooding
Pitches at a holiday caravan park open to the public Rival Non-excludable

Test kits for people showing symptoms of coronavirus Rival Allocation of tests might be based on
clinical need

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Public goods and market failure
• Private sector markets may fail to supply in part or in whole the optimum quantity of public goods.
• Pure public goods are not normally provided by the private sector because they would be unable to supply
them for a profit (due to the free rider problem, if a good is non-excludable, then it becomes impossible to
charge anyone for consuming it and without being able to charge a price, then a firm would gain no revenue.
• It is up to the government to decide what output of public goods is appropriate for society.
• To do this, it must estimate the net social benefits from making public goods available. Governments do not
have to provide public goods. They might finance them but leave delivery to the private sector.
Exam Hint:
Many students get confused about the definition and nature of public goods in exams. Too frequently, students write that public
goods are provided by the government as their defining feature – however, public sector provision is usually the solution to this
market failure and in no way constitutes the essential nature of a public good.

Every time students see the phrase ‘public goods’ in an exam, the first two things they should write down are that public goods are
non-rival and non-excludable. Questions often ask students “the extent to which a particular good is public or not?” Students need
to establish whether the good in question is both non-rival and non-excludable and consider circumstances in which it might not e.g.
a busy beach on a hot sunny day. Public goods can sometimes be quasi-public i.e. either non-rival or non-excludable, but not both.

Coronavirus update: Are vaccines public goods?

In theory, a new vaccine is not a pure public good because the supply of the vaccine is limited in a given time period and therefore,
giving a vaccination to one person means that there is less available to someone else I.e. the vaccine is rival with a positive (although
low) marginal cost of supply. In addition, vaccines may be priced in markets and exclude those who are unable or unwilling to pay
because they lack effective demand.

However, some economists are arguing that the development of a vaccine for covid-19 must be treated as a global public good in the
sense that the benefits of an effective, tested vaccine have large positive externalities. The hope is that $ billions can be made available
on a multi-lateral basis to speed up the development, manufacturing and equitable deployment of Covid-19 vaccines. This might follow
the example of life-saving treatments developed to tackle HIV-Aids over the last twenty years with higher unit prices charged in
advanced high-income nations helping to cross-subsidise supply of these drugs for developing / lower-income countries.

David Pilling, writing in the Financial Times made the point that “Health experts estimate it will cost some $20bn to vaccinate everyone
on earth, equivalent to roughly two hours of global output.” Given the scale of government financial support to prevent economic
collapse in many countries over recent months, this seems a small price to pay.

Quasi-Public Goods

Crowded Toll roads and Busy urban

Free Wi-Fi
beaches bridges parks

A quasi-public good is a near-public good. It has some of the characteristics of a public good. Quasi-public goods are:
1. Semi-non-rival: up to a point, more consumers using a park or road do not reduce the space available for
others. But beaches can become crowded as do parks/leisure facilities and open-access Wi-Fi networks.
2. Semi-non-excludable: it is possible but difficult or costly to exclude non-paying consumers. E.g. fencing a park
or beach and charging an entrance fee; or toll booths using digital technology on major roads and bridges

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The Free-Rider Problem

Open access to free Wi-

Accessing Open Spaces Fare Dodging Fly Tipping
Fi

Tax evasion Downloading / sharing

What is the free-rider problem?

• Because public goods are non-excludable it is difficult to charge people once a product is made available.
• Free riders have no incentive to reveal how much they are willing and able to pay for a public good.
• The free rider problem leads to non-provision of a pure public good and thus causes pure market failure.
Case for government intervention with public goods
• The non-rival nature of consumption provides a case for government to replace the market to provide and pay
for public goods.
• Many public goods are provided free at the point of use and funded by general taxation or a charge such as the
BBC’s licence fee which helps to finance public service broadcasting.
• State provision may help to prevent under-provision and under-consumption of public goods so that social
welfare is improved.
• If the government provides public goods, they may do so more efficiently because of economies of scale.
• Providing essential public goods helps affordability and access to important services for lower income
households and therefore help to address inequalities of income.
Arguments against state provision
• If the government becomes a monopoly provider, there is then a danger of a lack of efficiency arising from a
lack of market competition. This can lead to the prospect of higher taxes.
• In some cases, the state funds and the private sector provides public goods e.g. via the use of Public Private
Partnerships and the (much criticised) Private Finance Initiative (PFI).
Technology and the Changing Nature of Public Goods
• Advances in technology are causing a blurring of the distinction between public and private goods. For example,
in some cases, encryption allows suppliers to exclude non-payers – although the product remains non-rival.
• Technological progress reduces the cost of smart metering used in road pricing – this makes roads more of a
private (excludable) good. The open source / creative commons movement has made much information public
good in nature.

Encryption devices Smart Electronic Road Open Source Software Live Streaming of Events
Pricing

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Common pool goods and club goods
What is a common pool resource?
• When no one owns a resource, it may get over-used, for example fish stocks and deforestation - people (acting
in their own self-interest) benefit from using a common pool resource such as grazing land without regard to
the effect it has on other producers.
• Over-use of a renewable resource can lead to a long-term decline in maximum sustainable yield. This is known
as the tragedy of the commons.
What is a club good?
• Club goods are excludable but non-rival. For example, Wi-Fi internet access in a coffee store is excludable but
non-rival (normally) as extra users log on to a network. Online paid-for streaming services are club goods.
The importance of property rights
• Property rights confer legal control or ownership of scarce resources.
• For markets to operate efficiently, property rights must be protected.
• Failure to protect property rights may lead to the Tragedy of the Commons.
• Examples include the overuse of common land and the decline of fish stocks caused by over-fishing which
leads to permanent damage to the stock of natural resources – this is known as natural resource depletion.
Summary of the economic importance of public goods:
1. Important positive relationship between investment in public goods and long-term economic growth and
development.
2. Rule of law and protection of property rights – important for supporting innovation e.g. the ability to
commercialize research.
3. Technology needs public goods - e.g. cars needs roads, safety systems. Electricity needs industry standards,
smart phones need property rights on the spectrum.
4. State can be an important funder of ground-breaking research (GPS, SIRI, touch screen display, internet – were
all publicly funded).
5. Public good nature of new infrastructure – impacting (positively) on long run aggregate supply and
competitiveness.
6. Public goods are crucial to social welfare – many public goods have no market price and are not subject to the
profit motive.

