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YOUR NOTES
A Level Economics A Edexcel 
1. Introduction to Markets & Market Failure
CONTENTS
1.1 Nature of Economics
1.1.1 Economics as a Social Science
1.1.2 Positive & Normative Economic Statements
1.1.3 The Economic Problem
1.1.4 Production Possibility Frontiers
1.1.5 Specialisation & the Division of Labour
1.1.6 Free Market Economies, Mixed Economy and Command Economy
1.2 How Markets Work
1.2.1 Rational Decision Making
1.2.2 Demand
1.2.3 Price, Income & Cross Elasticities of Demand
1.2.4 Supply
1.2.5 Elasticity of Supply
1.2.6 Price Determination
1.2.7 Price Mechanism
1.2.8 Producer & Consumer Surplus
1.2.9 Indirect Taxes and Subsidies
1.2.10 Alternative Views of Consumer Behaviour
1.3 Market Failure
1.3.1 Types of Market Failure
1.3.2 Externalities
1.3.3 Public Goods
1.3.4 Information Gaps
1.4 Government Intervention
1.4.1 Government Intervention in Markets
1.4.2 Government Failure
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1.1 Nature of Economics YOUR NOTES


1.1.1 Economics as a Social Science
The Process of Developing Models
Economics is a social science
It studies societies and the human interactions within those societies
Human interactions are complex and are influenced by many variables
Social sciences also include subjects such as Psychology, Politics, Geography
and Business Studies
Due to the complexities within societies, economists build models so as to better
understand certain interactions
A model is a simplified version of reality
Some models are more complex than others. For example, the Circular Flow
of Income model seeks to demonstrate the interactions of all economic agents
(firms, households, government, banks, international trade) within an entire
economy
All models make a range of assumptions. These are often generalisations
about behaviour, choices and likely outcomes
These assumptions are necessary so as to account for complex human
behaviour and constantly changing variables
When evaluating different models, the underlying assumptions should always
be considered
To think like an economist involves identifying which variables will be studied and
which ones will be excluded
It considers the type of relationship between variables (causal or correlation).
For example, data shows that when ice cream sales increase, so do car thefts.
Correlation, yes. Causation, no
Some economists will build an argument to include certain variables in a
study and others will argue to exclude them. They will each provide a
justification for their decision
Two economists analysing the same data may end up with vastly different
interpretations. This is often due to the different variables that each
economist chooses to focus on. This is the complexity found within social
sciences
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The Use of Ceteris Paribus YOUR NOTES
Due to the large number of variables that can influence any particular economic 
interaction in society, economists create models using the principle of ceteris
paribus
Translated from Latin, ceteris paribus means 'all other variables remain
constant'
It allows economists to simplify and explain causes and effects, even if the
explanation is somewhat limited by the assumptions
For example, there are many factors that affect the level of unemployment in
an economy (interest rates, consumer confidence, firms investment,
government policies etc.). However, using ceteris paribus, economists can
simplify the economic model to analyse just two variables (unemployment
and interest rates). The analysis is conducted ceteris paribus. The analysis is
conducted ceteris paribus. All the other variables remain constant, even when
they are highly likely to have changed
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The Inability to Make Scientific Experiments YOUR NOTES
The natural sciences use the scientific method to prove a relationship between 
two variables
Briefly explained, the scientific method includes the following steps
Define a question to investigate
Develop a hypothesis (make a prediction)
Conduct a test
Gather data
Analyse the data
Report the conclusions
If the relationship between two variables is proven, then as long as the test
conditions are replicated, the conclusions to that experiment should be the
same anywhere in the world.
The social sciences use a variation of this method called the social scientific
method as there is an inability to make scientific experiments the results of
which can be proven time and time again
This is due to the complexity of human nature and the significant number of
social interactions that are taking place in any economy at any given point in
time
The steps in the social scientific method are similar but there is a key
difference
Define a question to investigate
Develop a hypothesis using ceteris paribus (make a prediction)
Conduct empirical research
Gather data
Analyse the data
Report the conclusions
Empirical research is collected through observations, surveys, opinion polls
etc.
The results of the same hypothesis can vary significantly when conducted by
different researchers at different time periods and between different places
and cultures
Economic models are developed by economists once a hypothesis has been

repeatedly proven or rejected in different circumstances.
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1.1.2 Positive & Normative Economic Statements YOUR NOTES


Positive & Normative Statements
Positive economics is concerned with objective statements of how a market or an
economy works
These positive economic statements are based on empirical evidence and
tend to be statements of fact
They can be proven to be true or false
These are examples of positive economic statements
The UK unemployment rate has fallen from 4% to 3.7% in the past three
months
Increasing the minimum wage last year in the UK resulted in
improvements to wage inequality
Prices in the UK have risen dramatically, partly due to the 20% increase in
the price of oil
Normative economics focuses on value judgements. These judgements are built

around opinions and beliefs as to what the best economic policies or solutions
may be
These judgements are called normative economic statements
Normative economic statements are what separate political parties and the
different economic agendas they put forward
These are examples of normative economic statements
Every economy should aim to provide free healthcare for its citizens
Corporation taxes in an economy should be higher than personal income
taxes
The best way to deal with a rise in crime is to employ more police
 Exam Tip
Examiners will often assess your understanding of positive and normative
economic statements in the MCQ questions. They do this by asking you to
identify either the positive or negative statement in the list.
Normative statements often have the word 'should' in them (but not always).
Positive statements usually include data that is hard to challenge. Any use of
concrete data points towards the statement being a positive statement.
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The Role of Value Judgements YOUR NOTES
Value judgements influence individuals choices in the economic decisions they 
make
These decisions can be related to any part of their lives, from what they eat, to
where they work, to how they maintain their health
For example, deciding not to eat meat is often a value judgement based
around unethical methods of food production. By providing statistics on the
harmful impact that meat production has on the environment, environmental
campaigners are attempting to demonstrate that this is no longer a normative
issue
Another example is the way that many individuals choose to smoke nicotine
based products. The value judgement they make is that the benefits they get
from smoking outweighs any risk of cancer.
Value judgements influence governments choices with regards to the economic
policies they choose to adopt and spend money on
The USA spends more money on imprisoning drug users than rehabilitating
them
In the UK, the Government has recently increased its spending on
rehabilitation
To say the UK approach is betterwould be a normative statement
To say that the UK government spends more per head on rehabilitation would
be a positive statement
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1.1.3 The Economic Problem YOUR NOTES


The Basic Economic Problem: Scarcity
The basic economic problem is that resources are scarce
There are finite resources available in relation to the infinite wants and needs
that humans have
In economics, these resources are called the factors of production
Due to the problem of scarcity, choices have to be made by producers,
consumers and governments about the best (most efficient) use of these
resources
Economics is the study of scarcity and its implications for resource allocation in
society
In a free market, scarcity has a direct influence on prices

The scarcer a resource, the higher the price for it will be
The less scarce a resource, the lower the price for it will be
Resources can either be renewable or non-renewable
Renewable resources can be used repeatedly and naturally replenished, for
example wind generated electricity
Non-renewable resources cannot be naturally replenished at a pace that
keeps up with consumption. For example, oil and coal
Opportunity Costs
Opportunity cost is the loss of the next best alternative when making a decision
Due to the problem of scarcity, choices have to be made about how to best
allocate limited resources amongst competing wants and needs
There is an opportunity cost in the allocation of resources

When a consumer chooses to purchase a new phone, they may be unable to
purchase new jeans. The jeans represent the loss of the next best alternative
(the opportunity cost)
When a producer decides to allocate all of their resources to producing
electric vehicles, they may be unable to produce petrol vehicles. The petrol
vehicles represent the loss of the next best alternative (the opportunity cost)
When a government decides to provide free school meals to all primary
students in the country, they may be unable to fund some rural libraries
which may have to close. The libraries represent the loss of the next best
alternative (the opportunity cost)
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1.1.4 Production Possibility Frontiers YOUR NOTES


Production Possibility Frontiers
The Production Possibility Frontiers (PPF) model is an economic model that
considers the maximum possible production (output) that a country can generate
if it uses all of its factors of production to produce only two goods/services
Any two goods/services can be used to demonstrate this model
Many PPF diagrams show capital goods and consumer goods on the axes
Capital goods are assets that help a firm or nation to produce output
(manufacturing). For example, a robotic arm in a car manufacturing company
is a capital good
Consumer goods are end products and have no future productive use. For
example, a watch
A PPF for an economy demonstrating the use of its resources to produce capital or
consumer goods
Diagram Explanation
The use of PPF to depict the maximum productive potential of an economy

The curve demonstrates the possible combinations of the maximum output
this economy can produce using all of its resources (factors of production)
At A, its resources are used to produce only consumer goods (300)
At B, its resources are used to produce only capital goods (200)
Points C & D both represent full (efficient) use of an economy's resources as
these points fall on the curve. At C, 150 capital goods and 120 consumer
goods are produced
The use of PPF to depict opportunity cost using marginal analysis
To produce one more unit of capital goods, this economy must give up
production of some units of consumer goods (limited resources)
If this economy moves from point C (120, 150) to D (225, 100), the
opportunity cost of producing an additional 105 units of consumer goods is
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50 capital goods YOUR NOTES
A movement in the PPF occurs when there is any change in the allocation of 
existing resources within an economy such as the movement from point C to
D
The use of PPF to depict efficiency, inefficiency, attainable and unattainable
production
Producing at any point on the curve represents productive efficiency
Any point inside the curve represents inefficiency (point E)
Using the current level of resources available, attainable production is any
point on or inside the curve and any point outside the curve is unattainable
(point F)
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Shifts in the PPF YOUR NOTES
As opposed to a movement in the PPF described above, the entire PPF of an 
economy can shift inwards or outwards
Outward shifts of a PPF show economic growth & inward shifts show economic
decline
Diagram Explanation
Economic growth occurs when there is an increase in the productive potential of

an economy
This is demonstrated by an outward shift of the entire curve. More consumer
goods and more capital goods can now be produced using all of the available
resources
This shift is caused by an increase in the quality or quantity of the available
factors of production
One example of how the quality of a factor of production can be
improved is through the impact of training and education on labour . An
educated workforce is a more productive workforce and the production
possibilities increase
One example of how the quantity of a factor of production can be
increased is through a change in migration policies. If an economy allows
more foreign workers to work productively in the economy, then the
production possibilities increase
Economic decline occurs when there is any impact on an economy that reduces
the quantity or quality of the available factors of production
One example of how this may happen is to consider how the Japanese tsunami
of 2011 devastated the production possibilities of Japan for many years. It
shifted their PPF inwards and resulted in economic decline
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1.1.5 Specialisation & the Division of Labour YOUR NOTES


