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WORKBOOK ANSWERS
OCR AS/A-level
Economics
Microeconomics 1
This Answers document provides suggestions for some of the possible answers that might be
given for the questions asked in the workbook. They are not exhaustive and other answers
may be acceptable, but they are intended as a guide to give teachers and students feedback.
The student responses for the longer essay-style questions (green text) are intended to give
some idea about how the exam questions might be answered. The examiner comments (blue
text) have been added to give you some sense of what is rewarded in the exam and which
areas can be developed. Again, these are not the only ways to answer such questions, but
they can be treated as one way of approaching questions of these types.
Topic 1 Scarcity and choice
The basic economic problem
1 An economic good is one which has a cost in terms of the resources used to produce it.
The goods are therefore scarce and so a price can be charged to obtain them.
A free good is one which does not have a cost of production and so no price needs to be
paid to obtain it. There are no property rights associated with free goods. Unlike economic
goods, they are not scarce. As a result, they do not require a market to act as an allocative
mechanism because demand is equal to supply at zero price.
2 A normative statement is one which expresses an opinion or a value judgement. The
statement cannot be tested against facts. For example, ‘the government should reduce
unemployment’ is a normative statement as it expresses a view or opinion.
A positive statement is one which can be tested against the factual evidence. For
example, ‘the unemployment rate in this country has fallen during the last 12 months’.
3 A need is something that is essential for the survival of a person. Examples of needs
include food, water, basic clothing and a place to live.
A want is something that is not essential for the survival of a person, but is an optional
item that is desirable. Examples of wants include a car, a television or a holiday.
4 Land refers to the natural resources, or gifts of nature, in an economy, such as agricultural
resources in the soil.
Labour refers to the factor of production which involves people contributing to the
production process; it can be seen in terms of both the quantity and quality of labour in an
economy. In that sense, it is sometimes described as human capital.
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Scarcity and choice
Capital has a very precise meaning when used as an economic resource. It refers to the
human-made aids to production, such as equipment, tools and machinery.
Enterprise refers to the taking of risk in combining the other factors of production to
produce something that will lead to the making of a profit.
5 The economic problem is essentially the existence of scarce resources, i.e. there are
infinite wants, but finite resources to satisfy those wants. The scarce resources are the
four factors of production of land, labour, capital and enterprise and there are insufficient
resources, in terms of both quantity and quality, to satisfy all the demands that are put on
these resources. As a result of the imbalance between needs and wants and the ability of
an economy to fully satisfy those needs and wants, choices will have to be made because
all of these resources have potential alternative uses.
6 Sustainability can be defined as meeting the needs of the present generation without
compromising the ability of future generations to meet their own needs.
The concept of sustainability is particularly relevant to the use of resources that are finite.
If these resources are overused by the present generation, there will not be enough to
satisfy the needs of future generations. This awareness of the finite nature of certain
resources impacts on scarcity and choice, especially in relation to the needs of future
generations.
7 The process of production will involve the combination of the four factors of production, as
in the example of the production of motor vehicles.
Land will be required in relation to the need to build a factory, such as at Cowley in Oxford.
Labour will be required in the production process to carry out a range of manual tasks.
These will vary in terms of the level of skill and training required of the labour. As well as in
production, labour will also be required in a variety of managerial and administrative
positions.
Capital will be required in the form of a variety of equipment, machinery, robots and tools
that will be needed on the production line. Computer equipment will also be required
throughout all stages of the production, research and development, and administration and
management process.
Enterprise will be needed in order to take the risk of bringing the other factors of
production together to produce products, such as motor cars, in the hope of making a
profit.
The market economy
8 A market is where all the buyers and sellers of a product come together and interact. It
may be a physical market, such as Banbury Market where there is a market in the town
square every Thursday and Saturday, or a more intangible market where buyers and
sellers can communicate with each other, such as eBay. Whichever type of market exists,
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it provides a way of bringing buyers and sellers together so that an equilibrium price and
an equilibrium quantity can be established.
9 In theory, a market economy would have no government intervention. However, in reality,
there is no economy in the world where the government does not intervene.
The role of government within the market economy is important for a number of reasons.
For example, laws and regulations are provided to help to balance the power of the
producer and the consumer. There are numerous laws which provide varying degrees of
consumer protection. There are also numerous laws which prevent a firm from gaining too
much power in a market.
Some goods may be over-produced and over-consumed in a market economy, such as
demerit goods, or under-produced and under-consumed, such as merit goods. A
government could intervene in a market economy to ‘nudge’ consumers to behave in a
certain way. For example, taxation could be used to discourage the consumption of
demerit goods and subsidies could be used to encourage the consumption of merit goods.
It is also the case that public goods would not be provided within a market economy
because it would be impossible to charge a price for them. This is why it is essential that a
government provides public goods, such as police and defence.
It is therefore clear that government can play a crucial role in a market economy in a
number of different ways.
Opportunity cost
10 Opportunity cost is a crucial concept in economics. This is because scarcity is at the heart
of the economic problem and, as a result of this condition of scarcity, choices have to be
made about the allocation and use of scarce resources.
The concept can be applied to various situations: for example, a decision taken by a
consumer to spend some money on one item rather than another. Another example would
be a decision in the labour market where a worker decides to take one job rather than
another. The concept can also be applied to decisions taken by a government, such as
when a government decides to spend money on education rather than on healthcare.
The concept, therefore, is extremely useful in stressing that scarce resources have
alternative uses and so a decision to use them to produce one good means that they
cannot be used to produce another good.
11 A movement along a production possibility curve shows the consequences in a twoproduct economy of changing the combination of resources to produce more of one
product and less of another. If a decision is taken to produce more of one product, this will
lead to less of the other product being produced.
12
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Position A is inside the production possibility curve. Good X and good Y can be produced,
but the total production is less than could be achieved at a position on the production
possibility curve. This is because at any point inside the curve, not all economic resources
are being fully utilised, i.e. there is some degree of unemployment of the resources which
could have been used in the process of production.
Position B is outside the production possibility curve and indicates that such a combination
of production of good X and good Y is not, at present, possible given the available
resources in the economy at the time.
Specialisation and trade
13 Specialisation refers to a situation where individuals, firms or whole economies tend to
concentrate on the production of those goods and services in which they have an
advantage. For example, the Scottish economist, Adam Smith, emphasised the
importance of the division of labour where the production process could be broken up into
a number of specific tasks and particular individuals would then concentrate on carrying
out those specific tasks. The example that he used was a pin factory.
14 The term ‘division of labour’ refers to the ways in which people specialise or concentrate in
particular types of job or in particular tasks in the production process. For example, an
assembly line in a car factory involves a sequence of particular tasks that are continually
repeated. This splitting up of the production process into distinct tasks speeds up the
process so that more can be produced at a lower cost. There is greater productivity, but a
disadvantage of division of labour is that it makes work more boring than it would
otherwise be, leading to lower levels of motivation among the workforce.
15 Adam Smith’s original analysis of the potential impact of specialisation on the process of
production was in relation to the production of pins, but the principle can be applied to any
production process where a number of separate tasks can be identified.
This is the case in the production of motor cars. The task of producing a motor car can be
broken down into a number of separate tasks, such as in relation to the engine, the
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Scarcity and choice
gearbox, the lights, the sound system, the tyres and many others. If all of these tasks were
performed by one person, production would be very slow.
However, if these tasks can be broken down and carried out by individuals, or teams of
individuals, workers will be able to concentrate on particular aspects of the work and will
become extremely efficient in the carrying out of such tasks. The subdivision of the work
also enables specialised machinery and equipment to be used at specific stages in the
production process. For example, at the BMW plant in Cowley, Oxford, a great deal of use
has been made of robotic welders.
16 Specialisation refers to the process of concentration on the production of those goods and
services where there is a distinct advantage of such concentration. This specialisation can
apply to individuals, firms, regions and national economies. The advantage of such
specialisation is that a greater output can be produced from a given quantity of resources.
However, specialisation also means that individuals, firms and economies cannot produce
everything that they need. If they concentrate on areas of production in which they have
an advantage, they will need to trade these products with the products produced by other
individuals, firms and economies. As a result of this, exchange is encouraged.
17 Specialisation has encouraged trade and exchange in economies, but this trade and
exchange requires an accepted way of conducting transactions.
In the past, barter systems were used to enable such trade and exchange to take place.
This is where one good or service was directly exchanged for another. The problem with
this system, however, is that it relied on a double coincidence of wants, i.e. two people
need to want what the other person is exchanging. Even if this were to exist, they would
still need to agree on an acceptable exchange rate.
As a result of these drawbacks of barter systems, it was realised that the expansion of
trade and exchange would be limited as it was difficult to organise the transactions.
Money, therefore, emerged in preference to barter because it was a generally acceptable
means of arranging transactions. The development of money has therefore facilitated the
expansion of trade and exchange, not only within countries but between them.
Exam-style questions
18
a Student answer:
15,000 divided by 20,000 is a percentage fall of 75% in the number of workers
employed in the factory between 1960 and 2015.
This is the correct answer.
b Student answer:
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Labour-intensive production refers to a situation where labour is more important
than capital in the production process. Capital-intensive production refers to a
situation where capital is more important than labour in the production process.
The explanations of the meaning of both labour-intensive and capital-intensive production are
rather vague. It would have been better if the student had referred specifically to the
labour:output ratio and the capital:output ratio.
c Student answer:
An advantage for individuals is that there will be more capital, i.e. more tools and
equipment, to be used in the process of production and this should benefit the
individual in terms of a greater level of productivity. If wages are linked to
productivity levels, this will benefit the individual in terms of the remuneration
gained from the employment.
It is appropriate to make the link with productivity, but the student does not actually define
precisely what is meant by productivity in terms of the output per worker per period of time. The
link with remuneration is valid, but this might have been developed more fully, e.g. by
suggesting whether such a wage rise might be a real increase in wages in relation to the level of
inflation in an economy.