Summary of key terms and concepts with public goods

Club goods Goods that are excludable but not rival in consumption e.g. streamed video
Common pool resources Goods available to everyone, but one user's consumption reduces the amount available for others
Cooperation Participating in a common project that is intended to produce mutual benefits.
Excludability Property of a good where a person can be prevented from using it if they do not pay
Free rider When we benefit from consuming a product without contributing to the cost of supply
Global public bad Something with severe negative externalities on communities leading to a loss of social welfare
Global public goods Public goods that benefit every country, irrespective of which ones provide them
Marginal cost The cost of producing one more unit of a good or service
Market failure When markets allocate resources in a Pareto-inefficient way.
Missing market Occurs when the private sector fails to provide certain products
Non-excludability When benefits from pure public goods cannot be confined solely to those who have paid

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 Non-rivalrous When consumption of a good by one person does not reduce the amount available for others
Private good A good that is both rival, and from which others can be excluded.
Quasi-public good A near-public good which is semi-rival and semi-excludable
Tragedy of the commons When no one owns a resource, it may get over-used, for example fish stocks

1.3.4 Information Gaps

Key specification content:
• Distinction between symmetric and asymmetric information
• How imperfect market information may lead to a misallocation of resources

The importance of information in economics.

Information lies at the heart of nearly every decision that we take – from which food and drink to buy, when the start
saving for a pension and which degree course to opt for. Information impacts also on suppliers (businesses) – who
should they employ? What prices should they charge? What are competitors doing? How best to monitor the
performance of their employed workforce and much else besides.

What is information failure?

• Information failure occurs when people have inaccurate, incomplete, uncertain or misunderstood data and so
make potentially wrong or sub-optimal choices.
• From pensions to computer games consoles, from investing in the stock market to ignorance about the
consequences of borrowing and debt, all of us suffer from one or more information failures.
• The key issue is whether the information failure is trivial or instead, it has a big effect on individuals, their families
and society as a whole.
• There may be a case for the government to intervene in a market in some way if information failures become
serious and persistent.
Causes of information failure
Imperfect information can be caused by:
 Misunderstanding the true costs/benefits: E.g. the side effects of using tanning salons or taking painkillers.
 Uncertainty about costs and benefits e.g. should younger workers be buying into pension schemes when we
can only guess at their financial condition in 40 years’ time?
 Complex information when buying specialist products such as smart-watches and electric vehicles.
 Inaccurate or misleading information - persuasive advertising may ‘oversell’ the benefits of a product leading
to more consumption than is optimal. Spam mail can be a cause of misinformation for consumers.
 Addiction e.g. drug addicts may be unable to stop consumption of harmful substances.
 Lack of awareness – a good example here is that of tuition fees in Britain – many parents and students find the
system of university finance difficult to understand.
 Habitual purchase – buying goods simply out of habit e.g. reordering the same items in an online grocery shop
because consumers are presented with their ‘favourites’ list when they log on.

Information gaps
An information gap occurs when people have inaccurate, incomplete, uncertain or misunderstood data and so make
potentially wrong choices. In nearly every market there are information gaps. Some are shown in the graphic below:

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 Risks from using tanning Addiction to painkillers & Gaining entry to elite Complexity of pension
salons other drugs degree courses schemes

Uncertain quality of Knowledge of the Cowboy builders or other Tourist Bazaars or buying
second hand products nutritional content of “rip-off merchants” and selling antiques
foods

Asymmetric Information
• For markets to work, there needs to be symmetric information i.e. consumers & producers have the same
knowledge about products, they know everything there is to know about the effects of consuming them
• Asymmetric information is when information does exist but there is an imbalance in information between buyer
and seller which can distort their choices

Borrowers and
Used vehicles Insider dealing Tenants & landlords Health insurance
lenders

Sometimes the supplier (seller) knows more about a product than the buyer:
• Dental treatment (there is a risk of supplier induced demand)
• Car repairs (likewise!), Electricians / plumbers and IT experts
• Pharmacy prescription advice
• Used vehicles (2nd hand cars) (see Akerlof’s market for lemons)
• Private tutoring / universities
• Housing market (e.g. structural faults in a property known by the seller)

On other occasions, the buyer of a product may know more than the seller:
• Market for health insurance (risk of adverse selection effects)
• Market for secured and unsecured loans (“creditworthiness” of borrower)
• Antiques experts (insiders who know more about the market)

Information Failure: Akerlof and the Markets for Lemons

George Akerlof was awarded the Nobel Prize in economics (2001) for his 1970 paper “The Market for Lemons” This
ground-breaking work used the second-hand car market to investigate this problem of asymmetric information between
buyers and sellers. Akerlof noted it could lead to adverse selection – with the price of second-hand cars being below the
equilibrium because there is an incentive to sell ‘lemons’ (dud cars) and therefore people hold back ‘peaches’ (good
cars.). People are reluctant to sell good quality cars because the equilibrium price is lower than real value of their good
car. There can be a collapse in market activity if the quality of used cars falls below a certain threshold.

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 This is typically lower
Buyers cannot tell
Sellers know more Buyers will therefore than the sellers
accurately the quality
about quality of used offer an average price perceived value
of cars available for
vehicles than buyers for all cars (especially for good
sale
cars)

Buyers no longer
Some sellers will
willing to buy at
The average quality of remove their “good”
average prices – this
cars therefore falls vehicles from open
increases risk of the
sale
market disappearing

Improving information /lowering the risk for buyers in the used vehicle market:
• Offer extended test drives for potential buyers
• Require a full-service history including MOT test logs
• Extended car warranties to lower risk of purchase
• Independently checked vehicles (by a 3rd party)
• Mandatory “cooling off” period after purchase e.g. 7-14 days to avoid “buyer remorse”
• Extensive pre-purchase diagnostic testing of vehicles by the dealer using skilled mechanics
• Social media – Customer review platforms to help improve trust between buyers and sellers

What influenced your decision to buy your used car from that particular dealer? (In %, 2016 survey)

Positive social media comments about dealer 3

Dealer advertised in local media 3
Positive online review of dealer 3
Low rate finance 3
Quick delivery 6
Easy negotiation 6
Recommended by friend 9
Offered a warranty or vehicle had warranty 11
Good aftersales service 11
Staff friendly, helpful and professional 11
Wide choice of vehicles 12
Dealer reliable and trustworthy 15
Have bought a used car from them before 16
Could trade in my old car 18
Local and convenient 20
Good deal on the car 32
Right car at best possible price 32

0 5 10 15 20 25 30 35

Moral Hazard and Adverse Selection

These are two important aspects of asymmetric information in insurance markets.

Moral Hazard
• Moral hazard occurs when insured consumers are likely to take greater risks, knowing that a claim will be paid
for by their cover.
• The consumer knows more about his/her intended actions than the producer (insurer).
Adverse Selection
• The adverse selection problem is seen in health insurance.
• Those most likely to purchase health insurance are those who are most likely to use it, i.e.
smokers/drinkers/those with chronic health conditions.
• The health insurance company knows this and so raises the average price of insurance cover.

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 • This may price some healthy low-risk consumers out of the market, meaning that mainly higher risk individuals
gain insurance – this causes a market failure.
Analysis of information gaps and market failure
• Individuals may have imperfect information about their own private benefits.
• If they had better/fuller information on the benefits to themselves of consuming a good or service, the marginal
private benefit curve would shift lower leading to a smaller equilibrium quantity.

