AQA A-level Economics: The price mechanism and the meaning of market failure (7136) – Revision Notes

These notes condense the How markets and prices allocate resources and The meaning of market failure sub-sections of AQA A-level Economics (7136), from the AQA specification version 1.3 (29 June 2022). The AQA website numbers them 3.1.8.1 and 3.1.8.2; the combined PDF prints 4.1.8.1 and 4.1.8.2. The specification states no AS-only or A-level-only labels for this content. The study guide has the full explanations. For testing, use the practice set, the course hub, the checklist and the free diagnostics. Related page: Individuals, firms, markets and market failure. All numbers here are invented.

Key definitions

Term	Meaning
Price mechanism	Prices, set by demand and supply, coordinating decisions in a market economy
Rationing function	Price limits demand to the available supply
Incentive function	Price and profit changes reward a change in behaviour
Signalling function	Price changes carry information to buyers and sellers
Impersonal allocation	Allocation by willingness and ability to pay, regardless of identity or need
Market failure	A market leads to a misallocation of resources
Complete failure	A missing market: it does not exist
Partial failure	The market exists but misallocates

The three functions: a chain to write

1. Demand rises, so there is a shortage at the old price.
2. Price rises, which signals scarcity to everyone.
3. Higher price rations: some buyers drop out.
4. Higher price and profit incentivise more supply and new entry.
5. A new equilibrium forms at a higher price and quantity.

Reverse every step for a fall in demand.

Method for equilibrium shifts. Set Qd = Qs, solve for P, then substitute for Q. Test the old price in the new equations to find the shortage or surplus.

Worked reminder. Qd = 500 − 20P and Qs = 30P − 100. Then 50P = 600, so P = 12 and Q = 260. Demand falls to Qd = 440 − 20P: 50P = 540, so P = 10.80 (a 10% fall) and Q = 224. At the old price of 12, Qd = 200 and Qs = 260, so the surplus is 60.

What, how and for whom

Question	Market answer
What	Goods with rising prices and profits attract resources
How	Firms pick the lowest-cost method at current input prices
For whom	Those with willingness and ability to pay

Advantages and disadvantages

Advantages	Disadvantages
No central planner or information overload	Ignores need when income is unequal
Profit rewards efficiency and innovation	External costs and benefits ignored
Consumer sovereignty	Public goods not provided
Low administration cost	Monopoly power
Fast response to change	Merit and demerit goods mispriced

Evaluating “the price mechanism is impersonal”

• Supports the view: buyers are treated alike; no favouritism; a price is quick to apply.
• Challenges the view: allocation tracks income; a high price may reflect wealth, not need; markets still involve firms with power over price.
• Judgement: matters most for necessities with no substitutes and where income differences are large.

Describing the diagram in words

In a demand and supply diagram, the vertical axis shows price and the horizontal axis shows quantity. The market settles at the point where the demand curve (sloping down) meets the supply curve (sloping up). Mark that point and read off its price and quantity.

Event	Shift	At the old price	Price then
Demand rises	Demand curve moves right	Shortage (Qd above Qs)	Rises
Demand falls	Demand curve moves left	Surplus (Qs above Qd)	Falls
Supply rises	Supply curve moves right	Surplus	Falls
Supply falls	Supply curve moves left	Shortage	Rises

After a shift, movements along the other curve do the rationing (along demand) and the incentive work (along supply). That is the link between the diagram and the three functions.

Worked reminder (both sides moving). Take the market with Qd = 500 − 20P and Qs = 30P − 100 again. Suppose supply rises by 50 at every price: Qs = 30P − 50. Then 500 − 20P = 30P − 50, so 50P = 550, P = 11 and Q = 280. Price falls from 12 to 11 and quantity rises from 260 to 280. At the old price of 12, Qs = 310 and Qd = 260, a surplus of 50.

Extending markets into new areas

• Possible gains: more supply, shorter queues, price information.
• Possible costs: payment can crowd out duty or altruism, change what the activity means, attract buyers or sellers with hidden information, and exclude those on low incomes.
• Blood example: a payment may raise the quantity offered but alter donor motives and quality; compare cost per usable unit, not just units collected.
• Judgement: depends on how far the activity is valued for its own sake, how safe the product is and whether quality can be checked.