An advantage for organisations is that once the capital equipment is installed and
paid for, it should lead to an increase in profit resulting from the greater level of
production. Also, capital equipment can be used 24/7 so it will contribute to more
output than labour.
This section might have been developed more fully. For instance, it assumes that it will be
relatively easy to pay for the capital, but the purchase of the equipment could represent a major
financial burden for a firm. The reference to the contrast of capital with labour might also have
gone further, such as in terms of the capital not being restricted by days off for sickness or
industrial disputes.
An advantage for societies is that many of the very boring and monotonous tasks
involved in the production process can now be carried out by machines rather than
labour and this will reduce the level of disenchantment and alienation experienced
by workers.
This is a valid point to have made.
On the other hand, however, there are potential disadvantages for all three. A move
towards capital-intensive production is likely to lead to a lowering of demand for
labour. This could have a negative effect on wage negotiations and could also lead
to a situation where some of the labour is no longer needed and people are made
redundant.
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The link with wages paid to labour is a good point to have made, but it could have been
developed more fully, such as in relation to demand and supply factors in the determination of
wages. The reference to some workers being made redundant might have been linked with this
particular type of unemployment, i.e. technological unemployment.
A potential disadvantage for the organisation is the cost of purchasing the capital
equipment. The money needed to pay for it may have to be borrowed. Also, if the
machinery is going to be used 24/7, this is likely to lead to it breaking down more
often.
This section could also have been developed more fully. For example, there is a reference to the
possible need to borrow money to pay for the capital equipment, but the student could have
linked this with the rate of interest to be paid on any funds borrowed from a financial institution.
There could also have been a reference to the difficulties of raising finance since the credit
crunch of 2007–08. In terms of the reference to the machinery breaking down more often, this
could have been linked to the costs of maintenance and repair and indeed to the issue of
depreciation over a period of time.
A potential disadvantage for societies could be the negative effects of a rise in the
level of unemployment. If some workers are no longer needed, they may lose their
sense of self-worth and this could lead to problems in the family and possibly an
increase in the level of crime.
The student could also have made the point that such problems might be localised in particular
areas of the country.
In conclusion, although there are a number of potential advantages of the move
from labour-intensive to capital-intensive production for all three, there are also
potential problems for all of them.
It is always good to end with a conclusion, but in this case it is rather superficial. There might
have been an attempt to balance the various advantages and disadvantages of such a change,
coming to a judgement as to whether overall such a change would be advantageous or not to the
three categories.
19 Student answer:
A market economy has both strengths and weaknesses.
This is a very brief introduction. It would have been useful to have given a definition of a market
economy, stressing the importance of prices acting as a signalling device.
The advantage of the market economy is that decisions about the allocation of
scarce resources are taken in response to market forces. Decisions are taken by
consumers which producers are expected to respond to, and so consumer
sovereignty is an important strength of such an economy.
This is a rather limited and superficial paragraph. For example, although there is a general
reference to market forces, there is no reference at all to the existence of the price mechanism in
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a market economy. Prices will act as a signal and changes in prices will lead to a reallocation of
scarce resources. This is what Adam Smith meant when he referred to prices acting as an
‘invisible hand’ in a market economy.
Competition will exist between firms to satisfy consumers, unless there is a
monopoly, and this is likely to encourage efficiency.
This section is also rather brief. There are varying degrees of competition in a market economy,
including not only monopoly, but also oligopoly. There is a brief reference to efficiency, but this
could have been developed much more fully, such as in relation to productive and allocative
efficiency.
A market economy, however, may also have certain weaknesses. As has already
been indicated, there may not always be competition and powerful monopolies
may exist which act against the public interest. There are also likely to be many
examples of market failure, such as the over-production and over-consumption of
demerit goods, the under-production and under-consumption of merit goods and
the failure to provide public goods.
The answer is well balanced in terms of a consideration of both the strengths and weaknesses of
a market economy, but this section could have been developed more fully. For example, there is
a recognition that monopolies may act against the public interest, but it is possible that they act
in the interests of the public, such as when a natural monopoly avoids an unnecessary
duplication of resources. There are passing references to merit goods, demerit goods and public
goods, but none of these are explained.
It can therefore be seen that market economies have both strengths and weaknesses
and this is why most economies today are mixed economies, i.e. they combine the
strengths of the market economy with a certain degree of government intervention.
This is a conclusion, but it does not go very far. It would have been useful if there had been more
of an attempt to evaluate, and not simply describe, the strengths and weaknesses of the market
economy. It is absolutely crucial that answers to a question do exactly what is required by it, as
indicated by the command or directive word used.
20
a Student answer:
Opportunity cost refers to the next best alternative that is foregone as a result of
taking a decision to produce or consume something else. It is the highest-valued
alternative that needs to be foregone, or given up, as a direct result of a choice
being made.
This is a very clear definition of the term.
b Student answer:
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A decision whether to go to university or get a job at the age of 18 or 19 is a
difficult one and it relates to the concept of opportunity cost. This concept comes
about as a result of the fact that a choice will have to be made.
It is useful to start with a clear reference to the concept of opportunity cost, but the reference to
this concept coming about ‘as a result of the fact that a choice will have to be made’ is rather
vague. It would have been better to have provided a clear and explicit definition of opportunity
cost in terms of the next best alternative that is foregone as a result of making a choice and
taking a decision.
There are many arguments in favour of going to university. One of these is in
terms of ‘becoming an adult’ and having to look after yourself more so than in the
past. However, going to university is not the only way to gain such experience. The
satisfaction of having studied a course in which a person is interested in is also a
very significant reason for studying at university. However, probably the main
reason in most cases is that a university degree ‘opens doors’ to people that might
otherwise have remained closed, leading to a significant increase in potential
earnings over a working lifetime.
This is a useful section and stresses the significance of the ‘time dimension’ in terms of
evaluating the consequences of taking a decision, i.e. a degree is likely to lead to higher
earnings over a working lifetime which could be about 40 years in length.
However, despite the potential advantages already indicated, there could be certain
reasons against going to university. There have always been financial implications
of going to university, but in the UK the financial burden has become greater in
recent years with the introduction of tuition fees of up to £9,000 for each of
(usually) 3 years. The average student now leaves university with debts of over
£15,000.
This section is useful in stressing the financial implications of going to university. Again, there
is an implicit consideration of the ‘time dimension’ here, contrasting the cost of 3 years at
university with the likely financial benefits over the next 40 years.
The opportunity cost of being at university for 3 years is the income that could
have been gained as a result of choosing employment rather than going to
university. Admittedly, the income may not have been that high, and would have
been lower than what a graduate could expect to earn once graduating from
university, but it would have been an income all the same.
The student might also have made the point that during these 3 years, the young worker would
have been able to make a start climbing the ‘career ladder’. It might have also been useful to
have made reference to some people who have been successful despite not going to university,
such as Sir Richard Branson.
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In conclusion, it is therefore difficult to be clear about whether a decision to go to
university is the correct one to take. It will depend on the personal circumstances
of people. However, it does illustrate very clearly the concept of opportunity cost
and the need to take into account the potential benefit that might be foregone as a
result of taking a choice.
This is a useful conclusion that does make a link to both personal circumstances and to the
concept of opportunity cost.
21 Student answer:
A production possibility curve shows the combination of two products that can be
produced in an economy as a result of combining the available economic
resources.
This is a good introduction which clearly states what is meant by a production possibility curve.
If there were more resources, this would enable the production possibility curve to
shift to the right and this would lead to more needs and wants being satisfied. The
production possibility curve, however, only shows what can be produced at a given
moment in time using the available resources, so in terms of not being able to shift
to the right, it does show the condition of scarcity to a large extent.
This paragraph makes it clear that at any one moment in time, it is not possible to shift the
production possibility curve to the right, so it does indicate the situation of scarcity.
It is possible to move along a production possibility curve by shifting resources
away from the production of one good and towards the production of another. In
this sense, it does show the existence of choice to a large extent as it is possible to
be at any position along a production possibility curve.
This could have been clearer. For example, there could have been a contrast between more
manufacturing production and more agricultural production. It would also have been useful to
have included a diagram of a production possibility curve, showing a movement from one point
on the curve to another.
However, if a decision is made to move along the curve, from one position to
another, this will lead to the production of more of one good and less of another.
This illustrates the implications of making a choice, producing more of one good
and less of another. Such a situation focuses on the next best alternative that is
foregone as a result of a movement along a production possibility curve, so the
concept of opportunity cost is being shown to a large extent. The only way that this
would not occur is if the production possibility curve shifted to the right, making it
possible to produce more of both goods.
This is a useful section, focusing on the link with the concept of opportunity cost.
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A production possibility curve can also be used to show the existence of productive
efficiency in an economy. At any point along a production possibility curve, there
will be productive efficiency because it will show that all resources are being
utilised as fully as possible. This is in contrast to a situation within the production
possibility curve where there will be some spare productive capacity.
This is a useful contrast between a position inside a curve and a position on the curve, in
relation to productive efficiency. Again, a diagram could have been included to illustrate this
point.
22 Student answer:
Specialisation and the division of labour are both very important in addressing the
problem of scarcity in an economy.
This introduction does not really say very much. It would have been better if the problem of
scarcity in an economy had been explained, i.e. the idea that the wants and needs of people are
always greater than the economic resources available to satisfy these needs and wants.
Specialisation refers to a situation where individuals, firms, regions and economies
concentrate on producing those products in which they have an advantage. The
advantage of specialisation is that a greater output can be produced from a given
quantity of inputs. This does not solve the problem of scarcity, but it does have the
advantage of making production more efficient than would otherwise be the case.
The scarce resources are therefore being put to a better use.
It is useful to refer to the fact that the concept of specialisation can be used in a number of
different contexts, including individuals, firms, regions and whole economies. The explanation of
specialisation in terms of the balance between inputs and output is good. There is a recognition
that although the problem of scarcity will not be solved by specialisation, the inputs will be used
in a more efficient and productive way.
