Notesale: Turn your study into money

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1 Introduction to markets and market failure
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1 Positive economics
→ Concerned with facts and is value-free
→ Positive statements are true or false according to their reference to the facts
→ A positive statement must be verifiable either in the present or in the future
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3 Role of value judgments in economic decision making and policy
→ Personal preference, belief, and subjective assessment underpins normative economics
→ An individual’s propensity to take risks affects much of their behaviour, such as whether they would
choose to spend all of this month’s pay check on an expensive holiday, or instead save those funds
→ Value judgments also have a major effect on government policy making, for example when a
government is choosing to cut taxes rather than increase government spending on healthcare or
education

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3 The economic problem
→ The economic problem is based on scarcity, which arises because there are finite physical resources
to meet infinite human wants
→ We have to make choices over the use of our limited resources to provide for our unlimited wants
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2 Renewable and non-renewable resources
→ Resources, or factors of production, are inputs used in the production of goods and services, and
take the form of land, labour, capital and enterprise

→ A renewable resource is one whose stock level can be replenished naturally, i
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solar energy, wind
power, tidal power, fish, timber and soil
→ A non-renewable resource is one whose stock level decreases over time and cannot be naturally
replenished, i
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fossil fuels, steel, copper and aluminium

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4 Production possibility frontiers
→ A production possibility frontier shows the maximum potential level of output for two goods and
services that an economy can achieve when all of its factors of production are fully and efficiently
employed
→ It can be used to illustrate scarcity and opportunity cost
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2 Opportunity cost shown on the production possibility frontier
→ According to the production possibility frontier above, the opportunity cost of increasing output of
capital by 20 units is 30 units of consumer goods
→ It is therefore possible to work out the opportunity cost of each unit of output of capital goods
→ 30 ÷ 20 = 1
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5 units of
consumer goods
→ Inversely, increasing consumer goods output by 30 units carries the opportunity cost of 20 units of
capital goods output
→ 20 ÷ 30 = 2⁄3, and so the opportunity cost of each unit of consumer goods output is 2⁄3 of a unit
of capital goods output

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As land that is better suited to farming wheat is used to produce livestock, the
marginal opportunity cost rises dramatically, creating a convex production possibility frontier
→ A straight production possibility frontier is possible where all factors of production are equally good
at producing both goods – the opportunity cost of each good is the same across all factors of
production
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These goods have more inelastic demand than
manufactured goods, and so when world GDP rises, the price of manufactured goods will
increase more than the price of primary products, causing the gap between developing and
developed countries to increase
→ The division of labour is one form of specialisation where individuals focus on the production of one
particular element of the production process of a good or service

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A production process is broken down into a series of simpler tasks which are conducted by
different workers, e
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house construction required specialised architects, surveyors,
bricklayers, carpenters and electricians
Adam Smith explained how if a pin factory broke production down into 18 different
specialist tasks, each carried out by a different worker, output of pins at the factory could
increase by 2000%

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Without the division of labour,
they would have to fulfil all these roles in the general job of ‘sandwich maker’, and so division of
labour provides a broader choice of jobs
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Previously, workers in Adam Smith’s pin
factory would have the satisfaction of knowing that their work created a pin from raw materials to
final product
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Workers will be less motivated, and will therefore put less effort into their work,
decreasing productivity
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3 The functions of money
→ Money is anything that is generally accepted as a form of payment for goods and services, or to
repay a debt
→ It is crucial that consumers and businesses have confidence in the ability of the money being used to
fulfil its functions, and where this confidence is lacking, problems arise, e
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in Zimbabwe where too
many Zim dollars were printed, leading to a lack of confidence in its function as a store of value
→ There are four functions of money
▪ Medium of exchange – enables the buying and selling of products, making exchange easier

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Measure of value – enables a value to be placed on products so they can be bought and sold
with ease
Store of value – convenient way of storing wealth so it can be spent at a later date; if
inflation is too high then money fails to fulfil this purpose
Method of deferred payments – enables borrowing and lending, so that somebody can
borrow to buy something now instead of nothing until enough money has been raised to pay
up front

