Edexcel Economics IAL Unit 1

Contents
1.3.1 The nature of economics .................................................................................................................... 5

1. Scarcity .................................................................................................................................................. 5
• The problem of unlimited wants and finite resources.................................................................. 5
• The distinction between renewable and non-renewable resources ............................................ 5
Additional Notes................................................................................................................................... 5
2. Production possibility frontiers............................................................................................................. 6
• The use of production possibility frontiers to depict opportunity cost ........................................ 7
• The use of production possibility frontiers to depict economic growth and the efficient
allocation of resources .......................................................................................................................... 7
• The use of marginal analysis in depicting opportunity cost ......................................................... 8
• The distinction between movements along and shifts in production possibility frontiers, and
their possible causes. ............................................................................................................................ 8
Additional Notes................................................................................................................................... 8
3. Specialization, the division of labor and the role of money ............................................................... 10
Additional Notes................................................................................................................................. 11
4. Free market and mixed economies..................................................................................................... 11
• The advantages and disadvantages of a free market economy and why there are mixed
economies. .......................................................................................................................................... 12
• The role of the state in a mixed economy. ................................................................................. 14
5. Positive and normative economics ..................................................................................................... 16
• The distinction between objective statements and value judgements on economic issues. .... 16
• The role of value judgements in influencing economic decision making and policy.................. 16
1.3.2 Demand and consumer behavior ..................................................................................................... 16
1 The demand curve ............................................................................................................................... 16
• The distinction between movements along a demand curve and shifts of a demand curve. .... 16
• The concept of diminishing marginal utility ............................................................................... 16
• The factors that may cause a shift in the demand curve ............................................................ 17
2 Price, income and cross elasticities of demand.................................................................................. 18
• Definition of elasticities of demand. ........................................................................................... 18
• Calculation and interpretation of numerical values of demand elasticities. .............................. 18
• The factors influencing elasticities of demand and their significance to firms and government.
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• The relationship between price elasticity of demand and total revenue................................... 22
3 Consumer behaviors............................................................................................................................ 23
• The assumption of rationality ..................................................................................................... 23
• Qualifications to assumption of rationality, alternate views of consumer behavior: ................ 23
1.3.3 Supply ......................................................................................................................................... 23
1. The supply curve ............................................................................................................................. 23
• The distinction between movements along a supply curve and shifts of a supply curve. ......... 23
• The factors that may cause a shift in the supply curve............................................................... 24
Additional Notes................................................................................................................................. 24
2 Price elasticity of supply....................................................................................................................... 24
• Definition of price elasticity of supply. ....................................................................................... 24
• Calculation and interpretation of numerical values of price elasticity of supply (PES). ............. 25
• Factors that influence price elasticity of supply. ........................................................................ 25
• The distinction between the short run and long run in economics and its significance to price
elasticity of supply. ............................................................................................................................. 25
1.3.4 Price determination ........................................................................................................................... 27
1 Determination of market equilibrium.................................................................................................. 27
• Equilibrium price and quantity and how they are determined. ................................................. 27
• The use of a supply and demand diagram to show how shifts in demand and supply curves
cause the equilibrium price and quantity to change. ......................................................................... 29
• The operation of market forces to eliminate excess demand and excess supply. ..................... 30
2 Consumer and producer surplus .......................................................................................................... 32
• The distinction between consumer and producer surplus. ........................................................ 32
• The use of a supply and demand diagram to illustrate consumer and producer surplus. ......... 33
• How changes in demand or supply might affect consumer and producer surplus. ................... 34
3 Functions of the price mechanism ....................................................................................................... 35
• The rationing, incentive and signaling functions of the price mechanism for allocating scarce
resources. ............................................................................................................................................ 35
• The price mechanism in the context of different types of markets, including local, national and
global market. ..................................................................................................................................... 35
4 Indirect taxes and subsidies ................................................................................................................. 36
1.3.5 Wage determination in labor markets............................................................................................... 42
1 The demand for labor .......................................................................................................................... 42
• The factors that influence the demand for labor. ...................................................................... 42
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• How the demand for labor in the private sector is derived from the demand for the final
product. ............................................................................................................................................... 43
• The elasticity of demand for labor. ............................................................................................. 44
2 The supply of labor............................................................................................................................... 44
• The factors that influence the supply of labor, e.g. population migration, income tax and
benefits, government regulations, trade unions. ............................................................................... 44
• The geographical and occupational mobility of labor. ............................................................... 47
• The elasticity of supply of labor. ................................................................................................. 48
3 Determination of wage rates ............................................................................................................... 49
• Use of supply and demand diagram to illustrate labor market equilibrium. ............................. 49
• Government intervention in the labor market, e.g. maximum and minimum wages. ............... 50
1.3.6 Market failure .................................................................................................................................... 51
1 Types of market failure ........................................................................................................................ 51
• Definition of market failure ........................................................................................................ 51
• Types of market failure, including externalities, public goods, imperfect market information,
labor immobility. ................................................................................................................................. 52
2 Externalities.......................................................................................................................................... 52
• Distinction between private costs, external costs and social costs. ........................................... 52
• Distinction between private benefits, external benefits and social benefits. ............................ 53
• Use of diagrams to illustrate the external costs from production and external benefits from
consumption using marginal analysis. The distinction between the market and social optimum
positions and identification of the welfare loss or gain areas. ........................................................... 53
• The impact of externalities and government intervention in various markets, e.g. transport,
health, education, environment. ........................................................................................................ 58
3 Public goods ......................................................................................................................................... 61
• Distinction between public and private goods using the concepts of nonrivalry and non-
excludability. ....................................................................................................................................... 61
• Why public goods may not be provided by the private sector making reference to the free-
rider problem. ..................................................................................................................................... 61
4 Imperfect market information ............................................................................................................. 62
• The distinction between symmetric and asymmetric information. ........................................... 62
• How imperfect market information may lead to a misallocation of resources, drawing
examples from areas such as healthcare, education, pensions and insurance. ................................. 62
5 Labor immobility .................................................................................................................................. 63
• Causes of geographical and occupational immobility of labor. .................................................. 63
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Measures to reduce immobility, including training programs, relocation subsidies. ........................ 64
1.3.7 Government intervention in markets ................................................................................................ 64
1 Methods of government intervention ................................................................................................. 64
• Government intervention in various contexts, e.g. labor market, health, housing, education,
transport, waste management, environment, energy, agriculture and commodities. ...................... 64
• Purpose of intervention including reference to market failure. ................................................. 65
• Methods of Government Intervention ....................................................................................... 65
• Evaluation of Government Intervention in Markets................................................................... 77
2 Government failure .............................................................................................................................. 77
• Definition of government failure as intervention that results in a net welfare loss. ................. 77
• Government failure, e.g. from agricultural stabilization policies, environmental policies,
transport and housing policies, maximum and minimum wages. ...................................................... 78
• Causes of government failure, e.g. distortion of price signals, unintended consequences,
excessive administrative costs. ........................................................................................................... 81
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1.3.1 The nature of economics
1. Scarcity
• The problem of unlimited wants and finite resources
Basic economic problem
The basic economic problem is about scarcity and choice. Every society must decide:
1. What goods and services to produce? E.g. does the economy use its resources to
build more hospitals, roads, schools or luxury hotels?
2. How best to produce goods and services? E.g. should school playing fields be sold off
to provide more land for affordable housing.
3. Who is to receive goods and services? Who will get expensive hospital treatment -
and who not?
Scarcity and Choices
• Because of scarcity, choices must be made by consumers, businesses and governments

• Trade-offs and Choices: Making a choice made normally involves a trade-off – this
means that choosing more of one thing can only be achieved by giving up something
else in exchange.
Opportunity Cost
In economics, “there is no such thing as a free lunch!” Opportunity cost measures the cost of any choice
in terms of the next best alternative foregone.
• The distinction between renewable and non-renewable resources

Renewable Resource: A resource that is used up at the same speed that it is renewed or a resource that
if managed well/is consumed at such a rate will be available for future generations/will not run-out/will
be a renewable resource. Example: Solar Energy
Non-renewable resource: A non-renewable resource is a resource of economic value that cannot be

readily replaced by natural means on a level equal to its consumption. Example: Fossil Fuel
Additional Notes
Economics: Economics is the study of how groups of individuals make decisions about the allocation of
scarce resources.
Use of Models in Economics
1. Economists build models and theories to explain economic interactions.

2. Models and theories are simplifications of reality.
3. Models can be distinguished according to whether they are static or dynamic, equilibrium or
disequilibrium or partial or general.
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Economic Data
1. Economic data are collected not only to verify or refute economic models but to provide a basis for
economic decision making.
2. Data may be expressed at nominal (current) prices or at real (or constant) prices. Data expressed in
real terms take into account the effects of inflation.
3. Indices are used to simplify statistics and to express averages.
4. Data can be presented in a variety of forms such as tables and graphs.
5. All data should be interpreted with care given that data can be selected and presented in a wide
variety of ways.
Q. Why economics is not a science?
• In sciences, like chemistry, experiments are conducted on scientific particles that can be easily
tested and react in the same way in the same experimental conditions.
• In social sciences, like economics, experiments often involve people/the behaviour of individuals
and they may not react in the same way when tested/can react in more unpredictable ways.
Advantage & Disadvantage of Index Numbers

Advantages
• Index numbers make trends easier to identify from data.
• It is also possible to see the extent of changes by examining index figures.
Disadvantages
• Index numbers do not allow evaluation of importance of particular aspects of expenditure
• The choice of base year is arbitrary. If the base year is chosen that is unrepresentative of the period
studied, then the figures may be distorted and conclusions from the figure could be misleading.
2. Production possibility frontiers

Definition: A production possibility frontier (PPF) shows the maximum possible output combinations of
two goods or services an economy can achieve when all resources are fully and efficiently employed.
Q. What concepts are mainly shown by the PPF?

A production possibility frontier is used to illustrate the concepts of:
• opportunity cost
• trade-offs
• effects of economic growth
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• The use of production possibility frontiers to depict opportunity cost
Reallocating scarce resources from one product to another involves an opportunity cost. If we
increase our output of consumer goods (i.e. moving along the PPF from point A to point B) then
fewer resources are available to produce capital goods
PPF and choices for government: Any government faces a trade-off in how to use scarce
resources and tax revenue. If the government increases spending on the military, then the
opportunity cost will be less spending on another public service, such as health care.
• The use of production possibility frontiers to depict economic growth and the efficient
allocation of resources
Points within the curve show when a country’s resources are not being fully utilised
• Any point inside the PPF: Combinations of the output of consumer and capital goods lying
inside the PPF happen when:
• there are unemployed resources, or
• when resources are used inefficiently.
Point inside curve indicates unemployment. Efficiency and total output could be increased by
moving towards the PPF.
• Any point beyond PPF: Unattainable level of production at the moment

• Any point on PPF: Maximum efficiency, highest attainable output. Point on curve shows
full employment. This is productive efficiency
Types of Efficiency
• Productive Efficiency refers to the absence of waste in the production process. (How)
• Allocative Efficiency is the situation in which society consumes a combination of goods and services that
maximizes its welfare – i.e., maximum utility. (What)
• Distributive Efficiency is achieved when goods and services are produced to those who want or need them
– not affected by an economy’s position on the PPC (For whom)
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• The use of marginal analysis in depicting opportunity cost
Q. Why is the PPF Concave?

Straight PP line indicates constant opportunity cost, which is next to impossible. We normally draw a
PPF on a diagram as concave to the origin i.e. as we move down the PPF, as more resources are
allocated towards Good Y the extra output gets smaller – so more of Good X has to be given up in
order to produce Good Y. This is an explanation of the law of diminishing returns and it occurs
because not all factor inputs are equally productive. Thus, the production possibility curve takes a
concave shape, indicating increasing opportunity cost, that is, the economy is willing to give up more
Y for an additional unit of X. There is increasing opportunity cost because of diminishing returns.
• The distinction between movements along and shifts in production possibility frontiers, and
their possible causes.
Movement along PPF uses same number and state of resources. It just indicates the opportunity
cost of producing more goods by producing less of the other good.
Shifting of PPF outwards indicates either utilization of more resources or using greater quality of
same amount of resources. This reduces opportunity cost of either capital or consumer goods,
since more goods can be produced overall.
Additional Notes
Q. How can a country reach a point beyond its existing PPF?
A country would require an increase in factor resources, an increase in the productivity or

an improvement in technology to reach this combination. Trade between countries allows
nations to consume beyond their own PPF. Producing more of both goods would represent an
improvement in welfare and a gain in what is called allocative efficiency.
FACTORS RESPONSIBLE FOR THE SHIFT:
1. Improvement in the state of technology

2. Increase in the labor force and labor productivity
3. Increase in capital stock (investment)
4. Discovery of new resources
5. Improvements in human capital
6. Improved resource management.
7.Privatisation.
Q. How can PPF shift without economic growth?
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In an open economy, suppose a country produces at point P along the production possibility curve AB. In
other words, with the available amount of resources, it produces 10 units of X and 20 units of Y.
Combination Q cannot be produced due to scarcity of resources unless there is economic growth.
However, even without economic growth, consumption at point Q could be attained only through
exchange, that is, only if the country engages itself in international trade. To attain combination Q, the
country has to export 4Y and import 10X.
Partial Shifts in PPC
• Partial outwards shifts in PPC means that the efficiency in producing that good has increased and
the opportunity cost has decreased however it still means there is some economic growth in the
economy
• The curve is bowed outwards due to diminishing returns and increasing opportunity costs
Link between LRAS and PPF

There is a link between macroeconomics and the long-run aggregate supply curve. If the PPF
curve shifts to the right, then it is similar effect to the LRAS shifting to the right
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3. Specialization, the division of labor and the role of money
Specialization is when we concentrate on a product or task. The concept of division of labor was stated by
Adam Smith. He showed that through division of labor, worker productivity can increase. Firms can take
advantage of increased efficiency and lower average costs of production. By dividing up a larger task into
smaller part, output can be increased as workers specialize in smaller parts of the work. Specialization can
be achieved by:
1. Individuals
2. Businesses
3. Regions of countries
4. Countries themselves
•The advantages and disadvantages of specialization and the division of labor in organizing
production.
ADVANTAGES OF DIVISION OF LABOR
1. More goods and services can be produced, so increased productivity

2. Time is saved
3. It allows the use of machinery
4. Lower cost per unit
5. More competitive prices
6. Higher-quality
7. Worker specialisation
8. Higher revenue and profit
9. Lower training costs
10. more effective use of capital
DISADVANTAGES OF DIVISION OF LABOR
1. Work may become boring leading to loss in productivity
2. Loss of craftsmanship, since greater use of machinery
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3. Workers become too dependent upon each other
4. Limited knowledge of labor leads to labor immobility
5. Products are standardized
7. Strikes and absenteeism
8. Some workers receive little training and may not be able to find alternative jobs if they find
themselves out of work - they may then suffer structural unemployment.
• The functions of money, e.g. medium of exchange, measure and store of value, method of
deferred payment.
Money must perform the following functions to overcome the problems with barter.
1. Money must act as a medium of exchange
2. Money acts as a measure of value
3. Money must act as a store of value
4. Money must act as a standard of deferred payment
Advantages of Money over barter:
• Avoids double coincidence of wants.

