3.1 The operation of markets and market failure

This section of the specification is primarily about microeconomics. Students will be required to acquire knowledge and understanding of a selection of microeconomic models and to apply these to current problems and issues. Microeconomic models such as demand and supply, the operation of the price mechanism and causes of market failure are central to this part of the specification. Students should be provided with opportunities to use these models to explore current economic behaviour. When applying and evaluating all the microeconomic models in the specification, such as supply and demand theory and production possibility curves, students should be critically aware of the assumptions upon which these models are based and their limitations when they are used to make sense of real world phenomena. Students should be able to apply their knowledge and skills to a wide variety of situations and to different markets and examples of market failure, including environmental market failures. They should appreciate that economic decisions relating to individual markets may be affected by developments in the macroeconomy.

3.1.1 Economic methodology and the economic problem

3.1.1.1 Economic methodology

Content

Additional information

  • Economics as a social science.
  • Similarities to and differences in methodology from natural and other sciences.
  • The difference between positive and normative statements.
  • How value judgements influence economic decision making and policy.
  • People’s views concerning the best option are influenced by the positive consequences of different decisions and by moral and political judgements.
Students should understand how thinking as an economist may differ from other forms of scientific enquiry.

3.1.1.2 The nature and purpose of economic activity

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Additional information

  • The central purpose of economic activity is the production of goods and services to satisfy needs and wants.
  • The key economic decisions are: what to produce, how to produce, and who is to benefit from the goods and services produced.
 

3.1.1.3 Economic resources

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Additional information

  • The economists’ classification of economic resources into land, labour, capital and enterprise, which are the factors of production.
  • The environment is a scarce resource.
 

3.1.1.4 Scarcity, choice and the allocation of resources

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Additional information

  • The fundamental economic problem is scarcity and that it results from limited resources and unlimited wants.
  • Scarcity means that choices have to be made about how scarce resources are allocated between different uses.
  • Choices have an opportunity cost.
 

3.1.1.5 Production possibility diagrams

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Additional information

  • Production possibility diagrams illustrate different features of the fundamental economic problem, such as: resource allocation, opportunity cost and trade-offs, unemployment of economic resources, economic growth.
  • Why all points on the boundary are productively efficient but not all points on the boundary are allocatively efficient.

Students should be able to use production possibility diagrams to illustrate these features.

3.1.2 Price determination in a competitive market

3.1.2.1 The determinants of the demand for goods and services

Content

Additional information

  • The factors which determine the demand for a good or service.
  • A demand curve shows the relationship between price and quantity demanded.
  • The causes of shifts in the demand curve.
Students should understand the factors that influence the spending decisions of consumers, including: price, income, wealth, the price of substitutes and complementary goods, and individual preferences. They should also appreciate that such decisions are influenced by social and emotional factors.

3.1.2.2 Price, income and cross elasticities of demand

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Additional information

  • Be able to calculate price, income and cross elasticities of demand.
  • The relationship between income elasticity of demand and normal and inferior goods.
  • The relationship between cross elasticity of demand and substitute and complementary goods.
  • The relationships between price elasticity of demand and firms’ total revenue (total expenditure).
  • The factors that influence these elasticities of demand.

Students should be able to interpret numerical values of these elasticities of demand.

3.1.2.3 The determinants of the supply of goods and services

Content

Additional information

  • The factors which determine the supply of a good or service.
  • A supply curve shows the relationship between price and quantity supplied.
  • Understand higher prices imply higher profits and that this will provide the incentive to expand production.
  • The causes of shifts in the supply curve.
 

3.1.2.4 Price elasticity of supply

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Additional information

  • Be able to calculate price elasticity of supply.
  • The factors that influence price elasticity of supply.

Students should be able to interpret numerical values of price elasticity of supply.

3.1.2.5 The determination of equilibrium market prices

Content

Additional information

  • How the interaction of demand and supply determines equilibrium prices in a market economy.
  • The difference between equilibrium and disequilibrium.
  • Why excess demand and excess supply lead to changes in price.

Students should be able to use demand and supply diagrams to help them to analyse causes of changes in equilibrium market prices.

They should be able to apply their knowledge of the basic model of demand and supply to a variety of real-world markets.

