OxfordAQA IGCSE Economics: How Markets Work — Revision Notes

Condensed for the final weeks. For the full explanation, use the How Markets Work study guide.

The economic problem

Wants are unlimited; resources are scarce. Therefore choices must be made, and every choice has an opportunity cost — the next best alternative forgone.

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

Demand

Demand slopes downward: as price falls, quantity demanded rises, because consumers’ real income goes further and the good becomes cheaper relative to substitutes.

The distinction that decides most marks:

• A change in the good’s own price → movement along the curve (extension or contraction).
• A change in anything else → shift of the whole curve.

Conditions of demand (causes of a shift): income, price of substitutes, price of complements, tastes and fashion, population, advertising, expectations.

For a normal good demand rises with income; for an inferior good it falls.

Supply

Supply slopes upward: higher prices make production more profitable, so firms supply more.

Conditions of supply: production costs, technology, indirect taxes, subsidies, the number of firms, and weather for agricultural products.

A subsidy shifts supply right; an indirect tax shifts supply left.

Equilibrium

Where demand meets supply. At a price above equilibrium there is excess supply (surplus), so price falls; below it there is excess demand (shortage), so price rises.

When answering “explain the effect of X on price and quantity”, always work in four steps: identify which curve moves, state which direction, describe the new equilibrium, and give the effect on both price and quantity. Answering only about price loses half the marks.

Elasticity

PED = %change in quantity demanded / %change in price
PES = %change in quantity supplied / %change in price
YED = %change in quantity demanded / %change in income

PED value	Meaning	Raising price will
> 1 (elastic)	Quantity is very responsive	Reduce total revenue
< 1 (inelastic)	Quantity barely responds	Increase total revenue
= 1 (unitary)	Proportional	Leave revenue unchanged

Determinants of PED: availability of substitutes (the most important), whether the good is a necessity or a luxury, the proportion of income spent on it, whether it is habit-forming, and the time period considered.

This is why taxes on cigarettes and fuel raise so much revenue: demand is inelastic, so consumption barely falls and the tax burden is passed almost entirely to consumers. It is also why such taxes are poor at changing behaviour — the same fact seen from the other side.

Determinants of PES: availability of stock, spare capacity, ease of switching production, and time. Supply is more elastic in the long run because firms can expand capacity.

Competition and monopoly

Competition benefits consumers in several ways: it tends to give lower prices, since firms must match rivals or lose customers; better quality and more choice, as firms differentiate to attract buyers; innovation, as firms invest in new products and processes to gain an edge; and greater efficiency, since firms must cut costs to survive. It also has costs — duplication and wasted resources, as competing firms each build their own networks or advertise heavily at a cost ultimately passed to consumers, and a possible loss of economies of scale, since several small firms may each face higher unit costs than one large one would.

A monopoly — a single dominant firm — can restrict output and charge a higher price than would prevail under competition, so consumers pay more and consume less. With no competitive pressure it may also let quality fall and become slow to innovate, since it retains customers regardless. Governments can regulate a monopoly by setting a maximum price or price cap, by using competition law to prevent mergers or break up the firm, or by opening the market to competition by removing barriers to entry.

Market failure

Failure	Consequence
Negative externality	Third parties bear costs — the good is over-produced
Positive externality	Third parties gain benefits — the good is under-produced
Public goods	Non-excludable and non-rival — free riding means the market provides none
Merit goods	Under-consumed because benefits are underestimated
Demerit goods	Over-consumed because harms are underestimated
Monopoly	Higher prices, lower output, less choice

A public good needs both properties. Street lighting and national defence are the examples to use; healthcare and education are merit goods, not public goods, because they can be, and are, provided privately.

Government intervention: indirect taxes, subsidies, regulation, state provision, minimum and maximum prices, and information campaigns.

• A maximum price set below equilibrium causes excess demand, shortages, queues and black markets.
• A minimum price set above equilibrium causes excess supply, a surplus the government may have to buy.

Both need to be drawn on a diagram to score fully — and both must be set on the correct side of equilibrium to have any effect at all.

Exam traps

• Treating a price change as a shift of the demand curve.
• Calling money a factor of production.
• Answering only about price when both price and quantity are asked for.
• Giving one property of a public good.
• Confusing merit goods with public goods.
• Drawing a maximum price above equilibrium, where it has no effect.
• Saying an inelastic tax is effective at reducing consumption.

Self-test

1. What causes a movement along the demand curve, and what causes a shift?
2. If PED = 0.4, what happens to total revenue when price rises?
3. Give the most important determinant of PED.
4. Both properties of a public good?
5. What happens when a maximum price is set below equilibrium?

Answers: 1. A change in the good’s own price causes a movement along; a change in any other condition of demand causes a shift. 2. Demand is inelastic, so quantity falls proportionally less than price rises and total revenue increases. 3. The availability of close substitutes. 4. Non-excludable and non-rival. 5. Quantity demanded exceeds quantity supplied, producing excess demand — shortages, queues and potentially a black market.