Division of labour refers to a situation where the process of production can be
broken up into a sequence of different tasks. Adam Smith described this in The
Wealth of Nations in terms of the production of pins. Production would be much
greater if the process was divided into different parts and workers concentrated on
these particular parts. An assembly line in a car factory is a good example of this.
Instead of each person working on all aspects of the assembly line, they would
concentrate on working in particular areas, so that they became very efficient.
This part of the answer demonstrates a sound knowledge and understanding of the idea of the
division of labour, especially in relation to a greater level of production. There is both a
traditional example, i.e. pin making, and a more recent example, i.e. car production, to support
the answer.
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The problem of scarcity will never disappear, but specialisation and the division of
labour will mean that scarce resources are used as effectively and productively as
possible.
This is a useful conclusion which recognises that although the problem of scarcity will never
disappear, specialisation and division of labour will lead to a more efficient and productive use
of the scarce resources in an economy.
23 C
24 B
25 B
26 A
27 A
28 D
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Topic 2
How competitive markets work
Topic 2 How competitive markets
work
Allocation of resources
1 A competitive market refers to a situation where there are a number of firms in an industry
competing against each other. There can be varying degrees of competition in different
markets. For example, in perfect competition, it is assumed that there is a large number of
firms competing against each other. This number would be less in a market characterised
by monopolistic competition. In oligopoly, there would only be competition among a few
firms, while in monopoly there is only one firm in the industry, although from a legal point
of view there could be four firms competing against one another (as in the UK a monopoly
is defined as a firm with at least a 25% share of a market).
2 The term ‘optimum’ refers to the best possible outcome in a given situation. In terms of the
best allocation of scarce resources, i.e. the factors of production of land, labour, capital
and enterprise, this would be where the price of a product is equal to the marginal cost of
producing the product. In this situation, allocative efficiency exists.
3 The behaviour of economic agents will be affected by different incentives and this will have
an effect on resource allocation in an economy. There may be financial incentives and
other kinds of rewards which can influence the decisions of firms and individuals.
The behaviour of consumers will be affected by the desire to maximise their utility or
satisfaction from the consumption of products, but this assumes that these decisions will
be influenced by rational behaviour. Behavioural approaches to how consumers take
decisions suggest that this process is not always as rational as had been supposed. An
incentive, such as a subsidy, which lowers the price of something, might encourage
consumption patterns, assuming that the price elasticity of demand is elastic.
The behaviour of workers could also be influenced by incentives. For example, some
workers might be persuaded to move from one job to another by the existence of pay
differentials. It must be remembered, however, that remuneration is only one of a number
of factors that can influence employment decisions.
The behaviour of firms will also be affected by incentives. It is generally assumed that the
main aim of the firms is the maximisation of profits and profits can certainly act as powerful
incentives. However, it must also be recognised that not all firms seek to maximise their
profits. For example, some will have other goals such as satisficing or sales revenue
maximisation.
It is therefore the case that incentives can be effective in influencing the behaviour of
economic agents, and therefore the allocation of resources in an economy, but their effect
will sometimes be limited by other considerations.
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Topic 2
How competitive markets work
The objectives of economic agents
4 Governments’ microeconomic objectives can include the encouragement of the
consumption of merit goods, the discouragement of the consumption of demerit goods and
the provision of public goods.
Firms’ objectives can include profit maximisation, satisficing, sales revenue maximisation
and growth maximisation. Many firms will also have objectives in relation to ethical
behaviour and corporate social responsibility.
Consumers are assumed to have the objective of the maximisation of utility or satisfaction.
This can be seen in relation to the satisfaction of needs, wants and aspirations.
Supply and demand and the interaction
of markets
5
A demand curve shows the relationship between the quantity demanded and the price
charged for a product. This is sometimes described as the functional relationship between
the change in price of a product and a change in the quantity demanded.
It is usually downward-sloping because as the price of a product falls, people tend to buy a
larger quantity. On the other hand, as the price of a product rises, people tend to buy a
smaller quantity.
6 The term ‘ceteris paribus’ is a Latin phrase which means ‘other things being equal’. It is
very useful in economic theory because it allows certain aspects to remain unchanged and
constant. For example, the demand for a product is determined by a number of different
factors, but if economists want to isolate the influence of price on the demand for a
product, ‘ceteris paribus’ can be used to indicate that all other possible influences on the
demand for a product can be ignored.
7 The term ‘consumer surplus’ refers to the fact that individual consumers would be willing to
pay particular prices for a product but, instead, the equilibrium price in a market is
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Topic 2
How competitive markets work
determined by the market demand, i.e. by all of the consumers. This means that some
individual consumers would pay less than they would otherwise have been willing to pay.
This consumption at a lower price creates a consumer surplus.
8
The shaded area between the horizontal price line and the demand curve is known as the
consumer surplus because individual consumers would have been willing to pay more
than this price. The diagram shows the equilibrium price and the equilibrium quantity. All
those consumers who would have been willing to pay more were not required to do so.
9 If there is an increase in the price of a product, the size of the consumer surplus will be
reduced. If there is a decrease in the price of a product, the size of the consumer surplus
will be increased.
10
A supply curve shows the relationship between changes in the price of a product and
changes in the supply of that product. As can be seen in the diagram, the supply curve is
usually upward-sloping because a higher price is likely to give a producer more of an
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incentive to produce more. The supply curve is actually the marginal cost of production
and so if the cost of producing one more product goes up, the firm will also want the price
to go up.
11 Different producers would be willing to accept various prices for a product before deciding
to sell it, but the equilibrium price in a market is a reflection of market demand and market
supply. The extra money received by the firms, above what they would have been
otherwise willing to accept is known as the producer surplus.
12
In the diagram, the producer surplus is shown by the shaded area between the horizontal
price line and the supply curve. Individual producers would have been willing to accept a
lower price, but the equilibrium price is determined by the intersection of market demand
and market supply. Producer surplus, therefore, is the additional amount received by
producers who would have been willing to supply a product at a lower price.
Elasticity
13 Elasticity refers to the degree of responsiveness, or the level of sensitivity, to a change in
a variable, such as the price of a good, the price of another good or income.
14 The price elasticity of demand for a product is calculated by the percentage change in the
quantity demanded divided by the percentage change in its price. In this case, this is
100% divided by 50% = 2.
15 Price elasticity of demand (PED) refers to the responsiveness of the quantity demanded of
a product to a change in its price. It is calculated by dividing the percentage change in the
demand of a product by the percentage change in its price. Its value can range from 0 to
infinity. If the value of PED is 0, then the PED is perfectly inelastic. If the value of PED is
between 0 and 1, then the PED is inelastic. If the value of PED is equal to 1, then the PED
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is unitary elastic. If the value of PED is between 1 and infinity, then the PED is elastic. If
the value of PED is infinity, then the PED is perfectly elastic.
The concept of price elasticity of demand is extremely relevant to a business in terms of
helping the business to increase its total revenue.
If the price elasticity of demand for a product is elastic, this means that the demand is very
responsive to a change in the price of the product. In this situation, it would be better for
the business to lower the price of the product. Although this means that less revenue will
be coming in for each item sold, this will be offset by the increase in the number of units
sold.
If the price elasticity of demand for a product is inelastic, this means that the demand is
not very responsive to a change in the price of the product. In this situation, it would be
better for the business to increase the price of the product. Although this will lead to fewer
units being sold, this will be offset by the increase in the price of each unit sold.
16 The price elasticity of demand for a product can have a significant effect on the impact of
an indirect tax and of a subsidy on a product.
In terms of an indirect tax, if the price elasticity of demand for a product is very elastic, the
effect of an indirect tax will be much more significant on the decrease in quantity than on
the increase in price. If the price elasticity of demand for a product is very inelastic, the
effect of an indirect tax will be much more significant on the increase in price rather than
on the reduction in quantity.
Price elasticity of demand will also have an effect on the impact of a subsidy. If the price
elasticity of demand for a product is very elastic, the effect of a subsidy will be much more
significant on the increase in quantity rather than on the reduction in price. If the price
elasticity of demand for a product is very inelastic, the effect of a subsidy will be much
more significant on the reduction in price rather than on the increase in quantity.
17 The income elasticity of demand for a product is calculated by dividing the percentage
change in the quantity demanded divided by the percentage change in income. In this
case, this is 25% divided by 5% = 5.
18 Income elasticity of demand refers to the relative change in the demand for a product in
relation to a change in income. It is calculated by dividing the percentage change in the
quantity demanded of a product by the percentage change in income.
In most cases, the income elasticity of demand for a product will be positive, i.e. as
incomes rise, so does the demand for goods and services. These are known as normal
goods.
However, in some cases, the income elasticity of demand for a product will be negative,
i.e. as incomes rise, there will be a fall in the demand for certain goods and services.
These are known as inferior goods. Examples could include bicycles if people are better
able to afford motor cars.
19 Cross elasticity of demand refers to the relationship between the demand for one product
and the change in price of another product. It is calculated by dividing the percentage
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change in the quantity demanded of product A by the percentage change in the price of
product B.
The relationship can be positive or negative, depending on whether the two goods are
substitutes or complements.
If the two goods are substitutes, say tea and coffee, then the cross elasticity of demand
will be positive.
If the two goods are complements, say DVDs and DVD players, then the cross elasticity of
demand will be negative.
20 The concept of cross elasticity of demand could be of great relevance to a business. For
example, if a firm produces tea and there is a substantial increase in the price of coffee,
the cross elasticity of demand will be positive. The tea producer will expect there to be a
decrease in the demand for coffee as a result of the increase in the price of that product.
The extent of the decrease in demand for coffee as a result of the price increase will
depend on the price elasticity of demand for the product. If tea is seen as an effective
substitute for coffee, then the price elasticity of demand for coffee is likely to be quite
elastic. The tea producer, therefore, can plan to produce more tea in the expectation that
demand for the product will increase, leading to an increase in revenue and profit.