Specialisation & The Division of Labour
Scotsman Adam Smith is often referred to as the 'father of Economics'
He published 'The Wealth of Nations' in March 1776 and explained many
fundamental economic principles that we still use today
The premise of the book was to discuss how to increase productivity and
wealth
Based on observations made during a visit to a pin factory, he developed the ideas
of specialisation and the division of labour
He noted that a single worker could not make more than 20 pins a day as it
involved around 18 different processes, such as cutting the wire, sharpening
the end, stamping the head etc.
However, if the labour was divided up into different tasks and workers
specialised in just that one task, Adam Smith estimated that just 10 workers
could produce 48,000 pins per day
The division of labour is when a task is broken up into several component tasks
This allows workers to specialise by focusing on one (or a few) of the components
that make up the production process and thereby gain significant skill in doing it
This results in higher output per worker and so increases productivity
Specialisation occurs on several different levels
On an individual level
On a business level. For example, one firm may only specialise in
manufacturing drill bits for concrete work
On a regional level. For example, Silicon Valley has specialised in the tech
industry
On a global level as countries seek to trade. For example, Bangladesh
specialises in textiles and exports them to the world
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Advantages & Disadvantages of the Division of Labour & YOUR NOTES
Specialisation 
Pros & Cons of the Division of Labour & Specialisation in Production
Pros Cons
Higher labour productivity lowers Task repetition often leads to boredom

cost/unit for firms and a decrease in worker motivation
A decrease in motivation may lead to less

Lower costs can be passed on to productivity and/or poorer manufacturing
consumers in the form of lower prices quality
Lower costs can mean higher profits for It may increase worker turnover rates as
the firms. This may lead to higher wages workers look to move on to a role that is
for workers more stimulating
Increased productivity allows some firms to Mass produced products often lack
sell beyond their local market into variety and do not take different consumer
international markets preferences into account
If workers lose their jobs, then it may be

It creates many low skilled jobs hard for them to find work as they are only
trained in one skill
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Pros & Cons of the Division of Labour & Specialisation in Trade YOUR NOTES
Pros & Cons of the Division of Labour & Specialisation in Trade 
Pros Cons
Higher labour productivity lowers cost / International trade is beneficial for the
unit for firms, which makes their goods firms that can compete globally. However,
more competitive internationally (exports) some industries will be unable to compete
and will go out of business
Increased exports can result in economic Many firms in an entire industry may close
growth for the nation leading to structural unemployment
Specialisation may create over-

dependency on other countries' resources.
Economic growth usually leads to higher
income and a better standard of living
This may cause problems if conflict arises
(For example, Europe's reliance on Russian
natural gas during the Ukraine crisis)
Income gained from exports can be used Specialisation using a country's own
to purchase other goods from around the resources will lead to resource depletion
world (imports). This increases the variety over time. Specialisation will increase the
of goods available in a country rate of resource depletion
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The Functions of Money YOUR NOTES
As individuals and firms trade with each other in order to acquire goods or raw 
materials, they require a means of exchange that is acceptable and easy to use
Modern currency fulfils this purpose and money functions as a medium of
exchange, a measure of value, a store of value, and a method of deferred
payment
The Four Functions of Money
A Medium of A Method of
A Measure of Value A Store of Value
Exchange Deferred Payment
Without money, Money provides Money holds its Money is an

it becomes a means of value over time acceptable way
necessary for ascribing value (of course to arrange terms
buyers and to different inflation means of credit (loans)
sellers to barter goods and that is not and to settle any
(exchange services always true!) future debts
goods) Knowing the This means that This allows
Bartering is price of a good money can be producers and
problematic as it in terms of saved consumers to
requires two money allows It remains acquire goods in
people to want both consumers valuable in the present and
each other's and producers to exchange over pay for them in
good (double make decisions long periods of the future
co-incidence of in their best time
wants) interests
Money easily Without this
facilitates the measure it is
exchange of difficult for
goods as no buyers and
double co- sellers to
incidence of arrange an
wants is agreeable
necessary exchange
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1.1.6 Free Market Economies, Mixed Economy and Command Economy YOUR NOTES

Free Market, Mixed & Command Economies
In order to solve the basic economic problem of scarcity, economic systems
emerge or are created by different economic agents within the economy
These agents include consumers, producers, the government, and special
interest groups (e.g. environmental or trade unions)
The economic system aims to allocate the scarce factors of production
Any economic system needs to decide how to answer the three fundamental
economic questions
What to produce? More weapons for the military or more schools to educate
the children?
Who to produce for? Only those who can afford to pay for it? Or for everyone
in society?
How to produce it? Should more labour be used or should the economy focus
on using technology instead?
Adam Smith, Karl Marx and Friedrich Hayek had very different ideas about how
these questions should be answered
The Distinction Between Free Markets, Mixed and Command Economies
Free Markets Mixed Economies Command Economies

Friedrich Hayek Adam Smith Karl Marx
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Friedrich Hayek Adam Smith advocated Karl Marx believed that YOUR NOTES
believed that free for free markets with free markets lead to 
markets with no some government capitalism in which the
government intervention owners of the factors of
intervention provided He recognised that production (Capitalists)
the most efficient there was a role for exploited the workers
allocation of resources governments to ensure This creates inequality
and that command efficiency in the which will lead to a
economies were flawed allocation of resources breakdown between the
He identified and provide public and classes
information gaps merit goods The role of the State is
between what the However, he believed therefore to share the
economies actually economies function best means of production
required and what the when private and ownership with all
central planners in individuals work in of the workers in society
command economies their own self-interest. This required the
were saying it required Famous quote: "It is not abolition of private
These gaps led to from the benevolence of property
shortages or surpluses the butcher, the brewer, This required the State
of goods/services in or the baker, that we to become the central
command economies expect our dinner, but planner, deciding how
He felt that the threat to from their regard to each of the three
efficiency and economic their own interest" economic questions will
growth is government be answered
intervention
A free-market economy is an economy that has no government intervention in

the allocation of resources and distribution of goods/services
A command economy is an economy in which all of the resources are owned by
the state and the government controls the distribution of goods/service
A mixed economy is a blend of the free market and planned economy as
individuals, firms and the government own factors of production and distribute
goods/services
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Pros & Cons of Free Market & Command Economies YOUR NOTES
Each economic system has numerous advantages and disadvantages. 
Understanding the strengths and weakness of each system helps policy makers to
tackle the disadvantages head on while building on its strengths
The Advantages and Disadvantages of Free Market Economies and Command

Economies
Type of Economy Advantages Disadvantages
Profit incentive motivates Wealth gets concentrated

people to work or develop in the hands of the few as
entrepreneurial ideas they are able to keep
Greater variety of buying up the scarce
goods/services factors of production
Competition leads to This increases inequality
better quality of such that the gap between
goods/services the rich and the poor
Competition leads to lower continues to grow
prices of goods/services Sometimes product quality
Competition encourages falls as firms lower quality
innovation and product standards in order to
Free Market Economy development increase profits
Profits, income and wealth Workers get exploited
are unlimited resulting in Resource depletion and
better standards of living environmental
More efficient use of scarce degradation are often
resources ignored
Monopolies develop as
firms increase market
power through mergers
and acquisitions
This leads to exploitation
of consumers and supply
chains
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Social equality is the goal Receiving the same wage YOUR NOTES
of the system as opposed disincentives people from 
to profit maximisation, so gaining difficult skills (e.g.
there is less inequality doctor) as 8 years of study
All workers receive the results in the same wage as
same wage irrespective of no study
role or career. This helps A lack of competition
create social equality means that there is less
Less unemployment innovation and product
Resources of the nation development
can be directed towards There is a continual lack of
urgent priorities quickly efficiency as central
Command Economy
The government owns planning always results in
monopoly businesses so surpluses or shortages of
consumer exploitation goods/services
through high prices can be Black markets multiply as
avoided the population seeks to
address shortages
Access to higher standards
of living is. limited for
most of the population
Personal freedoms are
restricted
 Exam Tip
Multiple choice questions often explore your understanding of the different
characteristics of free market, mixed and planned economic systems.
When answering structured questions that ask you to discuss/explain the
difference between two systems, ensure that the disadvantages of one
system are not always just the opposite points to the advantages of the
other system. Develop some unique points for each system.
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Role of the State in a Mixed Economy YOUR NOTES
Some mixed economies have a higher level of government intervention than 
others
Government intervention occurs mainly through taxation (to raise revenue) and
then spending that revenue to redistribute income and provide essential
goods/services
There are many different type of tax intervention including personal income
tax, corporation tax, value added tax, tariff on imports, inheritance tax etc.
Income is redistributed through the creation of a welfare system which often
includes unemployment benefits, healthcare, and pension provision
Government spending is often focused on infrastructure, merit goods (e.g.
schools) and public goods (e.g. national defense)
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1.2 How Markets Work YOUR NOTES


1.2.1 Rational Decision Making
Rational Decision Making
When analysing markets, a range of assumptions are made about the rationality
of economic agents involved in the transactions
In classical economic theory, the word 'rational' means that economic agents are
able to consider the outcome of their choices and recognise the net benefits of
each one. Rational agents will select the choice which presents the highest
benefits
Consumers are assumed to act rationally. They do this by maximising their
utility
Producers are assumed to act rationally. They do this by selling
goods/services in a way that maximises their profits
Workers are assumed to act rationally. They do this by balancing welfare at
work with consideration of both pay and benefits
Governments are assumed to act rationally. They do this by placing the
interests of the people they serve first in order to maximise their welfare
In many ways, the assumption of rational decision making is flawed. For
example, consumers are often more influenced by emotional purchasing
decisions than a rational computation of net benefits
 Exam Tip
In your examinations, the essay questions test your ability to think critically.
The command words for these questions are evaluate, discuss, or examine.
One way in which you can demonstrate critical thinking is to challenge the
underlying assumptions of economic theory. The idea of rational decision
making is one such assumption. Do consumers act rationally when they
make impulse purchases? Do workers act rationally when they accept
terrible working conditions for mediocre pay? Do governments actually
maximise public welfare or do they implement policies that mainly benefit
their core voter base?
Irrationality distorts markets and produces fundamentally different
outcomes than what would be achieved if all economic agents acted
rationally.
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1.2.2 Demand YOUR NOTES


Demand
Demand is the amount of a good/service that a consumer is willing and able to
purchase at a given price in a given time period
If a consumer is willing to purchase a good, but cannot afford to, it is not
effective demand
A demand curve is a graphical representation of the price and quantity demanded

(QD) by consumers
If data were plotted, it would be an actual curve, however economists simplify
curves in their sketches into straight lines so as to make analysis easier
Movements Along A Demand Curve