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6 Free market, mixed and command economies
→ An economy organises its resources in different ways to produce goods and services
→ The vast majority of economies comprise a mixture of both private enterprise (the free market) and
state economy (elements of command), thus being mixed economies
▪ In the UK, around 60% of resources are allocated by the private sector, and 40% are
allocated by the government
▪ In other European economies (France, Germany and Sweden) the state’s share is higher
▪ In North America (the USA and Canada) it is lower, but all are considered to be mixed
economies
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This results in productive efficiency
→ Quality of products: competition means that firms constantly try to improve the quality of their
goods to gain an advantage over rivals
→ Greater choice: consumers can often choose to buy from a wide selection of goods and services, and
workers have a wide range of employment opportunities
→ Private property rights provide an incentive to innovate, because the results of research can be
protected by intellectual property law
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For Marx,
the value of a good or service is equivalent to the value of the labour required to provide it (i
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the
price of a cup of coffee is the sum of the value of the labour of coffee bean farmers, milk producers,
wholesalers, distributors, baristas, and a share of the labour-value of the builders who constructed
the premises and the electricity producers providing energy to the premises)
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In this sense, profit is necessarily
exploitative

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Furthermore, the government sets the wage for all workers, so is able to legislate
against inequality
→ The government may limit the external costs from production and consumption: it can limit
pollution from firms and tax demerit goods, i
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tobacco and alcohol
→ The government can fund the provision of public goods such as defence or law and order
→ The government has more control of the economy so there are smaller swings in the economy
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2 Disadvantages of a command economy
→ The absence of the price mechanism may lead to shortages (excess demand) and surpluses (excess
supply), leading to allocative inefficiency
→ Lack of competition between firms leads to inefficiency, so productivity is low
→ Lack of competition leads to low-quality products, especially where the emphasis is on output
maximisation and not profit

→ There is less choice, both in terms of goods for consumers, and jobs for workers, who may be forced
into one role
→ Lack of financial incentives to innovate
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2 HOW MARKETS WORK
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1 Rational decision making in the market
→ Markets exist where consumers and producers come into contact with each other to exchange
goods and services
▪ A price, or exchange value, is arranged for goods and services
▪ Buyers or consumers represent the ‘demand’ side, and sellers or producers represent the
‘supply’ side of the market
→ Consumers are assumed to make rational decisions
▪ They will allocate their income to maximise utility, or the amount of satisfaction obtained
from consuming a good or service
▪ Economists assume that utility can be measured
→ Consumers do not have enough income to buy all the things they want, and so they have to make
decisions about where to allocate their income
→ If a consumer has an extra £100 to spend, and they choose to buy a £20 t-shirt and an £80 pair of
shoes
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5 units of utility per £1 spent)
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Firms will use their resources to maximise profits from goods and services produced,
producing at the level of output where total revenue exceeds total cost by the greatest amount, or
where marginal cost and marginal revenue intersect

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2 Demand
→ The buyers or consumers in an economy are said to demand goods and services
→ Demand refers to the quantity of a good or service that are purchased over a given time period
→ Demand is different from simply wanting a product; demand is comprised of those consumers who
are both willing and able to buy a certain product
→ Demand that is backed up by an ability to pay is also referred to as effective demand
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2 Marginal utility and the downward-sloping demand curve
→ The downward-sloping demand curve can also be explained in terms of diminishing marginal utility
→ As one consumes more of a good or service, the utility that is derived from the next unit of
consumption (the marginal utility) falls – this is known as the law of diminishing marginal utility
→ Total utility will increase as quantity increases – up to a point – but it will do so at an ever decreasing
rate, because marginal utility will be falling
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1 Price elasticity of demand
→ Price elasticity of demand (PEd) is the responsiveness of demand to a change in price
→ It can be calculated with the formula: 𝑃𝐸𝑑 =

%∆ 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑 (𝑄) 𝑜𝑓 𝑔𝑜𝑜𝑑 𝐴
%∆ 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 (𝑃) 𝑜𝑓 𝑔𝑜𝑜𝑑 𝐴

→ In most circumstances, a negative answer is the result, indicating that the two variables of price and
quantity demanded move in opposite directions
→ This illustrates that there is a negative gradient; the demand curve is downward-sloping for all the
reasons described above
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1 Types of price elasticity of demand
→ If PEd is greater than 1, demand for the good is relatively price elastic – the percentage change in
demand is greater than the change in the price, so to maximise revenues firms should decrease price
→ If PEd is less than 1, demand for the good is relatively price inelastic – the percentage change in
demand is less than the change in price, so to maximise revenues firms should increase prices
→ If PEd is equal to 1, demand for the good has unitary elasticity, so the percentage change in demand
is equal to the change in price – changing prices has no effect on the revenue of firms