• Permits evaluation.
• Enables giving change.
• Eases saving.
Additional Notes
What are the possible gains from specialization?
By concentrating on what people and businesses do best rather than relying on self-sufficiency:
1. Higher output: Total production of goods and services is raised, and quality can be improved
2. Variety; Consumers have access to a greater variety of higher quality products
3. A bigger market: Specialization and global trade increase the size of the market offering
opportunities for economies of scale
4. Competition and lower prices: Increased competition acts as an incentive to minimize costs,
keep prices down and therefore maintains low inflation
4. Free market and mixed economies

Economic Systems: An economic system is a network of organizations used by a society to resolve the
basic problem of what, how much, how and for whom to produce.
1. Free market economy: Where markets allocate resources through the price
mechanism.
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2. Planned or command economy: In a planned or command system associated with a
socialist or communist system, scarce resources are owned by the government.
3. Mixed economy: In a mixed economy, some resources are owned by the public
sector (government) and some are owned by the private sector.
• The advantages and disadvantages of a free market economy and why there are mixed
economies.
Market system Free economy Mixed economy
Definition An economy in which decisions regarding An economic system in which both the state
investment, production and distribution are and private sector direct the economy,
based on supply and demand and the prices reflecting characteristics of both market
of goods and services are determined in a free economies and planned economies.
price system.
Advantages • Capital return: • Provides fair competition:
Capital flows to where it will get the greatest The presence of private enterprise ensures
return, expanding the total size of the that there is fair competition in the market,
economy to its maximum level. and the quality of products and services are
not compromised.
• Supply and Demand: • Well regulated:
Supply and demand are closely linked: Market prices are well regulated. The
Someone who has a good idea or product can government with its regulatory bodies ensure
quickly put it into the market so that itis that the market price do not go beyond its
available to those who want it. Conversely, actual price.
when a certain type of product is desired by • Efficient use of resources:
enough people, it is a simple matter for Optimum utilization of national resources. In
someone to provide it. a mixed economy, the resources are utilized
• Economic freedom: efficiently as both government and private
In a market economy, it is easier for someone enterprises are utilizing them.
with initiative and virtue to create a better life • It does not allow monopoly at all.
for themselves and their family; economic Barring a few sectors, a mixed economy does
freedom makes it easier to transform hard not allow any monopoly as both government
work and perseverance into material wealth. and private enterprises enter every sector for
business.
Disadvantages • Unequal wealth distribution: • Inefficient:
A small percentage of society has the wealth . Its efficiency property reduces in
while the majority lives in poverty. progressively higher degree, the more its
mixed nature embraces more and more of
• No economic stability: government / state intervention and State
Greed and overproduction cause the planning and reduces the reliance on
economy to have wild swings ranging from competitive market economy management
times of robust growth to cataclysmic mechanisms.
recessions. • Less reliance on competition. Mixed
economy system has a natural tendency
• Too competitive. to move further and further away from
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A competitive environment creates an reliance on competitive market
atmosphere of survival of the fittest. This mechanism to greater and greater
causes many businesses to disregard the bureaucratic controls and interventions
safety of the general public to increase the • Encourage state monopolies: Mixed
bottom line. economy systems tend to encourage
more state monopolies, higher and higher
tax to GDP ratio and dominant public
finances, making the government a large
economic player as compared to
corporate or individual entities
Example USA, Japan, Brazil Canada, Germany, UK
ADVANTAGES OF MARKET ECONOMY
1. There is consumer sovereignty: This means that consumers can influence what goods are produced
directly by their purchase.
2. Wider consumer choice
3. The market system provides incentives to producers in the form of profits and workers in the form
of higher wages. This should encourage entrepreneurs to produce high quality products and to
innovate, and workers to work hard.
4. There is greater efficiency. The aim of firms in a market economy is to make maximum profit. Hence,
the market system encourages technological change to produce goods and services at low cost. Those
firms, which do not produce what people want at low cost and low prices, may go out of business.
DISADVANTAGES OF MARKET ECONOMY (Market Failures/Imperfections)
1. No provision for public goods or public utilities: Since public goods are goods produced on a
non-profit maximization basis because they aim at maximizing socio-economic welfare, thus,
they cannot be produced through the market.
2. Divergence between social cost and private cost: Since negative externalities are not
considered, nothing much is done to reduce pollution and other destruction caused to nature.
3. Harmful products may be produced and consumed: The absence of a government sector
implies the absence of taxes and the free operation of the market mechanism. Left to the price
system, there will be overproduction of certain harmful products such as drugs, alcoholic drinks
and cigarettes.
4. Luxuries in place of necessities: Since allocation of resources depends greatly on those goods
whose prices are high or are rising, more luxury goods will be produced.
5. Unequal wealth distribution
6. Persuasive advertising: Resources used in advertising could be better utilized elsewhere.
Need for mixed economies: It can be deduced that price mechanism determines allocation of
resources as per what consumers want more which initially sounds right. However, this system
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cannot be left to itself because of its various imperfections which undoubtedly necessitate
government intervention.
• The role of the state in a mixed economy.

A mixed economy is a mixture of planned economy and free market economy. A planned economy is run
solely by the government while a free market economy is run by the decisions made by the private sector
and market forces like demand and supply. In a free market economy, the only government intervention
is maintaining law and order.
A mixed economy has two sectors- private and government. A mixed economy is based on private
ownership, the profit motive, demand and supply, etc. with a role for the government. Private sector is
free to make decisions, but government can make an intervention, as and when needed, to alter the
actions of the private sector.
In a mixed economy, private sectors make private goods only. They employ the factors of production and
decide what to make and for whom to make. However, their decision is influenced by the “invisible hand”
and their aim is to maximize profit. The government employs policies to influence the behavior of the
private sector and markets and achieve a better allocation of resources. Some of the roles the government
might play are stated below:
1. The government ensures adequate existence of public goods like roads, railways, street lights,
electricity, etc. If it were entirely left to the private sector, then the citizens would be charged
exorbitant prices for these.
2. If the private sector is exploiting the consumers and charging a high price, government can
intervene and apply a price ceiling. If the producers are being exploited then the government can
impose a price floor.
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3. Government collects taxes from the private sector and use them to make public goods for the
people. The aim of the government is to maximize welfare so it could create job opportunities for
the unemployed without putting any pressure on the private sector to employ more workers.
4. Government can increase provision of merit goods. They can enhance awareness of merit goods
and restrict promotion of demerit goods. They can also provide subsidies to the producer of merit
goods, e.g. rice, to increase their allocation and impose taxes on demerit goods, e.g. cigarettes,
to decrease their allocation.
5. The government can intervene in the market to fix the balance of payments. It has the ability of
impose tariffs and quotas on the imports to reduce the demand and supply for imports
respectively. The government can also devalue the local currency for a limited time to make the
exports cheaper.
6. The role is to provide the environment in which the market can operate successfully. It’s the
government’s job to maintain law and order and invest in defense to protect the sovereignty of
the country. This will make the private sector secure and will also attract more foreign direct
investment.
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5. Positive and normative economics
Positive Economics Normative Economics

1. Objective statement 1. Subjective statement
2. Based on fact 2. Based on a value judgement
3. Can be tested as true or false 3. Cannot be tested as true or false
4. Involves a scientific approach 4. A non-scientific approach
• The distinction between objective statements and value judgements on economic issues.
Positive economics deals with statements of fact which can either be refuted or supported.
For example: A fall in incomes will lead to a rise in demand for own-label supermarket foods
Normative economics deals with value judgements, often in the context of policy
recommendation. A value judgement is a subjective statement of opinion rather than a fact
that can be tested by looking at the available evidence. For example: Pollution is the most
serious economic problem.
• The role of value judgements in influencing economic decision making and policy.
Most economic decisions and policy are influenced by value judgements, which vary from
person to person, resulting in fierce debate between competing political parties.
1.3.2 Demand and consumer behavior

1 The demand curve
• The distinction between movements along a demand curve and shifts of a demand curve.
a) A movement along the demand curve occurs when quantity demanded changes because of a
change in the price of the commodity alone, while other factors in conditions of demand income,
tastes, population, price of complements and substitutes, etc.) remain constant (ceteris paribus).
Thus, a rise in the price will cause quantity demanded to fall, and vice versa. In fact, when a
demand curve is drawn, only the price of the product can vary, while the conditions of demand
do not change.
b) A shift in the demand curve or a change in demand occurs when quantity demanded changes only
because there are changes in conditions of demand, while the price of the commodity remains
constant. The demand curve can shift either to the right or to the left, depending upon the
changes in the conditions of demand.
• The concept of diminishing marginal utility
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Total utility: The total satisfaction from a given level of consumption
Marginal utility: The change in satisfaction from consuming an extra unit
One of the earliest explanations of the inverse relationship between price and quantity demanded is the
law of diminishing marginal utility. This law suggests that as more of a product is consumed the marginal
(additional) benefit to the consumer falls, hence consumers are prepared to pay less. This can be explained
as follows:
Most benefit is generated by the first unit of a good consumed because it satisfies all or a large part of the
immediate need or desire. A second unit consumed would generate less utility - perhaps even zero, given
that the consumer now has less need or less desire. With less benefit derived, the rational consumer is
prepared to pay rather less for the second, and subsequent, units, because the marginal utility falls.
While total utility continues to rise from extra consumption, the additional (marginal) utility from each
bar falls. If marginal utility is expressed in a monetary form, the greater the quantity consumed the lower
the marginal utility and the less the rational consumer would be prepared to pay.
• The factors that may cause a shift in the demand curve

There are indeed several factors which affect the quantity demanded for a certain product.
Personal Determinants
a. Income
b. Taste
c. Prices of other goods or service
d. Expectations about future prices of this good or service
Market Determinants
1. Change in the price of the commodity itself
5. Changes in population: the larger the population, the bigger the demand, ceteris
paribus. Also, an ageing population means demand for certain products like hearing aids,
crutches, healthcare would rise while for other like fast fashion clothes will decline.
7. Changes in distribution of income
8. Government policy – income tax:
9. Rate of interest: This is especially important for house purchases, motor cars, long-life
consumer goods often on a credit card, or hire purchase generally. A higher rate of
interest means more to repay, so people tend to borrow less.
Additional Notes
Demand is the quantity of a good or service that consumers are willing and able to buy at a given price in
a given time period.
Types of Demand
a) Effective Demand: Effective demand is when a desire to buy a product is backed up by an ability
to pay for it
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b) Latent Demand: Latent demand exists when there is willingness to buy among people for a good
or service, but where consumers lack the purchasing power to be able to afford the product.
c) Derived Demand: The demand for a product X might be connected to the demand for a related
product Y – giving rise to the idea of a derived demand. For example, demand for steel is strongly
linked to the demand for new vehicles and other manufactured products, so that when an
economy goes into a recession, so we expect the demand for steel to decline likewise. Labor is a
derived demand as well.
The Law of Demand
• There is an inverse relationship between the price of a good and demand.
o As prices fall, we see an expansion of demand.
o If price rises, there will be a contraction of demand.
There are two reasons for this behavior:
1. The Income Effect: There is an income effect when the price of a good falls because the consumer can
maintain the same consumption for less expenditure. Provided that the good is normal, some of the
resulting increase in real income is used to buy more of this product.
2. The Substitution Effect: There is a substitution effect when the price of a good falls because the product
is now relatively cheaper than an alternative item and some consumers switch their spending from the
alternative good or service.
o As price falls, a person switches away from rival products towards the product
o As price falls, a person's willingness and ability to buy the product increases
o As price falls, a person's opportunity cost of purchasing the product falls
Ceteris paribus assumption
Many factors affect demand. When drawing a demand curve, economists assume all factors are held
constant except one – the price of the product itself. Ceteris paribus allows us to isolate the effect of one
variable on another variable
Why demand curve is downwards sloping?

a) The law of diminishing marginal utility
b) The income effect
c) The substitution effect
2 Price, income and cross elasticities of demand

• Definition of elasticities of demand.
Price elasticity of demand is a measure of the responsiveness of the quantity demanded to a small
change in price
• Calculation and interpretation of numerical values of demand elasticities.
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∆𝑄𝑑
𝑄𝑑
𝑃𝑟𝑖𝑐𝑒 𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝐷𝑒𝑚𝑎𝑛𝑑:
∆𝑃
𝑃
• The factors influencing elasticities of demand and their significance to firms and
government.
There are various factors which influence the price elasticity of demand.
1. Nature of commodity:
(a) Necessities: The demand for necessities is inelastic because when their prices rise, the
(b) consumers’ demand will fall very slightly.
(c) Luxuries: Demand for luxuries is elastic. If their prices fall, demand will increase by a much
greater percentage, but if their prices rise, consumers will reduce their demand
considerably.
2. Availability of substitutes: The more close and numerous availability of substitutes a commodity
has, the more will be its price elasticity of demand. But fewer substitutes a commodity has, the
lower is the price elasticity of demand (inelastic).
3. Proportion of income spent on a commodity: Commodities on which a very low proportion of
income is spent, the demand for the product is inelastic.
4. Number of uses of a product: A product, which has several uses, has an elastic demand. A slight
fall in the price of electricity will cause quantity demanded to increase by a larger extent.
Consumers will be in a position to afford its use even for less important purposes. On the other
hand, a product, which has a single use, has an inelastic demand, for example, toothpaste.
5. Habit: There are certain goods which people consume because they have developed a habit, for
example, cigarettes for a chain-smoker and demand is inelastic.
6. Time period: Demand tends to be more elastic in the long run than in the short run.
7. Price of commodity itself: Demand is generally more elastic at higher level of prices than at lower
levels.
8. The cost of switching between products: there may be costs involved in switching. In this case,
demand tends to be inelastic. For example, mobile phone service providers may insist on a 12
month contract which has the effect of locking-in some consumers once a choice has been made
9. Peak and off-peak demand: demand is price inelastic at peak times and more elastic at off-peak
times – this is particularly the case for transport services.
10. The breadth of definition of a good or service: if a good is broadly defined, i.e. the demand for
petrol or meat, demand is often inelastic. But specific brands of petrol or beef are likely to be
more elastic following a price change.
USEFULNESS OF A KNOWLEDGE OF PRICE ELASTICITY OF DEMAND FOR A FIRM
Firms can use knowledge of PED for the following:
• The effect of a change in price on total revenue of sellers