If price is the only factor that changes (ceteris paribus), there will be a change in
the QD
This change is shown by a movement along the demand curve
A demand curve showing a contraction in quantity demanded (QD) as prices increase

and an extension in quantity demanded (QD) as prices decrease
Diagram Analysis
An increase in price from £10 to £15 leads to a movement up the demand curve
from point A to B
Due to the increase in price, the QD has fallen from 10 to 7 units
This movement is called a contraction in QD
A decrease in price from £10 to £5 leads to a movement down the demand curve
from point A to point C
Due to the decrease in price, the QD has increased from 10 to 15 units
This movement is called an extension in QD
The law of demand captures this fundamental relationship between price and QD
It states that there is an inverse relationship between price and QD
When price rises the QD falls
When prices fall the QD rises
This relationship partly explains why the demand curve is downward sloping
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Conditions of Demand YOUR NOTES
Shifts Of The Entire Demand Curve 
There are numerous factors that will change the demand for a good/service,
irrespective of the price level. Collectively these factors are called the conditions
of demand
Changes to each of the conditions of demand, shifts the entire demand curve (as
opposed to a movement along the demand curve)
A graph that shows how changes to any of the conditions of demand shifts the entire
demand curve left or right, irrespective of the price level
For example, if a firm increases their Instagram advertising, there will be an

increase in demand as more consumers become aware of the product
This is a shift in demand from D to D1. The price remains unchanged at £7 but
the demand has increased from 15 to 25 units
An Explanation of How Each of the Conditions of Demand Shifts the Entire Demand
Curve at Every Price Level
Condition Explanation Condition Shift Condition Shift
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Real Income
YOUR NOTES
determines how many 
goods/services can be D D
Changes in Real
enjoyed by consumers Income Shifts Income Shifts
Income
There is a direct Increases Right Decreases Left
relationship between (D→D1) (D→D2)
income and demand for
normal goods
If goods/services
become more
fashionable then
demand for them Good D Good D
Changes in increases becomes Shifts becomes Shifts
taste/fashion There is a direct more Right less Left
relationship between fashionable (D→D ) fashionable (D→D )
1 2
changes in
taste/fashion and
demand
If more money is spent

on advertising or
branding , then demand
for goods/services will D D
Advertising/
increase as more Advertising Shifts Advertising Shifts
branding
consumers are aware of Increases Right Decreases Left
the product (D→D1) (D→D2)
There is a direct
relationship between
branding/advertising
and demand
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Changes in the price of YOUR NOTES

substitute goods will 
influence the demand
for a product/service
There is a direct D for D for
Changes in the relationship between Price of Good B Price of Good B
prices of the price of good A Good A Shifts Good A Shifts
substitute and demand for good Increases Right Decreases Left
goods B
(D→D1) (D→D2)
For example, the price
of a Sony 60" TV
increases so the
demand for LG 60" TV
increases
Changes in the price of

complementary goods
will influence the
demand for a
product/service D for D for
Changes in the There is an inverse Price of Good B Price of Good B
prices of relationship between Good A Good A
Shifts Shifts
complementary the price of good A Increases Left Decreases Right
goods and demand for good (D→D2) (D→D1)
B
For example, the price
of printer ink increases
so the demand for ink
printers decreases
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If the population size YOUR NOTES

of a country changes 
over time, then the
demand for
goods/services will
also change
There is a direct
relationship between
Changes in
the changes in D D
population
population size and Population Shifts Population Shifts
size/distribution
demand Increases Right Decreases Left
Demand will also (D→D1) (D→D2)
change if there is a
change to the age
distribution in a
country as different
ages demand different
goods/services e.g an
ageing population will
buy more hearing aids
 Exam Tip
The difference between a movement along the demand curve and a shift in
demand is essential to understand. You will be repeatedly examined on this
and it is important that you use the correct language to show that you
understand the difference between a change in quantity demanded and a
change in demand.
When price changes (ceteris paribus), there is a movement along the

demand curve resulting in a change to quantity demanded. When a
condition of demand changes, there is a shift of the entire demand curve
resulting in a change to demand.
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Diminishing Marginal Utility YOUR NOTES
Marginal utility is the additional utility (satisfaction) gained from the consumption 
of an additional product
The utility gained from consuming the first unit is usually higher than the utility
gained from consuming the next unit
For example, a hungry consumer gains high utility from eating their first
hamburger. They are still hungry and purchase a second hamburger but gain
less satisfaction from eating it than they did from the first hamburger
To calculate total utility, the marginal utility of each unit consumed is added
together
This means that total utility keeps increasing even while marginal utility is
decreasing
The Law of Diminishing Marginal Utility states that as additional products are
consumed, the utility gained from the next unit is lower than the utility gained
from the previous unit
The Law of Diminishing Marginal Utility helps to explain the reason why the
demand curve is downward sloping
When the first unit is purchased, the utility is high and consumers are willing
to pay a high price
When subsequent units are purchased, each one offers less utility and the
willingness of the consumer to pay the initial price decreases
Lowering the price makes it a more attractive proposition for the consumer to
keep consuming additional units
This is one reason why firms offer discounts such as '50% off the second item'
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1.2.3 Price, Income & Cross Elasticities of Demand YOUR NOTES


Price Elasticity of Demand (PED)
The law of demand states that when there is an increase in price, there will be a
fall in quantity demanded
Economists are interested by how much the quantity demanded will fall
Price elasticity of demand reveals how responsive the change in quantity
demanded is to a change in price
The responsiveness is different for different types of products
Calculation of PED
PED can be calculated using the following formula
% change in quantity demanded % △ in QD

PED = =
% change in price % △in P
To calculate a % change, use the following formula
new value − old value

% Change = × 100
old value
 Worked Example
A firm raises the price of its products from £10 to £15. Its sales fall from
100 to 40 units per day. Calculate the PED of its products
Step 1: Calculate the % change in QD
40 − 100
% △QD = × 100
100
% △QD = − 60 %
Step 2: Calculate the % change in P
15 − 10
% △P = x 100
10
% △P = 50 %
Step 3: Insert the above values in the PED formula
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PED =
% △ in QD YOUR NOTES
% △in P

− 60
PED =
50
PED = − 1. 2
The PED value will always be negative so economists ignore the sign and present
the answer as 1.2
Interpreting PED Values
The Size of PED Varies From 0 To Infinity (∞) & Is Classified As Follows
Value Name Explanation

The QD is completely unresponsive to a
0 Perfectly Inelastic
change in P (very theoretical value e.g. heart
transplant is extremely inelastic but possibly not
perfectly)
0→1 Relatively Inelastic
The %∆ in QD is less than proportional
to the %∆ in P (e.g. addictive products)
1 Unitary Elasticity The %∆ in QD is exactly equal to the %∆ in P
1→ ∞ Relatively Elastic
The %∆ in QD is more than proportional
to the %∆ in P (e.g. luxury products)
∞ Perfectly Elastic
The %∆ in QD will fall to zero with any
%∆ in P (highly theoretical elasticity)
Factors That Influence the PED
Some products are more responsive to changes in prices than other products
The factors that determine the responsiveness are called the determinants of PED
and include:
1. Availability of substitutes: good availability of substitutes results in a higher
value of PED (relatively elastic)
2. Addictiveness of the product: addictiveness turns products into necessities
resulting in a low value of PED (relatively inelastic)
3. Price of product as a proportion of income: the lower the proportion of income
the price represents, the lower the PED value will be. Consumers are less
responsive to price changes on cheap products (relatively inelastic)
4. Time period: In the short term, consumers are less responsive to price increases
resulting in a low value of PED (relatively inelastic). Over a longer time period
consumers may feel the price increase more and will then look for substitutes
resulting in a higher value of PED (relatively elastic)
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Income Elasticity of Demand (YED) YOUR NOTES
Changes in income result in changes to the demand for goods/services 
Economists are interested in how much the quantity demanded will change
for different products
Income elasticity of demand (YED) reveals how responsive the change in quantity
demanded is to a change in income
Calculation of YED
YED can be calculated using the following formula
% ch ang e in qu antity d em and ed % △ in QD

YED = =
% ch ang e in incom e % △in Y
 Worked Example
A consumer's income rises from £100 to £125 a week. They originally
consumed 12 bagels at the local bakery but this increased to 15 bagels a
week. Calculate the YED of the bagels
Step 1: Calculate the % change in QD
15 − 12
% △QD = × 100
12
% △QD = 25 %
Step 2: Calculate the % change in Y
125 − 100
% △Y = x 100
100
% △Y = 25 %
Step 3: Insert the above values in the YED formula
% △ in QD
PED =
% △in Y
25
YED =
25
YED = 1
Interpreting YED Values

The YED value can be positive or negative and the value is important in
determining the type of good
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The Value Of YED Determines The Type Of Good & Response To Changes In Income YOUR NOTES
Value Type of Good Explanation 
Demand increases when income increases. Income
0→1 Normal necessity inelastic which means that it is relatively
unresponsive to a change in income
Demand increases when income increases. Income
YED > 1 Normal luxury elastic which means that it is relatively responsive
to a change in income
YED < 0 Inferior Good Demand decreases when income increases
Factors That Influence YED
YED is influenced by any factors in an economy which change the wages of
workers
During a recession wages usually fall and demand for inferior goods rises
and luxury goods falls
During a period of economic growth and rising wages, demand for luxury
goods increases and demand for inferior goods decreases
Other influences on income include minimum wage legislation, taxation,
increased international trade
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Cross Price Elasticity of Demand (XED) YOUR NOTES
Changes in the prices of complementary goods and substitutes affect the demand 
for related products
Cross price elasticity of demand (XED) reveals how responsive the change in
quantity demanded for good A is to a change in price of good B
Calculation of XED
XED can be calculated using the following formula
% ch ang e in qu antity d em and ed of good A % △ in QDA

XED = =
% ch ang e in pric e of good B % △in P B
 Worked Example
Leading into the release of FIFA 22 Ultimate, EA Sports discounted the price
of FIFA 21 from £90 to £60. A game store in Winchester saw an increase in
sales of their PlayStation 5 consoles. Prior to the discount they were selling
50 units a week and after the discount this increased to 80 units. Calculate
the XED and explain the relationship between the two products
Step 1: Calculate the % change in QDA
80 − 50
% △QDA = × 100
50
% △ QDA = 60 %
Step 2: Calculate the % change in P B
60 − 90
% △PB = x 100
90
% △ P B = − 33 . 3 %
Step 3: Insert the above values in the XED formula
% △ in QDA
XED =
% △in P B
60 %
XED =
−33 . 3 %
XED = − 1. 8
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Step 4: Explain the relationship between the two products YOUR NOTES
The negative sign indicates that these two products are complements and the 
high value suggests they are strong complements
Interpreting XED Values
Using XED Values to Identify if Goods are Complements, Substitutes, Or Unrelated

The negative value indicates the two goods are
XED < 0 Complementary goods complements
The higher the value the stronger the relationship
The positive value indicates the two goods are
XED > 0 Substitutes substitutes
The higher the value the stronger the relationship
A value of zero indicates that there is no
XED = 0 Unrelated goods relationship between the two goods. The closer to
zero the weaker the relationship is
Significance of Elasticities to Firms & Governments