Insurance, Information Gaps and Market Failure

Insurance is a market contract to protect against well-defined risk. The insured pay a premium. The basic principle of
insurance is risk-pooling which itself is built around the law of big numbers which lowers the standard deviation of
random events allowing an average price to be set.

The market for health insurance can be affected by asymmetric information and a potential market failure. This is
described in the graphic below.

Health insurers Price coverages on Healthy consumers Average cost of

•Typically know less average cost of •Will choose not to insurance rises
than their consumers providing cover buy insurance •Harder to sell to new
about existing •Essentially pooling consumers
conditions the risk of insuring a •Market is left with
large number of large proportion of
potential claimants higher-risk
consumers

Bounded rationality
Bounded rationality is the idea that the cognitive, decision-making capacity of humans cannot be fully rational in part
because of the complexity of information involved.

Summary of key terms and concepts in information economics

Adverse selection Where the expected value of a transaction is known more accurately by the buyer e.g. health insurance.
Anchoring The use of irrelevant information as a reference point for helping to make an estimate of something
Asymmetric Where one party has more or better information than another
information
Confirmation bias Tendency for humans to only remember information that supports their own views.
Know-how Information required to develop, produce and bring products to market.
Moral hazard When the party with superior information alters his/her behaviour because they are insured against risk
Paradox of choice Observation that more choices can lead to less satisfaction and economic welfare

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 Risk A known-unknown, since agents can assign probabilities to each outcome.
Risk pooling Putting people into a large group to collectively absorb the risk faced by each individual
Screening Finding out as much as possible about another agent in a transaction
Signalling When changing prices in a market send important information to producers and consumers
Suppler induced When doctors & dentists can manipulate. their patients' demand for medical services to create
demand additional demand
Tail end risk Portfolio risk greater than shown by a normal distribution
Uncertainty When an outcome is unknown, and agents cannot (or will not) assign probabilities to each outcome.

1.4.1 Government Intervention in Markets

Key specification content:
• Purpose of intervention with reference to market failure and using diagrams in various contexts:
o Indirect taxation (ad valorem and specific)
o Subsidies
o Maximum and minimum prices
• Other methods of government intervention:
o Trade pollution permits
o State provision of public goods
o Provision of information
o Regulation

Laissez faire economics

• In a free market system, governments take the view that markets are best suited to allocating scarce resources
and allow the market forces of supply and demand to set prices.
• The role of the government is mainly to protect property rights, uphold the rule of law and maintain the value
of the currency.
• Competitive markets often deliver improvements in allocative, productive and dynamic efficiency
• But there are occasions when they fail – providing a case for intervention.
Government intervention
• Government intervention is when the state gets involved in markets and takes action to correct market failure,
improve economic efficiency and change the distribution of income and wealth.
• The government can use regulations, taxes, subsidies, maximum and minimum prices to change price signals,
better information or direct provision to change resource allocation.
• Often a combination of interventions is needed to be effective in addressing one or more market failures.
• In recent years, several governments have tried to use interventions designed to create behavioural nudges to
change the behaviour of consumers and businesses.

Type of Market Failure Consequence of Market Failure Example of Government Intervention

Factor immobility Structural unemployment State investment in education and training

Failure of market to provide pure public Government funded public goods for
Public goods
goods, free rider problem collective consumption
Over consumption of products with Information campaigns, minimum age for
Demerit goods
negative externalities consumption

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 Negative externalities from Consumption above the socially optimum Consumption taxes or tougher
consumption level environmental standards
Under consumption of products with
Merit goods Subsidies, information on private benefits
positive externalities
Damaging consequences for consumers
Imperfect information Statutory information / labelling
from poor choices
Low income families suffer social exclusion, Taxation and welfare to redistribute income
High relative poverty
negative externalities and wealth

Higher prices for consumers cause loss of Competition policy, measures to encourage
Monopoly power in a market
allocative efficiency new firms into a market

Main reasons for government intervention

The main reasons for government intervention are:
• To correct for one or multiple market failures.
• To achieve a more equitable final distribution of income and wealth.
• To improve the performance of the macroeconomy i.e. reduce unemployment or stimulate growth.
Fiscal Policy Intervention
Fiscal policy can be used to alter the level of demand for different products and the pattern of demand.
• Indirect taxes can be used to raise the price of de-merit goods and products with negative externalities designed
to increase the opportunity cost of consumption and thereby reduce demand towards a socially optimal level.
• Subsidies to consumers will lower the price of merit goods. They are designed to boost consumption and output
of products with positive externalities – remember that a subsidy causes an increase in market supply and leads
to a lower equilibrium price.
• Tax relief: The government may offer financial assistance such as tax credits for business investment in research
and development. Or a reduction in corporation tax (a tax on company profits) designed to promote new capital
investment and extra employment.
• Changes to taxation and welfare payments can be used to influence the overall distribution of income and
wealth – for example higher direct tax rates on rich households or an increase in the value of welfare benefits
for the poor to make the tax and benefit system more progressive.

Government Intervention and Stakeholders

• A stakeholder is any person or organization that has an interest in a specific project or policy decision.
• As an economist, whenever you are required to discuss the costs and benefits of an example of government
intervention it is worth asking yourself “who are the major stakeholders in this issue?”
• The decisions of government, businesses and other organisations inevitably affect groups within society.
Increasingly, many businesses are taking into account the effects of their actions not just on the value that such
decisions create for shareholders – but to a broader range of stakeholder groups.
• Typically, stakeholder issues come into play on major infrastructural projects where a cost benefit analysis might
be undertaken to assess the likely social costs and benefits – it is important to bring as many stakeholders into
the picture as possible – many people might be affected.

Examples of stakeholders you might think of bringing into a discussion include:

1. Employees of a business / organisation (who may / may not be members of a union)

2. Communities where a business is located or affected directly by a decision
3. Suppliers to a business (e.g. back down the supply chain)
4. Shareholders and other investors / financiers
5. Creditors (people owed money)

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 6. Government (and through them – taxpayers)
7. Trade unions (and the workers they represent)
8. Professional associations
9. NGOs and other advocacy groups (i.e. World Bank, IMF, individual Pressure Groups)
10. Prospective employees
11. Prospective customers
12. Local communities
13. National communities
14. International community
15. Competitors within a market