• The price volatility in a market following changes in supply – this is important for commodity
producers who suffer big price and revenue shifts from one time period to another.
• The effect of a change in an indirect tax on price and quantity demanded and also whether the
business is able to pass on some or all of the tax onto the consumer.
19
• Information on the PED can be used by a business for price discrimination. This is where a supplier
decides to charge different prices for the same product to different segments of the market e.g.
peak and off peak rail travel or prices charged by many of our domestic and international airlines.
• Usually a business will charge a higher price to consumers whose demand for the product is price
inelastic
A manufacturer / firm would find knowledge of price elasticity of demand for his commodity very useful
in adopting pricing policies and taking business decisions. In other words, a business firm cannot fix its
profit maximizing price unless it has a knowledge of price elasticity of demand. Thus, if the firm’s products
face an elastic demand, then the businessman would be able to maximize his net revenue if he lowers the
price. This is because a small decrease in price will lead to a more than proportionate increase in quantity
demanded, which ultimately will increase his total revenue. It will be a mistake to increase the price if
demand is elastic since revenue will fall. This can be illustrated diagrammatically as follows:
At the initial price 0P and Quantity 0Q, total revenue is given by the area A + B (0PRQ). If the producer
lowers the price to 0P1, total revenue will increase to the given area B + C (0P1SQ1).
However, if the firm faces an inelastic demand for his commodities, then pushing up prices will always
increase revenue. This can be explained by the fact that an increase in price will bring about a less than
proportionate decrease in quantity demanded. Therefore, it is not advisable for the businessman to lower
price if demand for his commodities is inelastic. This can be illustrated as follows:
20
EVALUATION:
• However, the firm cannot only rely on the concept of price elasticity of demand to increase
revenue. The data of price elasticity of demand do not reveal absolute truths. They are based on
survey carried out on small sample of consumers. Hence, they cannot be completely accurate.
• Moreover, the concept of price elasticity of demand is calculated based on all other factors
affecting demand remain constant. But, in practice, demand keeps changing due to changes in
other factors too.
• Besides, the concept of price elasticity of demand is useful for the producer to increase revenue.
But in fact, the producer aims to maximize profits. Hence, the firm needs to know more about its
costs. If the firm faces an inelastic demand curve, pushing up prices will reduce output, and
therefore, costs will fall at the same time. With revenue rising, and costs falling, profits must go
up. But the firm has a more difficult decision if facing an elastic demand curve. If price is lowered,
this will also increase output, and therefore, costs.
21
• The relationship between price elasticity of demand and total revenue.
An outward shift of demand will lead to a higher price, an expansion of production and a rise in total
producer revenue
22
3 Consumer behaviors
• The assumption of rationality
The underlying assumptions of rational economic decision making:
o Rational consumers wish to maximize their satisfaction or utility from
consumption by correctly choosing how to spend their limited income.
o Producers/firms wish to maximize profits, by producing at lowest cost the
goods and services that are desired by consumers. Profit = total revenue – total
costs.
o Government wishes to improve the economic and social welfare of citizens.
• Qualifications to assumption of rationality, alternate views of consumer behavior:

The reasons why consumers may not behave rationally:
• consideration of the influence of another people's behaviour: people are strongly
influenced by their social network
• the importance of habitual behaviour
• consumer weakness at computation: Have limited capacity to calculate all costs and
benefits of a decision
• inertia: people don’t want to move out of their comfort zone. Have a strong default to maintain
the status quo.
• consumers need to feel valued
• emotion overtakes logic: They make different choices in cold & emotional states
1.3.3 Supply
1. The supply curve
• The distinction between movements along a supply curve and shifts of a supply curve.
• A movement along the supply curve occurs when quantity supplied changes because of a change
in the price of the commodity alone, while other factors affecting supply remain constant. In fact,
when a supply curve is drawn, only the price of the product is allowed to vary, while the conditions
of supply do not change.
23
• Shift in the supply curve occurs when quantity supplied changes only because there are changes
in conditions of supply such as weather conditions, prices of factor inputs, etc. while the price of
the commodity remains constant. The supply curve can shift either to the right or to the left,
depending upon the changes in the conditions of demand.
• The factors that may cause a shift in the supply curve

1. The price of the good itself
2. Weather / climatic conditions
3. Technical progress: Technical progress means improvements in the performance of machines,

labor, production methods, management control and quality. This allows more to be produced and
supplied.
4. Changes in the prices / costs of factors of production: Movement in wages, prices of raw materials,
fuel and power, rents, interest rates and other factor prices affects the cost of production. For
instance, increase in wages paid to workers increases the cost of production and reduces the profits
of firms. Hence, firms will supply less goods.
5. Government policy – Indirect taxation and Subsidies: Governments can also influence supply. If
the government wants firms to produce more, it may give them a subsidy which will lower their costs,
boost their profits and increase supply. However, if government imposes indirect taxes on goods and
services to the producers, supply will fall because of the increase in costs of production.
Additional Notes
Supply is the quantity of a product that a producer is willing and able to supply onto the market at a given
price in a given time period
The law of supply
As the price of a product rises, so businesses expand supply to the market. A supply curve shows a
relationship between price and how much a firm is willing and able to sell
There are three main reasons why supply curves are drawn as sloping upwards:
1. The profit motive: When the market price rises following an increase in demand, it becomes
more profitable for businesses to increase their output
2. Production and costs: When output expands, a firm's production costs tend to rise, therefore
a higher price is needed to cover these extra costs of production. This may be due to the effects
of diminishing returns as more factor inputs are added to production.
3. New entrants coming into the market: Higher prices may create an incentive for other
businesses to enter the market leading to an increase in total supply.
2 Price elasticity of supply

• Definition of price elasticity of supply.
Price elasticity of supply (Pes) measures the relationship between change in quantity supplied and a
change in price. OR Price elasticity of supply measures the degree of responsiveness of quantity supplied
24
to a change in the price of the commodity. Price elasticity of supplied is always positive, indicating the
direct relationship between quantity supplied and price.
• Calculation and interpretation of numerical values of price elasticity of supply (PES).

∆𝑄𝑠
𝑄
𝑃𝑟𝑖𝑐𝑒 𝑒𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝑆𝑢𝑝𝑝𝑙𝑦: 𝑠
∆𝑃
𝑃
a) When Pes > 1, then supply is price elastic
b) when Pes < 1, then supply is price inelastic
c) When Pes = 0, supply is perfectly inelastic
d) when Pes = infinity, supply is perfectly elastic
• Factors that influence price elasticity of supply.

1. Time periods: The elasticity of supply tends to be greater in the long run than in the short run
because it is easier to increase the amount produced when the firm has more time in which to do
it.
2. Availability of resources: If a firm wishes to expand production, it will need more resources.
3. Availability of stocks: When suppliers are holding large stocks, supply will be elastic.
4. Producing at full or below capacity: Once industries operate at full capacity, supply will be
inelastic. However, if industries operate below full capacity, supply will be elastic.
5. Risk taking: The more willing entrepreneurs are to take risks the greater will be the elasticity
of supply. This will be partly influenced by the system of incentives in the economy. If the rates of
taxes are very high, this may reduce the elasticity of supply.
Limitations of Price Elasticity
• Problems with inaccurate or incomplete data collection

• Consumer price sensitivity changes over time
• Elasticity of demand varies by region/time
• Not all businesses are profit maximizers
• Elasticity will vary within product ranges, e.g. economy and premium products
• Rival producers will change their market strategies from time to time
• The distinction between the short run and long run in economics and its significance to
price elasticity of supply.
Supply is usually more price elastic the longer the time period that a supplier is allowed to adjust its
production levels.
Supply for Momentary Period
In some agricultural markets the momentary supply is fixed and is determined mainly by planting
decisions made months before, and climatic conditions, which affect the production yield. This means
that the price elasticity of supply in the momentary period is zero (a vertical supply curve)
25
Price Elasticity of Supply in the Short Run
Supply is likely to be price inelastic in the short run because it may be difficult to expand output and to
increase their use of factors of production such as land and capital. In the short run at least one factor
input is assumed to be fixed, for example the available stock of capital equipment.
Price Elasticity of Supply in the Long Run
In the long run all factor inputs are assumed to be variable and therefore short-term supply constraints
can usually be resolved and we expect to see a more elastic supply curve. Producers are better able to
respond to a higher level of market demand.
26
Additional Notes
Supply could be inelastic for the following reasons
• Firms operating close to full capacity.

• Firms have low levels of stocks, therefore there are no surplus goods to sell.
• In the short term, capital is fixed in the short run e.g. firms do not have time to build a bigger
factory.
• If it is difficult to employ factors of production, e.g. if highly skilled labor is needed
• With agricultural products, supply is inelastic in the short run, because it takes at least six months
to grow new crops. In September the farmer cannot suddenly produce more potatoes if the price
goes up.
Examples of goods with inelastic supply
• Nuclear reactors – It takes considerable time and expertise to build a new reactor. If there is high
demand, few firms would be able to increase output in quick time
• Grapes – Harvest is once a year, so in short-term, supply would be very inelastic.
• Flood defenses – If there is heavy rainfall and flooding, there would be high demand for flood
defenses. But, to supply barriers against the floods cannot occur overnight. It will take many
months of construction to build.
Supply could be elastic for the following reasons
• If there is spare capacity in the factory.

• If there are stocks available.
• In the long run, supply will be more elastic because capital can be varied.
• If it is easy to employ more factors of production.
• If a product can be sold from the internet which increases the scope of international
competition and increases options for supply.
Examples of goods with elastic supply
• Fidget spinners. These goods are relatively easy to make, requiring only basic raw materials of
plastic. Many manufacturing firms could easily adapt production to increase supply.
• Taxi services. It is relatively easy for people to work as a taxi driver. People can work part-time
and only need a qualified driving license. With mobile apps like Uber, it has also become easier to
fit consumers with a broader range of options. If price rises, Uber can offer higher wages and
encourage more people to come out to work. There are still some supply constraints on very
popular days. But, mostly, supply is quite elastic.
1.3.4 Price determination

1 Determination of market equilibrium
• Equilibrium price and quantity and how they are determined.
o Market equilibrium, also known as market clearing price, occurs where supply = demand.
When the market is in equilibrium, there is no tendency for prices to change. We say the
market clearing price has been achieved
27
o A market occurs where buyers and sellers meet to exchange money for goods.
o The price mechanism refers to how supply and demand interact to set the market price
and amount of goods sold
o At most prices planned demand does not equal planned supply. This is a state of
disequilibrium because there is either a shortage or surplus and firms have an incentive
to change the price.
o Equilibrium price refers to a state where there are neither excesses nor shortages of
commodities in the market. Since free market implies no government intervention, the
price of any commodity in the free market is determined by the combined forces of
demand and supply. With a downward sloping demand curve and an upward sloping
supply curve, equilibrium price occurs when these two intersect.
28
• The use of a supply and demand diagram to show how shifts in demand and supply
curves cause the equilibrium price and quantity to change.
• In (a) as demand curve shifts to the right, both the equilibrium price and quantity goes up.
• In (b) as demand curve shifts to the left, both the equilibrium price and quantity goes down.
• In (c) as supply curve shifts to the right, both the equilibrium price and quantity goes up.
• In (d) as supply curve shifts to the left, both the equilibrium price and quantity goes down.
When demand and supply curves shift simultaneously
Both the demand and the supply decrease. Since decreases in demand and supply, considered separately,
each cause equilibrium quantity to fall, the impact of both decreasing simultaneously means that a new
equilibrium quantity must be less than the old equilibrium quantity. In Panel (a), the demand curve shifts
farther to the left than does the supply curve, so equilibrium price falls. In Panel (b), the supply curve shifts
farther to the left than does the demand curve, so the equilibrium price rises. In Panel (c), both curves
shift to the left by the same amount, so equilibrium price stays the same.
29
Summary:
• The operation of market forces to eliminate excess demand and excess supply.
If price is below the equilibrium
• If price was below the equilibrium at P2 then demand would be greater than the supply. Therefore,
there is a shortage of (Q2 – Q1)
• If there is a shortage, firms will put up prices and supply more. As price rises, there will be a
movement along the demand curve and less will be demanded.
• Therefore, price will rise to Pe until there is no shortage and supply = demand
30
If price is above the equilibrium
• If price was above the equilibrium (e.g. P1), then supply (Q1) would be greater than demand (Q3)
and therefore there is too much supply. There is a surplus.
• Therefore, firms would reduce price and supply less. This would encourage more demand and
therefore the surplus will be eliminated. The market equilibrium will be at Q2 and Pe.
Movements to a new equilibrium
31
If there was an increase in income the demand curve would shift to the right (D to D2). Initially, there
would be a shortage of the good. Therefore, the price and quantity supplied will increase leading to a new
equilibrium at Q2. An increase in supply would lead to a lower price and more quantity sold.
So, the shift will only occur when there is excess demand or supply due to factors affecting demand change
like income, lifestyle, etc. But when there is excess demand or supply due to excess or shortage of
demand/supply, then there will be only movements along the curves.
2 Consumer and producer surplus

• The distinction between consumer and producer surplus.
Consumer surplus is a measure of the welfare that people gain from the consumption of goods and
services, or a measure of the benefits they derive from the exchange of goods. Consumer surplus is the
difference between the amount consumers are prepared to pay to obtain a particular good and the
amount they actually pay in the market. It is a measure of the surplus utility or welfare consumers receive
over and above what they pay for. Consumer surplus is shown by the area under the demand curve and
above the price.
Consumer surplus = Total utility – Total amount spent.