3.1.2.6 The interrelationship between markets

Content

Additional information

  • Changes in a particular market are likely to affect other markets.
  • The implications of joint demand, demand for substitute goods, composite demand, derived demand and joint supply.

Students should, for example, be able to explore the impact of changes in demand, supply and price in one market upon other related markets.

3.1.3 Production, costs and revenue

3.1.3.1 Production and productivity

Content

Additional information

  • Production converts inputs, or the services of factors of production such as capital and labour, into final output.
  • The meaning of productivity, including labour productivity.
 

3.1.3.2 Specialisation, division of labour and exchange

Content

Additional information

  • The benefits of specialisation and division of labour.
  • Why specialisation necessitates an efficient means of exchanging goods and services, such as the use of money as a medium of exchange.
 

3.1.3.3 Costs of production

Content

Additional information

  • The difference between the short run and the long run.
  • The difference between fixed and variable costs.
  • The difference between average and total costs.

Students should be able to calculate average and total costs from given data.

Students should appreciate that the short-run average cost curve is likely to be U-shaped but a formal link with the law of diminishing returns is not expected. They should understand that the shape of the long-run average cost curve is determined by economies and diseconomies of scale.

3.1.3.4 Economies and diseconomies of scale

Content

Additional information

  • The difference between internal and external economies of scale.
  • Reasons for diseconomies of scale.
  • The relationship between economies of scale, diseconomies of scale and the shape of the long-run average cost curve.

Students should be able to categorise and give examples of both internal and external economies of scale.

3.1.3.5 Average revenue, total revenue and profit

Content

Additional information

  • The difference between average and total revenue.
  • Why the average revenue curve is the firm’s demand curve.
  • Profit is the difference between total revenue and total costs.

Students should be able to calculate average, total revenue and profit from given data.

3.1.4 Competitive and concentrated markets

3.1.4.1 Market structures

Content

Additional information

  • There is a range of market structures.
  • Factors such as the number of firms, the degree of product differentiation and ease of entry are used to distinguish between different market structures.

Students are not required to draw or use the traditional ‘theory of the firm’ diagrams.

3.1.4.2 The objectives of firms

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Additional information

  • Profit is an important objective of most firms.
  • Firms may also have other objectives such as survival, growth and increasing their market share.

Students should be aware that firms may have a variety of objectives but a detailed knowledge of these objectives is not required. However, students should appreciate that the objectives of a firm will affect its behaviour.

3.1.4.3 Competitive markets

Content

Additional information

  • The main characteristics of a perfectly competitive market.
  • In such markets the price is determined by the interaction of demand and supply.
  • Why profits are likely to be lower in a competitive market than in a market which is dominated by a few large firms.

An understanding of the formal model of perfect competition and the associated diagrams is not required.

3.1.4.4 Monopoly and monopoly power

Content

Additional information

  • The difference between pure monopoly and monopoly power.
  • Monopoly power is influenced by factors such as barriers to entry, the number of competitors, advertising and the degree of product differentiation.
  • Concentration ratios and how to calculate a concentration ratio.
  • The basic model of monopoly suggests that higher prices and profits and inefficiency may result in a misallocation of resources compared to the outcome in a competitive market.
  • The potential benefits from monopoly, for example, economies of scale and possibly more invention and innovation.

Students should appreciate that there are few examples of pure monopoly but many firms have monopoly power.

A formal diagrammatic analysis of monopoly is not required but students should be able to use a demand curve to illustrate that if a monopolist raises the market price above the competitive level, output will fall. They should also be able to use a long-run average cost curve to illustrate the benefits from economies of scale that may result from monopoly.

Students should appreciate the various factors which affect the behaviour and performance of firms in a variety of real-world markets.

3.1.4.5 The competitive market process

Content

Additional information

  • Firms do not just compete on the basis of price but that competition will, for example, also lead firms to strive to improve products, reduce costs, improve the quality of the service provided.

Students should recognise that many large firms compete vigorously with each other but monopoly power may lead to consumers being exploited.