→ If PEd is equal to zero, demand for the good is perfectly inelastic – a change in price has no effect on
demand whatsoever, and so the demand curve is vertical
→ If PEd is infitinite, demand for the good is perfectly elastic – a rise in price causes demand to fall to
zero, and so the demand curve is horizontal
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2 The relationship between price elasticity of demand and total revenue
→ Elasticity varies along a straight-line demand curve
→ Elasticity falls as you move along the curve from top left to bottom right – at the mid-point, demand
has unit elasticity
→ Unit elasticity occurs where marginal revenue equals zero and total revenue is at its maximum point
→ Where marginal revenue is equal to zero, a change in price has no effect on quantity (its marginal
effect on revenue is neither positive nor negative), and so demand for the good has unitary elasticity
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3 Total revenue
→ Total revenue refers to the total payments a firm receives from selling a given quantity of goods or
services
→ It is the price per unit of a good multiplied by the quantity sold
→ The total revenue a firm receives from selling a good will be equal to the total spending by
consumers on that good
→ A firm’s total revenue will increase as long as price is elastic and moving towards the mid-point of
the demand curve, where there is unitary elasticity
→ It is important for firms to know the PEd of their output when making pricing decisions, because this
affects revenue and profitability
→ Once unitary elasticity has been reached, the firm is maximising its total revenue
→ If demand is inelastic, an increase in prices causes total consumer spending and revenues to
increase, and a fall in prices causes total consumer spending to decrease, hence revenue falls
→ If demand is elastic, a cut in prices increases total consumer spending and revenues rise, and a rise in
price causes a fall in total consumer spending leading to reduced revenues
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4 Determinants of price elasticity of demand
→ There are a number of determinants of price elasticity of demand:
▪ Availability of substitutes – the more narrowly a good is defined, the more substitutes it
tends to have and so the more elastic the demand, i
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demand for cod fillets weighing 100g
is very elastic because it can be substituted for any other kind of fish, but demand for fish in
general is far less elastic
▪ Luxury and necessity goods – luxury goods, such as sports cars and caviar, tend to have
elastic demand, whereas necessity goods, like bread and underwear, tend to have inelastic
demand
▪ Proportion of income spent on the good – if a high proportion of income is spent on the
good, as with a new house or car, demand tends to be more elastic than those which make
up a small percentage of income, like newspapers or ketchup, which tend toward inelastic
demand
▪ Addictive and habit-forming goods – tobacco, alcohol and coffee are types of goods that
tend to be price inelastic in demand
▪ The time period – for most goods, demand is less elastic in the short-run than in the longrun, because over time consumers are more able to identify and purchase substitute goods,
and it may also take some time for consumers to recognise changes in price, i
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the price of
electricity can only affect demand once monthly bills come through

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Brand image – some goods have a strong brand image, and so consumers are willing to pay a
high price for a name like Coca-Cola or Levi jeans; demand is therefore often inelastic

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3 Cross elasticity of demand
→ Cross elasticity of demand (XEd) is the responsiveness of demand for good B to a change in price of
good A
→ The formula used to calculate this is 𝑋𝐸𝑑 =

%∆ 𝑖𝑛 𝑞𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝑑𝑒𝑚𝑎𝑛𝑑𝑒𝑑 (𝑄) 𝑜𝑓 𝑔𝑜𝑜𝑑 𝐵
%∆ 𝑖𝑛 𝑝𝑟𝑖𝑐𝑒 (𝑃) 𝑜𝑓 𝑔𝑜𝑜𝑑 𝐴

→ Cross elasticity of demand is used to determine whether goods and services are complements or
substitutes for each other
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1 Substitute goods
→ Substitute goods are in competitive demand
→ For example, a rise in the price of coffee may cause an increase in demand for tea
→ XEd is positive for substitute goods, as the two variables of price and demand move in the same
direction
→ There is a positive gradient
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2 Complementary goods
→ Complementary goods are in joint demand; they tend to be consumed together
→ For example, a fall in the price of tennis rackets may cause an increase in demand for tennis balls
→ XEd is negative for complementary goods, as the two variables of price and demand move in
opposite directions
→ There is a negative gradient
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3 Unrelated goods
→ Unrelated goods have an XEd value of zero
→ For example, an increase in the price of cars will have no effect upon the demand for potatoes

