Edexcel IGCSE Economics: The Market System — Revision Notes

Condensed for the final weeks. For the full explanation, use the The Market System study guide.

The economic problem

Scarcity — unlimited wants, limited resources. Every choice therefore carries an opportunity cost: the next best alternative forgone.

Factors of production and rewards: land–rent, labour–wages, capital–interest, enterprise–profit. Capital means machinery and equipment, not money.

Production possibility curves: on the curve means efficient and fully employed; inside means unemployment or inefficiency; outside is unattainable. An outward shift represents economic growth from more or better resources, improved technology, or better education.

Demand and supply

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

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

For an inferior good, demand falls as income rises.

Equilibrium: above it, excess supply pushes price down; below it, excess demand pushes price up.

The four-step answer to “explain the effect of X on this market”: which curve shifts, which direction, the new equilibrium, and the effect on both price and quantity. Answering about price alone forfeits half the marks.

Elasticity

PED = %change in Qd / %change in P
PES = %change in Qs / %change in P
YED = %change in Qd / %change in income

PED	Raising price will
Inelastic (<1)	Increase total revenue
Elastic (>1)	Decrease total revenue

Determinants of PED: availability of substitutes (the most important by far), necessity versus luxury, proportion of income spent, whether it is addictive, and the time period.

Applying the determinants: petrol is inelastic — few close substitutes, and most journeys are necessary. A particular crisp brand is elastic — many close substitutes, so buyers switch readily. Salt is inelastic — a necessity taking a tiny share of income, with no real substitute. Foreign holidays are elastic — a luxury taking a large share of income, and easily postponed or replaced with a domestic trip.

PES is higher when there is spare capacity, available stock, and time to adjust — which is why supply is more elastic in the long run.

The practical application: taxes on cigarettes and fuel raise large revenue precisely because demand is inelastic, so consumption barely falls. The same fact means such taxes are weak at changing behaviour.

Worked example — YED. A 5% rise in income causes an 8% rise in quantity demanded: YED = 8 ÷ 5 = +1.6, a positive value greater than 1, so the good is a luxury (or income-elastic normal good) — demand rises proportionally faster than income. A negative YED indicates an inferior good: as income rises, demand actually falls, because consumers switch to better alternatives they can now afford — value supermarket own-brand products are a typical example.

Market failure

Failure	Result
Negative externality	Third parties bear costs — over-production
Positive externality	Third parties gain benefits — under-production
Public goods	Non-excludable and non-rival — the market provides none
Monopoly power	Restricted output, prices above the competitive level

A public good requires both properties. Street lighting and defence qualify.

Policies to correct externalities: taxation, subsidies, fines, regulation, and pollution permits.

Worked example: PED and the effect on revenue

A rail operator raises fares by 10%, and the quantity of tickets sold falls by 4%.

PED = %change in Qd / %change in P
    = -4 / 10
    = -0.4

Ignoring the sign (as is conventional for PED), the magnitude is 0.4, which is less than 1, so demand is price inelastic. Since demand is inelastic, the percentage rise in price (10%) is larger than the percentage fall in quantity (4%), so total revenue rises following the price increase — this is exactly the inelastic-demand row of the PED/revenue table above, applied to real figures rather than just recalled as a rule.

Worked example: identifying a negative externality

A factory’s production process releases smoke into the air, causing respiratory problems for people living nearby who are not involved in buying or selling the factory’s output.

Externality type:  Negative externality (production)
Who bears it:       Third parties -- the nearby residents -- who are
                    neither the producer nor the consumer of the
                    factory's output.
Market outcome:      Because the factory does not pay for the harm
                    caused to residents, its private cost of
                    production is lower than the true social cost,
                    so the free market produces MORE than the
                    socially optimal quantity -- over-production.
Correction:          Government could impose a tax on the factory
                    (raising its private cost closer to the social
                    cost) or introduce regulation limiting emissions.

This diagnose-the-externality-then-correct structure — naming the type, identifying who bears the cost or benefit, stating the market outcome, then naming a correction — is the reliable way to score full marks on market failure scenario questions, rather than jumping straight to “the government should tax it” without the reasoning in between.

Exam traps

• Treating a price change as a shift.
• Calling money a factor of production.
• Answering only about price when quantity is also required.
• Giving one property of a public good.
• Confusing a positive with a negative externality.
• Naming fewer than the five policies used to correct externalities.

Self-test

1. Define opportunity cost.
2. Give the four steps for answering “explain the effect of X on this market”.
3. If PED = 0.4, what happens to revenue when price rises, and why?
4. Give both properties of a public good.
5. Name the five policies a government can use to correct externalities.

Answers: 1. The next best alternative forgone when a choice is made. 2. Identify which curve shifts, state the direction, describe the new equilibrium, and give the effect on both price and quantity. 3. Revenue rises — demand is inelastic, so quantity falls proportionally less than price rises. 4. Non-excludable and non-rival. 5. Taxation, subsidies, fines, regulation, and pollution permits.