Knowledge of PED is important to firms seeking to maximise their revenue
If their product is price inelastic in demand, they should raise their prices
If price elastic in demand, then they should lower their prices
Knowledge of PED is important to Governments with regard to taxation and
subsidies
If they tax price inelastic in demand products, they can raise tax revenue
without harming firms too much
Consumers are less responsive to price changes so firms will pass on the tax
to the consumer
If they subsidies price elastic in demand products, there can be a greater than
proportional increase in demand
Knowledge of XED is important to firms as they seek to maximise their revenue

It can help them to adjust pricing strategies for substitute and
complementary goods
It can help them understand the likely impact of competitors' pricing
strategies on their sales
Knowledge of YED is important to firms as they seek to maintain sales and

maximise profits through periods of recession or economic growth
Firms should consider providing more inferior goods in a recessionary
environment
Firms should consider providing more luxury products during periods of
economic growth
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The Revenue Rule of PED YOUR NOTES
The total revenue rule states that in order to maximise revenue, firms should 
increase the price of products that are inelastic in demand and decrease prices on
products that are elastic in demand
 Worked Example
A firm raises the price of its products from £10 to £15. Its sales have
fallenfrom 100 to 40 units per day. Explain if they made the correct
decision
Step 1: Calculate the initial sales revenue
Sales Revenue = Price of product X Quantity sold

= £ 10 x 100
= £ 1,000
Step 2: Calculate the sales revenue after the price change
Sales Revenue = Price of product X Quantity sold

= £ 15 x 40
= £ 600
Step 3: Explain the decision
By raising the price, the total revenue has fallen by £400. This indicates that
the product is price elastic in demand and the firm should have lowered their
price in order to maximise revenue
 Exam Tip
A common error students make is to say that when prices increase and the
product is inelastic in demand, the quantity demanded does not fall. It
does! But it is a less than proportional fall than the increase in price.
So, when Governments tax demerit goods such as cigarettes, the increase in
price is greater than the decrease in QD, but QD still falls.
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1.2.4 Supply YOUR NOTES


Supply
Supply is the amount of a good/service that a producer is willing and able to
supply at a given price in a given time period
A supply curve is a graphical representation of the price and quantity supplied by

producers
If data were plotted, it would be an actual curve, however economists simplify
curves in their sketches into straight lines so as to make analysis easier
The supply curve is sloping upward as there is a positive relationship
between price and quantity supplied
Rational profit maximising producers would want to supply more as
prices increase in order to maximise their profits
A supply curve showing an extension in quantity supplied (QS) as prices increase and
a contraction in quantity supplied (QS) as prices decrease
Diagram Analysis
If price is the only factor that changes (ceteris paribus), there will be a change in
the quantity supplied (QS)
This change is shown by a movement along the supply curve
An increase in price from £7 to £9 leads to a movement up the supply curve from
point A to B
Due to the increase in price, the quantity supplied has increased from 10 to
14 units
This movement is called an extension in QS
A decrease in price from £7 to £4 leads to a movement down the supply curve
from point A to C
Due to the decrease in price, the quantity supplied has decreased from 10 to
7 units
This movement is called a contraction in QS
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The Conditions of Supply YOUR NOTES
There are several factors that will change the supply of a good/service, 
irrespective of the price level. Collectively these factors are called the conditions
of supply
Changes to any of the conditions of supply shifts the entire supply curve (as
opposed to a movement along the supply curve)
A graph that shows how changes to any of the conditions of supply shifts the entire
supply curve left or right, irrespective of the price level
For example, if a firm's cost of production increases due to the increase in price of
a key resource, then there will be a decrease in supply as the firm can now only
afford to produce fewer products
This is a shift in supply from S to S1. The price remains unchanged at £7 but
the supply has decreased from 10 to 2 units
An Explanation of How Each of the Conditions of Supply Shifts the Entire Supply
Curve at Every Price Level
Condition Explanation Condition Shift Condition Shift
If the price of raw materials

Costs of or other COP
S Shifts
COP
S Shifts
Production costs of production change, Increases
Left Right
(COP) firms respond by changing (S→S1) Decreases (S→S )
2
supply
Any changes to specific taxes S Shifts S Shifts
Indirect or ad valorem taxes change Taxes
Left
Taxes
Right
Taxes the cost of production for a Increase
(S→S1)
Decrease
(S→S2)
firm and impact supply
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Changes to producer S Shifts S Shifts
YOUR NOTES
subsidies directly impact the Subsidy Subsidy 
Subsidies Right Left
cost of production for the Increases Decreases
(S→S2) (S→S1)
firm
New technology increases
productivity and lowers costs Technology S Shifts Technology S Shifts
New
Technology
of production. Ageing Increases Right Decreases Left
technology can have the (S→S2) (S→S1)
opposite effect
The entry and exit of firms
Change in
into the market has a direct
the number
impact on the supply. If ten No. of S Shifts No. of S Shifts
of firms in
new firms start selling Firms Right Firms Left
the industry
building materials in Increases (S→S2) Decreases (S→S1)
Nuneaton, the supply of
building material will increase
 Exam Tip
Several of the conditions of supply change the costs of production.
However, be sure to explain each condition as its own point before linking it
to the cost of production (for example, a change in indirect taxation).
A common error by students is to explain that a subsidy (for example,
£3,000 subsidy for each electric vehicle produced) shifts the demand curve
for electric vehicles to the right. This is incorrect. The subsidy will shift the
supply curve to the right. Then due to the lower price, there will be a
movement along the demand curve (extension of quantity demanded) to
create a new market equilibrium.
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1.2.5 Elasticity of Supply YOUR NOTES


Price Elasticity of Supply (PES)
The law of supply states that when there is an increase in price (ceteris paribus),
producers will increase the quantity supplied and vice versa
Economists are interested by how much the quantity supplied will increase
Price elasticity of supply (PES) reveals how responsive the change in quantity
supplied is to a change in price
Calculation of PES
PES can be calculated using the following formula
% change in quantity supplied % △ in QS

PES = =
% change in price % △in P
To calculate a % change, use the following formula
new value − old value

% Change = × 100
old value
 Worked Example
In recent months, the price of avocados has increased from £0.90 to £1.45.
Bewdley Farm Shop in the Severn valley have sought to maximise their
profits by increasing the quantity supplied to market. They have been able
to increase sales from 110 units a week to 120 units a week. Calculate the
PES of avocados and explain one reason for the value
Step 1: Calculate the % change in QS
120 − 110
% △ QS = × 100
110
% △ QS = 9. 1 %
Step 2: Calculate the % change in P
1. 45 − 0. 90
% △P = x 100
0. 90
% △P = 61 %
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YOUR NOTES
Step 3: Insert the above values in the PES formula

% △ in QS
PE S =
% △in P
9. 1 %
PE S =
61 %
PE S = 0. 15
Step 4: Explain one reason for the value
The PES value of 0.15 indicates that avocados are very price inelastic in supply.
Even with a significant increase in price, suppliers are unable to supply more
likely due to the time it takes to grow additional avocados
 Exam Tip
When doing elasticity calculations make sure that your final answer is not
expressed as a percentage. This is a common error and loses marks.
Interpreting PES Values

The Values of PES Vary From 0 To Infinity (∞) & They Are Classified As Follows

The QS is completely unresponsive to a
0 Perfectly Inelastic change in P (e.g. fixed number of seats in a
theatre)
0→1 Relatively Inelastic
The %∆ in QS is less than proportional
to the %∆ in P (e.g agricultural products)
1→ ∞ Relatively Elastic
The %∆ in QS is more than proportional
to the %∆ in P (e.g t-shirts)
The %∆ in QS will fall to zero with any %∆ in P.
∞ Perfectly Elastic
However, supply is unlimited at a particular price.
This is a very theoretical scenario but is evident
when examining international trade diagrams
Factors That Influence the PES
Some products are more responsive to changes in prices than other products
The factors that determine the responsiveness are called the determinants of PES
and include:
1. Mobility of the factors of production: if producers can quickly switch their
resources between products, then the PES will be more elastic. For example, if
prices of hiking boots increase and shoe manufacturers can switch resources from
producing trainers to boots, then boots will be price elastic in supply
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2. Availability of raw materials: if raw materials are scarce then PES will be low YOUR NOTES
(inelastic). If they are abundant, PES will be higher (elastic) 
3. Ability to store goods: if products can be easily stored then PES will be higher
(elastic) as producers can quickly increase supply (for example, tinned food
products). An inability to store products results in lower PES (inelastic)
4. Spare capacity: if prices increase for a product and there is capacity to produce
more in the factories that make those products, then supply will be elastic. If there
is no spare capacity to increase production, then supply will be inelastic
5. Time period: In the short run, producers may find it harder to respond to an
increase in prices as it takes time to produce the product (e.g., avocados).
However, in the long run they can change any of their factors of production so as
to produce more
 Exam Tip
Many students confuse PES with PED and inadvertently answer questions
using knowledge from PED. When faced with PES questions, tell yourself to
think like a producer (and not a consumer!) and it will help you to stay
focused on providing the correct answer.
Distinction Between Short-run & Long-run

The resources used in production are called factors of production
All four factors of production are required to produce any good/service
Land: non man made resources used in production (e.g. coal)
Capital: man made resources used in production (e.g. MRI machine or
fertiliser)
Labour: people involved in the production process
Entrepreneurship: the individual(s) involved in organising the other factors of
production
Economists differentiate between the short-run and the long-run periods of
production and these definitions relate to the factors of production. It is not a
physical period of time
Short-run is any period of time in which at least one factor of production is
fixed and this is a limiting factor. For example, Lego may be able to vary all
factors of production in the short-run, except for the number of factories
(capital) that they have
Long-run is any period of time in which all the factors of production are
variable (it is also called the planning stage). Producers are able to vary all of
their resources so as to respond to changing market conditions. For example,
Lego could build a new factory so as to take advantage of higher prices or
greater demand
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1.2.6 Price Determination YOUR NOTES