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4 Supply
→ The sellers or producers in a market are said to supply goods and services
→ Supply refers to the quantity of a good or service that firms are willing to sell at a given price and
over a given period of time
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2 Movement along a supply curve
→ There is only a movement along the supply curve when there is a change in its price
→ A rise in prices causes an extension in supply, and a fall in price causes a contraction in supply
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1 Determinants of price elasticity of supply
→ There are a number of determinants of price elasticity of supply (PEs):
▪ Level of spare capacity – a high level of spare capacity in a firm means that it can raise
production quickly, so supply tends to be elastic; a firm or industry operating at full capacity
is unable to raise output quickly and so its supply tends to be inelastic
▪ State of the economy – in a recession there are many unemployed resources and so there is
a high level of spare capacity; firms find it relatively easy to raise supply if needed
▪ Level of stocks of finished goods in a firm – a high level of stock means that the firm can
increase supply quickly, so supply is elastic
▪ Perishability of the product – some goods cannot be stockpiled, such as flowers or fresh
fruit, and so these goods have inelastic supply
▪ Ease of entry to an industry – if there are high barriers to entry in an industry then it will be
difficult for new firms to enter, even with the attraction of supernormal profits
▪ Time period under consideration – this is perhaps the most important determinant of
elasticity of supply; the short-run is the period of time in which a firm is able to increase
supply with its existing capacity, where at least one factor of production is fixed, and so
supply is inelastic here, but in the long-run where all factors of production are variable
supply is elastic
→ For many agricultural products, supply is inelastic in the short-run because the output from the
summer and autumn harvests depend on the amount of seed planted at the start of the year
→ It takes an even longer period of time to raise the supply of products from livestock, such as milk and
beef, because these depend on the nurturing of animals over several years
→ The supply of minerals may also be inelastic in the short-run due to the length of time required to
explore and discover new deposits and then extract them

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6 Price determination
→ Price is determined through the interaction of demand and supply in a competitive market
→ An equilibrium price and quantity occurs where there is a balance in the market – it is where the
demand curve and the supply curve intersect
→ At this point, there is no pressure on price or quantity to rise or fall, and so price and quantity will
remain steady until there is a shift in demand or supply that causes the equilibrium to move
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The impact of an increase in demand
on producer surplus and consumer
surplus
An increase in demand is likely to
increase both producer surplus and
consumer surplus
When demand shifts from D1 to D2,
consumer surplus increases from AXP1
to CYP2
When demand shifts from D1 to D2,
producer surplus increases from P1XB
to P2YB
As a result, an increase in demand is
likely to result in an increase in total, or
net, welfare
Utility in the market as a whole will
improve following an increase in demand

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1 The incidence of an indirect tax
→ The incidence of a tax usually falls partly on consumers and partly on producers, depending on the
relative price elasticities of demand and supply for the good or service
→ A combination of price inelastic demand and price elastic supply tends to place most of the burden
on consumers
→ Addictive goods like alcohol and cigarettes tend to be price inelastic in demand; as a result, firms can
pass most of the tax burden on to consumers

→ A combination of price elastic demand and price inelastic supply tends to place most of the burden
on producers
→ Firms will take a long time to adjust supply in response to new, higher prices, and consumers will
react very quickly to changes in price – this may lead to a fall in output and unemployment
→ As a result, governments may be reluctant to impose indirect taxes on such goods and services

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10 Subsidies
→ A subsidy is a grant, usually provided by the government, to encourage suppliers to increase
production of a good or service, leading to a fall in price
→ Bus and train companies are often given subsidies in order to increase the number of bus and train
services which benefits both the firms and consumers
→ A subsidy is often paid directly to producers, but as they respond by increasing output, the market
falls and this is indirectly paid to consumers
→ If demand is price inelastic then the market price falls by a relatively large amount and so most of
the benefit is passed onto consumers
→ If demand in price elastic then the market price falls by a relatively small amount and so there is less
gain for consumers
→ It is important to note that the areas of consumer subsidy and producer subsidy are the opposite of
the areas of consumer and producer tax, and the areas of consumer and producer surplus – the area
of incidence for a subsidy is the reverse of the normal way around

