IB DP Economics: The market and equity (HL) – Study Guide

This guide covers sub-topic 2.12, the market’s inability to achieve equity, which is HL only. It follows the IB Diploma Programme Economics guide (first assessment 2022, published February 2020), the course examined from the 2022 session onwards. SL candidates do not study it. For the full course map see the IB DP Economics hub, and tick off what you know on the printable checklist. Pair this guide with the revision notes and the practice set. To find your weak spots first, take one of the free 10-minute diagnostics.

What the guide asks for

The content for 2.12 is short, so the skill is depth. The guide lists one statement and one diagram.

Syllabus item	What you must be able to do	Level
The workings of a free market economy may result in an unequal distribution of income and wealth	Explain how and why market forces leave some households with far more income and wealth than others	HL only
Diagram: the circular flow model	Draw and label it to show why the free market produces inequalities	HL only

The guide sets the depth of teaching at AO2, which means application and analysis. It lists no calculation for this sub-topic. The worked examples below use simple arithmetic only to make the ideas concrete, and every figure is invented.

How the content is examined, as printed in the guide: HL candidates sit three papers, and each includes HL-only material. Paper 1 (1 hour 15 minutes) is an extended response paper with no calculators. Paper 2 (1 hour 45 minutes) is a data response paper. Paper 3 (1 hour 45 minutes) is a policy paper. Calculators are allowed in Papers 2 and 3. For a topic taught at AO2 depth, the guide says questions may use command terms from AO2 or the lower AO1 level, such as explain, analyse, outline and distinguish. It also expects correctly labelled diagrams where appropriate.

Four terms to fix first

• Income is a flow: what a household earns over a period, such as a year. It comes from selling factors of production.
• Wealth is a stock: the value of what a household owns at a point in time, such as savings, property and shares.
• Equality means shares that are the same size. Equity means fairness, which is a judgement. A very unequal outcome may or may not be thought inequitable, but this sub-topic asks you to explain how the market produces the unequal outcome.
• A free market economy is one where prices and quantities are set by buyers and sellers, with no government taking part.

The circular flow model, drawn for this question

The guide wants the circular flow model used to show why inequalities arise. A plain household and firm loop is enough. Name the two markets, the four flows and the four factor incomes.

        Spending on goods and services (consumer expenditure)
     +--------------------------------------------------------+
     |                    PRODUCT MARKET                      |
     |  Goods and services                                    |
     |  <-----------------------------------------------+    |
     v                                                   |    |
+-----------+                                      +-----------+
|   FIRMS   |                                      | HOUSEHOLDS|
+-----------+                                      +-----------+
     ^                                                   |    |
     |  Factor services: labour, land, capital,          |    |
     |  enterprise  ------------------------------------>+    |
     |                    FACTOR MARKET                       |
     +--------------------------------------------------------+
        Factor incomes: wages, rent, interest, profit

Read it in two steps. The households own the factors of production and sell their services to firms in the factor market. Firms pay factor incomes back. Households then spend that income in the product market, which gives firms their revenue.

The inequality is created at the factor market. The size of each household’s income depends on two things: how many units of each factor it owns, and the price those factors fetch. Both differ widely across households, and nothing inside the loop evens them out.

Why the free market results in unequal income

1. Households own different factors. Most households own only their labour. Some own land, capital or a business as well. Rent, interest and profit go to the owners, so a household with several factors has several streams of income.

2. Factor prices are set by demand and supply. Each factor has its own market. Where a type of labour is scarce and strongly demanded, its price is high. Where many people offer similar labour and demand is weaker, the price is low. The market pays for what is scarce and wanted, not for what is needed.

3. Skills and training are unequally spread. Scarce, highly paid labour often takes years of training. A household with little income and no savings may find it hard to fund that. The result is that low incomes tend to keep the supply of scarce skills small, which keeps their price high.

4. Wealth earns income, and income builds wealth. A household with capital receives interest or profit without selling more labour. If it saves part of that income, its wealth grows and so does next year’s income. A household with no assets cannot do this.

5. The market has no rule that reflects need. Households with no factors to sell, or only low-priced ones, receive little. There is no step in the loop that tops up their income. Wealth can also pass between generations, so starting positions differ before anyone has entered the market.

Worked example 1: who gets what in Veldmark

Veldmark is an invented free market economy with no government. Total factor income is 1,000 veld a year, shared among ten equal-sized households. All income comes from the four factor payments.

