OxfordAQA A Level Economics: The Operation of Markets — Practice Questions

These are original questions written for Marlbridge, in the style and at the standard of the examination. They are not reproduced past-paper questions — examination boards hold copyright in their own papers. Use these alongside the official past papers available free from your board.

Related: The Operation of Markets revision notes

---

Section A

1. State the law of diminishing marginal utility and explain how it explains a downward-sloping demand curve. [4]

2. Define consumer surplus and producer surplus. [2]

Section B

3. Explain the difference between allocative and productive efficiency, and state the condition for each. [4]

4. Explain, using marginal analysis, why a negative production externality leads to market failure. [6]

5. Evaluate the use of tradable pollution permits compared with a carbon tax as a means of reducing emissions. [12]

6. Explain three reasons why government intervention may itself fail. [6]

Section C

7. Explain why public goods are unlikely to be provided by the free market, using the concepts of non-excludability and non-rivalry. [4]

8. Distinguish between merit goods and demerit goods, giving one example of each and explaining the market failure involved. [4]

9. A government imposes a specific tax of $3 per unit on a good with PED = −0.2. Explain the effect of this tax on (a) the price paid by consumers, (b) tax revenue, and (c) the achievement of the government’s welfare objective. [6]

10. Explain how the immobility of factors of production can lead to market failure. [4]

---

Answers

1. As successive units of a good are consumed, the additional satisfaction from each extra unit falls [1] [1]. Since a consumer is only willing to pay an amount reflecting the utility they gain, they will only buy an additional unit if the price is lower [1], so quantity demanded rises as price falls — a downward-sloping demand curve [1].

2. Consumer surplus — the difference between what consumers are willing to pay and what they actually pay [1]. Producer surplus — the difference between the price producers receive and the minimum they would have accepted [1].

3. Allocative efficiency occurs where resources are allocated to produce the combination of goods consumers most value; the condition is price = marginal cost [1] [1]. Productive efficiency occurs where output is produced at the lowest possible average cost; the condition is production at the minimum point of the average cost curve, and on the production possibility frontier [1] [1].

4. A negative production externality means the marginal social cost exceeds the marginal private cost by the value of the external cost [1] [1]. The firm makes its decisions on the basis of private costs only, so it produces where MPC = MPB [1]. The socially optimal output is where MSC = MSB, which is at a lower quantity [1]. The market therefore overproduces, and the difference between MSC and MSB over the excess units is the deadweight welfare loss [1] [1].

5. Tradable permits — for: the regulator sets a cap on total emissions, so the environmental outcome is certain [1]; firms that can cut emissions cheaply do so and sell their surplus permits, so the reduction is achieved at the lowest total cost to society [1]; the permit price gives a continuing incentive to invest in clean technology [1]. Against: setting the cap correctly is very difficult, and an over-generous cap makes permits nearly worthless — as happened in early emissions schemes [1]; the scheme has high administrative and monitoring costs and is only practical for large, measurable emitters [1]; a volatile permit price makes long-term investment planning hard [1]. Carbon tax — for: it gives a predictable, stable price for carbon, which aids investment planning [1]; it is simpler and cheaper to administer through existing tax systems and can cover many small emitters [1]; it raises revenue that can fund green investment or offset other taxes [1]. Against: the quantity of emissions reduced is uncertain, since it depends on elasticity [1]; setting the tax at the correct level requires knowing the external cost, which cannot be measured precisely [1]; it is regressive and may cause carbon leakage, with production relocating to untaxed countries [1]. Judgement: permits are preferable where the environmental target is the priority and emitters are few and measurable; a tax is preferable where price stability, administrative simplicity and wide coverage matter more [1] [1]. In practice the two are often combined, and the effectiveness of either depends far more on the stringency of the cap or the level of the tax than on the choice of instrument [1] [1].

6. Any three, 2 marks each: information failure — the government lacks the data to set the tax, subsidy or cap at the right level, so intervention over- or under-corrects [1] [1]; unintended consequences — for example a black market created by a tax, or a minimum price causing surpluses [1] [1]; administrative and enforcement costs may exceed the welfare gain from correcting the failure [1] [1]; regulatory capture or political motives — policy is shaped by lobbying or by the electoral cycle rather than by efficiency [1] [1].

7. Non-excludable — once the good is provided, non-payers cannot be prevented from consuming it, so individuals have an incentive to free ride rather than pay [1] [1]. Non-rival — one person’s consumption does not reduce what is available to others, so there is no price mechanism to ration it [1] [1]. Because free riders will not pay, a private firm has no profit incentive to supply the good, so the free market provides none at all — a public good must therefore usually be state-provided.

8. Merit goods generate a positive externality and are under-consumed relative to the social optimum, because consumers underestimate the benefit to themselves (information failure), e.g. education or healthcare [1] [1]. Demerit goods generate a negative externality, and are over-consumed because consumers underestimate the harm, e.g. tobacco or alcohol [1] [1].

9. (a) Because demand is inelastic (PED = −0.2), the leftward shift in supply from the tax causes quantity to fall only slightly, so most of the tax is passed to consumers as a higher price [1] [1]. (b) Because quantity barely changes, tax revenue is large and predictable [1] [1]. (c) The government’s welfare objective — reducing consumption of the good — is largely missed, since consumption is close to unchanged; the tax is effective at raising revenue but poor at changing behaviour, and is also regressive, taking a larger share of the income of poorer households [1] [1].

10. Geographical immobility — workers cannot easily move between regions, due to the cost of moving, family ties or regional differences in the cost of housing [1] [1]. Occupational immobility — workers made redundant in a declining industry often lack the skills required by expanding industries and cannot retrain quickly enough [1] [1]. Together these mean that workers displaced in one industry or region cannot move to where vacancies exist, so structural and regional unemployment persist even when jobs are available elsewhere — a misallocation of labour that the free market does not correct on its own [1] [1].

---

Where marks are usually lost

• Confusing allocative with productive efficiency.
• Not identifying the divergence between MPC and MSC explicitly.
• Evaluating permits and tax separately without a comparative judgement.
• Assuming government intervention always improves welfare.