Market economic system

Worked example 15 marks

1. 1

   Step 1: Identify the key decision-makers. In a market economy, decisions are made by individual consumers and private firms, not the government.

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   Step 2: Explain 'what to produce'. This is determined by consumer sovereignty. Firms produce goods and services that consumers are willing and able to buy, as this is how they make a profit.

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   Step 3: Explain 'how to produce'. This is determined by the profit motive. Firms will choose the most efficient, lowest-cost method of production to maximise their profits.

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   Step 4: Explain 'for whom to produce'. This is determined by purchasing power. Goods and services are allocated to those who can afford to pay the market price.

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   Step 5: Conclude by summarising the role of price. The price mechanism acts as the coordinating force, signalling consumer wants and producer costs to allocate scarce resources.

Worked example 16 marks

1. 1

   Step 1: Identify the initial impact. The health report will increase the tastes and preferences for oranges, leading to an increase in demand at every price level.

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   Step 2: Describe the effect on price and quantity. This increase in demand creates a shortage at the original price. Consumers will bid up the price to secure the limited supply of oranges.

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   Step 3: Explain the signalling function. The new, higher market price acts as a signal to producers that oranges are now more profitable.

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   Step 4: Explain the incentive function. The higher price and potential for greater profit create an incentive for existing farmers to grow more oranges and for new farmers to enter the market.

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   Step 5: Describe the resource allocation effect. In the long run, more resources (land, labour, capital) will be allocated to the production of oranges.

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   Step 6: Conclude the process. The price mechanism has reallocated resources towards producing more oranges in response to a change in consumer demand, without any central authority directing it.

Worked example 16 marks

1. 1

   Reason 1: Non-provision of Public Goods. A public good, like street lighting, is non-excludable and non-rivalrous. A private firm cannot charge individuals for using it or prevent non-payers from benefiting (the 'free-rider problem'). Therefore, there is no profit incentive to provide such goods, and the market will fail to provide them, resulting in a loss of welfare.

2. 2

   Reason 2: Existence of Negative Externalities. A private firm, aiming to maximise profit, will only consider its private costs of production (e.g., wages, materials). It will ignore external costs, such as the pollution it creates, which harm society. Because the firm does not pay the full social cost, the product is priced too low, and the market will over-produce and over-consume the good, leading to an inefficient allocation of resources.

Worked example 24 marks

1. 1

   Step 1: State the core principle. In a pure market system, if a product is profitable, firms will produce it.

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   Step 2: Apply to the example. There is demand for harmful goods like illegal drugs. Therefore, in an unregulated market, suppliers will emerge to meet this demand because they can make a profit.

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   Step 3: Identify the market failure. The market only considers the private benefits to the user and producer, not the significant negative externalities (external costs) to society, such as increased crime, health costs, and addiction.

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   Step 4: Conclude. The market fails by allocating resources to the production of goods that reduce overall social welfare, demonstrating a major drawback of the system.

Worked example 15 marks

1. 1

   Part (a): Identify the externality. A possible negative externality is noise pollution from aircraft, which affects residents living near the airport.

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   Part(b) Step 1: Define the private vs social cost. The airport operator (the producer) considers its private costs like fuel, staff, and planes. It does not consider the external cost of noise disturbance to residents.

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   Part(b) Step 2: Link to market price and quantity. Because the external cost is ignored, the full social cost of air travel is higher than the private cost. This means the market price of flights is too low.

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   Part(b) Step 3: Explain the inefficiency. The artificially low price leads to a higher quantity of flights being demanded and supplied than is socially optimal. The market has therefore over-allocated resources to air travel, causing a market failure and a net welfare loss.

Worked example 16 marks

1. 1

   Step 1: Define a merit good. A merit good is a good which is considered socially desirable but would be under-consumed in a free market.

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   Step 2: Explain why education is a merit good. Individuals may underestimate the private benefits of education (e.g., higher future income). Also, they do not consider the positive externalities.

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   Step 3: Identify the positive externalities of education. A more educated population leads to a more productive workforce, higher economic growth, lower crime rates, and a better-informed electorate. These are benefits to society as a whole, not just the individual.

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   Step 4: Explain the resulting market failure. Because individuals and firms only consider the private benefits, the demand for and supply of education will be lower than the socially optimal level. The market under-provides it.

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   Step 5: Explain the role of the subsidy. By subsidising education (e.g., funding public schools, offering student loans), the government lowers the private cost of education for individuals.

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   Step 6: Conclude the effect of the subsidy. This increases demand and consumption, moving the quantity of education closer to the socially optimal level and correcting the market failure.