Evaluation on Government Intervention

a) Value judgements: Be aware of the use of ‘value judgements’ in discussions about government intervention –
many people want intervention because of their own vested interests.
b) Changing prices to change incentives and behaviour: Many interventions work through the price mechanism
by changing the relative prices / relative costs of day-to-day decisions.
a. E.g. raising the price of fuel to curb consumption
b. Using tariffs to change the relative prices of imports in a domestic economy
c) Social science: Economics is a social science and the effects of intervention cannot be calibrated / forecast with
great accuracy – people’s behaviour is subject to change – remember the ‘law of unintended consequences.’
d) Combinations of policies: One single intervention is unlikely to produce a solution to deep-rooted economic and
social problems – try to build a variety of policy options into your discussion e.g. policies that work on market
demand and market supply
e) The power of markets: Is intervention always necessary? Market forces can be powerful in finding profitable
solutions to problems – don’t underestimate the importance of innovation and invention – government’s rarely
have all the answers and the new economics of collaboration offers insights into the impact that collusive
behaviour can have e.g. in fast-tracking ideas linked to reducing carbon emissions
f) Costs and benefits: You cannot go far wrong in evaluation by trying to identify and discuss the costs and benefits
of government intervention – some of which only become apparent over long time periods
g) The law of unintended consequences: Government intervention does not always work in the way in which it
was intended or the way in which economic theory predicts it should. Part of the fascination of studying
Economics is that the “law of unintended consequences” often comes into play – events can affect a policy, and
consumers and businesses rarely behave precisely in the way in which the government might want.
h) Case-by-case basis: you need to consider each scenario / market failure / example on its own terms. Just because
a particular type of intervention has been successful in a different market does not mean it will be effective in
another case! In other words, be specific to the scenario you are given, rather than generic.

Judging the Effects of Intervention – A Revision Check List

To help your evaluation of government intervention in an exam – it may be helpful to consider these questions:
1. Efficiency of a policy: Does an intervention lead to a better use of scarce resources? E.g. does it improve
allocative, productive and dynamic efficiency? For example - would introducing indirect taxes on high fat foods
be an efficient way of reducing external costs linked to the growing problem of obesity?
2. Effectiveness of a policy: Which policy is most likely to meet a specific economic or social objective? For
example, which policies are likely to be effective in reducing road congestion?
3. Equity effects of intervention: Is a policy thought of as fair or does one group in society gain more than another?
For example, would it be equitable for the government to increase the top rate of income tax to 50 per cent in
to make the distribution of income more equal?
4. Sustainability of a policy: Does a policy reduce the ability of future generations to engage in economic activity?
Inter-generational equity is an important issue in many current policy topics for example decisions on which
sources of energy we rely on in future years.
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 5. Does the policy need to be used alongside something else?

Exam tip:
Students should avoid concluding that a particular policy will always tackle a particular type of market failure. Instead, they should
consider the impact of a policy type on a case-by-case basis i.e. subsidies might help provision of rural bus services which have positive
externalities because bus-users are often quite price-sensitive (low income or elderly households, for example), whereas subsidising
healthy fruit and vegetables which have positive externalities may be less effective because there is usually a wider choice available
and a more competitive market, which should lead to lower prices anyway. Furthermore, policies rarely work on their own – it is nearly
always better for students to consider possible policy combinations.

Evaluating indirect taxes

Value Added Tax Plastic Bag Charge Fuel Duties Alcohol Duties Tobacco Duties

Sugar tax Carbon taxes Landfill tax

The aim of an indirect tax is to make the polluter pay and so internalise a negative externality. However, implementing
taxes is difficult:
1. Setting the ‘right’ tax rate e.g. if the monetary value of a negative externality is hard to measure.
2. Cost of collection: e.g. road charging requires expensive infrastructure e.g. IT system of billing.
3. Inelastic demand: higher petrol prices via higher indirect taxes has little effect on demand for fuel, likewise,
would a tax on sugar get people to cut their consumption of high-sugar products?
4. Redistribution effects: Indirect taxes are regressive and affect low-income household most.
5. Increased costs: Higher indirect taxes may cause inflation affecting consumers who did not pollute and
international competitiveness if taxes are higher in one country than another.
Example of intervention: Evaluating the benefits and costs of a sugar tax
Heavy consumption of high sugar food and drink can lead to weight gain which can increase the risk of medical conditions
such as type 2 diabetes, heart disease and stroke. In the 2016 Budget, the Government announced the introduction of a
levy on soft drinks. The levy would apply to manufacturers and importers of sugar added soft drinks and was implemented
in April 2018. There would be exemptions for fruit juices and milk-based drinks and for small producers.

This statistic shows the results of a survey in which respondents were asked how much the price of soft drinks would
have to increase by to discourage them from buying any in the United Kingdom in 2016.

The average price of a 330ml can of sugary carbonated soft drink is 69p. What price would discourage you from buying it?

Share of respondents
0.0% 5.0% 10.0% 15.0% 20.0% 25.0% 30.0%

Price increase would not discourage me 16%

50% increase 24%
20% increase 15%
10% increase 13%
5% increase 9%
Current is too much 22%

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Arguments in favour of a sugar tax
1. External costs of consuming sugary drinks – are a cause of market failure
2. Information failures – people under-estimate the long-term costs of their consumption
3. Sugar tax raises revenue – ring-fenced for other projects e.g. to help fund school sports / breakfast clubs
4. Tax encourages drink manufacturers to re-formulate their drinks (cutting the sugar content) and offer healthier
alternatives e.g. in vending machines
Arguments against a sugar tax
1. Might be regressive on lower income families – i.e. the tax might be inequitable
2. Other policies might be more effective in cutting consumption in the long-term (e.g. better information)
3. People might simply switch to other sugary products – i.e. the sugar tax might be ineffective
4. Risk of lost jobs in pubs and shops that rely heavily on drink sales
Exam Technique: Example of an analytical chain of reasoning:
Question: How might a tax on plastic bottles change behaviour?

Exam technique: Building strong analysis and evaluation exam paragraphs:

Question: Discuss the extent to which introducing a tax on disposable coffee cups is beneficial for all.

KAA Point 1:
Indirect taxes are taxes on spending. Examples include VAT and excise duties. A new tax on single use disposable plastic cups would
cause the supply curve for coffee retailers to shift to the left. My analysis diagram shows that prices rise with a tax. As a result of the
price rise, the quantity of coffee demanded should contract and the consumption of single-use plastic cups is therefore reduced
towards the socially optimum level. This can help overcome market failure due to negative externalities from consumption. More
people would choose reusable cups.

Evaluation Point 1:
Whilst in theory an indirect tax might be effective, in practice, market demand for coffee is usually price inelastic (i.e. the coefficient
of PED<1) in part because of strong habitual demand. Therefore, any reduction in the quantity consumed will be relatively low
making the latte charge less effective. The proposed levy of 25p per cup in the UK is small. For a £2.50 cup of coffee it is only 10% of
the retail price, so the socially optimal level of consumption (where MSB = MSC) is unlikely to be reached simply as a result of the
charge.