If two products are complements, and are consumed together, the situation is different.
Petrol (or diesel) and motor cars are complements, i.e. if you have a car, you will need
either petrol or diesel to put in it. If there is a substantial increase in the price of petrol or
diesel, this is likely to reduce the demand for the fuel and this could consequently lead to a
decrease in the demand for motor cars. The extent of the response to the rise in the price
of fuel will depend on the price elasticity of demand for it. A producer of motor cars may
decide, therefore, to plan for less production. Alternatively, it may anticipate a move away
from cars which consume a lot of fuel towards more fuel-efficient cars, and it will plan,
therefore, to alter production plans to produce more fuel-efficient cars. This will especially
be the case if the rise in the price of fuel is expected to be long term.
21 Elasticity of supply refers to the degree of responsiveness of a change in the supply of a
product to the change in the price of the product. The value of elasticity of supply can vary
from zero, when it is perfectly inelastic, to infinity, when it is perfectly elastic. If it is
perfectly inelastic, the supply curve will be vertical. If it is perfectly elastic, the supply curve
will be horizontal.
The value of elasticity of supply will vary over a period of time. In the short run, when at
least one factor of production is fixed, supply will be relatively inelastic. However, in the
long run, when all factors of production are variable, it becomes easier to change supply
and so the elasticity of supply becomes more elastic in the long run.
Productive and allocative efficiency
22 Productive efficiency refers to a situation in an economy when the costs of production
have been minimised. It is achieved when average total cost is at the minimum point. The
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achievement of productive efficiency involves the use of the lowest cost resource inputs in
the most effective way, i.e. production is at the lowest possible cost per unit.
23 Allocative efficiency refers to a situation in an economy when the scarce resources are
allocated in such a way that the resources are valued equally by both the producers and
the consumers. This occurs when the marginal cost of production is equal to the price of
the product produced.
Costs and revenue
24 Average cost refers to the total cost of production divided by the number of units of output
produced by a firm. It is also known as unit cost.
Marginal cost refers to the additional cost of producing just one more unit of output. It is
calculated by dividing the change in the total cost of production by the change in output.
Economies and diseconomies of scale
25 This term refers to the possibility of a firm being able to produce at a lower average cost
as a result of growing in size.
26 Internal economies of scale refer to a situation where production is at a lower average cost
than before as a result of a firm growing in size. However, beyond the point of minimum
average cost, the average total cost curve will begin to rise, indicating that as the output of
a firm continues to increase beyond this point, there will be internal diseconomies of scale.
External economies of scale refer to a situation where the average total cost falls not as a
result of any decision taken by a particular firm, but as a result of activity in the whole
industry. External diseconomies of scale refer to increases in average cost that affect all
firms in an industry.
27 Internal economies of scale can be caused by a number of different influences.
Purchasing or bulk-buying economies result from the ability of a firm to negotiate a
discount on prices. Managerial and administration economies can result from greater
efficiency; for example, if a firm doubles in size, it will probably not need to double the
number of managers that it has or the number of office staff.
Perhaps the most important internal economy of scale comes about as a result of
technical economies of scale. In many firms, there will be different examples of such
economies, such as economies of specialisation, economies of indivisibilities, economies
of increased dimensions and economies of linked processes.
Other possible internal economies of scale that can help to reduce the average cost of
production include financial economies, risk-bearing economies and marketing economies.
As well as the existence of internal economies of scale, it is also possible that a firm might
experience increasing average costs of production as it grows larger — these are known
as internal diseconomies of scale. In this situation, the average cost per unit of output rises
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as the firm increases its output. These are usually examples of management
diseconomies, such as those arising from poor communication and low levels of morale in
a firm as it grows larger. A lack of flexibility can also be an internal diseconomy of scale as
a larger firm may not be as effective at responding to changes in market conditions.
External economies of scale can affect all firms in an industry. Sometimes these will come
about because of the existence of a number of firms producing the same product in a
particular geographical area. These can be regarded as economies of concentration.
Examples could include the availability of a pool of specialised skilled labour in a particular
region, the existence of a number of suppliers with specialist knowledge in the region and
the existence of colleges which provide courses relating to dominant industries in the area.
Not all external economies are examples of economies of concentration in a particular
region. For example, there may be a research or marketing body which operates at the
national, rather than the regional, level.
A key distinction between internal and external economies of scale is that when there are
internal economies of scale, there will be a movement down the average total cost curve,
whereas when there are external economies of scale, the whole average total cost curve
shifts downwards.
External diseconomies of scale exist where all firms in an industry are negatively affected,
causing average total costs to increase. For example, if firms in an industry are
concentrated in a particular region, this may create problems of congestion. This may slow
down the transport and distribution provision, making it less efficient and therefore less
cost effective. There is also the possibility that if there is a good supply of skilled labour in
a particular area, this may drive up wage rates, making labour more expensive for firms in
the area to employ.
Exam-style questions
28 Student answer:
A market is often regarded as the best way to allocate scarce resources. A market
provides for both producers and consumers to exercise choice: producers can
decide on the combination of factors of production to be used in the production of
a product and consumers can express a preference to buy or not buy the product at
the market price.
The student has demonstrated an understanding of the way in which a market brings together
producers and consumers and has emphasised the importance of the expression of choice. The
answer could have been developed more fully, however, such as in relation to the identification
of the four factors of production, i.e. land, labour, capital and enterprise.
It is important to use a market to allocate scarce resources because of the very
existence of the condition of scarcity, given that there are infinite wants and finite
resources.
It is good that the student has emphasised the importance of the concept of scarcity, but there
might have been a better attempt to link this to the fundamental economic problem.
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The demand curve will indicate what the consumers are willing to buy at a
particular price and the supply curve will indicate what the producers are willing to
sell at a particular price. The intersection of the demand and supply curves will
lead to an equilibrium price and an equilibrium quantity in the market.
The student has stressed the importance of demand and supply coming together to produce an
equilibrium price and an equilibrium quantity in a market, but it would have been helpful if the
student had included a diagram to illustrate how market equilibrium is determined by the
intersection of the demand and supply curves.
A market, however, will not always produce the ‘best’ way to allocate scarce
resources. For example, a government may have given a subsidy to help the
producer to reduce the costs of production and so the price charged might be lower
than it would otherwise be. There is also the possibility that production has brought
about a negative externality in the form of pollution, but the cost of this will not
have been taken into account by the producer.
The student recognises that there are elements of market failure, such as in relation to the
provision of a subsidy or the existence of pollution, but there are other aspects of market failure
that might also have been considered. For example, a market is likely to lead to an overproduction and over-consumption of demerit goods, such as alcohol and tobacco, and to an
under-production and under-consumption of merit goods, such as education and healthcare.
Also, a market will not be able to provide public goods where it would be virtually impossible to
charge a price.
In conclusion, a market is a very efficient way to allocate scarce resources, but it is
not necessarily the best way. There are a number of other factors that need to be
taken into account when deciding how to allocate scarce resources.
The student attempts to provide a conclusion, always very important in a ‘discuss’ question, but
it is rather limited and superficial. It could have been developed more fully by, for example,
summarising some of the other factors that might need to be taken into account.
29 Student answer:
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A movement along a demand curve is caused by a change in the price of a product,
with all other possible influences on demand held constant. If there is a movement
down the demand curve, this is known as an extension of demand. If there is a
movement up the demand curve, this is known as a contraction of demand.
It is useful that the student has referred to the fact that if there is a movement along a demand
curve, showing the influence of changes in the price of the product, all other influences on
demand are assumed to be held constant, but it would have been helpful if the student had
pointed out that this is known as the ‘ceteris paribus’ assumption.
If, however, the other possible influences on the demand for a product can now be
taken into account, such as changes in income or changes in the prices of other
products, these changes can lead to an increase in the demand for a product. In this
case, the demand curve shifts to the right. If these changes lead to a decrease in the
demand for a product, however, the demand curve shifts to the left.
The student clearly understands the difference between the influence of the price of a product
on demand and the other possible influences, recognising the difference between a movement
along a demand curve and a complete shift of the curve, either to the left or to the right.
Although a diagram is included, the student could have made more of an effort to integrate the
diagram into the analysis to support the points being made.
30 Student answer:
A supply curve could shift to the right as a result of changes that are favourable to
the supply of a product. For example, a reduction in the costs of production, such
as raw materials or component parts, would lower the cost of production and this
would be likely to cause an increase in the level of production. A development in
technology might also encourage firms to produce more. The provision of a
subsidy by a government would also have the effect of lowering the costs of
production, causing the supply curve to shift to the right.
The student correctly recognises that a lowering of the costs of production would be favourable
to the supply of a product, causing the supply curve to shift to the right. There is a reference to
the possible influence of a development in technology, but it would have been helpful to have
included an example of such a development to support the point being made. One possible
example would be the use of robotic welders in car factories. The student correctly recognises
the importance of the provision of a subsidy, but examples of such situations might have been
given, such as essential foodstuffs. The student might also have referred to factors relevant to
agricultural production, such as favourable weather conditions.
On the other hand, a leftward shift of a supply curve would come about as a result
of changes that are not favourable to the supply of a product. For example, the
imposition of an indirect tax would cause supply to shift to the left. In the
production of agricultural products, adverse weather conditions would be likely to
shift the supply curve to the left.
The student recognises that the imposition of an indirect tax would cause supply to shift to the
left, but the student could have included appropriate examples of products to suggest where and
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when an indirect tax might be imposed, such as in relation to demerit goods, e.g. alcohol and
tobacco. There was no reference to agricultural production in terms of a rightward shift of a
supply curve, but it is brought in here in relation to a leftward shift of the supply curve.
