What is market failure?

Market failure happens when the free market allocates resources inefficiently, so total welfare (consumer + producer surplus) is not maximised. The gap between private and social costs/benefits is the key idea AQA wants you to explain, not just define.

Externalities

• A externality is a cost or benefit falling on a third party not involved in the transaction.
• Negative production externality (e.g. factory pollution): marginal social cost (MSC) exceeds marginal private cost (MPC), output is overproduced past the social optimum.
• Negative consumption externality (e.g. smoking, passive smoking): marginal social benefit (MSB) is below marginal private benefit (MPB).
• Positive externality (e.g. education, vaccinations): MSB exceeds MPB, the good is underconsumed relative to the social optimum.
• On a diagram, the welfare loss triangle sits between the private and social equilibrium output levels.

Public goods and the free rider problem

• Pure public goods have two defining features: non-excludable (cannot stop people using it once provided) and non-rivalrous (one person's use does not reduce availability for another).
• Because of this, the free rider problem means private firms will not supply them profitably, so the market fails completely (missing market) — think street lighting, national defence, flood defences.
• Quasi-public goods (e.g. toll roads, satellite TV) only partly meet these criteria.

Information gaps

• Occurs when buyers or sellers lack the information needed to make a fully informed decision, leading to under- or over-consumption, e.g. second-hand cars (adverse selection), private pensions, cigarettes before health warnings.

Government intervention

• Indirect taxes shift MPC up to meet MSC for negative externalities (e.g. UK Soft Drinks Industry Levy, fuel duty).
• Subsidies lower MPC to encourage positive externality goods (e.g. renewable energy, public transport).
• Regulation and legislation sets minimum standards or bans (e.g. smoking ban, emissions limits).
• Tradable pollution permits (e.g. UK ETS) cap total pollution and let firms trade allowances.
• State provision directly supplies public/merit goods (NHS, state schools).
• Provision of information corrects information gaps (health warnings, energy labels).

Government failure

• Government intervention can make things worse: policies can be poorly informed, have unintended consequences, involve regulatory capture, or shift costs elsewhere. Always evaluate — mention government failure to reach top mark bands.

Common mistakes

• Confusing merit/demerit goods (information-gap driven, judged by society) with public goods (defined by non-rivalry/non-excludability).
• Forgetting to distinguish MPC/MSC from MPB/MSB on diagrams — label axes and curves precisely.
• Not evaluating: always weigh intervention against government failure and time lags.

Demand

Demand is the quantity of a good consumers are willing and able to buy at a given price over a given time. The law of demand says quantity demanded falls as price rises, all else equal (ceteris paribus), giving a downward-sloping demand curve.

Non-price determinants that shift the whole curve: income, tastes, price of substitutes and complements, population, expectations of future price, advertising, interest rates (credit). A movement ALONG the curve is caused only by a change in the good's own price; a shift is caused by anything else.

Supply

Supply is the quantity producers are willing and able to sell at a given price. The law of supply says quantity supplied rises as price rises, giving an upward-sloping curve. Non-price shifters: costs of production, technology, indirect taxes and subsidies, number of firms, price of other goods (joint/competitive supply), weather (for agriculture), expectations.

Equilibrium

Market equilibrium is where quantity demanded equals quantity supplied (Qd=Qs), setting the equilibrium price and quantity. Excess demand (shortage) pushes price up; excess supply (surplus) pushes price down until equilibrium restores. Consumer and producer surplus are maximised at equilibrium (allocative efficiency), which is why AQA loves diagrams showing shifts and resulting surplus/shortage.

Elasticity

Price elasticity of demand (PED) = %change in Qd / %change in price. If PED > 1 demand is elastic; PED < 1 is inelastic; PED = 1 is unitary; PED = 0 is perfectly inelastic (vertical); PED = infinity is perfectly elastic (horizontal). PED is usually negative (inverse law) but AQA often quotes the magnitude only, so state whether you mean signed or absolute.

Key determinants of PED: availability of substitutes, proportion of income spent, necessity vs luxury, addictiveness, time period (elasticity rises over time as consumers adjust).

Income elasticity of demand (YED) = %change in Qd / %change in income. YED > 0 = normal good; YED < 0 = inferior good; YED > 1 = luxury/superior good.

Cross elasticity of demand (XED) = %change in Qd of good A / %change in price of good B. Positive XED = substitutes; negative XED = complements; the bigger the number (ignoring sign), the stronger the relationship.

Price elasticity of supply (PES) = %change in Qs / %change in price. Always positive because of the law of supply. PES depends on spare capacity, stock levels, time to increase production, and ease of factor mobility.

Common mistakes

• Confusing a shift in the curve with a movement along it.
• Forgetting elasticity changes along a straight-line demand curve (it is NOT constant).
• Writing 'demand increases' when price falls — that is a movement, not a shift; only say 'demand increases' for a rightward shift caused by a non-price factor.
• Not labelling axes (price on y-axis, quantity on x-axis) and not showing the shift direction with an arrow in diagrams.