When there is a shift in the demand curve leading to a change in the equilibrium market price and
quantity, then the level of consumer surplus will change too
Consumer Surplus Producer Surplus

Consumer surplus is defined as the difference Producer surplus is defined as the difference
between the highest price that the consumer is between the lowest price that a producer is
willing to pay and the market price. willing to accept and the market price.
When price decreases consumer surplus When price decreases the producer surplus
increase up to a certain point below the increases.
equilibrium price.
This is consumer’s welfare. This is producer’s welfare.
Similarity between consumer and producer surplus
32
• Both consumer and producer surplus have a negative relationship with price
• Both are welfare of their own party
• The use of a supply and demand diagram to illustrate consumer and producer surplus.
33
• How changes in demand or supply might affect consumer and producer surplus.
Producer Surplus as Demand Shifts
Consumer surplus and price elasticity of demand
• When the demand for a good or service is perfectly elastic, consumer surplus is zero because
the price that people pay matches precisely the price they are willing to pay. This is most likely
to happen in highly competitive markets where each individual firm is assumed to be a ‘price
taker’.
• In contrast, when demand is perfectly inelastic, consumer surplus is infinite. Demand is totally
invariant to a price change. Whatever the price, the quantity demanded remains the same.
The majority of demand curves in markets are assumed to be downward sloping. When demand is
inelastic (i.e. Ped<1), there is a greater potential consumer surplus because there are some buyers willing
to pay a high price to continue consuming the product. Businesses often raise prices when demand is
inelastic so that they can turn consumer surplus into producer surplus
Price discrimination and consumer surplus
Producers often take advantage of consumer surplus when setting prices. If a business can identify groups
of consumers within their market who are willing and able to pay different prices for the same products,
34
then sellers may engage in price discrimination – the aim of which is to extract from the purchaser, the
price they are willing to pay, thereby turning consumer surplus into extra revenue.
Example: Airlines are expert at practicing this form of yield management, extracting from consumers the
price they are willing and able to pay for flying to different destinations are various times of the day, and
exploiting variations in elasticity of demand for different types of passenger service.
3 Functions of the price mechanism

• The rationing, incentive and signaling functions of the price mechanism for allocating
scarce resources.
The price mechanism describes the means by which millions of decisions taken by consumers and
businesses interact to determine the allocation of scarce resources between competing uses. The price
mechanism plays three important functions in a market:
i. Signalling function: Prices perform a signalling function – they adjust to demonstrate where
resources are required, and where they are not. Prices rise and fall to reflect scarcities and
surpluses.
• If prices are rising because of high demand from consumers, this is a signal to suppliers
to expand production to meet the higher demand
• If there is excess supply in the market the price mechanism will help to eliminate a
surplus of a good by allowing the market price to fall.
ii. Transmission of preferences: Through their choices consumers send information to
producers about the changing nature of needs and wants. Higher prices act as an incentive to
raise output because the supplier stands to make a better profit. When demand is weaker in
a recession then supply contracts as producers cut back on output. One of the features of a
market economy system is that decision-making is decentralised i.e. there is no single body
responsible for deciding what is to be produced and in what quantities. This is a remarkable
feature of an organic market system.
iii. Rationing function: Prices serve to ration scarce resources when demand in a market
outstrips supply. When there is a shortage, the price is bid up – leaving only those with the
willingness and ability to pay to purchase the product. Be it the demand for tickets among
England supporters for an Ashes cricket series or the demand for a rare antique, the market
price acts a rationing device to equate demand with supply. The popularity of auctions as a
means of allocating resources is worth considering as a means of allocating resources and
clearing a market.
• The price mechanism in the context of different types of markets, including local,
national and global market.
The functions of the price mechanism can be seen in any free market whether local, national or global.
For example, in the UK there is a continuing issue with the scarcity of houses. This has resulted in increases
in the prices of houses in the UK to try and ration this demand. Furthermore, house prices are dependent
on the location of the house. For example, in London house prices are much greater than those in the
North West. The reason for this is because there is much more demand for houses in London due to its
greater population and the fact that it is the main place where big businesses locate. Therefore, the price
needed to ration this excess demand is much greater in London than the North West.
35
Although the price mechanism works to some extent in all types of market, the bigger the market gets the
harder that it will be for the market to work at equilibrium. In addition to this, government intervention
in the market can sometimes occur which can sometimes distort price signals and therefore prevents the
price mechanism from working freely.
4 Indirect taxes and subsidies

• The use of supply and demand analysis, including elasticities to demonstrate the impact and
incidence of taxes and subsidies on consumers, producers and the government.
i) The impact of indirect taxes on consumers, producers and government
Taxes fall into two main groups, direct and indirect.

• Direct taxes are those which are levied directly on people's incomes, for example income tax.
• On the other hand, indirect taxes are those which are levied on expenditure, that is, on goods
and services.
Indirect taxes are classified into 2 categories mainly:
(1) Ad valorem tax: is levied as a percentage of the selling price of the commodities, that is, on
value, for example, VAT
(2) Specific or per unit tax: is levied per unit of the commodity, irrespective of its price, for
example, excise duty.
Indirect taxes may be regarded as a cost of production. Hence, when indirect taxes are imposed, the
producers face a higher cost of production. As a result, the supply curve shifts to the left by the amount
of the tax. However, the shift is different for ad valorem tax and specific tax.
ii) The incidence of indirect taxes on consumers and producers
INCIDENCE V. BURDEN OF TAX
Incidence of Taxation Burden of Taxation

Who the tax falls upon; the formal incidence of a Who actually pays the tax
tax is upon the person who is legally responsible
for paying it.
▪ For direct taxation: The incidence and burden fall on one and the same person
36
▪ For indirect taxation: The incidence falls on producers, but the burden is on consumers. In other
words, the incidence of indirect tax can be shifted so that burden of the tax is wholly or partly
upon the consumers.
▪ The extent to which the tax is passed on to the consumer will be determined by the price elasticity
of demand and supply.
iii) The impact of subsidies on consumers, producers and government
AB is the total tax per unit imposed by the government. This tax is borne both by the producer and by the
consumer. AC is the tax per unit paid by consumers, while CB is paid by producers. Hence, it can be noted
that consumers pay more tax than producers if demand is inelastic. This follows that when demand is
perfectly inelastic, all the tax would be passed on to the consumers.
that producers pay more tax than consumers if demand is elastic. This follows that when demand is
perfectly elastic, all the tax is paid by producers only.
37
that producers pay more tax than consumers if supply is inelastic. This follows that when supply is
perfectly inelastic, all the tax is paid by producers only.
that consumers pay more tax than producers if supply is elastic.
Summary of Link between Elasticity and Incidence of Indirect Taxation
Type of Elasticity Burden of Taxation

Producers Consumers
1. Demand is inelastic Pay Less Pay More
2. Demand is perfectly inelastic Pay None Pay All
3. Demand is elastic Pay More Pay Less
4. Demand is perfectly elastic Pay All Pay None
5. Supply is inelastic Pay More Pay Less
6. Supply is perfectly inelastic Pay All Pay None
7. Supply is elastic Pay Less Pay More
8. Supply is perfectly elastic Pay None Pay All
38
iv) The area that represents the producer subsidy and consumer subsidy
Subsidy: A subsidy is a payment by the government to suppliers that reduce their costs of
production and encourages them to increase output
• To encourage production of certain goods and services, e.g. subsidising renewable energy to
reduce the demand for non-renewable energies and therefore reduce pollution.
• To support a failing industry, e.g. supporting the UK car industry in order to protect
employment.
What effect does a producer subsidy have on market price and output?
• State subsidises are financed from general taxation or by borrowing

• The subsidy causes the firm's supply curve to shift to the right
• The amount spent on the subsidy is equal to the subsidy per unit multiplied by total output
• A direct subsidy to the consumer has the effect of boosting demand i.e. an outward shift of
demand
Different Types of Producer Subsidy
1. A guaranteed payment on the factor cost of a product – e.g. a guaranteed minimum price
offered to farmers
2. An input subsidy which subsidises the cost of inputs used in production – e.g. an employment
subsidy for taking on more workers.
3. Government grants to cover losses made by a business – e.g. a grant given to cover losses in
the railway industry or a loss-making airline.
4. Bail-outs e.g. for financial organisations in the wake of the credit crunch
5. Financial assistance (loans and grants) for businesses setting up in areas of high unemployment
– e.g. as part of a regional policy designed to boost employment
Incidence of Taxation on Producers and Consumers
The government sometimes subsidizes a product by giving an amount of money to the producers for each
unit they sell. The benefit of the subsidy will be split between the producer and consumer. The division
will again depend upon the price elasticity of demand.
39
AC is the total subsidy per unit granted by the government. This subsidy is benefited both by the producer
and by the consumer. AB is the subsidy per unit benefited by consumers, while BC is benefited by
producers.
Analyzing and Evaluating Producer Subsidies
Showing a producer subsidy in a supply and demand
How do we show the total government spending on a producer subsidy?
40
To what extent will a subsidy feed through to lower prices for consumers?
This depends on price elasticity of demand. The more inelastic the demand curve the greater the
consumer's gain from a subsidy. Indeed when demand is perfectly inelastic the consumer gains most of
the benefit from the subsidy since all the subsidy is passed onto the consumer through a lower price.
When demand is relatively price elastic, the main effect of the subsidy is to increase the equilibrium
quantity traded rather than lead to a much lower market price.
41
1.3.5 Wage determination in labor markets
1 The demand for labor
The labor market is a factor market – it provides a means by which employers find the labor they need,
whilst millions of individuals offer their labor services in different jobs.
• Many factors influence how many people a business is willing and able to take on. But we start
with the most obvious – the wage rate or salary
• There is an inverse relationship between the demand for labor and the wage rate that a
business needs to pay as they take on more workers
• If the wage rate is high, it is costlier to hire extra employees
• When wages are lower, labor becomes relatively cheaper than for example using capital
inputs. A fall in the wage rate might create a substitution effect and lead to an expansion in
labor demand.
• The factors that influence the demand for labor.

The number of people employed at each wage level can change and in the next diagram we see an
outward shift of the labor demand curve. The curve shifts when there is a change in the conditions of
demand in the jobs market. For example:
42
• An increase in the productivity of labor which makes using labor more cost efficient
than using capital equipment. This will lead to higher revenue and profits, encouraging
firms to employ more people.
• A government employment subsidy which allows a business to employ more workers
• Demand for the final product: An increase in demand for a good or service is likely to
cause an increase in demand for the labor involved in making it. Firms have a profit
incentive, if demand and prices increase, to supply more of a good or service.
• Wage Rate: A fall in wage rate means that labor becomes more affordable and so firms
are likely to demand more labor.
The labor demand curve would shift inwards during a recession when sales of goods and services are in
decline, business profits are falling and many employers cannot afford to keep on their payrolls as many
workers. The result is often labor redundancies and an overall decline in the demand for labor at each
wage rate.
• How the demand for labor in the private sector is derived from the demand for the final
product.
The demand for all factor inputs, including labor, is a derived demand i.e. the demand depends on the
demand for the products they produce. When the economy is expanding, we see a rise in demand for
labor providing that the rise in output is greater than the increase in labor productivity. During a
recession or a slowdown, the aggregate demand for labor will decline as businesses look to cut their
operations costs and scale back on production. In a recession, business failures, plant closures and short-
term redundancies lead to a reduction in the derived demand for labor. In fast-growing markets, there is
often a strong rise in demand for labor – for example an increase in demand for new apps for smart
phones and tablets causes an increase in labor demand and then higher wage rates for app
programmers
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• The elasticity of demand for labor.
Elasticity of labor demand measures the responsiveness of demand for labor when there is a change in
the ruling market wage rate. The elasticity of demand for labor depends on these factors:
1. Labor costs as a % of total costs: When labor expenses are a high proportion of total costs, then labor
demand is more elastic than a business where fixed costs of capital are the dominant business expense.
In many service jobs such as customer service centers or gas boiler repairs, labor costs are a high
proportion of the total costs of a business.
2. The ease and cost of factor substitution: Labor demand will be more elastic when a firm can
substitute quickly and easily between labor and capital inputs. When specialised labor or capital is
needed, then the demand for labor will be more inelastic with respect to the wage rate. For example it
might be fairly easy and cheap to replace security guards with cameras but a hotel would find it almost
impossible to replace hotel cleaning staff with machinery!
3. The price elasticity of demand for the final output produced by a business: If a firm is operating in a
highly competitive market where final demand for the product is price elastic, they may have little
market power to pass on higher wage costs to consumers through a higher price. The demand for labor
may therefore be more elastic as a consequence. In contrast, a firm that sells a product where final
demand is inelastic will be better placed to pass on higher costs to consumers.
2 The supply of labor
The labor supply is the number of hours people are willing and able to supply at a given wage rate. It is
the number of workers willing and able to work in a particular job or industry for a given wage
The labor supply curve for any industry or occupation will be upward sloping. This is because, as wages
rise, other workers enter this industry attracted by the incentive of higher rewards. They may have moved
from other industries or they may not have previously held a job, such as housewives or the unemployed
The extent to which a rise in the prevailing wage or salary in an occupation leads to an expansion in the
supply of labor depends on the elasticity of labor supply.
• The factors that influence the supply of labor, e.g. population migration, income tax and
benefits, government regulations, trade unions.
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Figure 1 Factors affecting supply of labor
Additional Notes
Labor Migration
Cross-border migration of people from one country to another has become an increasingly important
feature of our globalising world and it raises many important economic, social and political
Factors affecting migration
1. Differences between in wages for equivalent jobs
2. Access to the benefits system of host countries plus state education, housing & health care
3. Employment opportunities vary between nations, in particular for younger workers
4. A desire to travel, learn a new language, build new skills and qualifications and develop
networks
5. A desire to escape repression and corruption in the country of origin especially in failing states
6. The impact of satellite television and the internet in changing people's expectations
7. The effects of cheaper trans-national phone calls and more affordable air travel and coach
travel for example within the European Union
8. The unwillingness of people within the domestic economy to take certain “drudge-filled" jobs
such as porters, cleaners and petrol attendants
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Economic Benefits from Cross-Border Migration
Supporters of inward labor migration have argued that migration provides numerous advantages:
1. Fresh skills: Migrants can provide complementary skills to domestic workers, which can raise
the productivity of both (a Brazilian child minder provides good quality child care at an affordable
price which allows a highly paid female magazine editor to continue to work.)
2. A driver of innovation and entrepreneurship: Inward migration can also be a driver of