3.1.5 The market mechanism, market failure and government intervention in markets

3.1.5.1 How markets and prices allocate resources

Content

Additional information

  • The rationing, incentive and signalling functions of prices in allocating resources and coordinating the decisions of buyers and sellers in a market economy.
  • The price mechanism is the way in which the basic economic problem is resolved in a market economy.

Students should understand how economic incentives influence what, how and for whom goods and services are produced.

3.1.5.2 The meaning of market failure

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Additional information

  • Market failure occurs whenever a market leads to a misallocation of resources.
  • What is meant by a misallocation of resources.
  • The difference between complete market failure (resulting in a missing market) and partial market failure (where a market exists but contributes to resource misallocation).
  • How public goods, positive and negative externalities, merit and demerit goods, monopoly and other market imperfections, and inequalities in the distribution of income and wealth can lead to market failure.

Students should be able to provide examples to inform their discussion of each of these causes of market failure.

3.1.5.3 Public goods, private goods and quasi-public goods

Content

Additional information

  • Pure public goods are non-rival and non-excludable and recognition of the significance of these characteristics.
  • The difference between a public good and a private good.
  • Circumstances when a public good may take on some of the characteristics of a private good and become a quasi-public good.
  • The significance of technological change, e.g. television broadcasting is now excludable.
  • The free-rider problem.
 

3.1.5.4 Positive and negative externalities in consumption and production

Content

Additional information

  • Externalities exist when there is a divergence between private and social costs and benefits.
  • Why negative externalities are likely to result in over-production and that positive externalities are likely to result in under-production.

Students should be able to illustrate the misallocation of resources resulting from externalities in both production and consumption, using demand and supply diagrams.

Students are not required to use Marginal Social Cost/Marginal Social Benefit (MSC/MSB) diagrams.

3.1.5.5 Merit and demerit goods

Content

Additional information

  • The classification of merit and demerit goods depends upon a value judgement.
  • Such products may be subject to positive and negative externalities in consumption.
  • How under-provision of merit goods and over-provision of demerit goods may also result from imperfect information.

Students should be able to illustrate the misallocation of resources resulting from the consumption of merit and demerit goods using demand and supply diagrams.

Students are not required to use MSC/MSB diagrams.

It should be understood that not all products that result in positive or negative externalities in consumption are either merit or demerit goods.

3.1.5.6 Market imperfections

Content

Additional information

  • Why imperfect and asymmetric information can lead to market failure.
  • Why the existence of monopoly and monopoly power can lead to market failure.
  • Why the immobility of factors of production can lead to market failure.
 

3.1.5.7 An inequitable distribution of income and wealth

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Additional information

  • In the absence of government intervention, the market mechanism is likely to result in a very unequal and inequitable distribution of income and wealth.
  • In a market economy, an individual’s ability to consume goods and services depends upon their income and wealth and an inequitable distribution of income and wealth is likely to lead to a misallocation of resources and hence market failure.
At AS, students are not expected to have an in-depth knowledge of the causes of inequality but they should be aware that progressive taxes and government spending are used to reduce inequality.

3.1.5.8 Government intervention in markets

Content

Additional information

  • The existence of market failure, in its various forms, provides an argument for government intervention in markets.
  • Governments influence the allocation of resources in a variety of ways, including through public expenditure, taxation and regulations.
  • Governments have a range of objectives and these affect how they intervene in a mixed economy to influence the allocation of resources.
  • The use of indirect taxation, subsidies, price controls, state provision and regulation to correct market failure.

Students should be able to apply economic models to assess the role of markets and the government in a variety of situations.

Students should appreciate the consequences of government intervention in markets for consumers, producers and other economic agents.

Students should be able to evaluate the case for and against government intervention in particular markets and to assess the relative merits of different methods of intervention.

3.1.5.9 Government failure

Content

Additional information

  • Government failure occurs when government intervention in the economy leads to a misallocation of resources.
  • Inadequate information, conflicting objectives and administrative costs are possible sources of government failure.
  • Governments may create, rather than remove, market distortions.
  • Government intervention can lead to unintended consequences.

Students should appreciate that the possibility of government failure means that, even when there is market failure, government intervention will not necessarily improve economic welfare.

Students should understand that consumers and producers may not have access to the same information and that this may contribute to markets operating inefficiently.