Household	Wages	Interest	Rent	Profit	Total income
H1	25	0	0	0	25
H2	30	0	0	0	30
H3	40	0	0	0	40
H4	50	5	0	0	55
H5	60	10	0	0	70
H6	70	15	5	0	90
H7	80	20	10	0	110
H8	90	25	10	15	140
H9	100	30	15	35	180
H10	110	40	30	80	260
All	655	145	70	130	1,000

Step 1: the shares at each end. The four poorest households (H1 to H4) receive 25 + 30 + 40 + 55 = 150 veld, which is 150 / 1,000 = 15% of income. The two richest (H9 and H10) receive 180 + 260 = 440 veld, which is 44%. H10 alone gets 26%.

Step 2: the gap. H10’s income divided by H1’s is 260 / 25 = 10.4, so the richest household earns about ten times as much.

Step 3: where the gap comes from. Wages total 655 and property income (interest, rent and profit) totals 145 + 70 + 130 = 345, or 34.5% of all income. The three richest households (H8, H9, H10) receive 50 + 80 + 150 = 280 of that 345, which is 81.2%, though they are 30% of households. For H10, 260 - 110 = 150 veld of its income is not wages, which is 57.7%. For H1 it is nothing.

Link to the diagram: the factor-market arrow carries the same total to every group of households, but the contents of each household’s arrow differ. The ones holding capital, land and a business receive more arrows.

Worked example 2: two labour markets

Factor prices come from demand and supply. In Veldmark, the market for basic service workers has demand Qd = 600 - 10w and supply Qs = 20w, where w is the hourly wage in veld and Q is thousands of hours. The market for specialist engineers has Qd = 500 - 2w and Qs = 3w.

Basic service work: set Qd = Qs, so 600 - 10w = 20w, which gives 30w = 600 and w = 20. Then Q = 20 x 20 = 400.

Specialist engineers: 500 - 2w = 3w gives 5w = 500, so w = 100. Then Q = 3 x 100 = 300.

Check: 600 - 10(20) = 400 and 500 - 2(100) = 300, both equal the supply figures.

The specialist wage is 100 / 20 = 5 times the basic wage. On a diagram of each market, the equilibrium wage sits where the demand and supply curves cross. The engineers’ supply curve is steeper and further left because training is long and costly, and demand is strong. Nobody set this gap. It emerged from the two markets.

Worked example 3: wealth builds on itself

Return to Veldmark. Assume capital earns a 5% return a year, that H10 holds wealth of 800 and H4 holds 100 (this fits their interest income of 40 and 5). H10 has 220 of other income each year (wages 110, rent 30, profit 80) and saves 20% of total income. H4 has 50 of other income and saves 10% of total income.

H10, year 1: interest = 0.05 x 800 = 40, income = 220 + 40 = 260, saving = 0.20 x 260 = 52, so wealth at the start of year 2 is 852.

H4, year 1: interest = 0.05 x 100 = 5, income = 50 + 5 = 55, saving = 0.10 x 55 = 5.5, so wealth at the start of year 2 is 105.5.

Continuing the same steps for each year:

Year	H10 income	H10 wealth (start)	H4 income	H4 wealth (start)
1	260.00	800.00	55.00	100.00
2	262.60	852.00	55.27	105.50
3	265.23	904.52	55.55	111.03
4	267.88	957.57	55.83	116.58
5	270.56	1,011.14	56.11	122.17

The income gap widens from 260 - 55 = 205 veld in year 1 to 270.56 - 56.11 = 214.45 veld in year 5. Both households save, yet the one that starts with more gains more in money terms each year. No policy and no wrongdoing is needed for this: the market’s own workings widen the gap.

How to answer an exam question on this

Command terms at AO2 ask you to apply and analyse, so assemble your answer as a chain.

1. Draw the circular flow with both markets labelled and the four factor incomes on the return arrow.
2. State that income depends on the factors owned and their prices.
3. Explain two or three causes from the list above, each linked to the diagram.
4. Include a small example from your own course, with an explanation of what it shows.
5. Keep to explanation. The guide places this sub-topic at AO2 depth, so stay with the workings of the market rather than arguing for a policy response.

Common errors

• Writing about what governments do. A free market diagram has no government, and the point here is the market’s own result.
• Mixing income and wealth. Say which one is a flow and which a stock, and show how one feeds the other.
• Saying the rich “work less hard”. The mechanism is factor ownership and factor prices, so keep the argument economic.
• Drawing the loop without labelling the factor market, or leaving out the four factor incomes.
• Treating “unequal” as the same as “unfair” without saying why. Keep equity as a judgement, and the market result as an explanation.
• Giving figures from memory as if they were fact. Use a clearly labelled example and explain it.

Next steps

Work through the revision notes for a short version, then the practice questions. If you are unsure how this unit fits with demand, supply and equilibrium, read the demand, supply and equilibrium study guide.

Official syllabus

IB Diploma Programme Economics guide, first assessment 2022, published February 2020 by the International Baccalaureate Organization. Sub-topic 2.12, the market’s inability to achieve equity (HL only).