technological change and a fresh source of entrepreneurs. Much innovation comes from the work
of teams of people who have different perspectives and experiences. Migrant networks
accelerate the spread of technology.
3. Pressure on government to reform: Labor migration can also put political pressure on failing
governments and regimes e.g. a mass exodus of productive workers from Zimbabwe.
4. Multiplier effects: New workers create new jobs, there is a multiplier effect if they find work
and contribute to a nation's GDP through a higher level of aggregate demand
5. Reducing skilled-labor shortages and expanding the labor supply: Migration can help to relieve
labor shortages and help to control wage inflation. For example, recruitment of skilled workers
from outside the European Union is important to many businesses in the UK, and evidence
indicates they currently make a positive contribution to UK's GDP.
6. Making a country attractive to FDI: Availability and quality of labor is known to be a key
investment location factor for many businesses. In a global battle for talent, if a country is not
successful in attracting and keeping skilled workers then FDI in high-knowledge industries will
eventually flow to other parts of the world.
7. Income flows (remittances): Remittances sent home by migrants add to the gross national
income of the home nations. And if these remittances boost spending in these countries, this
creates a fresh demand for the exports of other nations. According to the economist Professor
Ian Goldin from Oxford University, in Latin America and the Caribbean, more than 50-million
people are supported by remittances, and the numbers are even higher in Africa and Asia.
8. Tax revenues: Legal immigrants in work pay direct and indirect taxes and are likely to be net
contributors to the government's finances.
Supporters of allowing free movement of labor argue that labor mobility is a positive-sum game rather
than a zero-sum game.
Disadvantages of inward migration
On the other side there are several pressure groups campaigning for tighter restrictions on migrant
workers. Some of the arguments include:
1. Welfare costs: Increasing cost of providing public services as migrants come into a country.
2. Worker displacement: Possible displacement effects of domestic workers
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3. Social pressures: Social tensions arising from the problems of integrating hundreds of
thousands of extra workers into local areas and regions.
4. Pressure on property prices: Rising demand for housing which forces up prices and rents.
5. Benefit claims: Many immigrants find it hard to get work
6. Poverty risk: Migration may have the effect of worsening the level of relative poverty in a
society. And many migrant workers have complained of exploitation by businesses that have
monopsony power in a local labor market.
Main roles of trade unions
• Protecting and improving the real living standards of their members

• Protecting workers against unfair dismissal (employment rights)
• Promoting improvements in working conditions, workload & health and safety issues
• Workplace training and education, accumulation of human capital
• Protection of pension rights for union members
Zero-hour contracts
Create an incentive for workers to be more mobile. With an uncertain amount of work, they may need
to juggle more than one job to earn sufficient income.
• The geographical and occupational mobility of labor.

The mobility of labor refers to how easily workers can move to different jobs within the economy. The
two main factors of labor mobility are:
• Occupational mobility is the ability of labor to switch between different occupations.

Occupational mobility is affected by the level of transferable skills and educational requirements
of jobs.
• Geographical mobility is the ability of labor to move around an area, region or country in order
to work. Geographical mobility is affected by things such as family ties, transport networks,
transferable qualifications and common language.
Factors which affect occupational mobility are:
Skills / education: A key factor in determining occupational immobility is the relevant skills and
education of workers which make it possible to move to different jobs. This is both standard educational
qualifications, A-levels, degrees, but also more practical vocational qualifications, such as IT skills,
qualified electrician.
Factors which affect geographical mobility are:
1. Housing market: If rented accommodation is readily available and affordable, it will be

much easier to move. Low affordability of housing can make labor markets less mobile.
2. Transport: Transport is a factor which determines how easy it is to move around the
country. Another issue is the availability of public transport for commuting purposes.
Good rail links can make it easier for commuters to work in city centers with high
housing costs.
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3. Immigration policy: Within the EU, free movement of labor enables workers to move to
different countries in search of better job prospects. During the Irish construction boom,
immigrant labor helped to fill labor shortages; as the construction sector went into
decline, there was net outward migration.
Issues related to labor mobility
• An economy which relies on high levels of labor mobility can make labor markets more stressful,
with workers needing to rely on zero-hour contracts without any guarantee of sufficient work.
• Highly mobile labor markets may suit some workers who have the educational attainments and
freedom to move around in search of work, but others may lose out because they struggle to
cope with the pace of change.
• Another big issue is that the relative decline of manufacturing has caused workers to lose well-
paid, permanent manual work. With low education levels, new employment opportunities tend
to be of a different nature (temporary, no security) and therefore, the unemployed worker feels
the labor mobility requires a decline in employment status.
• High levels of net migration can cause other social issues such as an impact on the limited
housing stock.
• The elasticity of supply of labor.

Elasticity of labor supply measures the extent to which labor supply responds to a change in the wage
rate in a given time period.
Some of the key factors affecting the wage elasticity of supply of labor are as follows:
• Nature of skills and qualifications required to work in an industry

• Specific skills and educational requirements make supply inelastic
• Lengthy and costly training periods makes labor supply inelastic
• When the minimum skill factor needed is relatively low, then the pool of available labor will be
large, making labor supply elastic
• Vocational nature of work - in vocational jobs such as nursing, people are less sensitive to
changes in wages when deciding whether to work and how many hours to work
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• Time period – In the short run, the supply curve for labor to a particular occupation tends to be
relatively inelastic. It takes time for people to respond to changes in relative wages and
earnings– especially if people need to be re-trained to enter a new occupation
• When labor is geographically and occupationally mobile, then labor supply will tend to be
relatively elastic even in the short term
3 Determination of wage rates

• Use of supply and demand diagram to illustrate labor market equilibrium.
The equilibrium market wage rate is at the intersection of the supply and demand for labor. Employees
are hired up to the point where the extra cost of hiring an employee is equal to the extra sales revenue
from selling their output.
When demand for labor fall, e.g. in a recession, the demand curve for labor shifts from DL to D1 and the
wage rate drops from W to W1.
If supply of labor is increased, e.g. due to increasing retirement age, then the supply curve will shift and
the wage rate will drop.
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• Government intervention in the labor market, e.g. maximum and minimum wages.
Benefits of a Minimum Wage
• Reduces poverty. The minimum wage increases the wages of the lowest paid. These workers
will have increased income and will reduce relative poverty.
• Increase productivity. The efficiency wage theory states that higher wages can increase the
incentive for people to work harder and thus higher wages may increase labor productivity. If
firms have to pay higher wages, they may put more focus on increasing labor productivity, which
increases efficiency of the economy
• Increase the incentives to accept a job. With a minimum wage, there is a bigger difference
between the level of benefits and the income from employment. A minimum wage could also
increase the participation rate as the benefits of work become greater and more worthwhile.
• Increased investment. Firms will have an increased incentive to invest and increase labor
productivity because labor is costlier.
• Counterbalance the effect of monopsony employers. If firms have Monopsony power they can
drive wages down by employing fewer workers. However, minimum wages will make this more
difficult. Therefore, a minimum wage could have a positive effect on employment.
Problems of Minimum Wage
• Scope for unemployment If labor markets are competitive, a minimum wage above the
equilibrium could cause a fall in demand for workers, and excess supply
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Above the equilibrium, the national minimum wage can cause unemployment of Q3-Q2
• Certain industries vulnerable to a ‘living wage’ It is argued labor intensive industries, where
labor costs are a high percentage of overall costs could be hit by a high National Minimum
Wage. In particular, care workers for old people are often paid the Minimum Wage. With a rise
in number of old people needing care, this could significantly increase costs for old age care.
• Regional variations in wages A big problem with a national minimum wage is that wages vary
enormously within the UK. In London, with higher costs of living, not many people get the
minimum wage because wages are relatively higher. However, in some areas a minimum wage
of £9 could cause significant unemployment, especially in labor intensive industries. It is
estimated that in 10 hot spot low pay areas 30% of workers are on the Minimum Wage.
• Higher wages passed onto consumers. An increase in the minimum wage could cause firms to
increase prices and pass the costs onto consumers
What is the best rate to set?
The desirability of a minimum wage depends on various factors:
• State of the economy. During strong growth and falling unemployment, it is easier for firms to
pay higher wages.
• The elasticity of demand. Is demand for labor wage inelastic? or will some firms be very
sensitive to higher wages? Some service sector jobs like hairdressers/cleaners may argue a small
increase in their wage bill could lead to unemployment.
• Regional wage rates. Could you allow for regional differences in wages? (e.g. a London specific
minimum wage)
• Type of labor market. Are labor markets competitive or monopsonistic?
• Is there scope for firms to increase labor productivity? and therefore be able to afford the
wage increases.
1.3.6 Market failure

1 Types of market failure
• Definition of market failure
Definition: Too much or too little of a good is produced and/or consumed compared to the socially
optimal level of output.
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Market failure happens when:
• The price mechanism fails to allocate scarce resources efficiently

• When the operation of market forces leads to a net social welfare loss
Market failure exists when the competitive outcome of markets is not satisfactory from the point of
view of society. What is satisfactory nearly always involves value judgments.
Complete and partial market failure
• Complete market failure occurs when the market simply does not supply products at all - we
see "missing markets"
• Partial market failure occurs when the market does actually function but it produces either the
wrong quantity of a product or at the wrong price.
• Types of market failure, including externalities, public goods, imperfect market

information, labor immobility.
• Externalities
o Negative externalities (e.g. the effects of environmental pollution) causing the
social cost of production to exceed the private cost
o Positive externalities (e.g. the provision of education and health care) causing the
social benefit of consumption to exceed the private benefit
• Under-provision of public goods
o The private sector in a free-markets cannot profitably supply to consumers pure
public goods and quasi-public goods that are needed to meet people's needs and
wants
o Market dominance by monopolies can lead to under-production and higher prices
than would exist under conditions of competition, causing consumer welfare to be
damaged
o Factor immobility causes unemployment and a loss of productive efficiency
o Equity (fairness) issues. Markets can generate an 'unacceptable' distribution of
income and consequent social exclusion which the government may choose to
change
• Information Gaps
o Imperfect information or information failure means that merit goods are under-
produced while demerit goods are over-produced or over-consumed
• Labor Immobility
Labour immobility means that labour does not ‘move’ to where it is in greatest demand. It is
mainly due to geographical and occupational immobility.
2 Externalities
• Distinction between private costs, external costs and social costs.
a) Private costs are those costs which are borne solely by the individuals who incur
them, that is, by the users. Private costs are the costs faced by the producer or
consumer directly involved in a transaction. They are usually measured by the market
price of the resources that the firm uses. They may be an activity of a consumer or a
producer. For example, the private costs of a consumer who smokes would be the
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money he spends on cigarettes. A producer, who runs a business, incurs private costs
on labor, materials, machines, among others.
b) External cost arises when social cost exceeds private cost and disadvantages third
parties (cost which is borne by the non-users).
c) Social cost represents the full cost to society. It includes private costs and external
costs. In fact, social cost measures the best alternative use of resources that is
available to the whole society. In other words, for the society's point of view,
the price system must consider both private costs and external costs.
Social cost (SC) = Private costs (PC) + External costs (EC)
In marginal terms (when each additional unit of good is produced),
Marginal Social Costs (MSC) = Marginal Private Costs (MPC) + Marginal
External Costs (MEC)
• Distinction between private benefits, external benefits and social benefits.
a) Private benefits: It refers to the utility or benefit derived by the users, that is, the
person who generates the economic activity. For instance, it is the total satisfaction
derived by the consumers or the profits earned by the private producers. Indeed,
when a private firm carries out production, it does consider only its private costs
and private benefits.
b) External benefit arises when social benefit exceeds private benefit. It refers to the
benefit from production (or consumption) experienced by people other than the
producer (or consumer).
c) Social benefit refers to, the full benefit to society from consumption and production
of any good. From the society's point of view, the price system must consider both
private benefit and external benefit.
Social benefit (SB) = Private benefit (PB) + External benefit (EB)
In marginal terms (when each additional unit of good is produced),
Marginal Social benefit (MSB) =Marginal Private benefit (MPB) + Marginal
External benefit (MEB)
SOCIALLY OPTIMUM LEVEL OF OUTPUT AND MARKET FAILURES:

If MSB > MSC, then it is said to be socially efficient to produce more (or to consume) more. •
On the other hand, if MSC > MSB, then it is socially efficient to produce (or consume) less. It
follows, therefore, that if MSB = MSC, then the current level is optimum (socially equilibrium).
Hence, the socially optimum level of output occurs where MSB = MSC
Market system considers only private costs and private benefits, and ignores any
external costs and benefit. Hence, private producers produce too much of commodities that
generate harmful externalities because they bear none of the costs suffered by others. In other
words, external costs result in a level of output greater than the social optimum.
• Use of diagrams to illustrate the external costs from production and external benefits
from consumption using marginal analysis. The distinction between the market and social
optimum positions and identification of the welfare loss or gain areas.
Negative externalities occur when production and/or consumption impose external costs on third
parties outside of the market for which no appropriate compensation is paid. This causes social costs to
exceed private costs. Externalities occur outside of the market i.e. they affect people not directly
involved in the production and/or consumption of a good or service. They are also known as spill-over
effects. Example, Smokers ignore the harmful impact of toxic 'passive smoking' on non-smokers
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Externalities and market failure
The existence of externalities creates a divergence between private and social costs of production and
the private and social benefits of consumption.
Social Cost = Private Cost + External Cost
When negative production externalities exist, social costs exceed private cost. This leads to over-
production and market failure if producers do not consider the externalities.
a) External costs from production
• Production externalities are generated and received in supplying goods and services - examples
include noise and atmospheric pollution from factories, discharges of waste, etc.
b) External costs from consumption
• Consumption externalities are generated and received in consumption – e.g. pollution from
driving cars and motorbikes and externalities created by smoking and alcohol abuse and the noise
pollution created by loud music being played in built-up areas.
• Negative consumption externalities lead to a situation where the social benefit of consumption
is less than the private benefit.
Types of Externalities
Positive Externalities {Consumption} Negative Externalities {Production}

o More jobs to society o Acid Rain from power stations
o Decrease in Crime Rates o Environmental damage from fertilisers
o Enjoyment and satisfaction for others o Noise and air pollution
o Better Education and training o Pumping toxic waste
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o Better Healthcare o Nuclear waste
o Consuming Arts e.g. Museums, sports o Extensive farming
Positive Externalities {Production} Negative Externalities {Consumption}

o Research into new technologies = lower o Passive smoking
costs to copycat producers o Air pollution
o New buildings e.g. canals o Excess Alcohol leads to anti-social
o Factory in areas -> 𝑌 ↑ and population↑ = behaviour
regeneration of area o Drug and Alcohol abuse
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i) Analysis diagram showing negative externalities from production
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Analysis diagram showing negative externalities from production and the resulting market failure
The MPC curve represents the supply curve of the industry, and assumes no external benefit, MSB is also
the MPB and the demand curve for the industry. As the private producers reaches equilibrium where
Demand = Supply (consider only their private costs and private benefits), the equilibrium output of the
industry id thus 0QE. MSC lies above MPC as MSC includes both MPC and MEC. The socially optimum
output would be 0Qs, where MSB = MSC. Thus, in terms of socially efficiency, there is an overproduction
of goods which generate negative externalities. By summing the excess of MSB and MSC for the units
between Qs and Qe, a monetary measure of the welfare loss to society is occurred (shaded area).
Activities which generate positive externalities can also bring welfare loss.
Private producers will tend to produce too little of commodities that generate beneficial externalities
because they bear all the costs, while others reap part of the benefits. This is illustrated as follows:
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The MSB is greater than the MPB since there are external benefits. The socially optimum level
of output is OQs which is above the equilibrium output that would occur in an "uncorrected' free market,
0QE. In other words, when there are positive externalities, there is a tendency for
underproduction of the product in question. The shaded area shows the welfare loss brought by
underproduction. From the above expose, it can be deduced that whenever there are external benefits,
there will be too little produced or consumed. On the other hand, whenever, there are external costs,
there will be too much produced or consumed. The market will not equate marginal social benefit and
marginal social cost.
• The impact of externalities and government intervention in various markets, e.g.
transport, health, education, environment.
Externalities and the importance of Property Rights
• Property rights confer legal control or ownership

• For markets to operate efficiently, property rights must be protected – perhaps through
regulation
• Put another way, if an asset is un-owned, no one has an incentive to protect it from abuse. The
right to own property is essential in a market-based system
• Failure to protect property rights may lead to what is known as the Tragedy of the Commons -
examples include the over use of common land and the long-term decline of fish stocks caused
by over-fishing which leads to long term permanent damage to the stock of natural resources.
Negative Externalities and Government Intervention
Q. What forms of government intervention might help to correct the market failure from negative
externalities?
To many economists interested in environmental problems the key is to internalize external costs and
benefits to ensure that those who create the externalities include them when making decisions.
Pollution Taxes
• One common approach to adjust for externalities is to tax those who create negative externalities.
• This is known as "making the polluter pay".
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• Introducing a tax increases the private cost of consumption or production and ought to reduce
demand and output for the good that is creating the externality.
• Some economists argue that the revenue from pollution taxes should be 'ring-fenced' and
allocated to projects that protect or enhance our environment.
• For example, the money raised from a congestion charge on vehicles entering busy urban roads,
might be allocated towards improving mass transport services; or the revenue from higher taxes
on cigarettes might be used to fund better health care programs.
The government should impose a tax on each unit of output, where the amount of tax is equal to the
amount of pollution (MEC). Hence, the externality will be internalized by the imposition of the tax. This
means the government will make the externality to enter into the firm's own calculations of its private
costs and benefits. As a result, output would be reduced to the desired level. Assume, for example, that a
chemical plant emits smoke and thus pollutes the atmosphere. This creates external costs for the people
who breathe in the smoke.
The firm produces output 0QE where MPC = MPB (demand = supply), and in doing so, it takes no account
of the external pollution costs it imposes on society. If the government imposes a tax on production equal
to the Marginal pollution cost (MEC), it will effectively internalize the externality. The firm will have to pay
an amount equal to the external costs it creates. It will, therefore, now maximize profit at OQs, which is
the socially optimum output where MSB = MSC.
Examples of Environmental Taxes include:
1. The Landfill Tax - this tax aims to encourage producers to produce less waste and to recover more
value from waste, for example through recycling or composting and to use environmentally
friendly methods of waste disposal
2. The Congestion Charge: -this is a high profile environmental charge introduced in February 2003.
It is designed to cut traffic congestion in inner-London by charging motorists £8 per day to enter
the central charging zone
Evaluation: Problems with Environmental Taxes
Pollution taxes can lead to government failure
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1. Assigning the right level of taxation: There are problems in setting tax so that private cost will
exactly equate with the social cost.
2. Consumer welfare effects: Producers may pass on the tax to the consumers if the demand for the
good is inelastic and, as result, the tax may only have a small effect in reducing demand. Taxes on
some de-merit goods (for example cigarettes) may have a regressive effect on lower-income
consumers and leader to a widening of inequalities in the distribution of income.
3. Employment and investment consequences: If pollution taxes are raised in one country,
producers may shift to countries with lower taxes. This will not reduce global pollution, and create
problems such as unemployment and a loss of international
Alternative to taxing the bad - subsidizing positive externalities
• An alternative to taxing activities that create negative externalities is to subsidize activities that
lead to positive externalities
• This reduces the costs of production for suppliers and encourages a higher output
• For example, the Government may subsidize state health care; public transport or investment in
new technology for schools and colleges to help spread knowledge and understanding
• There is also a case for subsidies to encourage higher levels of training to raise labor productivity
and improve our international competitiveness
Consider the demand and supply conditions for education. The market reaches equilibrium at output
OQE. The government examines that there involves a positive externality. Hence, the government has
to encourage the consumption of such good so that the whole society will benefit and grant subsidies
on education. The subsequent effect is that the quantity consumed rises to OQs, the socially optimum
level of output where MSB - MSC.
Even if government decides to charge a tax equal to each firm's MEC or grant subsidy equal to MEB, it
would still have the problem of measuring these costs and benefits. It is very difficult to estimate the
value of the MEC and MEB in monetary terms.
Externalities and Regulation
The government can intervene in a market using regulations and laws. For example, the Health and
Safety at Work Act covers all public and private sector businesses. Local Councils can take action against
noisy, unruly neighbors and can pass by-laws preventing the public consumption of alcohol. The British
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government introduced a ban on smoking in public places from July 2007. The European Union has
introduced directives on how consumer durables such as cars, batteries, fridges freezers and other
products should be disposed of. The onus is now on producers to provide facilities for consumers to bring
back their unwanted products.
3 Public goods
• Distinction between public and private goods using the concepts of nonrivalry and non-
excludability.
Some goods may not be produced at all through the markets, despite offering significant benefits to
society. Where this occurs, it is known as a ‘missing market’ and the goods are called Public goods.
These goods involve a large element of collective consumption e.g. national defence, flood defence
systems, the criminal justice system and refuse collection.
Public goods demonstrate characteristics of non-excludability and non-rivalry:
o Non-excludability – means that once a good has been produced for the benefit of one person, it
is impossible to stop others from benefiting.
o Non-rivalry – means that as more people consume a good and enjoy its benefits, it does not
reduce the amount available for others. In effect, it is non-diminishable. Once a public good has
been provided, the cost of supplying it to an extra consumer is zero e.g. firework displays,
lighthouses, public beaches, public parks and street lighting.
Private goods display characteristics of rivalry and excludability in consumption e.g. Mars bar, the
consumption of which directly excludes other people from consuming that particular bar. The owners of
private goods are able to use private property rights which prevent other people from consuming them.
Private goods can also be rejected - one has a choice over whether to consume them or not.
• Why public goods may not be provided by the private sector making reference to the
free-rider problem.
Public goods are under-provided due to two problems;
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1. Free-rider problem ->once a public good has been provided for one individual, it is
automatically provided for all. The market fails because it is not possible for firms to withhold
the good from those consumers who refuse to pay for it e.g. national defence, security along a
street, potholes in a private road. The rational consumer would wait for someone else to
provide the good and then reap the rewards by consuming it for free. However if everyone waits
for others to supply a public good then it may never be provided. The non-excludability
characteristic means that the price mechanism cannon develop as free riders will not pay.
2. The valuation problem -> it is difficult to measure the value obtained by consumers of public
goods and hence it becomes hard to establish a market price for them. It is in the interests of
consumers to under-value the benefit gained from a public good so that they pay less for it; it is
in the interests of producers to over-value the benefit gained from a public good in order to
charge more for it. The uncertainty over valuation may deter firms from providing public goods.
Government Provision of public goods: In a mixed economy the government tends to provide public
goods to correct market failure. It raises funds from general taxation to pay for their provision. Without
government intervention, public goods may be under provided or not provided at all. The actual
quantity provided will be less than the amount required for achieving the social optimum position (SOP).
4 Imperfect market information

• The distinction between symmetric and asymmetric information.
i) Symmetric information – where consumers and producers have perfect and equal market information
on a good or service in which they can make their economic decisions. Assuming that consumers and
producers act in a rational way, it will lead to an efficient allocation of resources
ii) Asymmetric information – consumers and producers have imperfect and unequal knowledge on a good
or service in which they can make incorrect economic decisions. This could lead to a misallocation of
resources.
• How imperfect market information may lead to a misallocation of resources, drawing

examples from areas such as healthcare, education, pensions and insurance.
Where there is imperfect market information, markets are likely to fail. This be either under
consumption of health care, education and pensions (merit goods) or over consumption of tobacco,
alcohol and gambling (demerit goods). Often producers may know more than the consumers about a
good or service e.g. a second-hand car salesman may have greater knowledge about the history of the
vehicles for sale but also more technical knowledge. This could lead to the consumer paying too much
for a poor-quality car. The fear of buying a defective car tends to reduce the market price for second
hand cars even the non-defective cars. Consequently, both the buyers and sellers end up losing,
otherwise known as the Lemon market.
• Moral hazard – a special case of asymmetric info where consumers have more market
knowledge of future actions than producers. With insurance, people are more likely to be
careless. E.g. a consumer may purchase insurance policy concealing information about him/her
or know the more about future actions, which might include risky lifestyle choices and the
banks, knew they would be bailed out so they took crazy risks.
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• Adverse selection – The demand for insurance is positively correlated with the risk – means the
price is set higher than the total average.
5 Labor immobility
• Causes of geographical and occupational immobility of labor.
Factor Immobility: One cause of market failure is the immobility of factors of production. There are two
main types of factor immobility, occupational and geographical immobility.
Immobility of labor – a cause of unemployment and market failure
One of the main causes of unemployment is that workers lack the skills required by expanding industries
in the economy.
Occupational Immobility
Occupational immobility occurs when there are barriers to the mobility of factors of production
between different sectors of the economy leading to these factors remaining unemployed or being used
in ways that are not efficient.
• Some capital inputs are occupationally mobile – a computer can be put to use in many
different industries. And commercial buildings such as shops and offices can be altered to
provide a base for many businesses. However, some units of capital are specific to the industry
they have been designed for – a printing press or a nuclear power station for example!
• People often experience occupational immobility. For example, workers made redundant in
the steel industry or in heavy engineering may find it difficult to find a new job. They may have
specific skills that are not necessarily needed in growing industries which causes a mismatch
between the skills on offer from the unemployed and those required by employers looking for
workers. This problem is called structural unemployment. Clearly this leads to a waste of scarce
resources and represents market failure.
Geographical Immobility
Geographical immobility refers to barriers people moving from one area to another to find work. There
are good reasons why geographical immobility might exist:
• Family and social ties
• The financial costs involved in moving home including the costs of selling a house and removal
expenses.
• Huge regional variations in house prices leading to a shortage of affordable housing in many
areas
• The high cost of renting property
• Differences in the general cost of living between regions and also between countries
• Migration controls e.g. a cap on inward migration
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• Cultural and language barriers
Measures to reduce immobility, including training programs, relocation subsidies.

Policies to Improve the Mobility of Labor
• To reduce occupational immobility:

o Invest in training schemes for the unemployed to boost their human capital to equip
them with new skills and skills that can be transferred from one occupation to another.
o Subsidize the provision of vocational training by private sector firms to raise the skills
level
• To reduce geographical immobility:
• Reforms to the housing market designed to improve the supply and reduce the price of
rented properties and to increase the supply of affordable properties.
• Specific subsidies for people moving into areas where there are shortages of labor – for
example teachers and workers in the National Health Services
What are the effects on the economy of Labour immobility?
• Structural unemployment impacts government welfare costs, ↑wage rates in areas of low
unemployment which could lead to inflation as employers pass higher costs through to
consumers. This attracts economic migration to satisfy demand of economy, there could still be
a shortage requiring Government action to encourage re-training or relocation (results in more
employment and spending by the government).
1.3.7 Government intervention in markets

1 Methods of government intervention
• Government intervention in various contexts, e.g. labor market, health, housing,
education, transport, waste management, environment, energy, agriculture and
commodities.
In a free market system, governments take the view that markets are best suited to allocating scarce
resources and allow the market forces of supply and demand to set prices. The role of the government is
to protect property rights, uphold the rule of law and maintain the value of the currency. Competitive
markets often deliver improvements in allocative, productive and dynamic efficiency. But there are
occasions when they fail – providing a case for intervention.
Type of Market Consequence of Market Failure Example of Government

Failure Intervention
Factor immobility Structural unemployment State investment in education and
training
Public goods Failure of market to provide pure Government funded public goods
public goods, free rider problem for collective consumption
Demerit goods Over consumption of products with Information campaigns, minimum
negative externalities age for consumption
Merit goods Under consumption of products Subsidies, information on private
with positive externalities benefits
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Imperfect Damaging consequences for Statutory information / labeling
information consumers from poor choices
High relative Low income families suffer social Taxation and welfare to
poverty exclusion, negative externalities redistribute income and wealth
Monopoly power Higher prices for consumers causes Competition policy, measures to
in a market loss of allocative efficiency encourage new firms into a market
• Purpose of intervention including reference to market failure.