31 Student answer:
The equilibrium in any market, such as the housing market, is determined by the
forces of demand and supply. Any changes in the demand and/or supply conditions
could bring about a change in the equilibrium.
This is a useful first paragraph that sets the scene, although there could have been more of an
attempt to integrate the diagram into the answer.
a
A reduction in unemployment will mean that more people are working and earning
incomes, so demand for housing is likely to rise as more people will be able to
afford the mortgage payments on a property. This would be shown by a shift of the
demand curve to the right.
b
Similarly, an increase in real wages means that wages rose by more than the rate of
inflation. A real wage is an indication of the purchasing power of a nominal sum of
money, i.e. after the effects of inflation have been taken into account. This would
also have the effect of shifting the demand curve to the right.
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The student clearly recognises that both of these changes would cause the demand curve to
shift to the right, but again the changes shown in the diagram could have been brought into the
answer.
Whereas the first two parts of the question were concerned with changes in
demand factors, the last two parts are concerned with supply factors.
c
A reduction in the number of building firms would cause the supply curve to shift
to the left. If the number of building firms is reduced, this will make it likely that
fewer houses would be produced.
d
Similarly, adverse weather conditions over a prolonged period of time would make
it more difficult to build houses, so again the supply curve would shift to the left.
The diagram shows that in this situation, the two shifts would cause an increase in
the equilibrium price in the housing market. The effect on the equilibrium quantity
is less certain and would depend on which of the two shifts was more powerful.
Again, there is clear recognition by the student that the last two bullet points, in contrast with
the first two, are related to the supply side and would cause the supply curve to shift to the left.
The explanation of the effect on price is clear, but more could have been written on the effect on
the equilibrium quantity in the market. Again, there could have been more of an attempt to link
the answer to what was shown in the diagram.
32 Student answer:
Income elasticity of demand refers to the responsiveness of the quantity demanded
of a product to a change in the level of incomes. It is calculated by dividing the
percentage change in the quantity demanded of a product by the percentage change
in income. In most cases, it is positive and this is the situation with normal goods.
In some cases, however, it is negative and this is the situation with inferior goods.
The first paragraph is clear in defining what is meant by the concept of income elasticity of
demand and in explaining the distinction between normal and inferior goods.
If an economy is facing a rise in unemployment, and assuming that the benefits
paid to people who become unemployed are less than the income previously
received by the workers, then there will be a fall in the general level of people’s
incomes. The extent of this fall in an economy will depend on the number of
people who become unemployed and the difference between what they were
previously receiving and what they are now receiving while unemployed.
It would have been useful if the student had referred to net income in stressing the extent of the
difference in income. The student does appreciate, however, that in order to measure the
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difference in income, it will be necessary to take into account the value of the transfer payments
paid to those people who have become unemployed.
If this was the case, then a business could expect to experience a fall in the demand
of some normal goods and an increase in the demand of some inferior goods.
Different businesses could react to this in different ways. For example, a
supermarket might decide to sell fewer luxury ‘top-of-the-range’ products and
more cheaper and basic items, such as ‘own-brand’ products. Similarly, an
electrical store might decide to sell more basic models of televisions rather than the
more expensive models or it might decide to increase the number of models that
can be rented rather than purchased.
This is useful in supporting the analysis. It always helps to include examples to support the
points being made. These would seem to be appropriate examples to use, especially the ‘ownbrand’ basic foods.
It can be seen, therefore, that a business could use the concept of income elasticity
of demand to good effect in an economy which is facing a rise in unemployment.
The student attempts to offer a conclusion as a way of bringing the analysis to an end, but it
would have been clearer if there had been an explicit reference to inferior goods.
33 Student answer:
Price elasticity of demand is potentially of great relevance to a business. It gives an
indication of the link between changes in the price of a good and changes in
demand. If a business owner knows whether the demand for a good is price elastic
or price inelastic, it will inform a decision as to whether to increase or decrease
price in order to raise revenue.
The student demonstrates that they understand the link between a change in the price of a good
and the change in demand, but the link could have been defined more clearly, i.e. price elasticity
of demand is the percentage change in the quantity demanded of a product divided by the
percentage change in the price of the product. The link between change in price and change in
revenue is made, but the student needed to go much further on this, e.g. by pointing out that if
the demand for a good is price elastic, its price should be reduced to increase revenue, but if the
demand for a good is price inelastic, its price should be increased to raise revenue. Appropriate
diagrams could have been included to illustrate this.
Although the price elasticity of demand for a product is very important to a
business, the other two types of elasticity are also potentially important. The
income elasticity of demand shows the link between the demand for a product and
changes in income. Knowledge of changes in income in an economy can help a
producer decide which products to sell.
Again, the student demonstrates knowledge and understanding of the link between changes in
income and changes in demand for a product, but it would have been helpful if the concept had
been defined more clearly, i.e. it is the percentage change in the quantity demanded of a product
divided by the percentage change in income. The student should also have made clear the
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distinction between the demand for normal and for inferior goods. If it is a normal good, the
income elasticity of demand is positive, i.e. when there is an increase in income, there is an
increase in the demand for a normal good. If it is an inferior good, the income elasticity of
demand is negative, i.e. when there is an increase in income, there is a decrease in the demand
for an inferior good. The last sentence also needs to be developed more fully, e.g. if incomes are
generally rising in an economy, a producer should plan to produce more normal goods and
fewer inferior goods, whereas if incomes are generally falling in an economy, a producer should
plan to produce fewer normal goods and more inferior goods.
Cross elasticity of demand is also potentially of great relevance to a business. This
shows the link between changes in the demand for one good and changes in the
price of another good. These goods can either be substitutes or complements. A
business would be keen to know about changes in the prices of other products and
how such changes would affect the demand for the firm’s own products.
The student clearly understands that cross elasticity of demand is concerned with the link
between the change in demand for one product and the change in the price of another product. It
could have been more clearly defined in terms of the percentage change in the demand of good
A divided by the percentage change in the price of good B. The student appreciates that goods
can be either substitutes or complements, but this needed to be discussed more fully, e.g. by
pointing out that the cross elasticity of demand for substitutes will be positive whereas the cross
elasticity of demand for complements will be negative. The last sentence is rather superficial —
it would have been helpful if the student had used examples of substitutes and complements to
support the point being made. For example, a coffee producer will plan to produce more coffee if
the price of tea rises significantly, because some consumers will switch from the consumption
of tea to the consumption of coffee as a result of the substantial rise in the price of tea — coffee
and tea being substitutes. On the other hand, a producer of DVD players will plan to produce
more of these if the price of DVDs falls significantly, because consumers will be likely to
increase the demand for DVDs as a result of the fall in their price and so the demand for DVD
players will increase — DVDs and DVD players being complements.
In conclusion, all three types of elasticity are potentially of great importance to a
business.
It is always good in a ‘discuss’ question to end with a conclusion, but in this case the conclusion
does not really go very far. A key word in the question is ‘more relevance’, and the student has
not really addressed the issue of whether price elasticity of demand is of more relevance to a
business than the other two. If the student thought that all three were of equal relevance to a
business, this should have been made clear, along with the reasons and the justification to
support this conclusion.
34 Student answer:
Elasticity of supply measures the responsiveness of the change in the quantity
supplied as a result of a change in the price of a product. It is calculated by
dividing the percentage change in the quantity supplied by the percentage change
in the price of a product.
This is a useful introductory paragraph, introducing the concept of elasticity of supply and
explaining how it can be calculated.
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In the short run, a least one factor of production will be fixed. In this situation,
even if there is a substantial increase in the price of a product, it may not be very
easy to substantially increase supply in response to this price change. Of course, if
there are unsold stocks that can be released on to the market fairly quickly, this
will make supply more elastic than it would otherwise have been.
The student links the extent of supply elasticity to a period of time, pointing out that in the short
run at least one factor of production will be fixed and that this will, therefore, limit the extent of
the elasticity. A useful point is made in relation to the possible existence of unsold stocks,
although this point could have been developed more fully, such as in terms of a contrast
between manufactured and agricultural products; it is generally much easier to store
manufactured goods over a period of time than agricultural goods. There are also questions
about storage space and costs that could have been brought into the analysis.
In the long run, all factors of production become variable and so it becomes easier
to adjust supply to the change in the price of a product. A greater number of
resources can be allocated to the production of the product and so, in the long run,
supply will become more elastic.
The student then moves on to the long run, pointing out that in this situation, all factors of
production become variable and so supply can respond more easily to any change in price, i.e.
supply becomes more elastic. Again, a contrast might have been made between manufactured
goods and agricultural goods. The length of time to grow crops will usually be longer than would
be the case with the production of manufactured goods.
In conclusion, supply is likely to be more elastic over a period of time because as
all factors of production become variable, it is possible to allocate resources
accordingly to take account of the change in price of the product.
This is a useful conclusion, but again a contrast might have been made between manufactured
and agricultural products.
35 Student answer:
Economies of scale clearly have potential benefits to a business.
This brief introduction does not really say very much. It would have been better to combine it
with the next paragraph.
Economies of scale, both internal and external, come about as a result of a decrease
in the average total costs of production of a firm as a result of developments in
either a firm or an industry.
Economies of scale are clearly defined in terms of a decrease in the average total costs of a firm
and it is useful to contrast the situation in a firm with that of the industry. However, it would have
been useful to have included a diagram here to support the evaluation, distinguishing between a
movement along an average total cost curve, as in the case of a firm, and a shift downwards of
the entire curve, as in the case of an industry.
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Topic 2
How competitive markets work
Internal economies relate to the reduction in total average cost in a particular firm
as a result of the firm growing in size and expanding its output. Technical
economies of scale are particularly important and these can be of four types:
economies of specialisation, of indivisibilities, of increased dimensions and of
linked processes. However, there are other examples of internal economies of scale
that can contribute to the lowering of a firm’s average total cost and these include
purchasing, managerial, financial, risk-bearing and marketing economies.