KAA Point 2:
A second argument in favour of a charge on single-use disposable coffee cups is that the forecast revenue from the latte tax can be
hypothecated (or “ring-fenced”) thereby increasing funding to help improve the UK’s recycling and reprocessing facilities. This will
help to lift recycling rates from their current very low levels as well as creating extra jobs. Tax revenues might help fund research into
innovative start-ups who are developing biodegradable food packaging, including cups.

Evaluation Point 2:

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On the other hand, manufacturers of disposable coffee cups argue that a tax places an unfair (inequitable) extra cost on coffee-
drinking consumers, many of whom are on relatively low incomes and that waste from paper cups accounts for less than 1 percent
of total paper packaging waste. A tax on disposable cups might actually be damaging to smaller firms who are developing paper cups
that are sourced sustainably and which do less harm to the environment. This would be an unintended consequence of the
government intervention.

In theory …. but in practice. Alternative policies might be Challenge the assumptions

Would a latte levy be as considered: What impact can behind the theory: Price
successful as the plastic bag behavioural nudges have on elasticity of demand for coffee
charge? consumer choices? varies by types of consumer.

Analysis diagrams – using indirect taxes to correct for market failure caused by externalities
Earlier in this course companion, you met specific and ad valorem taxes in relation to demand and supply diagrams. The
diagrams below simply apply the two types of indirect tax to two market failure situations. In each case, the indirect tax
has been set such that the socially optimal level of output (Q*) is achieved, and therefore the government intervention
has, in each case, effectively tackled the market failure. The tax has the effect of internalising the externality. I.e. the
externality has been reflected in a higher market price. In reality, setting the tax at exactly the ‘right’ amount is virtually
impossible because we cannot easily put a value on the externalities.

Exam hint: Always worth stating that marginal social costs are difficult to measure – this can make it hard to assign the right level of
taxation to correct for externalities and overcome the market failure.

Subsidies
Subsidies provide financial support for producers with the aim of lowering market prices and encouraging consumption
of goods and services perceived to lead to positive externalities. As with indirect taxes, there are costs and benefits of
subsidies that can be considered in your analysis and evaluation. Some evaluation points might include:
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 • Are subsidies effective in meeting their aims?
o Will they achieve the desired stimulus to demand / consumption?
o Is a subsidy sufficient? Might other incentives be needed to change behaviour e.g. some “nudges”
• Will a subsidy affect productivity / efficiency?
o Subsidies for investment and research can bring positive spill overs
o But firms may become dependent on state aid / financial assistance and innovate less over time
• How much does a subsidy cost and who benefits?
o Is a subsidy part self-financing? Will it create more tax revenue?
o Or does a subsidy create an expensive extra burden for taxpayers who may not have benefitted and
therefore be inequitable?
• Does the subsidy help to correct one or more market failure(s)?
o For example – do more people find work with childcare subsidies?
o Do subsidies for school meals help to address malnutrition among children in poorer families?
o Or does a subsidy lead to undesired / unintended consequences leading to government failure?
As with other forms of intervention in markets, it is a good idea to assess the benefits and costs of government financial
support on a case-by-case basis. Find evidence on the actual impact rather than a textbook prediction.

Like with indirect taxes, you have already met subsidies in relation to demand and supply diagrams earlier in this course
companion. The diagram that follows shows how they can be used in relation to correct the market failure of positive
consumption externalities. In this case, the subsidy increases supply by lowering the Marginal Social Cost, so that the
socially optimal quantity Q* is achieved.

Maximum prices
What is a maximum price?
• This is a legally imposed maximum price (or price ceiling) in a market that suppliers cannot exceed. A maximum
price is introduced in an attempt to prevent price from rising above a certain level.
• The main aim of a maximum price is to promote equity so that certain goods and services are more widely
available to the general population.
• To be effective as a form of intervention, a maximum price has to be set below the existing free market
equilibrium price.
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 Rent controls to Energy Price Caps to Caps on CEO Pay Cap on Mobile Roaming
improve affordability control fuel bills /Bonuses in the labour Charges in the EU
market

Price capping for Cap on interest rates Cap on annual charges Currency pegs e.g. the
regional monopoly charged by pay-day to occupational pension Hong Kong / US dollar
water companies lenders plans

Analysis diagram for a maximum price

In the diagram above the free market price is P1. If a maximum price is imposed, quantity supplied contracts from Q1 to
Q3 whilst quantity demanded extends from Q1 to Q2. Therefore, a maximum price drawn beneath the equilibrium price
leads to a disequilibrium with excess demand equal to the quantity Q3-Q2.

Maximum prices often lead to secondary (unofficial) markets developing because a scarcity of supply means that some
consumers are willing and able to pay above the regulated price. A good example of this might be a rent ceiling imposed
on rented properties in towns and cities.

A maximum price involves a normative judgement on behalf of the government about what that price should be

Example: Analysis of a maximum rent on city centre properties:

The diagram below shows how imposing rent controls might lead to a possible shadow market for rented property

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Exam Technique: Example of a chain of analytical reasoning:
Question: Assess the case for introducing rent controls in the UK

Building strong evaluation: Question: Assess the case for introducing rent controls in the UK

Arguments in favour of rent controls for housing Evaluation points – Drawbacks of rent controls for housing

Rent controls are needed to reduce the excess profits of Capping rents would result in landlords withdrawing investment
landlords who may exploit those in greatest need leading to a diminished supply of private sector rented housing

High private sector rents impede the geographical mobility of Landlords might cut back on the level of maintenance spending -
labour and therefor keep structural unemployment higher. this would reduce the quality of rented housing and increase risks
for tenants such as damp and danger from poorly maintained
properties.
High rents reduce people’s effective disposable incomes Some landlords may demolish homes for rent and replace with
(leaving them with less to spend on food and fuel) and this new housing to buy. This can drive average property prices even
increases the demands on the state welfare benefit system. higher in areas where affordability is already a major problem
especially for young people

Minimum prices

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What is a minimum price?
A minimum price is a price floor. It is a legally imposed price floor below which the normal market price cannot fall. To
be effective, a minimum price has to be set above the normal equilibrium price.

Minimum prices are most commonly associated with minimum wages in the labour market or guaranteed price support
schemes for farmers or other producers. There is much debate at the moment about introducing minimum prices for
consumers in an attempt to reduce sales of high fat, salt and sugar foods and high calorie drinks deemed to be de-merit
goods. The UK government introduced a ban on the sale of alcohol below cost price from May 2014. A can of average
strength lager cannot be sold for less than 41p and a standard bottle of vodka cannot be sold for less than £9.06.