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11 Alternative views of consumer behaviour
→ Economists often assume that consumers behave in a rational manner and so allocate their income
to buy goods and services that will maximise their utility or satisfaction
→ Furthermore, economists allow for the fact that an individual may rationally choose to save if the
utility that could be gained in future is greater than the utility of spending immediately
→ Rational economic decision making comes from a deductive approach to the subject, where models
are created on the basis of how consumers are expected to behave and that their aims should be to
maximise total utility
→ However, an inductive approach to economics starts by investigating how consumers actually
behave and then develops models from the results
→ This alternative view of consumer behaviour attempts to explain why they may not always make
rational decisions
→ Consumers can be considered irrational in that they seek a satisfactory level of utility rather than a
maximising approach – there are several factors which help to explain this behaviour
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2 The importance of habitual behaviour
→ Consumers are creatures of habit and prefer what they know and have, rather than risking
something new where there is more uncertainty
→ For example, switching bank accounts to getting lower charges or better interest rates, or switching
energy suppliers to get lower gas and electricity prices may be avoided because consumers fear the
hassle of switching, or they worry about the uncertainty of a new bank or energy supplier
→ Habitual behaviour is also referred to as consumer inertia
→ Furthermore, consumers are also unrealistic about their future behaviour – for example, many
overweight adults continue their habit of eating too much, and yet they expect to change this habit
and lose weight in future
→ They underestimate the power of consumer inertia, overvaluing the utility from eating more today
and undervaluing the utility from being thinner and avoiding health problems in future
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3 MARKET FAILURE
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1 Types of market failure
→ Market failure occurs when the price mechanism causes an inefficient allocation of resources and so
leads to a net welfare loss
→ Consequently, resources are not allocated to their best or optimum use
→ There are various types of market failure:
▪ Externalities
▪ Under-provision of public goods
▪ Information gaps
→ Other forms of market failure exist, but the only ones explored in detail on the Edexcel spec are
those above

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2 Externalities
→ Externalities are those costs or benefits which are external to an exchange; they are third-party
effects which are ignored by the price mechanism
→ They are also known as indirect costs and benefits, or as spillovers from production or consumption
of a good or service
→ In effect, external costs are negative externalities and external benefits are positive externalities
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2 Benefits
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1 External benefits
→ External benefits may occur in the production and consumption of a good or service
→ An example of an external benefit in production is the recycling of waste materials such as
newspapers, glass and tins; it has the benefit of reducing the amount of waste disposal for landfill
sites as well as re-using materials for production and helps to promote sustainable economic growth
→ An external benefit in consumption is the vaccination of an individual against various diseases, which
reduces the possibility of other people catching a disease who come into contact with the vaccinated
individual
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2 Private benefits
→ In a free market, consumers are only concerned with the private benefits or utility from consuming a
good or service
→ Economists assume this can be measured by the price that consumers are willing to pay for a good
or service
→ Private benefits may also refer to the revenue that a firm obtains from selling a good or service
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3 Social benefits
→ By adding private benefits to external benefits, we obtain social benefits
→ This means external benefits are the difference between private benefits and social benefits
→ The marginal private benefit and marginal social benefit curves often diverge indicating that external
benefits increase disproportionately with output consumed
→ However, it is possible that external benefit per unit consumed will remain constant, in which case
the 𝑀𝑃𝐵 and 𝑀𝑆𝐵 curves are drawn parallel with each other
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4 The free market equilibrium
→ The supply curve for a firm is the marginal private cost curve (𝑀𝑃𝐶)
→ The addition of all the 𝑀𝑃𝐶 curves of firms in a market for a particular good or service will form the
market supply curve
→ The demand curve for consumers is the marginal private benefit curve (𝑀𝑃𝐵)
→ Economists assume that it is possible to measure the benefit obtained frm consuming a good by the
price that people are prepared to pay for it
→ As an individual consumes more unit of a good the marginal benefit (marginal utility) will fall, which
is why the demand curve slopes downwards from left to right
→ The addition of all the consumers’ 𝑀𝑃𝐵 curves for a particular good or service will form the market
demand curve
→ Market equilibrium occurs at the price and output position where marginal private benefit (𝑀𝑃𝐵)
equals marginal private cost (𝑀𝑃𝐶)
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6 External costs and the triangle of welfare loss
→ The free market ignores negative externalities
→ However, adding external costs on to the
production of a good or service causes the
supply curve of the firm to shift to the left