It would have been helpful if this paragraph had been expanded to evaluate the benefits from
these different types of economies. There is a reference to the fact that technical economies of
scale can be divided into four types, but none of these is explained. The other possible
economies of scale are referred to, but again none is explained. It would also have been useful if
some examples had been included to support the evaluation of the benefits, such as the
example of an oil tanker in relation to economies of increased dimensions.
Economies of scale are not limited to internal economies. There may be external
economies which extend beyond a particular firm to the industry in which a firm
operates. These can also contribute to a lowering of average total costs of
production.
This is a rather brief and superficial treatment of external economies of scale. For example, no
examples are included to show how external economies of scale are different from internal
economies of scale.
Diseconomies of scale, whether internal or external, will lead to an increase in the
average total costs of a firm and so a firm will need to find out when production
has gone beyond the minimum point of the average total cost curve.
The drawbacks of diseconomies of scale, whether internal or external, are only briefly referred
to. It would have been useful to have included some examples of diseconomies of scale to
support the evaluation. Also, the last point could have been evaluated much more fully, given
that this difficulty in knowing when the minimum point of the average total cost curve has been
passed is crucial to the evaluation.
36 A
37 A
38 A
39 A
40 B
41 D
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Philip Allan for Hodder Education
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Topic 3
Market failure and government intervention
Topic 3 Market failure and
government intervention
Market failure
1 Market failure refers to a situation in an economy where there is an inefficient, or suboptimal, allocation of scarce resources. This happens due to various types of market
imperfection.
These market imperfections can take different forms. For example, some goods might be
over-produced and over-consumed, such as in the case of demerit goods. Some goods
might be under-produced and under-consumed, such as in the case of merit goods. Some
goods might not be provided at all in a market, without any government intervention, and
these are called public goods. Some markets might not be competitive and may be
dominated by just one firm, as in the case of a monopoly. Firms may only take into
account private costs and benefits, and not the possible external costs and benefits, giving
rise to the existence of externalities. Some decisions may be based on insufficient
knowledge about the implications of taking certain decisions — a situation known as
information failure.
Market failure, therefore, is a collective term for all those imperfections in an economy
where resources are not being allocated in the best and most efficient way.
2 Market failure means that the scarce resources of an economy are not being used in their
most efficient way. Some goods are over-produced and over-consumed and so too many
resources will be allocated to the production of such goods. Some goods are underproduced and under-consumed and so too few resources in an economy will be allocated
to the production of those goods.
The market imperfections that exist in an economy when there is market failure mean that
the allocation of scarce resources is less efficient than would otherwise be the case.
3 A public good is one which must be provided by a society, such as through government
provision. This is for three reasons.
First, public goods are non-excludable, i.e. nobody in a society can be excluded from
benefiting from them. If they were provided through the private, rather than the public,
sector, it would be impossible to charge everybody for them and so there would be free
riders who benefited without paying anything.
Second, public goods are non-rivalrous, i.e. the consumption of a public good by one
person does not prevent the consumption of the good by another person, as would be the
case with a private good. This characteristic of non-rivalry can also be called nondiminishability.
Finally, public goods are non-rejectable, i.e. it is impossible for consumers to reject a
public good, such as being protected by a defence force.
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Topic 3
Market failure and government intervention
Examples of public goods include street lighting, defence and police. These goods have to
be provided in the public sector for the three reasons given above. It would be impossible
to provide them through the private sector.
Externalities
4 The term ‘third party’ refers to those people who are not directly involved in the production
process, but who are still affected by it. This is why it is often linked with the idea of a
‘spillover effect’.
5 A social cost takes into account the full cost to a society or community of a production
process. This means that it includes both the private cost, which is the internal cost of
production to a firm, such as wages and raw materials, and the external cost to the
society, which might be the impact of pollution or congestion in the area.
Social cost is important because it emphasises the full cost of the use of resources used in
the production process, including both internal and external costs.
6 An external benefit is one that comes about as a result of production, benefiting someone
who is a third party and, therefore, not directly involved in the production process. In this
sense, there is a positive ‘spillover’ effect.
An example could include a situation where a factory is built in an area, employing many
workers. These workers receive payment; some of this money will then be spent in the
area in shops, restaurants and petrol stations. This extra spending benefits the people
who work in these shops, restaurants and petrol stations so this is an external benefit to
them of the workers being employed in the factory.
7 An externality is a cost or a benefit which is paid for by, or gives benefit to, third parties.
They can also be called ‘spillover’ effects.
8 A negative externality that is caused by production is a cost that is borne by the
community, such as health problems caused by pollution. This is caused by the
divergence between private cost and social cost.
A positive externality of consumption is the benefit to the community as a result of a
consumption decision, such as an area looking good as a result of people improving their
gardens. This is caused by the divergence between private benefit and social benefit.
Information asymmetries
9 Information failure refers to a situation where decisions are taken in an economy by some
people who do not have all the information necessary to make rational and well-informed
decisions. For example, some products may be under-consumed or over-consumed
because some people do not fully appreciate the positive or negative effects of taking
certain decisions.
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Topic 3
Market failure and government intervention
10 Asymmetric information refers to a situation where not all decision takers have the same
information. In an efficient market, buyers and sellers would have perfect information
relating to the market. However, the existence of asymmetric information indicates that
information may not always be perfect. This can contribute to market failure because
imperfect information can lead to imperfect decision making.
Moral hazard also stems from asymmetric information and can contribute to market failure.
This is a situation where certain actions may occur as a result of having, or not having,
certain information. For example, a consumer may not take as much care with their
possessions if they know that they are insured, but the insurance companies may not be
aware of this.
11 Information failure refers to a situation where decisions that are taken by some people in
an economy are not based on all the information required to make an informed judgement.
Information failure can lead to market failure because some products will be underconsumed while others will be over-consumed.
In the case of under-consumption, this is because some consumers do not fully appreciate
the potential worth of consuming certain products. These are known as merit goods and
examples could include education and healthcare. As a result of information failure, some
consumers will under-value the worth of such consumption, creating a market failure.
In the case of over-consumption, some consumers do not appreciate the possible negative
side-effects of consuming certain products, such as alcohol and tobacco. As a result of
information failure, some consumers do not realise the potential negative effect of the
consumption of such products on their health, creating a market failure.
12 A merit good is an example of market failure in that it is a private good which could be
under-produced and under-consumed in a market as a result of the existence of
information failure.
13 A demerit good is an example of market failure in that it is a private good which could be
over-produced and over-consumed in a market.
A demerit good refers to the fact that there is something potentially negative about the
consumption of such a good, such as in relation to possible damage to a person’s health
and general wellbeing. Alcohol and cigarettes are often given as examples of demerit
goods because excessive consumption of either (or both) of these products can be
damaging to a person’s health.
This is why, in many countries, there is information on such products warning people of
the consequences of consuming them. For example, in the case of cigarettes, packets
may contain a warning such as ‘smoking can kill’. This is an example of where a
government has intervened to overcome information failure.
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Topic 3
Market failure and government intervention
Alternative methods of government
intervention
14 Education and healthcare are both examples of merit goods, i.e. the consumption of them
has some intrinsic merit, value or worth and yet there is the possibility that they could be
under-produced and under-consumed in a market.
They are, however, private goods, not public goods, and so they will not be provided
exclusively through the public sector, as would be the case with, say, police or national
defence.
They are, therefore, provided through both the private sector and the public sector. Just
like any private good, such as food and clothing, they can be given a market price and
people can pay this price for education and healthcare if they so wish.
The problem, however, is that if a market price is charged, some consumers will be
unwilling or unable to pay this price. The government may decide that as education and
healthcare are examples of merit goods, they need to be provided through the public
sector, operating alongside provision through the private sector.
15 An indirect tax is a tax that is taken out of expenditure, i.e. the tax is usually included in the
price of goods and services that are being purchased. Examples include Value Added
Tax, Goods and Services Tax or an excise duty.
16 A subsidy is a payment, usually made by a government, to a producer in order to keep
down the costs of production borne by the producer. In this way, it should be possible for a
lower price to be charged than would otherwise be the case. It is shown in a demand and
supply diagram by a rightward shift of the supply curve, leading to a lower equilibrium price
and a greater equilibrium quantity.
17 a
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Topic 3
Market failure and government intervention
The above diagram shows the impact of the imposition of an indirect tax on the equilibrium
price and the equilibrium quantity of a good in a market. The supply curve shifts to the left,
causing an increase in the equilibrium price and a reduction in the equilibrium quantity.
b
The above diagram shows the impact of the provision of a subsidy on the equilibrium price
and the equilibrium quantity of a good in a market. The supply curve shifts to the right,
causing a decrease in the equilibrium price and an increase in the equilibrium quantity.
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Topic 3
Market failure and government intervention
18 A variety of regulations and laws can be used in an economy to reduce the extent of
market failure.
For example, a government could pass a variety of consumer protection laws to give
consumers more power. In the UK, these include the Trade Descriptions Act, the Weights
and Measures Act, the Consumer Credit Act, the Sale of Goods Act and the Consumer
Protection Act.
Regulations could also apply to the degree of competition in a market, especially in terms
of restricting the power of monopolies. In the UK, these would include the Fair Trading Act,
the Restrictive Trade Practices Act and the Competition Act.
Regulations could be brought in to try to control the extent of pollution in an economy. In
the UK, this include the Clean Air Act.
All these regulations are designed to reduce the extent of imperfections in markets and so
reduce the extent of market failure, bringing about a greater degree of allocative efficiency
in markets than would otherwise be the case.
19 Pollution permits can be issued by a government in the form of a licence issued to firms.
This licence allows a firm to emit pollution, but only up to a certain level. This level,
established in the licence, will be less than the current amount of pollution being created
by the firm, so this will reduce the extent of the negative externality.
Over a period of time, the various licences issued by the government to a firm can bring
down the maximum level of pollution committed each time.