The main reasons for policy intervention by the government are:
1. To correct for market failures
2. To achieve a more equitable distribution of income and wealth
3. To improve the performance of the economy
• Methods of Government Intervention

a) indirect taxation
b) subsidies
c) maximum and minimum prices
d) buffer stocks
e) tradable pollution permits
f) extension of property rights
g) state provision
h) regulation
a) Government Intervention - Indirect Taxes
An indirect tax is imposed on producers (suppliers) by the government. Examples include duties on
cigarettes, alcohol and fuel and also VAT. A carbon tax is also an indirect tax. Indirect taxes can be used
to raise the price of de-merit goods and products with negative externalities designed to increase the
opportunity cost of consumption and thereby reduce consumer demand towards a socially optimal level
• A tax increases the costs of production causing an inward shift in the supply curve
• The vertical distance between the pre-tax and the post-tax supply curve shows the tax per unit
• With an indirect tax, the supplier may be able to pass on some or all of this tax onto the
consumer through a higher price
• This is known as shifting the burden of the tax and the ability of businesses to do this depends
on the price elasticity of demand and supply
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The Government would rather place indirect taxes on commodities where demand is inelastic because
the tax causes only a small fall in the quantity consumed and as a result the total revenue from taxes will
be greater. An example of this is the high level of duty on cigarettes and petrol.
There are two types of indirect taxes:
• Specific taxes: A specific tax is where the tax per unit is a fixed amount – for example the duty
on a pint of beer or the tax per packet of twenty cigarettes. Another example is air passenger
duty
The more inelastic the demand, the higher the burden of tax on the consumer and lower the burden of
tax on the producer.
• Ad valorem taxes: Where the tax is a percentage of the cost of supply – e.g. value added
tax currently levied at the standard rate of 20%. In the diagram below, an ad valorem tax has
been imposed on producers. The incidence of tax might fall differently on producers and
consumers. Producers could make consumers pay the whole tax (P3-P2) or they could choose to
pay part of the tax if they fear raising the price will reduce consumer demand to the extent that
they lose revenue. So, Producers might pay (P1-P2), while consumers will pay (P3-P1). The
incidence of tax will depend on price elasticity of demand.
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This should, in theory, reduce the consumption of demerit goods and reduce negative externalities.
Also, government revenue from ad valorem tax is larger if price elasticity of demand is inelastic.
How does it solve the market failure?

→ An indirect tax shifts the marginal private cost curve to the left to MPC + Tax, as the costs of
production to producers has increased and therefore supply decreases.
→ This means that the equilibrium shifts from the free market equilibrium of P1Q1 to the more
socially optimum equilibrium of P2Q2.
→ The external cost per unit of the good in the diagram is represented by the vertical distance
between the MSC curve and the MPC curve – imposing a tax equal to this external cost will mean
that the negative externality is successfully internalized.
Problems with using taxes as a way of correcting for externalities and market failure
The aim of an indirect tax is to make the polluter pay and so internalize the externality. However,
implementing taxes is problematic:
1. Setting the 'right' tax rate e.g. if the monetary value of a negative externality is hard to measure
2. Cost of collection: e.g. road charging requires expensive infrastructure e.g. IT system of billing
3. Inelastic demand: higher petrol prices via higher indirect taxes has little effect on demand for
fuel, likewise, would a tax on sugar get people to cut their consumption of high-sugar products?
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4. Redistribution effects: Indirect taxes are regressive and affect low-income household most.
5. Increased costs: Higher indirect taxes may cause inflation affecting consumers who did not
pollute and international competitiveness if taxes are higher in one country than another
b) Government Intervention- Subsidies
Subsidies are a form of government intervention. They are introduced for a variety of economic, social and
political reasons. Subsidies to consumers will lower the price of merit goods. They are designed to boost
consumption and output of products with positive externalities – remember that a subsidy causes an
increase in market supply and leads to a lower equilibrium price. A subsidy might be justified if it
encourages increased supply and consumption of products that yield high external benefits. This can help
to overcome a market failure problem.
Advantages
1. To keep prices down and control inflation – in the last couple of years several countries have
been offering fuel subsidies to consumers and businesses in the wake of the steep increase in
world crude oil prices.
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2. To encourage consumption of merit goods and services which are said to generate positive
externalities (increased social benefits). Examples might include subsidies for investment in
environmental goods and services.
3. Reduce the cost of capital investment projects – which might help to stimulate economic
growth by increasing long-run aggregate supply.
4. Subsidies to slow-down the process of long term decline in an industry e.g. fishing or mining
5. Subsidies to boost demand for industries during a recession e.g. the car scrappage scheme
6. To help poorer families, e.g. with food and child care costs.
7. Protect jobs in loss making industries
8. Make some healthcare treatments more affordable
9. Reduce the cost of training and employing workers
10. Reduce external costs of transport
11. Subsidies for research and investment can bring positive spill overs
Economic Arguments against Subsidies
The economic and social case for a subsidy should be judged carefully on the grounds
of efficiency and fairness.
• Might the money used up in subsidy payments be better spent elsewhere? Government
subsidies inevitably carry an opportunity cost and in the long run there might be better ways
of providing financial support to producers and workers in specific industries.
• Free market economists argue that subsidies distort the working of the free market
mechanism and can lead to government failure where intervention leads to a worse
distribution of resources.
• Distortion of the Market: Subsidies distort market prices – for example, export
subsidies distort the trade in goods and services and can curtail the ability of LEDCs to
compete in the markets of rich nations.
• Arbitrary Assistance: Decisions about who receives a subsidy can be arbitrary, based on
political aims
• Financial Cost: Subsidies can become expensive in the long run due to the opportunity cost.
• Who pays and who benefits? The final cost of a subsidy usually falls on consumers (or tax-
payers) who themselves may have derived no benefit from the subsidy.
• Encouraging inefficiency: Subsidy can artificially protect inefficient firms who need to
restructure – i.e. it delays much needed reforms.
• Risk of Fraud: Ever-present risk of fraud when allocating subsidy payments (the system of CAP
farm subsidies have been heavily criticized for the level of fraud involved)
• There are alternatives: It may be possible to achieve the objectives of subsidies by alternative
means which have less distorting effects.
Subsides used in isolation are less effective than if part of strategic integrated solution to a economic /
social problem.
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Consumers gain more from subsidy when demand is price inelastic, while producers gain more when the
demand is price elastic.
c) Government Intervention – Maximum and Minimum Prices
Maximum Price: The government or an industry regulator can set a maximum price to prevent the market
price from rising above a certain level. This is to increase the consumption or production of a good so that
it doesn’t become too expensive to consume. A maximum price has to be set below the free market price,
otherwise they would be ineffective.
• One aim of this might be to prevent the monopolistic exploitation of consumers

• Price capping also happens when the competition authorities judge that consumers are being
exploited by businesses using their monopoly power.
• A maximum price seeks to control the price – but also involves a normative judgement on behalf
of the government about what that price should be.
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The free market equilibrium is at P1, Q1. If suppliers only produced at Q3, there would be excess
demand in the market of (Q3-Q2). Consumers would be willing to Pay P2. So, the shaded area shows the
consumer surplus. So, the quantity of Q3 would need rationing.
Maximum prices can lead to welfare gains for the consumers by keeping the prices low and could
increase efficiency of the firms since they have an incentive to keep the costs low.
Disadvantage of Maximum Price
Black Markets: A black market (or shadow market) is an illegal market in which the market price is higher
than a legally imposed price ceiling. Black markets develop where there is excess demand. Some
consumers are prepared to pay higher prices in black markets to get the goods or services they want. With
a shortage, higher prices are a rationing device.
Good examples of black markets include tickets for major sporting events, rock concerts and black markets
for children's toys and designer products that are in scarce supply. There is also evidence of black markets
in the illegal distribution and sale of computer software products where pirated copies can often dwarf
sales of legally produced software.
Rationing when there is a market shortage: Rationing when there is a maximum price might also be
achieved by allocating the good on a 'first come, first served' basis – e.g. queues of consumers. Suppliers
might also allocate the scarce goods by distributing only to preferred customers. Both ways of rationing
goods might be considered as inequitable (unfair) – because it is likely that eventually those who might
have the greatest need for a commodity are unlikely to have their needs met.
Another problem arising from the maintenance of a maximum price is that in the long run, suppliers might
respond to a maximum price by reducing their supply – the supply curve becomes more elastic in the long
term. This is illustrated in the next diagram which looks at the effect of a maximum price for rented
properties.
Minimum Price: Minimum Wage and Living Wage
A minimum price is a price floor below which the market price cannot fall. To be effective the minimum
price must be set above the equilibrium price. The best example of a minimum price is a minimum wage in
the labor market
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How does a minimum wage work?
• Employers cannot legally undercut the current minimum wage rate per hour. This applies both to
full-time and part-time workers
• A diagram showing the possible effects of a minimum wage is shown below. The market
equilibrium wage for this particular labor market is at W1 (where demand = supply)
If the minimum wage is set at Wmin, there will be an excess supply of labor equal to E3 – E2 because the
supply of labor will expand (more workers will be willing and able to offer themselves for work at the
higher wage than before) but there is a risk that the demand for workers from employers (businesses) will
contract if the minimum wage is introduced
The main aims of the minimum wage
1. The equity justification: That every job should offer a fair rate of pay commensurate with the
skills and experience of an employee.
2. Labor market incentives: The NMW is designed to improve incentives for people to start looking
for work – thereby boosting the economy's labor supply.
3. Labor market discrimination: The NMW is a tool designed to offset some of the effects of
persistent discrimination of many low-paid female workers and younger employees.
Possible Disadvantages of a Minimum Wage
Although all political parties are now committed to keeping the minimum wage, there are still plenty of
economists who believe that setting a pay floor represents a distortion to the way the labor market works
because it reduces the flexibility of the labor market
1. Competitiveness and Jobs: A minimum wage may cost jobs because a rise in labor costs makes it
more expensive to employ people. It will be interesting to observe whether the minimum wage is
said to have caused extra unemployment during the current economic downturn.
2. Effect on relative poverty: Is the minimum wage the most effective policy to reduce relative
poverty? There is evidence that it tends to boost the incomes of middle-income households where
more than one household member is already in work whereas the greatest risk of relative poverty
is among the unemployed, elderly and single parent families where the parent is not employed.
Can a minimum wage increase employment?
• The Keynesian argument that higher wage rates will increase the disposable incomes of lower-
paid workers many of whom have a high propensity to consume. Thus, they will increase their
spending, and this will feed through the circular flow of income and spending
• The efficiency wage argument that raising pay levels for low-paid employees may have a positive
effect on their productivity. In addition to the psychological benefits of being paid more,
businesses may take steps to improve production processes, workplace training etc if they know
that they must pay at least the statutory pay floor.
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d) Government Intervention – Buffer Stock
The prices of agricultural products such as wheat, cotton, cocoa, tea and coffee tend to fluctuate more
than prices of manufactured products and services. This is largely due to the volatility in the market
supply of agricultural products coupled with the fact that demand and supply are price inelastic. One way
to smooth out the fluctuations in prices is to operate price support schemes using buffer stocks.
Definition: Buffer stock schemes seek to stabilize the market price of agricultural products by buying up
supplies of the product when harvests are plentiful and selling stocks of the product onto the market
when supplies are low.
How it solve the market failure? The market failure is the fact that price would vary wildly between P1
and P2 were the Government not to intervene. The intervention ensures a constant price hence solving
the market failure of price instability
Advantages of a successful buffer-stock scheme:
• Stable prices help maintain farmers' incomes and improve the incentive to grow legal crops
• Stability enables capital investment in agriculture needed to lift agricultural productivity
• Farming has positive externalities it helps to sustain rural communities
• Stable prices prevent excess prices for consumers – helping consumer welfare
Problems with buffer stock schemes
In theory buffer stock schemes should be profit making, since they buy up stocks of the product when the
price is low and sell them onto the market when the price is high. However, they do not often work well
in practice. Clearly, perishable items cannot be stored for long periods of time and can therefore be
immediately ruled out of buffer stock schemes. Other problems are:
• Cost of buying excess supply can cause a buffer stock scheme to run out of cash
• A guaranteed minimum price might cause over-production and rising surpluses which has
economic and environmental costs
• Setting up a buffer stock scheme also requires a significant amount of startup capital, since
money is needed to buy up the product when prices are low.
• There are also high administrative and storage costs to be considered.
The success of a buffer stock scheme however ultimately depends on the ability of those managing a
scheme to correctly estimate the average price of the product over a period. This estimate is the scheme's
target price and obviously determines the maximum and minimum price boundaries. But if the target
price is significantly above the correct average price then the organization will buy more produce than it
is selling, and it will eventually run out of money. The price of the product will then crash as the excess
stocks built up by the organization are dumped onto the market. Conversely if the target price is too low
then the organization will often find the price rising above the boundary, it will end up selling more than
it is buying and will eventually run out of stocks
Advantages Disadvantages
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o Reduce commodity price fluctuations Government failure may occur if the
to help stabilise producer incomes regulations serve to misallocate resources
Costs of storing the goods are high.
o Greater certainty in the market, Some goods are perishable and can’t be
leading to investment stored.
Administration costs are high.
o Help to ensure provision of If the fixed cost is set too high, the
commodities for consumers even in government is continually buying up goods,
years of poor harvests leading to ‘wine lakes’ and ‘butter mountains’.
With technology improving this is a
continuous problem.
If weather goes through a very bad period
there may be inadequate supplies.
Intervention requires money
e) Government Intervention- tradable pollution permits
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How does it solve the market failure?
Low polluters sell excess to high polluters to make a profit. It makes being a high polluter very
expensive, thus providing a large incentive for firms to cut their pollution so that they can sell permits to
others. Hence pollution is generally discouraged and the negative externality is removed.
o Uses market system for buying and selling o It is difficult to set the ‘right level of
carbon permits – in effect the price pollution’ and hence hard to allocate
mechanism is used to internalize the external permits, the EC may issue too many
costs associated with carbon emissions carbon firms, causing little incentive for
o Pollution permits can be reduced over time firms e.g. first phase of ETS {2005-2007}
as part of a coordinated plan led to a collapse in the price of carbon
o National governments can raise funds by allowances -> reflected the absence of a
selling their reserve of pollution permits means to bank spare allowances at the
industry - the revenue could then be used to time
clean up the environment to compensate o Firms may make higher costs to pay for
victims buying more permits
o Firms are incentivized to invest in clean
technology
o Production costs↑ for firms that exceed their
pollution, additional purchase of permits
provides a source of revenue for cleaner
firms selling the extra credits
o Firms are able to bank their excess pollution
permits for use in future years
f) Government Intervention- extension of property rights
Externalities can arise because property rights aren’t fully allocated, for example nobody owns the
atmosphere or oceans. An alternative to regulation is the extension of property rights. It gives water
companies the right to charge companies who pollute the rivers and seas. Examples of common property
resources include; oceans, rivers and canals; beaches; the air; roads and pavements, and even images,
words and ideas. Because property rights cannot be established, the effectiveness of markets in terms of
the allocation, pricing and rationing of these resources is substantially reduced. Extending property rights
is a method of internalizing the externality.
Advantages of extending property rights are:
• The government doesn’t have to assess the value of property as it is assumed the owners of the
property will have a better knowledge of its value.
• There will be a direct transfer of resources from the polluters those who suffer. With regulation
it isn’t those who suffer that receive the compensation.
There are however several disadvantages:
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• The government may not have the ability to extend property rights, e.g., how would the British
government prevent Brazilian firms from destroying the rainforests which leads to global
warming.
• Extending property rights within a nation’s borders can be difficult if the link between the
pollution and the problem, e.g., asbestos and various carcinogenic leading to medical problems.
It is often difficult for the owner of the property to assess its value, e.g., if one home owner may place a
different value on his trees than another, which value of compensation should be paid if the trees are
destroyed?
g) Government Intervention- state provision
h) Government Intervention - Regulations
Regulations are a form of government intervention in markets - there are many examples we can use
Examples include:
• Laws on minimum age for buying cigarettes and alcohol

