Edexcel A-Level Economics (A)
THEME 1
Introduction to Markets and
Market Failure
STUDENT COMPANION
Author: Geoff Riley
Series Editor: Ruth Tarrant
EDITION DATE: SEPTEMBER 2019
WWW.TUTOR2U.NET/ECONOMICS
,COMPANION CONTENTS
1.1.1 Economics as a social science .......................................................................................... 3
1.1.2 Positive and Normative Statements ................................................................................ 4
1.1.3 The Economic Problem .................................................................................................... 5
1.1.4 Production Possibility Frontiers ....................................................................................... 9
1.1.5 Specialisation and the Division of Labour ...................................................................... 14
1.1.7 Free market economies, mixed economy and command economy .............................. 17
1.2.1 Rational Decision Making............................................................................................... 22
1.2.2 Demand.......................................................................................................................... 23
1.2.3 Price, income and cross elasticities of demand ............................................................. 26
1.2.4 Supply ............................................................................................................................ 33
1.2.5 Elasticity of supply ......................................................................................................... 36
1.2.6 Price determination ....................................................................................................... 38
1.2.7 Price mechanism ............................................................................................................ 43
1.2.8 Consumer and producer surplus .................................................................................... 46
1.2.9 Indirect taxes and subsidies ........................................................................................... 49
1.2.10 Alternative views of consumer behaviour ................................................................... 56
1.3.1 Types of market failure .................................................................................................. 60
1.3.2 Externalities ................................................................................................................... 61
1.3.3 Public Goods .................................................................................................................. 68
1.3.4 Information Gaps ........................................................................................................... 71
1.4.1 Government Intervention in Markets ............................................................................ 75
1.4.2 Government failure........................................................................................................ 90
Edexcel A-Level Economics Theme 1 Companion www.tutor2u.net/economics Page 2
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,1.1.1 Economics as a social science
Key specification content
• Thinking like an economist: the process of developing models in economics, including the need
to make assumptions
• The use of the ceteris paribus assumption in building models
• The inability in economics to make scientific experiments
Models in Economics
Economists develop models and theories to help explain the multiple choices we make in our daily lives. These
models are built on assumptions that can help to simplify analysis and allow us to think about links between
one variable and another. However, many of the assumptions that economists make risk being criticised for
not being sufficiently realistic – the real world is far more complex than most economic models suggest.
What are assumptions?
• Assumptions are initial or prior conditions made before a micro or macroeconomic analysis is built.
• Sometimes assumptions are used for simplification of a theoretical idea or an economic relationship
Ceteris paribus assumption
To simplify analysis, economists isolate the relationship between two variables by assuming ceteris paribus –
i.e. all other influencing factors are held constant. For example, “an increase in real income will cause an
increase in demand, ceteris paribus.” Here we keep constant all other factors that might lead to a change in
demand for a product.
Other assumptions
Most of the economics that we study is based on a “neo-classical” approach. Neo-classical economists make
a number of key assumptions in their analysis, including:
• people are rational;
• people (e.g. workers, business owners etc) aim to maximise their “utility” i.e. their ‘satisfaction’. For
businesses, this means aiming to maximise their profit;
• people act independently of each other when making their decisions;
• the information needed to make decisions is always accurate and complete.
Examiner Tip
Try to note down at least one assumption when you are writing analysis points in exam answers. This then
allows you to critique and evaluate your analysis later in their answer by simply questioning the assumptions
that have made. For example:
“An increase in real income should cause an increase in demand for products, assuming that they are normal
goods and have a positive income elasticity of demand. However, some goods and services are classified as
inferior goods and have a negative income elasticity of demand, so demand for them will fall when income
rises.”
Edexcel A-Level Economics Theme 1 Companion www.tutor2u.net/economics Page 3
SCHOOL LICENCE – Copyright Tutor2u
, 1.1.2 Positive and Normative Statements
Key specification content
• Distinction between positive and normative economic statements
• The role of value judgements in influencing economic decision-making and policy
Positive Statements
Positive statements are objective statements that can be tested, amended or rejected by referring to the
available evidence. Positive economics deals with objective explanation and the testing and rejection of
theories. For example:
• If the government raises the tax on beer, this will then lead to a fall in profits of brewers.
• A fall in the cost of generating solar energy may cause a contraction of demand for coal
• A reduction in income tax will improve the incentives of the unemployed to find work.
• Higher mortgage interest rates will eventually reduce the average level of house prices
Normative Statements
Normative statements are subjective statements – i.e. they carry value judgements. For example:
• High unemployment is more harmful to a country such as the UK than high rates of inflation
• The retirement age in Britain should be raised to 70 to combat the effects of an ageing
population.
• Scarce resources are best allocated by allowing the price mechanism to work without any
intervention
• The government should enforce a minimum price for beers and lagers sold in supermarkets and
off-licences to help control alcohol consumption and reduce the number of pubs that are closing
The role of value judgements
Most economic decisions and policy are influenced by “value judgements”. These vary from person to person,
from company to company, from government to government, and from country to country. Value judgements
help us to explain why economic policies vary from place to place, and from time to time.
Examiner Tip
Deciding whether a statement is positive or normative is a common multiple-choice question. Examiners may
include words such as ‘should’ in statements that are actually positive (this is done to make students think that
they are normative). The rule-of-thumb is that students should always consider whether the statement can be
tested. If it can be tested, then it is a positive statement.