These permits can also be traded between different firms, when they are known as
tradeable permits. The polluting firms can sell or buy these permits from one another. The
purpose is to fix a maximum amount of pollution that will be allowed and then the various
firms can bargain among themselves in terms of buying and selling the permits.
20 A government could provide information that would hopefully influence consumption
decisions and reduce the extent of market failure in an economy.
For example, in terms of the consumption of a demerit good, such as tobacco, a
government could insist that packets of cigarettes carry a health warning, such as
‘smoking can kill’.
Another example could be in relation to the consumption of alcohol. Again, information
could be provided by a government to encourage people to ‘drink sensibly’.
In terms of a merit good, a government could provide information which encourages
people to behave in a certain way. For example, encouragement could be given to
inoculate against certain diseases.
21 A government could intervene in a market through the imposition of a maximum price to
prevent the prices of certain products becoming too expensive.
The controlled price will need to be established in the market below the normal
equilibrium, or market clearing price, otherwise there would be no effect.
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Topic 3
Market failure and government intervention
In the diagram, a price of P would be the equilibrium, or market clearing price, where
demand and supply intersect. However, if a government decided to intervene through a
price control to prevent the prices of certain products becoming too expensive, it would
establish a maximum price of P1, i.e. below the market clearing price.
22 With some agricultural products, there is a great deal of price instability. This is because
adverse weather conditions restrict supply, causing prices to rise, while good weather
conditions increase supply, causing prices to fall.
In order to reduce the extent of this price instability, a government could decide to use a
buffer stock system. When there are good weather conditions, a government can store
some of the supply to prevent the price falling too much. When there are adverse weather
conditions, a government can sell of some of this stock to prevent the price rising too
much.
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Topic 3
Market failure and government intervention
In the diagram, when supply is high, at S2, the price would fall to P2, so the government
buys up some of the stock to maintain a price of P0. When supply is low, at S0, the price
would rise to P1, so the government would release some of the stock to maintain a price of
P0.
There are, however, some potential problems to such a scheme. For example, there will
be storage and administration costs and some goods may be perishable.
23 A subsidy refers to a payment, usually by a government, to a producer in order to reduce
the cost of production, enabling the producer ultimately to lower the price charged to a
consumer. This would be likely to lead to an increase in demand.
A subsidy can be shown in a demand and supply diagram by shifting the supply curve to
the right, leading to a decrease in equilibrium price and an increase in equilibrium quantity.
Education is regarded as a good example of a merit good. In a market without government
intervention, there could be under-production and under-consumption of such a good.
Education could be provided through the public sector, with the finance raised from the
receipts of taxation, or it could be provided through the private sector, but a government
could make it affordable to people by providing a subsidy which would either substantially
reduce the price or make it free.
This would be likely to increase the demand for education, assuming that the demand is
relatively price elastic.
One problem, however, is the quality of education provided through this system. If parents
believe that the quality of education being provided in a particular institution is below that
provided by other institutions, the price elasticity of demand is likely to become relatively
inelastic. In such a situation, the subsidy is not likely to increase the demand to a large
extent.
Government failure
24 Government failure can occur when a government acts to deal with market failure, using
one or more of the possible methods of intervention, but in the process of intervention
creates further distortions in the market. The aim of any such intervention should be to
increase economic welfare, but it is possible that as a result of certain decisions taken by a
government, there is a reduction in economic welfare. This is because further distortions
have been created in the market.
25 It is also possible that some forms of intervention create disincentives, such as in the case
of taxation. For example, in some countries, a government has increased income tax on
relatively rich people, only to find that there has been a ‘brain drain’ of such people leaving
the country.
26 There are a number of possible causes of government failure. For example, the
government may not have had the necessary information to adopt the right policies. If a
government has inadequate and/or incorrect information, such as about the state of an
economy, it may end up taking the wrong decision.
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Topic 3
Market failure and government intervention
Another possible cause of government failure is as a result of the potential conflict
between different policies taken by government. For example, a government could decide
to invest money into a failing industry to keep it going and provide jobs for people, only to
eventually discover that no amount of state support will save it from collapse.
Exam-style questions
27 Student answer:
A private good is one which is bought by individuals for their own benefit, such as
food and clothing. Private goods are rival and excludable in consumption, i.e. once
consumed by one person, they cannot be consumed by another. Other potential
consumers are excluded from consumption. They are rival in that different
consumers are competing with each other to buy the private goods that are needed
to satisfy their needs and wants.
The student offers a clear explanation of the meaning of private goods, in being rival and
excludable, and gives a couple of examples of them.
A public good, on the other hand, is very different from a private good. Public
goods are both non-rival and non-excludable in consumption, i.e. no one is
excluded from benefiting from a public good and there is no rivalry in
consumption.
The contrast with public goods is made clear, especially in terms of them being both non-rival
and non-excludable.
A public good is provided through the public sector because it would be very
difficult, if not impossible, to charge for the consumption of them. Examples
include street lighting, national defence and the operation of the police force. It
would be impossible to provide them through the private sector because it would
be impossible to exclude those who had not paid.
Some appropriate examples of public goods are provided. There is a reference to the difficulty of
charging a price for them in the private sector, but this could have been developed more fully,
such as in relation to the existence of ‘free riders’.
There are, therefore, clear differences between a private good and a public good.
This is a rather superficial conclusion. It would have been better to have developed it more fully
by referring to the key differences between them, especially in relation to the fact that private
goods are rival and excludable whereas public goods are non-rival and non-excludable.
28 Student answer:
An externality is where there is a positive or negative effect on a community as a
result of the production process. The existence of an externality means that there is
not allocative efficiency.
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Market failure and government intervention
The student makes it clear that an externality can be either positive or negative and links this
with the concept of allocative efficiency.
A negative externality occurs where there is a divergence between private costs
and social costs. A firm will only take into account the private cost of production,
but there are likely to be side effects of this production on the community, known
as a ‘spillover’ effect. The private cost of the firm does not take into account the
costs created as a result of the effect of the production in the community — these
are the external, as opposed to the internal, costs of production. There is, therefore,
market failure because the true value of the costs to the community has not been
expressed. These would be the social costs of the production because these take
into account both the private and the external costs.
This section focuses on the existence of a negative externality. There is a clear contrast between
private and external costs, although there could have been an explicit reference to ‘third party’
effects. The student could also have provided an appropriate example of a negative externality.
In a similar way, a positive externality can exist as a result of the production
process. This is where there is a divergence between private benefits and social
benefits. There will clearly be private benefits of production, such as the wages
paid to the workers and the profit made by the firm, but there may also be
additional benefits that affect the community. For example, some of the wages that
are earned by the workers will be spent in the local community and this could
contribute to an increase in the revenue and profit of local firms. The private
benefit alone would, therefore, not give a true picture of the full value of the
production process. The social benefit, however, would represent the true value of
this because it would take into account both private and external benefits of
production.
This section focuses on the existence of a positive externality. The divergence between private
benefits and social benefits is made clear. There is a useful example provided to illustrate the
existence of a positive externality.
In conclusion, externalities, both positive and negative, can lead to market failure
in an economy because the true cost of production is not being taken into account
unless social costs and social benefits are used to represent the value of the
production process.
The student could have made the link between externalities and a sub-optimal allocative
efficiency in an economy more clearly.
29 Student answer:
A public good is one which would not be provided in a market economy because
of its characteristics of non-excludability, non-rivalry and non-rejectability. It
would be very difficult, if not impossible, to provide a public good through
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Topic 3
Market failure and government intervention
charging a price and so therefore the government is required to provide such a
good.
It is useful to start with a statement on what is meant by a public good and reference to these
three essential characteristics of a public good is helpful. There is reference to the difficulties of
charging a price for public goods, but it would have helped if there had been reference to the
concept of a ‘free rider’, i.e. the idea that nobody would actually pay for the use of a public good,
such as a street light.
The importance of public goods can be seen when certain examples of them are
considered, such as a police force and the armed forces of a country. Other
examples include street lighting and the provision of a lighthouse.
It is useful to include examples of public goods to indicate their importance in an economy, but
this point could have been developed more fully, especially in terms of the provision of a police
force. For example, it would be illogical to think of paying for the police service each time
somebody used it.
The government provides public goods, not by charging a price, but by financing
the expenditure on them out of taxation. In this way, everybody, or at least all
taxpayers, contribute to the financing of them. This enables them to be provided
‘free’ at the point of use.
This is an important point to make, but it might have been developed more fully, especially in
terms of the huge demands placed on government in relation to its expenditure decisions.
However, governments only have a certain amount of income to spend and so there
will be an element of opportunity cost in the provision of public goods, i.e. the
money used to finance public goods has alternative possible uses, such as in terms
of expenditure on health or education.
It is important that the conclusion brings in the concept of opportunity cost, but there is no clear
definition or explanation of what is meant by opportunity cost, although the examples of health
and education as possible alternative uses of a limited sum of money suggest an implicit, if not
explicit, understanding of the concept.
30 a
Student answer:
A merit good is one which is generally regarded as being of merit or value and yet
there is the possibility that many people will undervalue their consumption of it,
leading to market failure. A merit good, such as education or healthcare, will
benefit people throughout their lives and this is why governments in many
countries support their provision. A merit good is a private good and, like all
private goods, is both rival and excludable in consumption.
The student clearly explains what is meant by a merit good and links this with the possible
existence of market failure in terms of the under-consumption of such a good.
b Student answer:
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A museum can be regarded as a very good example of a merit good. There are
many different kinds of museum in a society which people could visit, covering
such areas of interest as history, geography, geology, archaeology, music, transport
and art. The underlying idea of a merit good is that the consumption of such a good
has some form of worthwhile value and a museum would be a very good example
of this. They are extremely informative and people would benefit a great deal from
visiting one.
The case is clearly put for regarding a museum as an example of a merit good, giving some
indication of how people could benefit from visiting one, i.e. the merit of a museum is clearly
demonstrated.