Litres of alcohol consumed per capita in the United Kingdom from 2002 to 2016
14
11.3 11.6 11.4
Average litres per head

12 11.1 11 11.1 10.8

10.1 10.1 9.9 9.6 9.4 9.4 9.5 9.5
10
8
6
4
2
0
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Context: The Alcohol (Minimum Pricing) (Scotland) Act 2012 introduced a statutory minimum price for alcohol, initially set at 50p per
unit of alcohol. Scotland is the first country in the world to introduce minimum unit pricing (MUP)

Arguments for a minimum price on alcohol sold in supermarkets:

1. Reduces some of the negative externalities from people pre-loading cheap supermarket alcohol at home. Hence
a minimum price is designed to reduce consumption towards the socially optimum level.
2. In the long term, a minimum price intervention would cut premature deaths, reduce workplace absenteeism
and reduce the burden of treating chronic illnesses linked to alcoholism. Alcohol is estimated to cost the NHS
over £billion a year and there is an £11 billion annual cost of alcohol-related crime.
3. Pubs may benefit from higher minimum prices in supermarkets due to the substitution effect
4. A minimum price might target cheaper, higher-strength drinks often used by younger drinkers
Counterarguments against using minimum prices for alcohol:
1. Minimum price is a tax on responsible drinkers – this can be seen as inequitable for this group
2. Might be better in the long run for drinks producers to agree voluntary policies on alcohol price / strength
3. Better to raise alcohol duties which will raise tax revenues to be used for socially beneficial projects
4. Demand for alcohol among problem-drinkers is likely to be inelastic and, thus, any increase in price is likely to
have little effect upon their consumption. It will have a regressive effect on lower-income families.
5. Imposing a minimum price will require extra spending on enforcement e.g. across every drink retailer
6. There could be some unintended consequences – e.g. drinkers may look to make use of cross border shopping.

Exam hint: Take a look back at the evaluation of specific examples in the previous section (e.g. sugar taxes, maximum prices on rent
and minimum prices on alcohol). Can you see that the points made are very specific to those markets? The best way to achieve high
evaluation marks is to be as specific as you can, rather than just reproducing a list of generic evaluation points. Always think carefully
about the specific market in question.

Tradable Pollution Permits and Carbon Taxes

What are tradable pollution permits?
Many environmental economists recommend applying the polluter pays principle and placing a price on carbon dioxide
and other greenhouse gases. This can be implemented either through a carbon tax (known as a price instrument) or a
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cap-and-trade scheme (a so-called quantity instrument). For the purposes of your Edexcel Economics A level, it is the
latter approach (permits) that you need to know about in detail.

Carbon pricing either through emissions trading or a carbon tax is becoming more common in a number of countries:
• Sweden’s CO2 tax (first introduced in 1991, Euro 137 per tonne) – Sweden has the world’s largest carbon tax
• European Union emissions trading scheme (ETS) began in 2005
• China launched an emissions cap & trade system in 2017
• India (2010) introduced a carbon tax of 50 rupees per tonne of coal produced and imported to India
• Chile (2014) became the first country in South America to impose a climate pollution tax
• South Korea introduced carbon emissions trading in 2015
• 2017 – Alberta (Canada) started a new carbon tax
• 2019 – Singapore introduced a carbon tax
What is carbon emissions trading?
• Carbon trading is a form of pollution control that uses the market mechanism to change relative prices and the
incentives of producers and consumers to reduce their carbon emissions.
• The EU Carbon Emissions Trading Scheme is cap-and-trade scheme for carbon dioxide. It operates in 30 countries
(the 27 EU countries, Iceland, Liechtenstein and Norway). It covers the 45% of the EU’s greenhouse gas emissions
that come from energy intensive sectors.
• The tradeable pollution permits scheme sets a decreasing cap for CO2 from energy intensive industries and
allocates or auctions emissions allowances which can be traded on the open market.
• Businesses need to buy enough emissions allowances – the higher the price, the greater the incentive to cut
pollution. Increasing the scarcity of carbon permits leads to an increase in market price.
• This makes it more expensive for firms to emit carbon which in turn increases the incentive for investment in
low carbon ‘green’ technologies.
• Carbon trading provides a quantity adjustment to CO2 emissions working through the price mechanism

If the carbon price is high, power generators might decide to shift some investment towards renewable projects since
this will have a lower carbon impact. And smaller businesses might switch to small-scale wind and solar schemes to
reduce the expenses of buying carbon permits in the market.

The main problem with the EU carbon trading scheme is that the price per tonne of CO2 has been volatile and, in recent
years, extremely low – sometimes as low as Euro 5 per tonne. This means that the incentives to use renewable energy
have been weak and some UK-based power companies have gone back to burning imported coal.

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The UK Carbon Price Floor
The UK Carbon Price Floor applies to fossil fuels used for electricity generation. The minimum price for carbon emissions
is designed to provide a stable carbon price signal as a way of internalising externalities. In 2014 the government
announced a price floor of £18/tCO2 from 2016-2020

Arguments for a carbon price floor:

1. Reduces the risks, and thus costs, of investing in new nuclear energy capacity.
2. Helps to reduce carbon price volatility – this sends a clear signal to polluters.
3. Makes low carbon electricity more competitive – this gives boost to renewables.
Disadvantages of a carbon price floor:
1. Better to restrict more tightly the total supply of carbon permits to increase market price.
2. A carbon tax is perhaps a more effective alternative and raises useful tax revenues for the government.
3. Price floor might damage international competitiveness e.g. of the UK steel industry compared to China/Poland
and lead to lower exports and lost jobs.
Carbon taxes
A tax on carbon increases the private cost of emitting carbon and in theory, this will cause output to contract towards
the social optimum. It will raise tax revenues that might be used by the government to fund other projects or use as a
rebate to those affected (e.g. consumers).

Advantages of a carbon tax

1. A pollution tax internalizes the externality and makes the polluter pay – it is fairly easy to administer, and the
tax is predictable for businesses affected.
2. Carbon fee on imported products will help reduce risk of domestic businesses re-locating to avoid paying a
national carbon tax.
3. A tax raises extra revenue which can be ear-marked for other uses e.g. research in cleaner energy.
4. Might be offsetting tax cuts on employment / childcare or tax rebates to lower-income families.
Disadvantages of a carbon tax
1. Low price elasticity of demand – the tax may not change behaviour, there might be more effective alternative
policies on offer.
2. Risk of higher structural unemployment among workers in carbon intensive sectors such as mining, oil and gas
– renewables employs relatively few people.
3. Risk that the burden of new / higher carbon taxes will fall more heavily on lower-income families.

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 4. Might damage the competitiveness of domestic businesses in overseas markets e.g. the UK steel industry
complaining about carbon price floor which may have contributed to rising losses and threats to jobs.
Overall, comparing the two instruments, most economists favour a carbon tax over tradeable permits. But public support
for carbon taxes, however, is generally low and people tend not to believe that they are environmentally efficient.

Government Provision of Public Goods

Should the state both fund and provide public goods? One argument is that the state needs to provide public goods to
help overcome the free-rider problem. Because (pure) public goods are non-excludable it is difficult to charge people
for benefitting once a product is available. The free rider problem can lead to the non-provision of a good and thus causes
market failure. Free riders have no incentive to reveal what they are willing and able to pay for a public good because
they enjoy a benefit without paying.