Edexcel A-Level Economics Theme 1 Companion www.tutor2u.net/economics Page 4
SCHOOL LICENCE – Copyright Tutor2u
THEME 1
Introduction to Markets and
Market Failure
STUDENT COMPANION
Author: Geoff Riley
Series Editor: Ruth Tarrant
EDITION DATE: SEPTEMBER 2019
WWW.TUTOR2U.NET/ECONOMICS
,COMPANION CONTENTS
1.1.1 Economics as a social science .......................................................................................... 3
1.1.2 Positive and Normative Statements ................................................................................ 4
1.1.3 The Economic Problem .................................................................................................... 5
1.1.4 Production Possibility Frontiers ....................................................................................... 9
1.1.5 Specialisation and the Division of Labour ...................................................................... 14
1.1.7 Free market economies, mixed economy and command economy .............................. 17
1.2.1 Rational Decision Making............................................................................................... 22
1.2.2 Demand.......................................................................................................................... 23
1.2.3 Price, income and cross elasticities of demand ............................................................. 26
1.2.4 Supply ............................................................................................................................ 33
1.2.5 Elasticity of supply ......................................................................................................... 36
1.2.6 Price determination ....................................................................................................... 38
1.2.7 Price mechanism ............................................................................................................ 43
1.2.8 Consumer and producer surplus .................................................................................... 46
1.2.9 Indirect taxes and subsidies ........................................................................................... 49
1.2.10 Alternative views of consumer behaviour ................................................................... 56
1.3.1 Types of market failure .................................................................................................. 60
1.3.2 Externalities ................................................................................................................... 61
1.3.3 Public Goods .................................................................................................................. 68
1.3.4 Information Gaps ........................................................................................................... 71
1.4.1 Government Intervention in Markets ............................................................................ 75
1.4.2 Government failure........................................................................................................ 90
Edexcel A-Level Economics Theme 1 Companion www.tutor2u.net/economics Page 2
SCHOOL LICENCE – Copyright Tutor2u
,1.1.1 Economics as a social science
Key specification content
• Thinking like an economist: the process of developing models in economics, including the need
to make assumptions
• The use of the ceteris paribus assumption in building models
• The inability in economics to make scientific experiments
Models in Economics
Economists develop models and theories to help explain the multiple choices we make in our daily lives. These
models are built on assumptions that can help to simplify analysis and allow us to think about links between
one variable and another. However, many of the assumptions that economists make risk being criticised for
not being sufficiently realistic – the real world is far more complex than most economic models suggest.
What are assumptions?
• Assumptions are initial or prior conditions made before a micro or macroeconomic analysis is built.
• Sometimes assumptions are used for simplification of a theoretical idea or an economic relationship
Ceteris paribus assumption
To simplify analysis, economists isolate the relationship between two variables by assuming ceteris paribus –
i.e. all other influencing factors are held constant. For example, “an increase in real income will cause an
increase in demand, ceteris paribus.” Here we keep constant all other factors that might lead to a change in
demand for a product.
Other assumptions
Most of the economics that we study is based on a “neo-classical” approach. Neo-classical economists make
a number of key assumptions in their analysis, including:
• people are rational;
• people (e.g. workers, business owners etc) aim to maximise their “utility” i.e. their ‘satisfaction’. For
businesses, this means aiming to maximise their profit;
• people act independently of each other when making their decisions;
• the information needed to make decisions is always accurate and complete.
Examiner Tip
Try to note down at least one assumption when you are writing analysis points in exam answers. This then
allows you to critique and evaluate your analysis later in their answer by simply questioning the assumptions
that have made. For example:
“An increase in real income should cause an increase in demand for products, assuming that they are normal
goods and have a positive income elasticity of demand. However, some goods and services are classified as
inferior goods and have a negative income elasticity of demand, so demand for them will fall when income
rises.”
Edexcel A-Level Economics Theme 1 Companion www.tutor2u.net/economics Page 3
SCHOOL LICENCE – Copyright Tutor2u
, 1.1.2 Positive and Normative Statements
Key specification content
• Distinction between positive and normative economic statements
• The role of value judgements in influencing economic decision-making and policy
Positive Statements
Positive statements are objective statements that can be tested, amended or rejected by referring to the
available evidence. Positive economics deals with objective explanation and the testing and rejection of
theories. For example:
• If the government raises the tax on beer, this will then lead to a fall in profits of brewers.
• A fall in the cost of generating solar energy may cause a contraction of demand for coal
• A reduction in income tax will improve the incentives of the unemployed to find work.
• Higher mortgage interest rates will eventually reduce the average level of house prices
Normative Statements
Normative statements are subjective statements – i.e. they carry value judgements. For example:
• High unemployment is more harmful to a country such as the UK than high rates of inflation
• The retirement age in Britain should be raised to 70 to combat the effects of an ageing
population.
• Scarce resources are best allocated by allowing the price mechanism to work without any
intervention
• The government should enforce a minimum price for beers and lagers sold in supermarkets and
off-licences to help control alcohol consumption and reduce the number of pubs that are closing
The role of value judgements
Most economic decisions and policy are influenced by “value judgements”. These vary from person to person,
from company to company, from government to government, and from country to country. Value judgements
help us to explain why economic policies vary from place to place, and from time to time.
Examiner Tip
Deciding whether a statement is positive or normative is a common multiple-choice question. Examiners may
include words such as ‘should’ in statements that are actually positive (this is done to make students think that
they are normative). The rule-of-thumb is that students should always consider whether the statement can be
tested. If it can be tested, then it is a positive statement.
Edexcel A-Level Economics Theme 1 Companion www.tutor2u.net/economics Page 4
SCHOOL LICENCE – Copyright Tutor2u
