A Level Economics: Markets in Action — Practice Questions

These are original questions written for Marlbridge, for revision and practice on this content. They are not reproduced past-paper questions, and they do not replicate the exam’s exact structure, question count or mark tariffs — examination boards hold copyright in their own papers. Use these alongside the official past papers available free from your board.

Related: Markets in Action revision notes

This paper follows the specification’s four-section structure for a Unit 1/2-style paper: Section A is six multiple-choice questions (6 marks), Section B is five short-answer questions (20 marks), Section C is a five-part question built around a single scenario (34 marks), and Section D is one essay answered from a choice of two (20 marks). Command words and their mark tariffs follow the specification’s command word table: define (2), calculate (2 or 4), draw (4), explain (4), analyse (6), examine (8), discuss (14), and evaluate / to what extent (20).

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Section A — Multiple choice

1. Which of the following would cause a shift of the demand curve for a good, rather than a movement along it? A) A fall in the good’s own price B) A rise in consumer income C) The change in quantity demanded that follows a price change D) A movement to a different point on the same curve [1]

2. A good has an income elasticity of demand of −0.6. This good is: A) A normal luxury good B) A normal necessity C) An inferior good D) A Giffen good [1]

3. Which of the following best describes a public good? A) Excludable and rival B) Non-excludable and rival C) Excludable and non-rival D) Non-excludable and non-rival [1]

4. Adverse selection in an insurance market arises because: A) Insured individuals become more careless after buying cover B) The insurer has more information than the buyer C) Higher-risk individuals are more likely to buy insurance than lower-risk individuals D) The government sets the premium too low [1]

5. A minimum wage is most likely to raise employment in a labour market where: A) The employer is a wage taker in a competitive labour market B) The employer is a monopsonist and the minimum wage is set between the monopsony wage and the competitive wage C) Labour supply is perfectly inelastic D) The minimum wage is set below the current market wage [1]

6. Government failure occurs when: A) A market fails to reach equilibrium B) Government intervention leads to a less efficient allocation of resources than before the intervention C) A firm exploits monopoly power D) A tax fails to raise any revenue [1]

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Section B — Short-answer questions

7. Define price elasticity of demand. [2]

8. When average household income rises from $20,000 to $22,000 a year, the quantity demanded of a good falls from 500 to 480 units a week. Calculate the income elasticity of demand for the good. You are advised to show your working. [4]

9. Draw and fully label a diagram to show a positive externality of consumption (for example, vaccination), indicating the free-market equilibrium, the social optimum, and the resulting welfare loss. [4]

10. Explain why a public good will not be provided by a free market. [4]

11. Analyse how a tradable permit scheme corrects a negative externality differently from a fixed indirect tax. [6]

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Section C — Five-part question

12. A government introduces an indirect tax on sugary drinks. The health cost of excessive sugar consumption falls mainly on the consumer, so this is a negative externality of consumption rather than of production.

(a) Define what is meant by an indirect tax. [2]

(b) The tax raises the price of a bottle of a sugary drink from $2.00 to $2.20, and weekly sales fall from 50,000 to 47,000 bottles. Calculate the price elasticity of demand for sugary drinks. You are advised to show your working. [4]

(c) Draw and fully label a diagram to show the negative externality of consumption in the market for sugary drinks. [4]

(d) Explain why this tax may raise substantial government revenue but achieve only a small reduction in the quantity of sugary drinks consumed. [4]

(e) Evaluate the extent to which this indirect tax is likely to be an effective policy for reducing the negative externality associated with sugar consumption. [20]

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Section D — Essay (answer ONE)

EITHER

13. Evaluate the view that a tradable permit scheme is a more effective way of correcting a negative externality than a fixed indirect tax. [20]

OR

14. Evaluate the extent to which government intervention can improve economic welfare when a market fails. [20]

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Answers

1. B) A rise in consumer income is a change in a condition of demand other than the good’s own price, so it shifts the whole curve; the other options describe movements along the curve or restate what a movement along the curve is [1].