Causes of market failure, with examples

Cause	Failure	Complete or partial	Example
Public goods	No market; free riding	Complete	Flood defences
Negative externality	Overproduction	Partial	Traffic congestion
Positive externality	Underproduction	Partial	Training workers
Merit goods	Under-consumption	Partial	Health checks
Demerit goods	Over-consumption	Partial	Alcohol
Monopoly, imperfections	Price above cost, immobile factors, information gaps	Partial	A single supplier
Inequality	Distribution follows income	Partial	Unaffordable essentials

A numerical reminder of a missing market: three households would pay £25, £18 and £12 for a service costing £40. Total willingness to pay is 25 + 18 + 12 = £55. Net benefit is 55 − 40 = £15, but free riding stops a market forming.

A reminder of partial failure: marginal private benefit 50 − 0.2Q, marginal private cost 10 + 0.2Q. Market output: 40 = 0.4Q, so Q = 100. With an external cost of £8, marginal social cost is 18 + 0.2Q: 32 = 0.4Q, so Q = 80. The market overproduces by 20, and the welfare loss is ½ × 8 × 20 = £80.

Building a judgement

A good judgement names the condition on which the conclusion depends. Use this order in an extended answer.

1. State the claim in the question in your own words.
2. Give one or two points in support, each as a chain of cause and effect.
3. Give one or two points against, also as chains.
4. Weigh them: which matters more, for whom, in the short or long run?
5. Finish with a conclusion that says “it depends on” a named factor, then commits to the more likely case.

Conditions worth naming. How large the income gap is. Whether the good is a necessity with no close substitute. How big the third-party effects are. Whether information about quality is easy to check. Whether the government can cheaply support those on low incomes. Whether people value the activity for its own sake, as with giving.

Linking the two sub-sections. The first half of the topic explains how markets succeed. The second half asks when they fail. A strong answer uses the same language in both: a market fails when price signals do not reflect full costs and benefits, when no price exists, or when the result is judged unacceptable because of who can pay.

Quick self-test

1. Name the three functions of price.
2. Qd = 500 − 20P and Qs = 30P − 100. Find equilibrium.
3. Demand falls to Qd = 440 − 20P. Find the surplus at the old price.
4. A cost of £12 for a service is paid by two households with monthly incomes of £2,400 and £800. Express each as a percentage of income.
5. State the difference between complete and partial market failure.
6. Why can a private firm not sell a pure public good easily?
7. Give one reason a market for a donated product might reduce supply.
8. Is monopoly a partial or a complete failure? Explain.
9. Name the cause of market failure when allocation follows income rather than need.
10. Willingness to pay of £25, £18 and £12 and a cost of £40: find the net benefit.

Answers

1. Rationing, incentive and signalling.
2. P = £12, Q = 260.
3. The surplus is 60 (Qd = 200, Qs = 260 at £12).
4. 12 ÷ 2,400 = 0.5%; 12 ÷ 800 = 1.5%.
5. Complete: no market exists. Partial: a market exists but misallocates.
6. People cannot be excluded, so many will free ride and revenue cannot be collected.
7. Payment may crowd out intrinsic motives such as duty.
8. Partial: the market exists, but price is above marginal cost and output is too low.
9. Inequality in the distribution of income and wealth.
10. £55 − £40 = £15.

Where marks are usually lost

• Describing a price change without naming the function it performs.
• Forgetting to test the old price when asked for a shortage or surplus.
• Treating “impersonal” as only good or only bad.
• Calling every unfair outcome market failure without showing misallocation.
• Using “no market” and “small market” as if they meant the same thing.
• Writing about the blood example from opinion rather than incentives and nature of the activity.
• Giving causes of market failure with no example.
• Dropping the units from a welfare-loss answer.

Official syllabus

AQA, AS and A-level Economics (7135 and 7136), specification version 1.3, 29 June 2022, sections 4.1.8.1 and 4.1.8.2 as printed in the combined PDF; for first teaching from September 2015.