→ As a result, the supply curve, represented by the marginal private cost curve (𝑀𝑃𝐶), shifts to equal
the marginal social cost curve (𝑀𝑆𝐶)
→ An example of this is in the production of chemical goods
→ Assuming there are no external benefits in the production of a chemical good, the social optimum
equilibrium is at P1Q1, but when external costs are ignored there is under-pricing and
overproduction
→ A deadweight welfare loss exists in the shaded area, where production at a lower output could
create higher welfare
→ The area of deadweight welfare loss
represents all of the welfare forgone by
operating at a higher output at the private
equilibrium
→ The social optimum can be reached if the
externality is ‘internalised’, causing the
marginal private and social cost curves (𝑀𝑃𝐶
and 𝑀𝑆𝐶) to be equal
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8 The impact of external costs on consumers and producers
→ External costs can be ignored by consumers and producers when they make their economic
decisions, so causing market failure, which leads to:
▪ Under-pricing – the free market price is below the social optimum price
▪ Overproduction – the free market level of output exceeds the social optimum level of output
▪ Welfare loss – marginal social costs exceed marginal social benefits
▪ Concerns over the availability of resources for future generations, e
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overfishing will lead
to a collapse in fishing stocks, which may become unsustainable
▪ Concerns over pollution levels, e
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burning fossil fuels to produce energy could lead to
global warming and consequent problems of climate change, and air pollution could also
increase respiratory diseases and reduce life expectancy

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Calls for government intervention to internalise the external costs and so correct market
failure, i
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indirect taxes or trade pollution permits

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This leads to:
▪ Under-pricing – the free market price is below the social optimum price
▪ Underproduction – the free market level of output is less than the social optimum level of
output
▪ Potential welfare gain – marginal social benefits (𝑀𝑆𝐵) exceed marginal social costs (𝑀𝑆𝐶)
▪ Concerns over the long-term implications of underproduction, e
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underproduction of
education and healthcare could lead to lower economic growth and a less competitive
economy; living standards may rise more slowly
▪ Calls for government intervention to internalise the external benefits and so correct market
failure, i
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regulation, government provision and subsidies

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3 Public goods
→ Some goods may not be produced at all through the markets, despite offering significant benefits to
society
→ Where this occurs, it is known as a ‘missing market’, and the goods which the market fails to provide
are called public goods
→ These goods involve a large element of collective consumption, e
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national defence, flood defence
systems, the criminal justice system, and refuse collection
→ Public goods demonstrate two characteristics:
▪ Non-excludability – once a good has been produced for the benefit of one person, it is
impossible to stop others from benefitting
▪ Non-rivalry – as more people consume a good and enjoy its benefits, it does not reduce the
amount available for others, and it is therefore non-diminishable
→ Once a public good has been provided, the cost of supplying it to an extra consumer is zero
→ Further examples include public firework displays, lighthouses, public beaches, public parks, drains
and street lighting
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2 The free-rider problem
→ In a free market economy, public goods are underprovided due to the free-rider problem
→ Once a public good has been provided for one individual, it is automatically provided for all – the
market falls because it is not possible for firms to withhold the good from all those consumers who
refuse to pay for it
→ Examples include national defence systems and street lighting

→ The rational consumer would wait for someone else to provide the good and then reap the rewards
by consuming it for free
→ If everyone waits for others to supply a public good then it may never be provided
→ The non-excludability characteristic means that the price mechanism cannot develop as free riders
will not pay
→ Firms are reluctant to supply such a good in a free market as it is difficult to gain profits from it, and
so the solution is for the government to provide public goods and fund them from general taxation

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4 Information gaps
→ Information gaps can lead to market failure due to either consumers or producers having more
market knowledge than the other about a particular good or service
→ It means there is an unequal balance upon which to conduct economic transactions between them,
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a second-hand car market
→ Information gaps can also lead to market failure when consumers or producers simply lack perfect
knowledge about a particular good or service and so end up making non-rational economic decisions
→ A good example is the pensions market where people tend to make too few contributions for their
retirement
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2 Asymmetric information
→ In reality, consumers and producers have asymmetric information
→ That is, unequal market knowledge upon which to make their economic decisions
→ This could lead to a misallocation of resources
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4 GOVERNMENT INTERVENTION
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1 Government intervention in markets
→ The UK is a mixed economy, meaning that both private enterprise and the government allocate
resources to solve the economic problem of what, how, and for whom to produce
→ Often the government intervenes where there is market failure and attempts to correct this so that
resources are allocated more efficiently
→ There are various measures a government could undertake to correct market failure:
▪ Indirect taxation
▪ Subsidies
▪ Maximum prices
▪ Minimum prices
▪ Trade pollution permits
▪ Regulation
▪ Provision of information
→ The relative advantages of each form are considered below with regard to correcting market failure
– the disadvantages of these measure may point to government failure
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2 Subsidies
→ A subsidy is a grant provided by the government to encourage the production and consumption of a
particular good or service
→ Subsidies are often applied on goods and services with significant external benefits, such as
education and healthcare
→ They may also be applied to alternative forms of economic activity which carry negative
externalities, but less negative externalities than their more prominent substitutes, e
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subsidies for
public transport over driving, and subsidies for renewable energy instead of traditional fossil fuel
energy
→ The incidence of a subsidy is the reverse of that of a tax; the area below the original equilibrium
price is enjoyed by the consumer, and the area above the original equilibrium price is enjoyed by the
producer