However, if an entrance fee was charged, it is possible that many potential
consumers would not pay to go into a museum because they would not think that it
was worthwhile to pay the fee. In terms of opportunity cost, they would need to
consider the possible alternative products that they could spend their money on.
This section addresses the possible existence of under-consumption if an entrance fee was
charged, linking it to the concept of opportunity cost and the idea of possible alternatives being
foregone.
It is for this reason that, in many countries, the government decides either to
abolish entrance fees and make museums free, or to provide a subsidy to keep the
entrance fee lower than it would otherwise be.
The first example is valid if a museum is in the public sector, but a museum is an example of a
private good and some museums will be in the private sector. In such a situation, there is not a
lot that a government could do. The second example, however, could apply to both the private
and the public sector. The consideration of the effect of a subsidy could have been developed
further by explaining more fully how the provision of a subsidy would shift the supply curve to
the right, reducing the equilibrium price. A diagram could have been included to show this
impact.
In conclusion, it should be clear that museums can be regarded as a merit good to a
very large extent.
The conclusion could have been developed more fully, such as in relation to market failure and
the need for government intervention.
31 Student answer:
An indirect tax is an expenditure tax, i.e. it is a tax that is placed on goods and
services when they are being purchased. Examples include Value Added Tax and
excise duties.
The answer begins with a useful explanation of what is meant by an indirect tax and appropriate
examples are given.
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A government could decide to impose an equal amount of indirect tax on every
product purchased in an economy. This would be fair in the sense that every
product is treated equally. However, governments usually decide to place different
rates of tax on various products.
The student introduces the idea that there is differential taxation on various products.
One example of this would be fuel. In the UK, over 70% of the price of diesel or
petrol is tax. Governments impose such a high rate of tax on fuel to discourage
consumption. Fuel is a finite resource and will eventually run out, so governments
tax it at such a high rate to make people think twice before purchasing it.
Governments also know that the demand for fuel is extremely price inelastic and
so, if tax is increased on it, the effect on demand will be minimal. It is, therefore, a
very useful source of revenue for the government.
The student includes an appropriate example of a product which carries a relatively high rate of
indirect tax. There is also a useful link with the concept of price elasticity of demand, although
this concept could have been explained more fully. In terms of the final sentence of this section,
it would have been helpful to have linked this to fiscal policy.
Another example of products having a higher rate of tax imposed on them than
other products relates to the purchase of demerit goods. The price of alcohol and
tobacco in the UK includes over 70% of tax. Governments know that without such
high taxation, the consumption of such products would probably increase
significantly, causing a range of harmful effects on those people consuming such
products. As with petrol and diesel, it is also the case that the demand for such
addictive products is very price inelastic.
Another example is given to support the analysis, although there could have been a clearer
explanation of what is meant by a demerit good. There could also have been a fuller link with
elasticity in the final sentence.
However, in many countries, governments will decide to tax other products at
lower than average rates or not tax them at all. For example, in the UK, most items
of food are not taxed. Although items of clothing are taxed, children’s clothing is
exempt from taxation. Fuel bills are taxed at a VAT rate of only 5% compared to
20% on most goods and services.
The student gives some interesting examples of products which are taxed at lower rates or not
taxed at all. This helps to give a balanced approach to the analysis.
It can therefore be seen that while some items in an economy are taxed at higher
rates, there are lower rates on other products, or no tax is imposed at all.
It would have been useful if the conclusion had been linked more clearly to the concept of
fairness as this is a key part of the question. For example, there could have been some
consideration of what is meant by fairness, especially in relation to normative, as opposed to
positive, economics.
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32 Student answer:
The imposition of an indirect tax, such as Value Added Tax or an excise duty, on
expenditure on certain products, such as tobacco, is potentially a good way of
reducing the demand for such a demerit good.
It would have been helpful if the student had actually explained what is meant by a demerit good,
i.e. one where there is likely to be an over-production and over-consumption without
government intervention.
The idea behind such a policy is that the indirect tax will lead to a much higher
price than would otherwise be the case in a market without government
intervention. For example, in the UK, taxation represents over 70% of the price of
cigarettes.
The student recognises that indirect taxation can be a significant proportion of the price of such
a product, but this needs to be more clearly linked to the possible effect on demand.
If the price elasticity of demand for such goods was relatively elastic, the increase
in the price would have a more than proportionate effect on the level of demand for
the product, reducing demand by a large extent.
The student brings in the concept of price elasticity of demand, but does not actually explain
what it is or how it is calculated. It would have been helpful if the student had pointed out that it
is calculated by dividing the percentage change in the quantity demanded by the percentage
change in the price of a product.
The situation with many demerit goods, however, such as the demand for tobacco,
is that the demand is relatively price inelastic. This is because the consumption of
such a product is largely addictive.
The reference to demand being relatively price inelastic could have been developed more fully,
e.g. by stating that the PED figure would be between 0 and 1. It would also have been useful if
the student had included a diagram to show an inelastic demand curve.
Therefore, the imposition of an indirect tax may not always have a significant
impact on the demand for a demerit good, such as tobacco, because the demand is
likely to be relatively inelastic.
The conclusion might have been developed more fully by pointing out that the addictive nature
of the demand was an important reason for the demand being relatively inelastic.
33 Student answer:
Market failure is a situation in an economy where there is an inefficient, or suboptimal, use of scarce resources. It can come about as a result of many factors,
including the over-consumption and under-consumption of certain products, the
existence of externalities, information failure and the non-provision of essential
services.
OCR AS/A-level Economics
© Terry Cook
Microeconomics 1
Philip Allan for Hodder Education
42
Topic 3
Market failure and government intervention
The student has a clear understanding of what is meant by the term market failure. However, this
introductory paragraph could have been developed more fully by referring to the existence of
market imperfections in an economy, leading to an absence of efficiency in the allocation of
resources.
Government intervention can certainly reduce the extent of market failure in an
economy, although it is more questionable whether it can eliminate it entirely.
This is a brief reference to what is required in the question, although it might have been better to
have included it in the conclusion at the end of the answer.
The production and consumption of merit goods can be encouraged through the
use of subsidies, but this will not guarantee that demand for the goods is increased.
This section is very brief. The student might have referred to some particular examples of merit
goods, such as education and healthcare. The reference to subsidies is very limited — there is
no real attempt to explain what a subsidy is. The student could have explained that it was a
financial contribution to a firm by a government to lower the cost of production and, hopefully,
the price. A diagram could have been included to aid the discussion, showing a shift of the
supply to the right, bringing about a lowering of equilibrium price and an increase of equilibrium
quantity. The student is correct to state that the provision of a subsidy will not guarantee that
the demand for the good is increased, but the discussion of this could have gone further, such
as commenting on the demand being related to the quality of the service being provided as a
result of the provision of a subsidy.
The production and consumption of demerit goods can be discouraged through the
use of an indirect tax, but this will not guarantee that demand for the good is
decreased.
This section is also rather brief. The student could have referred to some particular examples of
demerit goods, such as alcohol and tobacco. The reference to indirect taxes is very limited —
there is no real attempt to explain what an indirect tax is. The student could have explained that
it was a tax imposed by a government on expenditure. The effect of the imposition of an indirect
tax would be to shift the supply curve to the left, raising the equilibrium price and reducing the
equilibrium quantity. A diagram could have been included to illustrate this. Again, the end of this
section is very superficial — the student could have brought in the concept of price elasticity of
demand, pointing out that the demand for such goods as alcohol and tobacco is likely to be
inelastic, given the addictive nature of the consumption.
Externalities can exist where there is a divergence between private costs and
benefits and social costs and benefits. For example, pollution would be an example
of a negative externality. A government could try to reduce the extent of pollution
by issuing a firm with a pollution licence, designed to reduce the emission of
pollution by the firm over a period of time, gradually reducing the extent of
pollution allowed. However, it is not always possible to enforce such licences
effectively.
This is a better section of the answer and the student has made more of an attempt to develop
the discussion. The student recognises the importance of needing to enforce pollution licences
effectively. Again, a diagram could have been included to indicate how a negative externality
could exist in a market.
OCR AS/A-level Economics
© Terry Cook
Microeconomics 1
Philip Allan for Hodder Education
43
Topic 3
Market failure and government intervention
Information failure is a contributory factor in the existence of market failure and
governments can certainly try to ensure that the degree of information that is made
available in an economy can help to reduce the extent of this failure. A good
example of this is the use of warning signs on packets of cigarettes, but the actual
effect of this is likely to be limited by the fact that the consumption of such goods
is largely addictive.
The student recognises the importance of information failure as a contributory factor in market
failure and understands how a government can try to provide appropriate information. An
appropriate example is given and there is an attempt to explain why warning signs on cigarettes
may not be as effective as might be supposed, but the discussion of this would have been
enhanced by bringing in the concept of price elasticity of demand to explain why the demand for
such goods is relatively inelastic.
Certain essential services, such as police and national defence, could not really be
provided through the private sector and so these are generally provided by the
state, using funds obtained from taxation.
This section is also rather brief. There is a reference to essential services, but these examples
are not explicitly identified as public goods. The reason why such goods could not really be
provided through the private sector could have been developed more fully, especially in relation
to non-excludability and non-rivalry. The contrast with the existence of free riders if the service
was provided through the private sector could also have been made. There is a passing
reference to ‘the funds obtained by taxation’, but this could have been developed more fully,
such as in relation to fiscal policy and the existence of opportunity cost.
In conclusion, it is most unlikely that market failure can be eliminated entirely in
an economy, but government intervention, through a variety of different methods,
can certainly help to reduce its extent.
It is always good to include a conclusion in a ‘discuss’ question, but in this case the conclusion
does not go very far and really needed to have been developed more fully.
34 B
35 C
36 B
37 A
38 D
OCR AS/A-level Economics
© Terry Cook
Microeconomics 1
Philip Allan for Hodder Education
44