Price Determination & Equilibrium
Price Determination
In a free market economy, prices are determined by the interaction of demand
and supply in a market
A market is any place that brings buyers and sellers together
Markets can be physical (e.g. Waterstones) or virtual (e.g. eBay)
Buyers and sellers meet to trade at an agreed price
Buyers agree the price by purchasing the good/service
If they do not agree on the price then they do not purchase the good/service
and are exercising their consumer sovereignty
Based on this interaction with buyers, sellers will gradually adjust their prices
until there is an equilibrium price and quantity that works for both parties
At the equilibrium price, sellers will be satisfied with the rate/quantity of
sales
At the equilibrium price, the utility/price combination is maximised for the
buyers
Equilibrium
Equilibrium in a market occurs when demand = supply
At this point the price is called the market clearing price
This is the price at which sellers are clearing their stock at an acceptable rate
A graph showing a market in equilibrium with a market clearing price at P and

quantity at Q
Any price above or below P creates disequilibrium in this market

Disequilibrium occurs whenever there is excess demand or supply in a market
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Market Disequilibrium YOUR NOTES
Disequilibrium - Excess Demand 
Excess demand occurs when the demand is greater than the supply
It can occur when prices are too low or when demand is so high that supply
cannot keep up with it
A graph that depicts the condition of excess demand in the market for electric
scooters
Diagram Analysis
At a price of P1, the quantity demanded of electric scooters (Qd) is greater than
the quantity supplied (Qs)
There is a shortage in the market equivalent to QsQd
Market response
This market is in disequilibrium
Sellers are frustrated that products are selling so quickly at a price that is
obviously too low
Some buyers are frustrated as they will not be able to purchase the product
Sellers realise they can increase prices and generate more revenue and profits
Sellers gradually raise prices
This causes a contraction in QD as some buyers no longer desire the
good/service at a higher price
This causes an extension in QS as sellers are more incentivised to supply at
higher prices
In time, the market will have cleared the excess demand and arrive at a position of
equilibrium (P eQ e)
Different markets take different lengths of time to resolve disequilibrium. For
example, retail clothing can do so in a few days. Whereas the housing market
may take several months
Disequilibrium - Excess Supply
Excess supply occurs when the supply is greater than the demand
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It can occur when prices are too high or when demand falls unexpectedly YOUR NOTES
During the later stages of the pandemic the market for face masks was in 
disequilibrium
A graph that depicts the condition of excess supply in the market for Covid-19 face
masks during the later stages of the pandemic
Diagram Analysis
At a price of P1, the quantity supplied of face masks (Qs) is greater than the
quantity demanded (Qd)
There is a surplus in the market equivalent to QdQs
Market Response
This market is in disequilibrium
Sellers are frustrated that the masks are not selling and that the price is
obviously too high
Some buyers are frustrated as they want to purchase the masks but are not
willing to pay the high price
Sellers will gradually lower prices in order to generate more revenue
This causes a contraction in QS as some sellers no longer desire to supply
masks
This causes an extension in QD as buyers are more willing to purchase masks
at lower prices
In time, the market will have cleared the excess supply and arrive at a position of
equilibrium (P eQ e)
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Use of Diagrams to Show Market Changes YOUR NOTES
Real world markets are constantly changing and are referred to as dynamic 
markets
Market equilibrium can change every few minutes in some markets (e.g. stocks
and shares), or every few weeks or months in others (e.g clothing)
Any change to a condition of demand or supply will temporarily create
disequilibrium and market forces will then seek to clear the excess demand or
supply
Real World Example: Changes to Demand That Increase Price

During lock downs associated with the Covid-19 pandemic, furniture retailers
experienced unexpectedly high demand for their products (especially desks and
sofas)
Diagram showing an increase in demand for desks due to a temporary change in

tastes/fashions
Diagram Analysis
Due to the Covid mandated change of working from home, consumers
experienced a temporary change in taste as they sought to set up comfortable
home offices
This led to an increase in demand for desks from D1→D2
At the original market clearing price of P1, a condition of excess demand now
exists
The demand for desks is greater than the supply
In response, suppliers raise prices
This causes a contraction of demand and an extension of supply leading to a
new market equilibrium at P 2Q2
Both the equilibrium price (P2) and the equilibrium quantity (Q2) are higher
than before
The excess demand in the market has been cleared
Real World Example: Changes to Supply That Increase Price
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Ukraine is one of the world's largest producers of wheat. During the Russian- YOUR NOTES
Ukrainian war, exports of wheat have been halted 
India imported 13% of the nation's wheat requirements from the Ukraine
Diagram showing an decrease in supply of wheat in India due to a supply shock

caused by the war in Ukraine
Diagram Analysis
Due to the war in the Ukraine, India is experiencing a supply shock in its wheat
market
This causes a decrease in supply of S1→S2
At the original market clearing price of P1, a condition of excess demand now
exists (shortage)
The demand for wheat is greater than the supply
In response, sellers in India raise prices
This causes a contraction of demand and an extension of supply leading to a
new market equilibrium at P 2Q 2
The equilibrium price (P2) is higher and the equilibrium quantity (Q2) is lower
than before
The excess demand in the market has been cleared
Real World Example: Changes to Demand That Decrease Price

Demand for lobsters in Maine, USA has been falling steadily in recent months
This has resulted in a price fall from $12.35 /pound on the 1st April to $9.35
/pound on the 1st May
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YOUR NOTES

Diagram showing a decrease in demand for lobsters due to a decrease in real income
Diagram Analysis
In recent months the USA has been experiencing an increasing rate of inflation
Inflation lowers the purchasing power of money in a consumer's pocket and
so effectively reduces their real income
With reduced real income fewer luxuries are consumed
This led to a decrease in demand for lobsters from D1→D2
At the original market clearing price of P1, a condition of excess supply now
exists
The demand for lobsters is less than the supply
In response, suppliers gradually reduce prices
This causes a contraction of supply and an extension of demand leading to a
new market equilibrium in P 2Q2
Both the equilibrium price (P2) and the equilibrium quantity (Q2) are lower
than before
The excess supply in the market has been cleared
Real World Example: Changes to Supply That Decrease Price
In order to help meet their climate targets and to lower energy costs for
households, the EU is providing subsidies for solar panels
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Diagram showing an increase in supply of solar panels in the EU due to a per unit YOUR NOTES
subsidy

Diagram Analysis
To help meet its climate change targets and lower household energy bills the EU
has provided a subsidy to solar panel retailers
This causes an increase in supply of S1→S2
At the original market clearing price of P1, a condition of excess supply now
exists (surplus)
The supply of solar panels is greater than the demand
In response, sellers in the EU lower prices
This causes an extension of demand and a contraction of supply leading to a
new market equilibrium at P2Q 2
The equilibrium price (P2) is lower and the equilibrium quantity (Q2) is higher
than before
The excess supply in the market has been cleared
 Exam Tip
MCQ, short answer and essay questions frequently require you to explain
dynamic changes in markets. Explaining the steps in the change is often
referred to as chains of analysis and students frequently leave out some
steps in the chain.
Step 1: From the scenario, identify if the change in condition is on the
demand side or supply side.
Step2: State which way the demand or supply curve moves and use notation
e.g. S1→S2.
Step 3: State the disequilibrium that now exists at the original market price.
Step 4: State if sellers raise or lower prices to clear the disequilibrium.
Explain the relevant contraction and extension that occurs on the
Step 5:
demand and supply curves due to the change in price.
Step 6: State the new market equilibrium points e.g. P2Q2.
Step 7: Explain the market outcome (is the new price/quantity higher/lower
than the original?)
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1.2.7 Price Mechanism YOUR NOTES


Functions of The Price Mechanism
The price mechanism is the interaction of demand and supply in a free market
This interaction determines prices which are the means by which scarce
resources are allocated between competing wants/needs
The price mechanism fulfils three functions in the relationship between buyers
and sellers
Rationing: prices allocate (ration) scarce resources. When resources become
scarcer the price will rise further. Only those who can afford to pay for them
will receive them. If there is a surplus then prices fall and more consumers
can afford them
Signalling: prices provide information to producers & consumers where
resources are required (in markets where prices increase) & where they are not
(in markets where prices fall)
Incentive: when prices for a good/service rise, it incentivises producers to
reallocate resources from a less profitable market to this market in order to
maximise their profits. Falling prices incentivise reallocation of resources to
new markets
Adam Smith referred to the functions of the price mechanism as the 'mystery of
the invisible hand'
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Price Mechanism at Work in Different Markets YOUR NOTES
The price mechanism operates in all markets including local, national and global 
Price Mechanism in a Local Market

Long Island, USA has a rich history of agriculture and many producers set up farm
shops selling directly to the public. In recent years, honey consumption has
increased
A diagram showing the increase in demand for honey in a local market, Long Island
Due to a change in one of the conditions of demand (most likely change in tastes),
the demand for honey in the local market has increased from D1→D2 and the
price has increased from $15 to $18
The higher price serves to ration a valuable product. Those consumers who
can afford to purchase it at $18, receive it
The higher price incentivises producers to allocate more factors of
production to producing honey and this is evident from the extension in
supply from Q1 to Q2
The shift in demand signals to other producers that demand for honey is
strong and they should consider entering the market
 Exam Tip
It can get confusing explaining some of the differences between the three
functions. Thinking about it in the following way helps to simplify the
process. If there is shift in demand/supply the market is sending a signal to
consumers and producers. If there is a movement along one of the curves,
this is as a result of the incentive function.
Price Mechanism in a National Market

The T-Shirt market in the UK is highly competitive. In 2018 the price of cotton fell
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YOUR NOTES

A diagram showing an increase in the supply of T-shirts in the UK market
Due to a change in one of the conditions of supply (a decrease in costs of

production), the supply of T-shirts in the UK has increased from S1→S2 and the
price has fallen from P 1 to P 2
The lower price increases the number of consumers who can access this
product. It is rationed more widely as there is an excess in supply
The lower price incentivises consumers to purchase more T-shirts and this is
evident from the increase in demand from Q1 to Q2
The shift in supply signals to other producers that there is excess supply and
they should consider leaving the market
Price Mechanism in a Global Market
Cash crops such as wheat, oats, barley, soy, corn, sunflowers etc. can be grown
using the same factors of production
Many countries export excess crops into the world market
Producers use world prices to guide their production decisions
A diagram showing the price mechanism at work in two related global markets, corn
and potatoes
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Farmers in France have been producing corn for many years and the market price YOUR NOTES
is $2/kg. The price of potatoes in global markets has until recently been steady at 
$2/kg
Due to a change in one of the conditions of demand (possibly an increase in
global population), the demand for potatoes has increased from D1→D2 and the
price has increased from $2/kg to $3/kg
The higher price serves to ration the potatoes. Those consumers who can
afford to purchase it for $3, receive it
The higher price incentivises producers to allocate more factors of
production to producing potatoes and this is evident from the extension in
supply from Q1 to Q2
The shift in global demand signals to producers in France that demand for
potatoes is strong and they should consider switching some of their
production from corn to potatoes
 Exam Tip
Whenever you are faced with questions on the functions of the price
mechanism, remember that all three functions are built on the principle of
self-interest. This will help you to explain each function.
For example, lower prices incentivises consumers to purchase more of the

product with the same income. Conversely, the incentive for producers is
the opposite encouraging them to reallocate their factors of production to
producing more profitable products.
Each party acts in their self interest
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1.2.8 Producer & Consumer Surplus YOUR NOTES