Pure public goods are usually provided – perhaps to a basic standard – by the state on the grounds of:
1. Fairness – the (normative) view that everyone should have equitable access to good quality public goods such
as sanitation systems, public service broadcasting, flood defence systems, the rule of law and open access to
justice.
2. Efficiency – collective provision funded through taxation can lead to economies of scale and a more efficient use
of scarce resources.
3. Social welfare – there are positive externalities (social benefits) from good quality public services not all of which
can be measured by a market price
However, there might be inefficiencies in relying on the state to provide public goods. Those who favour a smaller role
for the government believe that the private sector is more efficient and innovative and that high government spending
on public goods leads in the long run to a rising tax burden which might crowd-out or hinder the growth of private sector
businesses.

Technological change is changing the degree to which public goods are non-excludable. Not all public goods need
providing – think of fireworks displays, for example. And some can be provided on a local small scale by local organisations
able to collect fees. Others are provided by charitable organisations, for example the RNLI.
Provision of Information

Health warnings Nutritional labelling Gamble aware Industry standards

There are many examples of intervention designed to change the perceived benefits and costs for consumers when
making their choices in markets. These include:
• Compulsory labelling on products (e.g. on cigarettes)
• Fuller and clearer nutritional information on food & drinks
• Campaigns to raise awareness of risks of drink-driving
• Gambling addiction awareness campaigns
• Performance league tables for schools & colleges
• Consumer protection laws e.g. refunds of faulty goods
• Guarantees for used products such as second-hand cars
• Industry standards/certification e.g. in building industry
• Requirement for vehicles to have regular MOT tests

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Regulation to correct externalities

Maximum C02
Smoking bans Minimum age laws
emissions for vehicles

Recycling directives Speed limits Fishing quotas

Regulations of the behaviour of businesses and consumers are best described as a command and control approach to
intervention in a market - backed up by inspection and penalties for non-compliance. Regulation does not work directly
through the price mechanism contrasted for example with indirect taxes and subsidies.

Context: Example of regulation and externalities: In July 2019, Southern Water was hit with a £126m fine for spills of wastewater into
the environment from its sewage plants. Each customer was set to get a rebate of £60 on their bills.

Arguments for regulation as a way of correcting for market failures:

1. Regulations act as a spur for business innovation e.g. to cut the level of carbon emissions – e.g. the decision to
introduce a ban on petrol and diesel vehicles in the UK from 2030, tougher standards for air conditioning units.
2. Regulations may be more effective if demand is unresponsive to price changes (i.e. a low PED) e.g. a ban on
smoking in public places or a ban on under 18s using tanning salons
3. Regulations can be gradually toughened each year – this will help stimulate capital investment. A good example
of this is the EU cutting the maximum level of CO2 emissions per km for new vehicles.
Risks / disadvantages from heavy use of regulation in markets:
1. High cost of enforcement / administration of laws – regulation needs to be policed. An example is the cost to
local authorities of enforcing health and safety regulations in workplaces and restaurants etc.
2. Regulations can lead to unintended consequences – this is a source of government failure
3. The cost of meeting regulations can discourage small businesses because it adds to their costs and can lead to
less competition in markets. Some businesses for example might outsource their production to alternative
countries with weaker environmental and employment laws.
Government policy in focus: Legalising cannabis
Question: Assess the argument that legalizing cannabis in the UK would lead to an improvement in social welfare

In the UK, cannabis is currently a controlled drug as classified by the Misuse of Drugs Act 1971. Canada recently became
the second country in the world (after Uruguay) to legalize the recreational use of cannabis.

Economic and social arguments for legalising cannabis:

1. Tax revenues from a legalized and regulated cannabis industry
2. Reduced policing costs from a smaller illegal cannabis industry - reduces the burden on the police and the
justice system
3. Benefits of cannabis to some people with illnesses such as brain seizures - using cannabis to treat epilepsy,
advanced Parkinson’s Disease and MS
A regulated market would allow Government to control the safety and potency of cannabis sold by legal vendors
One study found that legalising cannabis could bring in £900m in taxes every year, save £400m on policing cannabis and
create over 10,000 new jobs.
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Risks and drawbacks from legalising cannabis:
1. Increased power consumption from cannabis farms + associated C02 emissions + increased water scarcity
2. Evidence that over-use among teenagers can be harmful for brain development.
3. External costs in the long term associated with addiction i.e. costs of dealing with mental health issues, higher
risk of schizophrenia, lung cancer
4. Risks to others in the community from heavy users of cannabis e.g. driving under influence, risk of violence in
the home
Those against legalisation argue that such a move would be an example of government failure.

Building strong evaluation points:

In theory …. but in practice: Problems of measurement: Discounting future costs and

We might expect prices to fall How do we accurately and benefits: How far into the
if (legal) market supply equitably measure the value future should be include in the
increases but what if there is a of human life and some of the social costs and benefits?
boom in demand wider social effects of
legalization?

1.4.2 Government failure

Key specification content:
• Understanding of government failure as intervention that results in a net welfare loss
• Causes of government failure:
o Distortion of price signals
o Unintended consequences
o Excessive administrative costs
o Information gaps

What is Government Failure?

• When government intervention in a market leads to a less efficient allocation of resources and therefore makes
a situation worse
• When government intervention to correct market failure leads to a net social welfare loss.
• When the costs of government intervention to correct market failure exceeds the benefits.
• Government failure can happen if a policy decision fails to create enough of an incentive to change people’s
actual behaviour.
Government intervention can be ineffective, inequitable and misplaced.

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 Political self interest / lobbying Policy myopia – search for Regulatory Capture Information failures
“quick fixes”

Disincentive effects High Enforcement / Compliance Conflicting Policy Objectives Damaging effects of red tape
Costs

Cause of government failure Brief explanation of problem caused Examples of government failure to consider

Political self interest Government influenced by influential Farm support policies, the drinks industry,
political lobbying transport lobby

Poor value for money Low productivity / high waste makes Investment on ICT projects in the NHS, poor
government spending less effective record of PFI projects

Policy short-termism Governments are often looking for a “quick Road widening to reduce congestion, ASBOs for
fix” solution for political purposes offenders

Regulatory capture When a government agency operates in The drinks industry has favoured self-regulation
favour of producers not consumers on alcohol prices whilst campaigning against the
introduction of a minimum price
Conflicting objectives One policy objective might conflict with Minimum carbon price could damage UK
another competitiveness and possibly cost jobs

Bureaucracy & red tape Costs of enforcement may hurt enterprise & Costs of meeting health and safety and
incentives environmental laws

Unintended consequences Policies have unanticipated or unintended Smoking ban – led to an increased use of outdoor
side-effects patio heaters