2. C) A negative income elasticity of demand means quantity demanded falls as income rises, which is the definition of an inferior good [1].

3. D) A public good is non-excludable (non-payers cannot be prevented from consuming it) and non-rival (one person’s consumption does not reduce what is available to others) [1].

4. C) Adverse selection arises because the buyer knows more about their own risk than the insurer, so higher-risk individuals are more likely to seek insurance, pushing up the average risk (and cost) of the insured pool [1].

5. B) A monopsonist restricts employment below the competitive level to keep wages down; a minimum wage set between the monopsony wage and the competitive wage removes the incentive to restrict employment, so both wages and employment can rise [1].

6. B) Government failure is where intervention leaves resource allocation less efficient than before, for example through information gaps, administrative costs, unintended consequences, or regulatory capture [1].

7. Price elasticity of demand measures the responsiveness of quantity demanded to a change in price [1], calculated as %ΔQd ÷ %ΔP [1].

8. %Δ quantity demanded = (480 − 500) ÷ 500 × 100 = −4% [1]. %Δ income = (22,000 − 20,000) ÷ 20,000 × 100 = +10% [1]. YED = %ΔQd ÷ %Δincome [1] = −4 ÷ 10 = −0.4 [1]. (The negative sign shows the good is an inferior good.)

9. For a positive consumption externality, marginal social benefit (MSB) lies above marginal private benefit (MPB), with a single marginal cost (MC) curve [1] [1]. The free-market equilibrium is where MPB = MC, at a lower quantity [1]; the social optimum is where MSB = MC, at a higher quantity, with the welfare loss (the foregone net benefit) shaded between the two output levels [1].

10. A public good is non-excludable — a supplier cannot stop a non-payer from consuming it [1] — and non-rival — one person’s consumption does not reduce what is available to others [1]. Because non-payers cannot be excluded, a free-rider problem arises: no one has an incentive to pay [1], so a private firm cannot generate enough revenue to profitably supply the good, and the market provides none at all [1].

11. A tradable permit scheme sets a cap on total output or emissions [1] and allows firms to buy and sell permits within that cap [1], so the market finds the cheapest way to reduce the externality across firms with different abatement costs [1]. A fixed indirect tax instead sets a price on the externality [1], but leaves the resulting quantity of the externality uncertain [1], whereas a permit scheme fixes the quantity and lets the price of a permit adjust in the market [1].

12. (a) An indirect tax is a tax imposed on spending on goods and services [1], collected by an intermediary such as the seller rather than paid directly to the government by the consumer, and typically added to the price of the good [1].

(b) %Δ quantity demanded = (47,000 − 50,000) ÷ 50,000 × 100 = −6% [1]. %Δ price = (2.20 − 2.00) ÷ 2.00 × 100 = +10% [1]. PED = %ΔQd ÷ %ΔP [1] = −6 ÷ 10 = −0.6 [1]. (Because the magnitude is less than 1, demand is price inelastic, which part (d) uses.)

(c) For a negative consumption externality, marginal private benefit (MPB) lies above marginal social benefit (MSB), with a single marginal cost (MC) curve, since production itself imposes no extra cost [1] [1]. The free-market equilibrium is where MPB = MC, at a higher quantity than is socially desirable [1]; the social optimum is where MSB = MC, at a lower quantity, with the welfare loss shaded between the two [1].

(d) Because demand is price inelastic (|PED| = 0.6, from (b)), a price rise causes only a proportionally smaller fall in quantity demanded [1], so the tax is collected on almost the same quantity as before, generating large and stable revenue [1]. For the same reason, consumption — and therefore the externality — falls only slightly [1], so the tax is only weakly effective at correcting the externality itself, even though it raises substantial revenue [1].