Producer & Consumer Surplus
Consumer surplus is the difference between the amount the consumer is willing
to pay for a product and the price they have actually paid
For example, if a consumer is willing to pay £18 to watch a movie and the
price is £15, their consumer surplus is £3
Producer surplus is the difference between the amount that the producer is
willing to sell a product for and the price they actually do
For example, if a producer is willing to sell a laptop for £450 and the price is
£595, their producer surplus is £145
A market diagram illustrating consumer and producer surplus
Diagram Analysis
The area between the equilibrium price and the demand curve represents the
consumer surplus in the market (ABP e)
The consumer surplus lies underneath the demand curve
The area between the equilibrium price and the supply curve represents the
producer surplus in the market (CBP e)
Producer surplus lies above the supply curve
When the market is at equilibrium the producer and consumer surplus are
maximised
Consumer surplus + producer surplus = social/community surplus
Any disequilibrium reduces the social surplus
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How Market Changes Affect Producer & Consumer Surplus YOUR NOTES
Any change to the condition of supply or demand will cause a shift in the relevant 
curve
This shift will change the consumer and producer surplus in the market
An Increase in Supply
The condition of supply has changed and the diagram on the left shows the resulting
change to consumer surplus while the diagram on the right shows the change to
producer surplus
Diagram Analysis
Prior to the change in the condition of supply
Consumer surplus was equivalent to ACE and producer surplus was
equivalent to ACF
Social surplus was equivalent to ECF
After the change, supply increased S1→S2
Consumer surplus was equivalent to BED and producer surplus was
equivalent to BDG
Social surplus was equivalent to DEG
Both the consumer surplus and producer surplus have increased as a result of the
increased supply in the market
An Increase in Demand
The condition of demand has changed and the diagram on the left shows the
resulting change to producer surplus while the diagram on the right shows the
change to consumer surplus
Diagram Analysis
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Prior to the change in the condition of demand YOUR NOTES
Producer surplus was equivalent to ACE and consumer surplus was 
equivalent to ACF
Social surplus was equivalent to ECF
After the change, demand increased D1→D2
Producer surplus was equivalent to BED and consumer surplus was
equivalent to BDG
Social surplus was equivalent to DEG
Both the producer surplus and consumer surplus have increased as a result of the
increased demand in the market
 Exam Tip
MCQ frequently tests your ability to identify changes to consumer and
producer surplus. In essay responses, even if it is not explicitly mentioned,
you can refer to these concepts when evaluating dynamic markets and the
impacts on different stakeholders. It demonstrates excellent economic
knowledge and analysis.
Changes to consumer and producer surplus become slightly more
complicated when analysing the impact of government intervention such as
indirect taxes, subsidies and price controls.
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1.2.9 Indirect Taxes and Subsidies YOUR NOTES


Indirect Taxes
An indirect tax is paid on the consumption of goods/services
It is only paid if consumers make a purchase
It is usually levied by the government on demerit goods to reduce the quantity
demanded (QD) and/or to raise government revenue
Government revenue is used to fund government provision of
goods/services e.g education
Indirect taxes can occur as a specific or ad valorem tax

They are levied by the government on producers. This is why the supply curve
shifts
Producers and consumers each pay a share (incidence) of the tax
The Incidence of a Specific Tax
A diagram that demonstrates the share of a specific tax paid by the consumer (A)
and the producer (B)
Diagram Analysis
The government places a specific tax on a demerit good

The supply curve shifts left from S1→S2 by the amount of the tax
The price the consumer pays has increased from P1 before the tax, to P2 after the
tax
The price the producer receives has decreased from P1 before the tax to P3 after
the tax
The government receives tax revenue = (P2-P3) x Q2
The consumer incidence (share) of the tax is equal to area A - (P2-P1) x Q2
The producer incidence (share) of the tax is equal to area B - (P1-P3) x Q2
The QD in this market has decreased from Q1→Q2
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If the decrease in QD is significant enough, it may force producers to lay off YOUR NOTES
some workers

 Exam Tip
When drawing this diagram, students often find it hard to identify the three
price points.
The tax incidence boxes are formed by drawing the new equilibrium
quantity through the original supply curve. The three price points are the
old equilibrium point, new equilibrium point - and where the new quantity
crosses the original supply curve.
Irrespective if you are dealing with taxes or subsidies, always use the new
equilibrium point to determine your incidence boxes.
The consumer incidence is paid from the consumer surplus area and the
producer incidence is paid from the producer surplus area.
A Side by Side Comparison of The Impact of PED on Tax Incidence

Aiming to maximise their profits, producers pass on as much of the indirect tax
as they can to consumers and pay the balance themselves
The amount passed on to consumers depends on the price elasticity of
demand (PED) of the product
A diagram that demonstrates the tax incidence for a product whose PED is inelastic
(left) and elastic (right). A is the consumer incidence and B is the producer incidence
Diagram Analysis
In both diagrams, the specific tax shifts the supply curve from S1→S2
There is a higher market price at P2 and lower QD at Q2
Tax revenue for the government is the sum of A+B
Consumer incidence is represented by A and producer incidence by B
Total revenue for the seller is calculated using P3 X Q 2
The difference in PED results in a different steepness to the demand curve

For an inelastic product (e.g., cigarettes), producers pass on a much higher
proportion of the tax to consumers (A) and pay the rest themselves (B)
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The QD decreases (Q1→Q2) but by a much smaller proportion than the YOUR NOTES
increase in price (P1→P2) 
For an elastic product (e.g., pizza), producers pass on a much smaller
proportion of the tax to consumers (A) and pay the rest themselves (B)
The QD decreases (Q1→Q2) but by a much larger proportion than the
increase in price (P1→P2)
 Exam Tip
When asked to evaluate the impact of a tax in a particular market, it is
essential to apply knowledge of PED to the impact it will have on producers,
consumers and the government.
It should be obvious from the context if the product in the question is
elastic or inelastic in demand . If not, work through the factors that
determine PED and make a judgement as to whether the product is elastic
or inelastic in demand. In your answer, explain your reasoning.
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Subsidies YOUR NOTES
A producer subsidy is a per unit amount of money given to a firm by the 
government
To increase production
To increase provision of a merit good
The incidence (share) of the subsidy is determined by the PED of the product
If governments subsidise goods/services with high PED, the increase in QD
will be more than proportional to the decrease in price
Producers keep some of the subsidy and pass the rest on to the consumers
A diagram which demonstrates the cost of a subsidy to the government (A+B) and
the incidence received by the consumer (A) and producer (B)
Diagram Analysis
The original equilibrium is at P1Q1
The subsidy shifts the supply curve from S → S + subsidy:
This increases the QD in the market from Q1→Q2
The new market equilibrium is P2Q2
This is a lower price and higher QD in the market
Producers receive P2 from the consumer PLUS the subsidy per unit from the
government
Producer revenue is therefore P3 x Q2
Producer incidence of the subsidy is marked B in the diagram
The subsidy decreases the price that consumers pay from P1 → P2
Consumer incidence of the subsidy is marked A in the diagram
The total cost to the government of the subsidy is (P3 - P2) x Q2 represented by
area A+B
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YOUR NOTES
 Exam Tip
Memorise the distinction below as students get very confused when

answering questions on subsidies.
When dealing with a subsidy, the producer benefit is now the top portion
of the incidence area and consumer incidence is below. This can be
confusing as in all other diagrams, it is the other way around (surplus,
indirect tax etc.)
Logically, it makes sense. Producers are given an extra amount of money for
each unit by the government so this raises the sales revenue they receive,
while at the same time lowering the price consumers pay.
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1.3 Market Failure YOUR NOTES


1.3.1 Types of Market Failure
Understanding Market Failure
In a free market, the price mechanism determines the most efficient allocation of
scarce resources in response to the competing wants and needs in the marketplace
Scarce resources are the factors of production (land, labour, capital,
enterprise)
Free markets often work very well
However, the free market sometimes leads to Market Failure, where there is a less
than optimum allocation of resources from the point of view of society. For
example, when the free market causes a lack of equity (inequality) or
environmental degradation
There is either over-provision or under-provision of the goods/services and
therefore an over-allocation or under-allocation of the resources (factors of
production) used to make these goods/services
From society’s point of view there is a lack of allocative efficiency
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Types of Market Failure YOUR NOTES
Sources of market failure include the existence of externalities, an under- 
provision of public goods, and the existence of information gaps in markets
Externalities
Externalities occur when there is an external impact (cost or benefit) on a third
party not involved in the economic transaction
These impacts can be positive or negative
A positive externality of consumption occurs when the external impact on
society/third party is positive such as when electric vehicles are consumed
CO2 emissions fall
A positive externality of production occurs when the external impact on
society/third party is positive such as when managed pine forests produce
timber but also increase CO2 absorption
A negative externality of consumption occurs when the external impact on
society/third party is negative such as when the consumption of alcohol
increases anti social behaviour
A negative externality of production occurs when the external impact on
society/third party is negative such as when the production of electricity
increases air pollution
If these externalities were acknowledged, then the price and output in the
market would be different
The price mechanism in a free market ignores these externalities
Public Goods
Public goods are beneficial to society but would be under-provided by a free
market as there is less opportunity for sellers to make economic profits from
providing these goods/services
Good examples include national defence, parks, libraries and lighthouses
They are therefore provided by the government for the public benefit
Information Gaps
Information gaps exist in nearly all free markets and distort market outcomes
resulting in market failure
One of the underlying assumptions of a free market is that there is perfect
information in the market
The reality is that in many markets buyers and sellers have different levels of
information. This is called asymmetric information and distorts market prices
and quantities
For example, goods/services with dangerous side effects would be sold in
lower quantities if buyers were aware of these effects. Similarly,
goods/services with extra benefits would be sold in higher quantities if
buyers were aware of them
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1.3.2 Externalities YOUR NOTES