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1 Advantages of subsidies applied to renewable energy markets
→ Subsidies can reduce air pollution and other forms of external costs
→ Subsidies on renewable energy generation promote sustained economic growth
→ The rate of consumption of non-renewable energy resources is reduced
→ Subsidies work with market force – they help to internalise the external benefits from renewable
forms of energy so that firms have an incentive to operate at the social optimum
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2 Disadvantages of subsidies applied to renewable energy markets
→ It is difficult to quantify external benefits and then place a monetary value on them; consequently
the social optimum position might not be achieved
→ There is an opportunity cost to government subsidies – they may lead to higher taxes or cuts in
government spending elsewhere; they may be a waste of money, e
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many subsidised bus services
operate along routes with hardly any passengers
→ Unintended consequences may occur, e
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firms may become dependent on the subsidies and
inefficient in production
→ Wind power and solar power may be less reliable sources of energy than traditional fossil fuels
→ There are external costs associated with the provision of renewable energy sources, e
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noise and
visual pollution from wind farms, and can also reduce property prices nearby
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or who can potentially offer higher tips and the like) so the maximum
price may not be effective
→ It is difficult for the government to monitor and enforce maximum price controls in markets; there is
a danger of shadow markets being created, where some are willing to pay a premium for the good
or service to ensure they obtain it, e
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ticket-touting for football matches and theatre shows
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5 Tradable pollution permits
→ In 2005, the European Commission set up an Emissions Trading Scheme (ETS) in an attempt to limit
greenhouse gas emissions from heavy industry
→ Initially the scheme focused on the power generation, steel, paper, cement and ceramics industries
→ In 2012, the scheme was extended to include the aviation industry
→ The ETS is a ‘cap and trade’ scheme, which works in the following way:
▪ Each year, the European Commission allocates a set amount of carbon dioxide permits to
national governments, which then divide up the allowances among the firms covered by the
scheme
▪ The system ‘caps’ the amount of carbon emissions for the year because there are only a
finite number of permits
▪ The pollution permits are tradeable, which is central to the effectiveness of the scheme
▪ Since the permits are tradeable, if a firm exceeds their pollution limit then they need to buy
more permits to cover this, incurring an actual cost to the firm for polluting, which
internalises the externality

▪

→
→
→
→
→

Even where a firm does not meet the limit of their permits, the ETS means that for every
unit of pollution, there is an opportunity cost incurred because the permit used to cover that
unit of pollution could have been traded, bringing revenue into the firm
▪ As a result, regardless of a firm’s actual level of pollution (whether they exceed their
pollution limit or not), the ETS internalises the externality
▪ Over time, the European Commission plans to reduce the number of permits, which allows
net pollution to decrease over time
Most of the tradeable pollution permits have been given for free to industry and allocated on the
basis of the amount of pollution
However, national governments are able to retain up to 10% of carbon permits and offer them for
sale, depending on the level of scarcity
The ETS gives an incentive to firms to invest in clean technology and so reduce emission in the long
term
There is also a reserve of carbon permits to enable new firms to enter those industries within the
Emissions Trading Scheme (ETS)
The ETS allows firms to invest in scheme that reduce carbon emissions outside the European Union,
for example in India or China, and these savings can be offset against their own emissions in the EU