The Law of Unintended Consequences

• Actions of consumers, producers and government always have at least one and often many effects that are
unanticipated or "unintended.”
• Well-intentioned legislation often acts against the interests of those it is intended to serve
• People and businesses find imaginative ways to circumvent new laws
• Shadow markets develop to undermine an official policy e.g. when there is a maximum price cap
• Examples of unintended consequences:
o Bank bail-outs – raises the problem of moral hazard
o Bio-fuel subsidy –may divert production away from food, cause food price inflation and this hits the
poorest in society
o Import tariffs on steel – hits domestic car and construction firms
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 o Targets for treating patients – contributed to a reduction in the quality of care e.g. the Mid-
Staffordshire General scandal

Minimum Wage Smoking ban Tariffs on steel Price caps on texts Targets for treating
leads to a reduction encouraged causes damager to leads to higher prices patients might lead
in staff non-wage widespread use of car makers for mobile handsets to a lower quality of
benefits patio heaters care

Regulatory Failure
The actions of regulators may bring about government failure

Regulators may limit Capping prices might Regulation becomes May lack the powers
innovation in fast- prevent new firms bureaucratic & costly to be truly effective in
growth markets entering a market protecting consumers

Regulator might be Frequent rule changes

“behind the curve” can stifle business
with new investment
technologies
What is regulatory capture?
• Regulatory capture is a form of government failure
• It happens when a government agency operates in favour of producers rather than consumers
• This often happens when suppliers have significant lobbying power e.g. with government agencies

What are some of the main causes of regulatory capture?

• Asymmetric information – regulators may rely on critical information supplied by regulated firms themselves
about costs, investment requirements
• Under-resourced – regulatory agencies may not have enough funding to scrutinize an industry properly
• Information gaps – people working for a regulator may not understand the complexities of an industry e.g.
financial services – they may not understand risk

Why does regulatory capture matter?

1. Consumers interests may be harmed if regulators fail to hold suppliers to account and enforce minimum
standards of service
2. Prices will be higher leading to lower real incomes and regressive effects on lower income households
3. There can be damaging externalities if the regulator fails to act leading to a social welfare loss

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Recent examples of regulatory capture:
1. OFWAT (water industry regulator) accused of allowing water bills charged by monopoly utilities to rise by
more than they should - regulators are dependent on the utilities for information on costs, and end up being
overly sympathetic to those utilities when setting price controls
2. Financial Services Authority (FSA) was heavily criticised for not monitoring the lending activities of commercial
banks in the run up to the 2007-2009 global financial crisis

Key revision points about government failure:

1. Free market economists are distrustful of intervention. They believe that the price mechanism should be given
freedom to operate.
2. Often, we can accuse the government of policy failure only with the benefit of hindsight.
3. Limited information - no government has the resources and information available to it to make fully informed,
objective judgements. That is the nature of politics.
4. Government failure is most likely to occur when decisions are made in the vested interest of special interest
groups, at the expense of other groups (the result is a loss of equity).
5. Government interventions in markets more often than not result in net effects, rather than straightforward one-
directional effects. I.e. in each case try to consider some of the positive and negative consequences of a policy.

Exam hint:
Many microeconomic exam essay questions relate to the effectiveness of government intervention to tackle a particular market failure.
An excellent way to push your answer into the very top level of response for evaluation (AO4) is to consider whether the welfare gain
as a result of government intervention is likely to exceed (or not) the welfare loss as a result of the market failure i.e. will government
failure outweigh the market failure.

Junk food taxes and government failure

Share of people enjoying certain food products classified as not healthy in Europe in 2016, by country

Share of people enjoying certain food products classified as not healthy in Europe in 2016, by country
80 71
70 63
60 56
49
50
40
30
20
10
0
United Kingdom France Germany Spain

To what extent might a government be introducing a tax on junk foods lead to government failure? This happens when
government intervention to correct one or more market failures leads to a greater net social welfare loss

The main causes of government failure are:

• Impact on inequality e.g. effects on lower-income families
• Cost of compliance and implementation
• Possible unintended consequences
• Possible conflict with other micro/macro objectives
• Information failures before a policy is introduced
• Policy may prove to be ineffective in changing behaviour

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Obesity prevalence among individuals in England from 2000 to 2018, by gender

Obesity prevalence among individuals in England from 2000 to 2018, by gender

35
29
30 26 26 26
25 21 21
20
15
10
5
0
2000 2010 2018

Men Women

Arguments for introducing a tax on junk foods:

• Higher prices incentives consumers to reduce demand which reduces the impact on a country’s health system
• Helps to correct market failure – pricing closer to social cost
• Tax revenues can be used to fund public health programmes
• There is an educational component to launching a new tax
• Encourages manufacturers to reformulate ingredients

Analysis diagram showing a tax

Why might a junk food tax lead to government failure?

1. Tax might be ineffective i.e. low coefficient of price elasticity of demand + people might just switch to
other sugary products
2. Tax might be inequitable – i.e. regressive on lower income families i.e. they face a higher tax burden
3. Possible conflict with other objectives - risk of lost jobs in pubs & shops that rely on drink and
confectionery sales
4. Administration costs in collecting tax from unhealthy foods

Alternative interventions to a junk food tax might include:

• Subsidies for healthy food supplied by the farming industry
• Investment in nutritional and lifestyle medicine
• Tougher legislation of processed food sector
• Advertising bans
• Better nutritional information / food literacy
• Evidence-informed behavioural nudges such as improved choice architecture and changing default options on
menus

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Exam Support – Revision Checklist
Theme 1: Introduction to Markets and Market Failure

The Economic Problem

Assumptions in economics
Positive and normative economic statements (& value judgements)
Problem of scarcity
Renewable and non-renewable resources
Opportunity cost and choices
Production possibility frontiers
Specialisation of factors of production
Advantages and limitations of division of labour
Functions of money
Free market economies, mixed economy and command economy

How Markets Work

Rational decision making
Utility theory & maximisation
Theory of demand
Price elasticity of demand
Income elasticity of demand
Cross price elasticity of demand
Theory of supply
Price elasticity of supply
Price determination
Functions of the price mechanism
Consumer and producer surplus
Alternative views of consumer behaviour including satisficing / bounded rationality / herd behaviour

Market Failure
Meaning of market failure
Negative externalities from production
Negative externalities from consumption
Positive externalities from production
Public goods and private goods
Quasi-public goods
Environmental market failure including the tragedy of the commons
Information gaps / failure
Asymmetric information
Adverse selection

Government intervention and government failure

Indirect taxation (ad valorem and specific)
Subsidies
Minimum prices
Maximum prices
Tradeable pollution permits
State provision of public goods
Provision of information
Regulation of markets
Strengthening property rights
Government failure – causes and consequences (including law of unintended consequences and information failure)
Basics of cost-benefit analysis when applied to different forms of intervention

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