Externalities & Different Types of Costs
Externalitiesoccur when there is an external impact on a third party not involved
in the economic transaction
These impacts can be positive or negative and are often referred to as
spillover effects
These impacts can be on the production side of the market (producer supply)
or on the consumption side of the market (consumer demand)
External costs occur when the social costs of an economic transaction are greater
than the private costs
A private cost for the producer is what they actually pay to produce a
good/service
An external cost (negative externality) is the damage not factored in to the
economic activity (for example, generating air pollution when producing
electricity)
Private cost + external cost = social costs
External benefits occur when the social benefits of an economic transaction are
greater than the private benefits
A private benefit for the consumer is what they actually gain from consuming
a good/service
An external benefit (positive externality) is the benefit not factored in to the
economic activity (for example, someone who studies law enjoys private
benefits but society benefits from having strong legal institutions)
Private benefit + external benefit = social benefits
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External Costs of Production YOUR NOTES
Negative externalities of production are often created during the production of a 
good/service
The market is failing due to over-provision of these goods/services as only the
private costs are considered by the producers and not the external costs
If the external costs were considered, the quantity of the goods/services
provided would decrease and they would be sold at a higher price
Marginal analysis in economics considers the cost or benefit of the next unit
produced or consumed
The marginal private cost (MPC) is the cost of the next unit produced or
consumed
The marginal private benefit (MPB) is the benefit derived from the production
or consumption of the next unit
External costs of production (negative externality) result in an over-provision shown

by the gap between Qopt and Qe
Diagram Analysis
The marginal social benefit (MSB) is assumed to be equal to the marginal private
benefit (MPB) as the focus is on the producer side of the market
The free-market equilibrium can be seen at PeQe. This is where the MPC = MSB
The larger the external costs in production, the larger the gap between the MPC
and the marginal social cost (MSC)
The optimal allocation of resources from society’s point of view, would generate
an equilibrium where MSB = MSC. This can be found at PoptQopt. There is no
market failure at this equilibrium
The free market is failing due to over-provision of this good/service at Qe
The factors of production used to manufacture this over-provision represent a
welfare loss to society (pink triangle)
To be socially efficient, fewer factors of production should be allocated to
producing this good/service
There is an opportunity for government intervention (indirect taxes, legislation,
regulation etc.), to force this market to be more socially efficient
Any intervention that reduces the welfare loss will be beneficial
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External Benefits of Consumption YOUR NOTES
Positive externalities of consumption are created during the consumption of a 
good/service (merit goods)
The market is failing due to under-consumption of these goods/services as only
the private benefits are considered by the consumers and not the external
benefits
If the external benefits were considered, the quantity of the goods/services
consumed would increase and they would be sold at a higher price
External benefits of consumption (positive externality) result in an under-

consumption represented by the gap between Qe and Qopt
Diagram Analysis
MSC is assumed to be equal to the MPC as the focus is on the consumer side of
the market
The free-market equilibrium can be seen at PeQe. This is where the MPB = MSC
The larger the external benefits in consumption (positive externality), the larger
the gap between the MPB and MSB
The optimal allocation of resources from society’s point of view would generate an
equilibrium where MSB = MSC. This can be found at PoptQopt. There is no market
failure here
The free market is failing due to an under-consumption of this good/service at Qe
More factors of production should be allocated to producing the optimal quantity
as societal welfare will be gained (pink triangle)
There is an opportunity for government intervention (subsidies, partial provision
etc.) to force this market to be more socially efficient
Any intervention that gains welfare will be beneficial
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YOUR NOTES
 Exam Tip
Your understanding of externalities is frequently examined in MCQ. You will 
be asked questions in language which can seem confusing, such as:
MSC is greater than MSB at free market equilibrium
The free-market quantity is less than the social optimum quantity
Increasing output will lead to a net welfare gain
It is intentionally confusing as there is only one right answer. Work through
the options step by step and apply your theory and one option will stand
out. That is the correct answer!
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The Impact of Externalities & Government Intervention in YOUR NOTES
Different Markets 
Analysing externalities and the government intervention necessary to correct
them is best done by considering real world examples
Analysis should always include the impact on stakeholders including producers,
consumers, government, and relevant third parties
The Impact of Negative Externalities & Government Intervention
Possible Government
Example External Costs
Stakeholders Intervention
Extraction of iron Soil erosion Producers Indirect taxation

ore (mining) Loss of habitat (Miners) Legislation &
for species Manufacturers regulation,
Decrease in air who purchase enforcement
quality iron ore through fines
Chemical Environment Any intervention
leakage into the Community who has both
water table live nearby advantages and
Government disadvantages
Special interest e.g. decreasing
groups e.g. the external
environmental costs may
pressure groups decrease output
such as which may
Greenpeace decrease
economic growth
The Impact of Positive Externalities & Government Intervention
Possible Government
Example External Benefits
Stakeholders Intervention
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Leisure Centres Healthy people Leisure Centre Increase YOUR NOTES

require less state Owners provision 
medical care Consumers Subsidise
Relieves stress & (Members) existing
increases Community who provision
productivity in live nearby Advertise to
the workplace Government raise awareness
Older people Local health of benefits
maintain services Any intervention
independence Employers has both
for longer and Economy advantages and
less of a burden disadvantages
on family/state e.g. subsidising
Improves Leisure Centre
memory and memberships
concentration may reduce
which raises funding available
productivity in for libraries
the workplace
Improves
relationships
and helps others
to be more
productive
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1.3.3 Public Goods YOUR NOTES


Public Goods
A public good is substantially different to a private good
Private goods are goods which firms are able to provide to generate profits. They
can generate profits as these goods are excludable and rivalrous
The firm is able to exclude certain customers from purchasing their goods
through use of the price mechanism. If customers cannot afford to buy them,
then they are excluded
Customers can also compete for these goods which are limited in supply and
this rivalry helps to generate profits for firms
Public goods are goods that are beneficial to society but which will not be
provided by private firms due to the principles of non-excludability and non-
rivalry
Non-excludability refers to the inability of private firms to exclude certain
customers from using their products. In effect, the price mechanism cannot be
used to exclude customers e.g. street lighting
Non-rivalry refers to the inability of the product to be used up, so there is no
competitive rivalry in consumption to drive up prices and generate profits for
firms
Therefore, governments will often provide these beneficial goods themselves,
and so they are called public goods
If firms decided to provide these goods anyway, it would give rise to what is called
the ‘free rider’ problem
This is a situation where customers realise that they can still access the
goods, even without paying for them
If they are paying, they stop and continue to enjoy the benefits. They are
‘free-riding’ on the backs of other paying customers
Over time, any customers who are paying for the goods will stop
At some point firms will cease to provide these goods and they will become
under-provided in society
 Exam Tip
Make sure that you know the difference between public goods and merit
goods. The key idea is that private firms will not provide public goods, so
under-provision (or no provision) occurs in society.
On the other hand, private firms will provide some merit goods as they are
able to make a profit on them. However, due to the profit incentive and high
prices that firms charge, not all members of society will be able to afford
these goods. So merit goods are also under-provided, but there is some
provision of them.
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1.3.4 Information Gaps YOUR NOTES


Information Gaps
Information gaps exist in nearly all free markets and distort market outcomes
resulting in market failure
One of the underlying assumptions of a free market is that there is perfect
information in the market
This means that buyers and sellers have exactly the same level of information
about the good/service. This is called symmetric information
In many markets buyers and sellers have different levels of information. This is
called asymmetric information. For example, there is asymmetric information
in the used car market - sellers know more about the vehicle than the buyers
Asymmetric information distorts socially optimal prices and quantities in markets
resulting in over-provision or under-provision of goods/services
For example, goods/services with dangerous side effects would be sold in
lower quantities if buyers were aware of these effects (consider the VW
emissions scandal). Fewer factors of production should be allocated towards
producing these
Similarly, goods/services with extra benefits would be sold in higher
quantities if buyers were aware of them. More factors of production should be
allocated towards producing these
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1.4 Government Intervention YOUR NOTES


1.4.1 Government Intervention in Markets
Government Intervention in Markets
Nearly every economy in the world is a mixed economy and has varying degrees of
government intervention
Governments intervention is necessary for several reasons
A diagram showing several reasons for government intervention in mixed economic

systems
Correct market failure: in many markets there is a less than optimal allocation of
resources from society's point of view
In maximising their self-interest, firms and individuals will not self-correct
this allocation of resources and there is a role for the government
They often achieve this by influencing the level of production or consumption
Earn government revenue: governments need money to provide essential
services, public and merit goods
Revenue is raised through intervention such as taxation, privatisation, sale of
licenses (e.g. 5G licenses), and sale of goods/services
Promote equity: to reduce the opportunity gap between the rich and poor
Support firms: in a global economy, governments choose to support key
industries so as to help them remain competitive
Support poorer households: poverty has multiple impacts on both the individual
and the economy
Intervention seeks to redistribute income (tax the rich and give to the poor) so
as to reduce the impact of poverty
Four of the most common methods used to intervene in markets are indirect
taxation, use of subsidies, maximum prices, and minimum prices
Indirect Taxation
An indirect tax can be either ad valorem or specific
Ad Valorem Tax
Value added tax (VAT) is 20% in the UK in 2022. The more goods/services
consumed, the larger the tax bill
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This causes the second supply curve to diverge from the original supply curve YOUR NOTES
VAT raises significant government revenue 
A diagram showing an ad valorem tax (VAT) and the tax incidence for producers and
consumers
Diagram Analysis
Initial equilibrium is at P1Q1

Supply shifts left due to the tax from S → S + tax
The two supply curves diverge as percentage tax means more tax is paid at
higher prices
Consumer incidence of tax is (P 2 - P 1) x Q2 - Area A
Producer incidence of tax is (P 1 - P 3) x Q2 - Area B
New equilibrium is at P2Q2
Final price is higher (P2) and QD is lower (Q2)
Specific Tax on Negative Externality of Production

Governments frequently tax firms that pollute or create harmful external costs in
production
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YOUR NOTES

A diagram that shows the impact of a tax on a product that is over-provided in

society. The tax reduces the welfare loss and moves production closer to the
optimum level of production
Diagram Analysis
The free-market equilibrium is at PeQe - where MSB = MPC

Market failure exists as MSC > MSB at equilibrium
Optimum level of output is at Qopt
There is over-provision of this product
A specific tax shifts the supply curve left from S → S1
The tax does not completely eradicate the welfare loss but moves the market
closer to the optimum level of output (Qopt)
The welfare loss has been reduced as shown in the diagram
The new market equilibrium is at P1Q1
This is a higher price and less output
There is less over-provision and so less market failure
The external costs have been reduced
Specific Tax on Negative Externality of Consumption
Governments frequently tax demerit goods such as cigarettes, alcohol, fatty
foods, and polluting vehicles
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YOUR NOTES

A diagram that shows the impact of a tax on a product that is over-consumed in

society. The tax reduces the welfare loss and moves consumption closer to the
optimum level of production
Diagram Analysis
The free-market equilibrium is at PeQe - where MPB = MSC

Market failure exists as MSC > MSB at equilibrium
Optimum level of consumption is at Qopt
There is over-consumption of this product
A specific tax shifts the supply curve left from S → S1
The tax does not completely eradicate the welfare loss but moves the market
closer to the optimum level of output (Q opt)
The welfare loss has been reduced as shown in the diagram
This is a higher price and lower output
There is less over-consumption and so less market failure
The external costs have been reduced
Subsidies
Governments frequently use subsidies to encourage production/consumption of
merit goods such as energy efficient products, electric vehicles, healthcare, and
education
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YOUR NOTES

A diagram that shows the impact of a subsidy on a product that is under-consumed

in society. The subsidy reduces the potential welfare gain and moves consumption
closer to the optimum level
Diagram Analysis
The free-market equilibrium is at PeQe - where MPB = MSC

