A Level Economics: Markets in Action — Revision Notes

Condensed for the final weeks. For the full explanation, use the Markets in Action study guide.

Demand, supply and equilibrium

Movement along the curve is caused by a change in the good’s own price; a shift is caused by anything else.

Conditions of demand: income, price of substitutes and complements, tastes, population, expectations, advertising. Conditions of supply: costs, technology, taxes, subsidies, number of firms, weather.

Consumer surplus — the difference between what consumers are willing to pay and what they actually pay. Producer surplus — the difference between the price received and the minimum acceptable price.

Total surplus (consumer + producer) falls when a market moves away from equilibrium — this fall is the welfare loss measured on a diagram. The two components need not move together: a binding maximum price raises consumer surplus at producers’ expense; a binding minimum price raises producer surplus at consumers’ expense; a subsidy raises both.

Elasticity

PED = %change in Qd / %change in P        PES = %change in Qs / %change in P
YED = %change in Qd / %change in income   XED = %change in Qd of A / %change in P of B

Value	Interpretation
PED inelastic (<1)	Raising price raises total revenue
PED elastic (>1)	Raising price lowers total revenue
YED negative	Inferior good
XED positive	Substitutes
XED negative	Complements

Tax incidence follows elasticity, and this is the single most useful application: the more inelastic side of the market bears more of the tax. Where demand is inelastic and supply elastic, consumers pay most of it.

Market failure

Failure	Mechanism
Negative externality in production	MSC > MPC — over-produced
Negative externality in consumption	MSB < MPB — over-consumed
Positive externality in consumption	MSB > MPB — under-consumed
Public goods	Non-excludable, non-rival — free riding means zero private provision
Imperfect market information	Asymmetric information — the better-informed party exploits the other
Moral hazard	Behaviour becomes more risky once a party is insured or otherwise protected from the consequences
Speculation and market bubbles	Buying based on expected future price rises inflates asset prices above fundamental value, until the bubble bursts and prices collapse

Externality diagrams are where the marks are. Label the private and social curves, mark the market outcome and the socially optimum outcome, and shade the welfare loss triangle between them. An unlabelled diagram is much weaker evidence of diagram technique, even when the surrounding explanation is correct.

Asymmetric information produces two distinct problems worth naming: adverse selection (the wrong people select in — the used-car and insurance cases) and moral hazard (behaviour changes once insured).

Government intervention

Policy	Strength	Weakness
Indirect tax	Internalises the externality; raises revenue	Optimal rate hard to set; inelastic demand means little behaviour change; regressive
Subsidy	Corrects positive externalities	Opportunity cost; may encourage inefficiency
Regulation	Direct, enforceable	Monitoring costs; can create black markets
Tradable permits	Market finds the cheapest abatement	The cap must be set correctly
Minimum/maximum price	Protects producers or consumers	Creates surpluses or shortages
State provision	Guarantees public and merit goods	Risk of inefficiency without a profit motive

Government failure — intervention producing a worse outcome than the market: information gaps, administrative costs, unintended consequences (black markets, smuggling), and regulatory capture. A strong evaluation of intervention usually raises it.

The tax paradox is worth stating explicitly: a tax on a demerit good with inelastic demand raises large, stable revenue and barely reduces consumption. Those are not contradictory findings — they are the same fact viewed from two ends, and combining the tax with education (which shifts demand left and makes it more elastic over time) is the standard evaluated recommendation.

Reasons consumers may not maximise utility

Traditional theory assumes rational utility-maximising agents with full information. This specification names six reasons consumers may not act this way:

• The influence of other people’s behaviour (herding) — following what others do rather than independently weighing costs and benefits.
• Habitual behaviour — repeating past choices out of habit rather than re-evaluating each time.
• Inertia — sticking with the status quo rather than switching, even when switching would be beneficial.
• Poor computational skills — difficulty processing the information needed to make a fully rational decision.
• The need to feel valued — a preference for being treated well by a seller, distinct from the good’s price or quality.
• Framing and bias — decisions are influenced by how choices are presented, not just their objective content.

Evaluation: each of these weakens the assumption of rational utility maximisation that underlies conventional demand theory, and is used to explain apparently irrational consumer behaviour in exam scenarios.

Exam traps

• Treating a price change as a shift.
• Drawing an externality diagram without labelling MPC, MSC or the welfare loss.
• Omitting government failure from an evaluation of intervention.
• Confusing adverse selection with moral hazard.
• Claiming a tax on an inelastic demerit good will substantially reduce consumption.
• Importing nudge theory, choice architecture or default effects — this specification’s reasons for not maximising utility are herding, habitual behaviour, inertia, poor computational skills, the need to feel valued, and framing and bias.
• Claiming both consumer and producer surplus always shrink together when a market moves away from equilibrium — only total surplus necessarily falls.
• Concluding without a criterion — “it depends on the size of the externality” is a conclusion; “there are pros and cons” is not.

Self-test

1. Who bears more of an indirect tax, and what determines it?
2. Give both defining properties of a public good.
3. Explain the difference between adverse selection and moral hazard.
4. Why can a tax on a demerit good raise large revenue yet change little behaviour?
5. Name three reasons, other than imperfect information, why a consumer may not maximise utility.

Answers: 1. The more inelastic side of the market; if demand is inelastic relative to supply, consumers bear most of it. 2. Non-excludable and non-rival. 3. Adverse selection occurs before the transaction — the worse risks are the ones who select in; moral hazard occurs after — behaviour becomes riskier once covered. 4. Demand is inelastic, so quantity barely falls while the tax is collected on nearly the same volume; the two results are the same fact seen from opposite ends. 5. Any three of: herding (the influence of other people’s behaviour), habitual behaviour, inertia, poor computational skills, the need to feel valued, and framing and bias.