• The Competition Act which penalizes businesses found guilty of price fixing cartels
• Statutory national minimum wage
• A new law in Scotland banning under-18s from using sun-beds
• Equal Pay Act and acts preventing other forms of discrimination
• Changes in the law on cannabis
• Maximum CO2 emissions for new vehicles, laws which restrict flight times at night
Government appointed utility regulators who may impose price controls on privatized monopolists e.g.
telecommunications, the water industry
The economy operates with a huge and growing amount of regulation. The government appointed
regulators who can impose price controls in most of the main utilities such as telecommunications,
electricity, gas and rail transport.
Free market economists criticize the scale of regulation in the economy arguing that it creates an
unnecessary burden of costs for businesses – with a huge amount of "red tape" damaging the
competitiveness of businesses.
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Regulation may be used to introduce fresh competition into a market – for example breaking up the
existing monopoly power of a service provider. A good example of this is the attempt to introduce more
competition for British Telecom. This is known as market liberalization.
Problems that regulators of markets / industries can face
• Hard to find evidence of anti-competitive behavior

• Lack of spoken or written evidence
• Conflicting or asymmetric information
• Complex information
• Conflicting evidence – e.g. it might be markets forces or collusion in an oligopoly
• Fear of fines or other control mean that there is strong incentive to conceal collusion
• Lack of regulator power and lack of regulator resources
• Evaluation of Government Intervention in Markets
2 Government failure
• Definition of government failure as intervention that results in a net welfare loss.
Government failure is a government intervention that results in a net welfare loss. Even with good
intentions governments seldom get their policy application correct. They can tax, control and regulate
but the outcome may be a deepening of the market failure or even worse a new failure may arise.
Government failure may range from the trivial, when intervention is merely ineffective, but where harm
is restricted to the cost of resources used up and wasted by the intervention, to cases where
intervention produces new and more serious problems that did not exist before. The consequences of
this can take many years to reverse.
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• Government failure, e.g. from agricultural stabilization policies, environmental policies,
transport and housing policies, maximum and minimum wages.
1. High taxation on tobacco, alcohol
Disadvantages
o Encourage illegal smuggling into the UK, a significant loss of revenue for
the government
o Smuggled goods could increase consumption if offered at a cheaper price

to the shops
o Smuggling could lead to less regulation of sales so younger people may

consume and quality could decrease
o Organised crime entering the markets = smuggling on a massive scale
2. High taxes on waste -– The theory of charging households an extra fee if they have more than
two sacks of rubbish collected each week
Disadvantages
o Social unrest
o Fly tipping increase and disputes over ownership of rubbish
o Large families consume more than small families, could end up

costing them more
o Low income households buy cheaper foods = more packaging

therefore costing more
3. Subsidies to bus transport
Disadvantages
o People might not use it as people prefer private car journeys
o Bus Transport is characterised as an 'inferior' good
o As real incomes increase demand for bus services will fall
o Opportunity cost
o May increase passenger numbers by a small amount
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4. Road pricing
o Reduces external costs such as traffic o If set too high could lead to an
congestion, air and noise pollution under-utilisation of road space
o Potential increase in public services such as o Unfair to low income motorists

the trains or buses who cannot afford to pay daily
charge
o Reduce trade for businesses

within the congestion charge zone
o The SoP quantity may not be

achieved
5. Buffer stocks and Minimum prices in the agricultural market
Disadvantages
o Lead to huge food surpluses which have to be destroyed or dumped on markets in

developing countries
o Government has distorted the operation of these markets , leads to oversupply and
misallocation of resources
o Opportunity cost
6. National Minimum Wage (NMW)

The government introduced a minimum wage to ensure that all
workers were paid a fair amount per hour. The minimum wage
was a price floor on the labour market, which meant more were
willing to supply labour than the firms demanded it, hence many
works went unemployed. The amount of unemployment is
dependent on the elasticity of the labour market and how high
it is set at. The result on aggregate was probable a more inefficient market outcome hence
could be described as a government failure.
o helps those on lower paid rates o ↑Poverty as unemployment caused
o Gives more incentive to work o Workers paid higher than the NMW
o May actually ↑ demand for goods and demanded higher wages to
services compensate
o Potentially ↑employment.
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7. Allocation of fish quotas – The European Commission is responsible for ensuring a sustainable
level of fishing in the North sea by allocating quotas per commercial fishing boat
o There is some form of regulation being o Fish stocks are still being
upheld depleted
o Fish quotas are set at too high a

level
o Fish boats throw dead fish back

into the sea to keep within their
quota
o Poor monitoring of fish stocks
8. Government bureaucracy - (Administration costs) – Various rules and regulations 'red tape' that
hinders operation of market forces: Construction of a third runway at Heathrow Airport or a
o Ensures the correct health o Planning is time consuming and has to be undertaken before
and safety checks are carried major projects can go ahead
out
o Could lead to under investment in the physical infrastructure
of the economy, reducing the UK inward investment and UK
international competitiveness
o Time lags – government are too inflexible to respond to the

needs of producers and consumers
scheme to help the job seekers to get a job – many have done so without the help of the
scheme
9. Maximum rent ceiling – maximum price you can rent your property for
o More affordable for those who o Excess demand and less people to supply
cannot afford to buy property or houses and flats
get on the property ladder
o Cause waiting lists which could lead to
exploitation e.g. more people in a house or
placed illegally in a garage/shed
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• Causes of government failure, e.g. distortion of price signals, unintended consequences,
excessive administrative costs.
a) distortion of price signals

b) unintended consequences
c) excessive administrative costs
d) information gaps
Causes of Government Failure
Government intervention can prove to be ineffective, inequitable and misplaced.
(a) Political self-interest
• The pursuit of self-interest amongst politicians and civil servants can often lead to a misallocation
of resources. For example, decisions about where to build new roads, by-passes, schools and
hospitals may be decided with at least one eye to the political consequences.
• The pressures of a looming election or the influence exerted by special interest groups can foster
an environment in which inappropriate spending and tax decisions are made. - e.g. boosting
welfare spending in the run up to an election or bringing forward major items of capital spending
on infrastructural projects without the projects being subjected to a full and proper cost-benefit
analysis to determine the likely social costs and benefits. Critics of current government policy
towards tobacco taxation and advertising, and the controversial issue of genetically modified
foods argue that government departments are too sensitive to political lobbying from the major
corporations.
(b) Policy myopia
• Critics of government intervention in the economy argue that politicians have a tendency to look
for short term solutions or "quick fixes" to difficult economic problems rather than making
considered analysis of long term considerations. For example, a decision to build more roads and
by-passes might simply add to the problems of traffic congestion in the long run encouraging an
increase in the total number of cars on the roads.
• The risk is that myopic decision-making will only provide short term relief to particular problems
but does little to address structural economic problems.
• Critics of government subsidies to particular industries also claim that they distort the proper
functioning of markets and lead to inefficiencies in the economy. For example short term financial
support to coal producers to keep open loss-making coal pits might prove to be a waste of scarce
resources if the industry concerned has little realistic prospect of achieving a viable rate of return
in the long run given the strength of global competition.
(c) Regulatory Capture
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• This is when the industries under the control of a regulatory body (i.e. a government agency)
appear to operate in favour of the vested interest of producers rather can consumers
• Some economists argue that regulators can prevent the ability of the market to operate freely.
We might find examples of this in agriculture, telecommunications, the main household utilities
and in transport regulation.
(d) Disincentive effects
• Free market economists who fear government failure at every turn argue that attempts to reduce
income and wealth inequalities can worsen incentives and productivity. They would argue
against the National Minimum Wage because they believe that it artificially raises wages above
their true free-market level and can lead to real-wage unemployment.
• They would argue against raising the higher rates of income tax because it is deemed to have a
negative effect on the incentives of wealth-creators in the economy and generally acts as a
disincentive to work longer hours or take a better paid job.
(e) Government intervention and evasion
• A decision by the government to raise taxes on de-merit goods such as cigarettes might lead to
an increase in attempted tax avoidance, tax evasion, smuggling and the development of grey
markets where trade takes place between consumers and suppliers without paying tax
• A decision to legalize and then tax some drugs might lead to a rapid expansion of the supply of
drugs and a substantial loss of social welfare arising from over consumption.
(f) Policy decisions based on imperfect information
• Often a government will choose to go ahead with a project or policy without having the full
amount of information required for a proper cost-benefit analysis. The result can be misguided
policies and damaging long-term consequences.
(g) The Law of Unintended Consequences
(i) The law of unintended consequences is that actions of consumer and producers — and especially
of government—always have effects that are unanticipated or "unintended." Particularly when
people do not always act in the way that the economics textbooks would predict
• The law of unintended consequences is often used to criticize the effects of government
legislation, taxation and regulation. People find ways to circumvent laws; shadow markets
develop to undermine an official policy; people act in unexpected ways because of ignorance and
/ or error. Unintended consequences can add hugely to the financial costs of some government
programs so that they make them extremely expensive when set against their original goals and
objectives.
(h) Costs of administration and enforcement
Government intervention can prove costly to administer and enforce. The estimated social benefits of a
particular policy might be largely swamped by the administrative costs of introducing it.
82
i) Limited information - no government has the resources and information available to it to make fully-
informed, objective judgements. That is the nature of politics.
83

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Edexcel Economics IAL Unit 1

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1.3.1 The nature of economics .................................................................................................................... 5

Scarcity and Choices

• Because of scarcity, choices must be made by consumers, businesses and governments

• The distinction between renewable and non-renewable resources

Non-renewable resource: A non-renewable resource is a resource of economic value that cannot be

Use of Models in Economics

1. Economists build models and theories to explain economic interactions.

3. Indices are used to simplify statistics and to express averages.

4. Data can be presented in a variety of forms such as tables and graphs.

Q. Why economics is not a science?

Advantage & Disadvantage of Index Numbers

• Index numbers make trends easier to identify from data.

• It is also possible to see the extent of changes by examining index figures.

• Index numbers do not allow evaluation of importance of particular aspects of expenditure

2. Production possibility frontiers

Q. What concepts are mainly shown by the PPF?

• Any point beyond PPF: Unattainable level of production at the moment

Q. Why is the PPF Concave?

Q. How can a country reach a point beyond its existing PPF?

A country would require an increase in factor resources, an increase in the productivity or

FACTORS RESPONSIBLE FOR THE SHIFT:

1. Improvement in the state of technology

Q. How can PPF shift without economic growth?

Link between LRAS and PPF

1. More goods and services can be produced, so increased productivity

DISADVANTAGES OF DIVISION OF LABOR

1. Work may become boring leading to loss in productivity

2. Loss of craftsmanship, since greater use of machinery

4. Limited knowledge of labor leads to labor immobility

5. Products are standardized

7. Strikes and absenteeism

1. Money must act as a medium of exchange

2. Money acts as a measure of value

3. Money must act as a store of value

4. Money must act as a standard of deferred payment

Advantages of Money over barter:

• Avoids double coincidence of wants.

What are the possible gains from specialization?

4. Free market and mixed economies

Market system Free economy Mixed economy

ADVANTAGES OF MARKET ECONOMY

2. Wider consumer choice

DISADVANTAGES OF MARKET ECONOMY (Market Failures/Imperfections)

• The role of the state in a mixed economy.

Positive Economics Normative Economics

1.3.2 Demand and consumer behavior

• The concept of diminishing marginal utility

Marginal utility: The change in satisfaction from consuming an extra unit

• The factors that may cause a shift in the demand curve

1. Change in the price of the commodity itself

7. Changes in distribution of income

8. Government policy – income tax:

Why demand curve is downwards sloping?

2 Price, income and cross elasticities of demand

• Calculation and interpretation of numerical values of demand elasticities.

USEFULNESS OF A KNOWLEDGE OF PRICE ELASTICITY OF DEMAND FOR A FIRM

Firms can use knowledge of PED for the following:

• The effect of a change in price on total revenue of sellers

• Qualifications to assumption of rationality, alternate views of consumer behavior:

• The factors that may cause a shift in the supply curve

2. Weather / climatic conditions

3. Technical progress: Technical progress means improvements in the performance of machines,

The law of supply