Market failure exists as MSB > MSC at equilibrium
Optimum level of output is at Qopt
There is under-consumption of this product
A subsidy shifts the supply curve right from S → S1
It does not completely eradicate the potential welfare gain but moves the
market closer to the optimum level of output (Qopt)
The potential welfare gain has been reduced as shown in the diagram
This is a lower price and higher output
There is less under-consumption and so less market failure
Some of the external benefits available have been realised
Maximum Prices
Governments will often use maximum prices in order to help consumers.
Sometimes they are used for long periods of time e.g. housing rental markets.
Other times they are short-term solutions to unusual price increases e.g. petrol
A maximum price is set by the government below the existing free market
equilibrium price and sellers cannot legally sell the good/service at a higher price
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YOUR NOTES

A diagram that shows the imposition of a maximum price (Pmax) which sits below the
free market price (Pe) and creates a condition of excess demand (shortage)
Diagram Analysis
Initial market equilibrium is at PeQe

A maximum price is imposed at Pmax
The lower price reduces the incentive to supply and there is contraction in QS
from Qe → Qs
The lower price increases the incentive to consume and there is an extension
in QD from Qe → Qd
This creates a condition of excess demand QsQd
Some consumers benefit as they purchase at lower prices
Others are unable to purchase due to the shortage
This unmet demand usually encourages the creation of illegal markets
(black/grey markets)
Minimum Prices
Governments will often use minimum prices in order to help producers or to
decrease consumption of a demerit good e.g. alcohol
A minimum price is set by the government above the existing free market
equilibrium price and sellers cannot legally sell the good/service at a lower price
Minimum prices are also used in the labour market to protect workers from wage
exploitation. These are called minimum wages
A diagram that shows the imposition of a minimum price (Pmin) which sits above the
free market price (Pe) and creates a condition of excess supply (surplus)
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Diagram Analysis YOUR NOTES
Initial market equilibrium is at PeQe 
A minimum price is imposed at Pmin
The higher price increases the incentive to supply and there is an extension
in QS from Qe → Qs
The higher price decreases the incentive to consume and there is a
contraction in QD from Qe → Qd
This creates a condition of excess supply QdQs
Differences in Government Responses to the Excess Supply
In agricultural markets, if a minimum price is set by the government producers

benefit as they receive a higher price
Governments will often purchase the excess supply and export it
In demerit markets, producers suffer as QD contracts
Governments will not purchase the excess supply
Producers usually lower their output in the market to match the QD at the
minimum price
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Other Methods of Government Intervention YOUR NOTES
Trade Pollution Permits 
Governments create a pollution permit market and issue permits to polluting
firms
This helps to reduce negative externalities of production
Each permit is typically valid for the emission of one ton of pollutant
More polluting firms have to buy additional permits from less polluting firms
The price of the permit represents an additional cost of production
If the price of additional permits is more than the cost of investing in new
pollution technology, firms will be incentivised to switch to cleaner technology:
Firms can then sell their spare permits and gain additional revenue
State Provision of Public Goods

Public goods are beneficial for society and are not provided by private firms due
to the free rider problem
They are usually provided free at the point of consumption, but are paid for
through general taxation
Examples include roads, parks, lighthouses, national defence
Provision of Information
Information gapscause market failure
Governments can set up information portals so as to reduce the asymmetric
information
Examples include job centres, consumer rights websites, nutritional labels
Regulation
Governments create rules to limit harm from negative externalities of
consumption/production
They create regulatory agencies to monitor that the rules are not broken
There are more than 90 regulators in the UK
Individuals or firms may be fined/imprisoned for breaking the rules
Examples of some industry regulators include the Environment Agency, Ofsted,
and the Financial Conduct Authority
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1.4.2 Government Failure YOUR NOTES


Government Failure
Government failure occurs when the government intervenes in a market to correct
market failure, but the intervention results in a more inefficient allocation of
resources from society's point of view
This results in even greater welfare loss
Usually represents poor value for money
May have long term consequences
Causes of Government Failure

Distortion of Price Signals
The signaling function of the price mechanism is artificially altered
For example, a minimum price sends a signal to producers to supply more
In agricultural markets this has often resulted in an excess of perishable
products which end up going to waste i.e. inefficient allocation of
resources
In demerit markets higher prices seem to be sending the message to
increase supply (e.g. minimum price on alcohol). if producers do that,
they will make greater losses. They often have to reduce supply
Price intervention may help solve one problem but creates others
Unintended Consequences
Producers and consumers aim to maximise their self interest
This often leads them to look for legal or illegal loop holes to bypass
government intervention
This result creates unintended consequences such as the creation of illegal
markets and/or illegal production/consumption
Excessive Administrative Costs

Regulation or administration costs can be expensive
The costs can sometimes be greater than the savings in social welfare
Information Gaps
Government decision making is subject to the same information gaps and
cognitive biases (e.g. anchoring) that consumers face
Decision makers do not have perfect information
Decision makers are subject to political pressure
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Government Failure in Various Markets YOUR NOTES
Environment Agency - Regulatory Failure 
The Environment Agency is responsible for regulating major industry, waste, and
treatment of contaminated land. water quality and resources
According to the BBC, in 2021 there were more than 375,000 instances of raw
sewage pumped into England's rivers
UK Energy Market - Regulatory Failure

The UK energy market was privatised between 1986 and 1990
Ofgem, the energy market regulator in the UK sets a maximum price on energy
costs
In 2021, British Gas (owned by Centrica) profits were £948m
In 2022, Ofgem raised the maximum price by 53%
Unable to afford the increased payments, some pensioners ride buses in the
winter to stay warm
Smoking Ban - Unintended Consequence

In July 2007 an indoor smoking ban was implemented in the UK
Unintended consequences of this policy included:
Congestion around office & restaurant doorways
Increased use of outdoor patio heaters, thus increasing CO2 emissions
Increased cigarette stump littering
Illegal Markets
The introduction of minimum prices on alcohol in Scotland has increased the
amount of cross-border driving to Carlisle to purchase alcohol
In 2017, a report found that the illegal trade in drugs was worth £10bn.
Badly Executed Policies - Information Gaps

Defence Information Infrastructure, a secure military network owned by the
United Kingdom's Ministry of Defence (MOD), cost £7.1bn to create compared to
the original budget of £2.8bn. (and it did not meet most of the operational targets
that the MOD had originally envisaged)
NHS National IT Program. Abandoned in 2013 after more than £10bn. was spent
on it. It never worked
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1.2 How Markets Work YOUR NOTES


1.2.10 Alternative Views of Consumer Behaviour
Alternative Views of Consumer Behaviour
Free markets are built on the assumptions of rational decision making
In classical economic theory, the word 'rational' means that economic agents are
able to consider the outcome of their choices and recognise the net benefits of
each one
Rational agents will select the choice which presents the highest benefits
In many ways, the assumption of rational decision making is flawed. Consumers
are often more influenced by the following than a rational computation of net
benefits
The influence of other people's behaviour
The importance of habitual behaviour
Consumer weakness in computation
The Influence of Other People's Behaviour

Peer pressure often prompts consumers to make purchasing decisions that may
go against a computation of net benefits
Producers influence consumers choices through various forms of advertising ,
including lifestyle, celebrity endorsement and influencer culture
This results in emotional decisions and not necessarily rational decisions e.g.
consumers purchasing the branded Nurofen when they could purchase the
much cheaper (and essentially identical) Ibuprofen
Producers use advanced behavioural psychology techniques to influence
consumer choices e.g. Neuro branding
The Importance of Habitual Behaviour

Consumers make so many purchasing decisions that they often rely on habits to
speed up the process
Using rule of thumb refers to a short cut that makes a quick estimation of
benefits without gathering too much information
Consumers use information from the past, which may be outdated, as they
habitually purchase the same products e.g. visiting the same sections in a
supermarket for several years
Consumer inertia often develops as convenience is prioritised
Consumers make purchasing decisions that directly harm them and are usually
addictive, for e.g. alcohol
Sellers recognise habitual patterns and exploit them. for example, products
placed at the checkout till to benefit from impulse purchasing (chewing gum)
Consumer Weakness at Computation
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The wider the range of choice, the harder it is for a consumer to gather YOUR NOTES
information and compute which one offers the highest net benefits 
Consumers often lack the time or ability to consider the relative prices of different
products and sellers will frequently make it difficult for them to do so
Products the seller wants to sell are often placed at eye level where
computation is easy
Many products that would deliver higher benefits are placed below knee level
or high on the shelf where computation is hard
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1. Introduction to Markets & Market Failure

1.1 Nature of Economics YOUR NOTES

Economic models are developed by economists once a hypothesis has been

1.1.2 Positive & Normative Economic Statements YOUR NOTES

Normative economics focuses on value judgements. These judgements are built

1.1.3 The Economic Problem YOUR NOTES

In a free market, scarcity has a direct influence on prices

There is an opportunity cost in the allocation of resources

1.1.4 Production Possibility Frontiers YOUR NOTES

The use of PPF to depict the maximum productive potential of an economy

Economic growth occurs when there is an increase in the productive potential of

1.1.5 Specialisation & the Division of Labour YOUR NOTES

Higher labour productivity lowers Task repetition often leads to boredom

A decrease in motivation may lead to less

If workers lose their jobs, then it may be

Specialisation may create over-

The Four Functions of Money

Without money, Money provides Money holds its Money is an

The Distinction Between Free Markets, Mixed and Command Economies

Free Markets Mixed Economies Command Economies

A free-market economy is an economy that has no government intervention in

The Advantages and Disadvantages of Free Market Economies and Command

Type of Economy Advantages Disadvantages

Profit incentive motivates Wealth gets concentrated

1.2 How Markets Work YOUR NOTES

1.2.2 Demand YOUR NOTES

A demand curve is a graphical representation of the price and quantity demanded

Movements Along A Demand Curve

A demand curve showing a contraction in quantity demanded (QD) as prices increase

For example, if a firm increases their Instagram advertising, there will be an

Condition Explanation Condition Shift Condition Shift

If more money is spent

Changes in the price of YOUR NOTES

Changes in the price of

If the population size YOUR NOTES

When price changes (ceteris paribus), there is a movement along the

1.2.3 Price, Income & Cross Elasticities of Demand YOUR NOTES

% change in quantity demanded % △ in QD

To calculate a % change, use the following formula

new value − old value

Step 1: Calculate the % change in QD

Step 2: Calculate the % change in P

Step 3: Insert the above values in the PED formula

Value Name Explanation

% ch ang e in qu antity d em and ed % △ in QD

Step 1: Calculate the % change in QD

Step 2: Calculate the % change in Y

Step 3: Insert the above values in the YED formula

Interpreting YED Values

% ch ang e in qu antity d em and ed of good A % △ in QDA

Step 1: Calculate the % change in QDA

Step 2: Calculate the % change in P B

Step 3: Insert the above values in the XED formula

Value Name Explanation

Significance of Elasticities to Firms & Governments

Knowledge of XED is important to firms as they seek to maximise their revenue

Knowledge of YED is important to firms as they seek to maintain sales and

Step 1: Calculate the initial sales revenue

Sales Revenue = Price of product X Quantity sold

Step 2: Calculate the sales revenue after the price change