(e) Indicative content. For [up to 8, 2 marks each]: it internalises the external cost, moving consumption towards the social optimum; it raises revenue that could fund health education or treatment; it signals the product’s harm to consumers; combined with public information, it can still shift demand over time even if the immediate effect is small. Against [up to 8, 2 marks each]: demand is inelastic, so it is weak at its stated aim in the short run; it is regressive, taking a larger share of poorer households’ income; it may cause substitution to other unhealthy, untaxed products; the optimal rate is difficult to identify (a form of government failure) — too low and it has little effect, too high and it is seen as excessive. Judgement [4]: the tax is likely to be effective as a revenue-raiser and as a signal of harm, but weak as a stand-alone tool for changing behaviour given inelastic demand; it is most effective when combined with measures (such as education) that make demand more elastic over time, and its overall effectiveness depends on the size of the external cost and how the revenue raised is used.

13. Indicative content. For tradable permits [up to 8, 2 marks each]: the cap guarantees the target level of the externality is met, unlike a tax where the resulting quantity is uncertain; the market finds the cheapest-cost firms to reduce output/emissions first, giving cost-effective abatement across the industry; permits can be auctioned to raise revenue, similar to a tax; the scheme adapts automatically as the number of firms or output changes, since permits are simply bought and sold. Against tradable permits [up to 8, 2 marks each]: setting the cap correctly requires as much information as setting a tax rate correctly, so the same information problem persists; a new permit market must be created and monitored, which has administrative costs; firms may pass on the cost of buying permits to consumers just as with a tax, so the burden may still be regressive; in practice a fixed tax may already achieve a similar effect with lower administrative complexity. Judgement [4]: a tradable permit scheme has the advantage of certainty over quantity, which is valuable where the externality has a critical threshold (e.g. total emissions), while a tax is simpler to administer and gives certainty over price; which is more effective depends on whether the priority is controlling the exact quantity of the externality or minimising administrative cost and complexity.

14. Indicative content. For intervention improving welfare [up to 8, 2 marks each]: correcting a negative externality (e.g. a tax or regulation) reduces over-consumption or over-production towards the social optimum, increasing total welfare; correcting a positive externality (e.g. a subsidy or direct provision) increases under-consumed output towards the social optimum; providing a public good directly addresses the complete non-provision that a free market would otherwise leave; information provision can correct a market failure without the deadweight loss risked by a price-based intervention. Against intervention improving welfare [up to 8, 2 marks each]: government failure can leave the market allocation worse than before, through poor information, administrative cost, or unintended consequences such as black markets; intervention often has opportunity costs (e.g. subsidy spending funded by taxation elsewhere) that are not always visible in the market being corrected; regulatory capture or political pressure can result in intervention that serves producers rather than consumers; the size of the externality is difficult to measure precisely, so intervention may over-correct or under-correct the market failure. Judgement [4]: intervention can improve welfare where the market failure and its remedy are both well understood and correctly sized, but the risk of government failure means intervention does not automatically improve on the market outcome — the case for intervening depends on comparing the specific market failure against the specific risks of the chosen policy tool.

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Where marks are usually lost

• Using a production-externality diagram (MSC above MPC) for a scenario where the externality is on the consumption side (MSB/MPB) or vice versa.
• Unlabelled externality diagrams — an unlabelled diagram earns no diagram marks.
• Confusing adverse selection with moral hazard.
• Claiming a tax on a good with inelastic demand will substantially cut consumption, rather than recognising that it raises revenue precisely because consumption barely changes.
• Omitting government failure from an evaluation of intervention.
• A conclusion with no criterion — “it depends on the size of the externality” is a conclusion; “there are pros and cons” is not.
• Giving only one property of a public good.
• Confusing what a tax fixes (price, leaving quantity uncertain) with what a tradable permit scheme fixes (quantity, leaving price to the market).
• Using a command word (e.g. “describe”, “state”, “distinguish”) that is not one of this specification’s eight command words, or setting a tariff that does not match the mark allocation the specification gives for the command word used.