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1 Advantages of trade pollution permits
→ A market is created for buying and selling carbon permits, just like other goods and services; in
effect, the price mechanism is used to internalise the external costs associated with carbon
emissions
→ Pollution permits can be reduced over time as part of a coordinated plan, e
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in 2008 the European
Commission cut permit allocations by 5%
→ National governments can raise funds by selling their reserve pollution permits to industry; the
revenue could then be used to clean up the environment or compensate victims
→ Firms have an incentive to invest in clean technology
→ Production costs will increase for firms that exceed their pollution permits, since they have to
purchase additional permits, and this provides a source of revenue for cleaner firms that can afford
to sell excess permits
→ The ETS may act as a foundation for a global-wide scheme; it has attracted interest from developed
countries outside the EU, and a parallel scheme has been set up in the north-eastern USA and will
soon be introduced in the state of California
→ Firms are able to bank their excess pollution permits for use in future years
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2 Disadvantages of trade pollution permits
→ An information gap might cause the European Commission to issue too many carbon permits, so
that there is little incentive for firms to reduce pollution; this occurred during the first phase of the
ETS (2005-07) and led to a collapse in the price of carbon permits
→ An information gap might cause the European Commission to issue too few carbon permits, so that
the production costs for EU firms increase rapidly, reducing their international competitiveness;
some firms may even relocate outside of the EU to reduce production costs
→ Disputes have arisen over the allocation of carbon permits to firms; some companies believe they
should receive larger allowances and have taken legal proceedings against the European
Commission
→ Firms may pass the costs of purchasing pollution permits on to their customers, leading to higher
prices of, for example, electricity, steel, glass and paper, especially if demand is price inelastic

→ Unintended consequences may occur: e
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there is less pressure on major polluting firms to clean up
their act if they can buy extra permits from elsewhere
→ EU firms may avoid investing in expensive technology to reduce their own emissions by funding
cheaper carbon-offsetting schemes in developing countries
→ The price of pollution permits has fluctuated considerably since their inception in 2005, e
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the price
of carbon emissions has varied from over €24 to less than €1 per ton, creating uncertainty among
firms over whether to invest heavily in carbon-reducing technology; firms need clear guidance over
what emission prices will be for the next decade in order to determine their investment levels
→ There is a cost to the government in terms of monitoring pollution emissions from the various
companies within the scheme
→ The EU is just one part of the world; unless all countries engage in similar carbon trading schemes,
global emissions will continue to increase – in 2007, China became the world’s largest carbon
polluter, and until the Paris Agreement it was not subject to any limits
→ The valuation of pollution permits is an inexact science, which perhaps should not simply be left to
the market
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7 State provision of information
→ It was mentioned earlier that information gaps cause market failure and so require government
intervention to reduce this
→ Today, government provision of information comes through various promotions using social media,
such as the internet, television, radio, newspapers and text messages
→ The reasons are:
▪ To encourage the production and consumption of healthy goods and services, e
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fruit and
vegetables, or goods that yield long-term benefits, such as pensions, which are often underprovided by the market
▪ To discourage the production and consumption of unhealthy goods and services, e
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tobacco, alcohol and drugs, which are often over-provided by the market
▪ To notify and remind people of laws for their own protection, such as wearing seatbelts in
motor vehicles and not drinking alcohol and driving
→ Government provision of information, along with other measure, plays an important role in reducing
market failure
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1 Distortion of price signals
→ Maximum and minimum price controls provide good examples of the distortion of price signals –
how government intervention distorts the operation of the price mechanism and misallocates
resources
→ This can be explained in more detail:
▪ Maximum price controls lead to an excess demand or shortage, as shown in the example of
rental housing; long-term implications include a reduction in both the quality and quantity of
rental housing available, possibly leading to an increase in the number of homeless
▪ Minimum price controls lead to an excess supply or surplus, with the example of agriculture
products; long-term implications include problems of disposing of food surpluses, which are
perishable and expensive to store, as well as the need for government expenditure on the
surpluses, which has an opportunity cost
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3 Excessive administration costs
→ Government intervention in markets incurs administration costs, whether it concerns taxes,
subsidies, price controls, pollution permits or regulations
→ Sometimes the administration costs are so high as to put into question the cost effectiveness and
validity of government intervention
→ These costs could arise in the formulation, monitoring or enforcement of government measures
→ Most areas of government intervention suffer from this, with the following examples:
▪ Tax administration and collection can prove difficult and expensive for government, e
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tax
changes in a Budget may take a year to implement

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▪

Welfare benefits are difficult to calculate and monitor to make sure the right claimants
receive the correct payments, e
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changes to housing benefit according to the number of
spare bedrooms a claiming might have (the ‘bedroom tax’)
Regulations require constant monitoring to ensure they are adhered to, e
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ensuring fishing
boats do not exceed their fish catches or quotas

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