Costs: short run vs long run

In the short run at least one factor (usually capital) is fixed, so firms face fixed costs (FC) and variable costs (VC). Total cost (TC) = FC + VC. Average cost (AC) = TC/output. Marginal cost (MC) is the cost of producing one more unit.

• Short-run MC first falls then rises due to the law of diminishing marginal returns: as more variable input (labour) is added to fixed capital, output per worker eventually falls.
• MC always cuts AC and average variable cost (AVC) at their lowest points — a key diagram rule examiners check.
• In the long run all factors are variable, so there are no fixed costs; firms can change scale entirely.

Economies and diseconomies of scale

Long-run average cost (LRAC) falls as output rises due to internal economies of scale: purchasing (bulk-buy discounts), technical (specialist machinery), managerial (specialist staff), financial (cheaper borrowing), and risk-bearing.

• Diseconomies of scale raise LRAC at very large output — usually from poor communication and coordination difficulty in oversized firms.
• The minimum efficient scale (MES) is the lowest output at which LRAC stops falling; industries with a high MES relative to market size tend toward oligopoly.

Revenue

• Total revenue (TR) = price × quantity.
• Average revenue (AR) = TR/Q = price (AR curve is the same as the demand curve).
• Marginal revenue (MR) = change in TR from one more unit sold.
• Under perfect competition AR = MR (horizontal, firm is a price taker). Under imperfect competition (monopoly, oligopoly, monopolistic competition) the demand curve slopes down, so MR falls twice as fast as AR — a common exam trip-up.

Profit maximisation and market structures

Firms maximise profit where MC = MR. The four market structures on the spec: perfect competition (many firms, homogeneous product, free entry/exit, perfect information), monopolistic competition (many firms, differentiated product, low barriers), oligopoly (few firms dominate, interdependent pricing, high barriers), and monopoly (one firm, high barriers, price maker).

Common mistakes

• Confusing AC and MC curve shapes — MC is U-shaped and always crosses AC/AVC at their minimum.
• Forgetting that in perfect competition supernormal profit attracts new entrants, shifting supply until only normal profit remains long run.
• Mixing up AR/MR gradients for a downward-sloping demand curve — MR falls at twice the slope of AR/demand.
• Treating economies of scale as automatic — beyond MES, diseconomies can push LRAC back up.

What is national income?

National income measures the total value of goods and services produced in an economy over a year. The main measure is Gross Domestic Product (GDP) - the value of output produced within a country's borders. Real GDP adjusts for inflation, so it shows changes in the actual volume of output, not just price rises. GDP per capita divides GDP by population, giving a better sense of living standards than GDP alone.

Economic growth

Economic growth is the percentage increase in real GDP over time. Actual growth is a rise in real output; potential growth is a rise in the economy's productive capacity, shown by an outward shift of the Production Possibility Frontier (PPF) or Long-Run Aggregate Supply (LRAS) curve. The economic cycle (or trade cycle) shows GDP fluctuating around its long-run trend, moving through boom, downturn, recession and recovery. A recession is technically defined in the UK as two consecutive quarters of negative real GDP growth.

Aggregate Demand (AD)

AD is total planned spending on goods and services in an economy at a given price level. The formula is AD = C + I + G + (X - M), where C is consumer spending (around 60-65% of UK GDP, the largest component), I is investment by firms, G is government spending, X is exports and M is imports. The AD curve slopes downward because of the real balance effect, the interest rate effect, and the international trade effect.

Aggregate Supply (AS)

AS shows the total output firms are willing to supply at each price level. Short-run AS (SRAS) slopes upward - higher prices raise profits so firms produce more. Long-run AS (LRAS) depends on the economy's productive capacity (labour, capital, land, enterprise, technology), not price level. Classical economists draw LRAS as vertical at full employment output; Keynesians draw it with a horizontal section (spare capacity), an upward-sloping section, then vertical at full capacity.

Equilibrium and shifts

Macroeconomic equilibrium occurs where AD meets AS, determining the price level and real output. A rightward shift of AD (e.g. tax cuts, lower interest rates, rising confidence, weaker pound boosting exports) raises output and price level. A rightward shift of LRAS (e.g. investment, innovation, improved education, immigration of workers) raises potential output without raising prices - genuine economic growth.

Common mistakes

• Confusing a shift of AD with a movement along AD when the price level changes.
• Forgetting M is subtracted in the AD formula, not added.
• Mixing up SRAS shifts (costs of production, e.g. oil price) with LRAS shifts (productive capacity).
• Saying growth and a rise in living standards are the same - GDP per capita and distribution matter too.

What macro policy is trying to do

Governments juggle four main objectives: low unemployment, low and stable inflation (the Bank of England targets 2% CPI, with a 1% tolerance band either side), sustainable economic growth, and a healthy balance of payments on the current account. These can conflict, so policy is a constant trade-off exercise.

Monetary policy

Run by the Bank of England's Monetary Policy Committee (MPC), which meets roughly every six weeks and votes on Bank Rate. Raising Bank Rate raises the cost of borrowing, cools consumer spending and investment, and should bring inflation down; cutting it does the opposite. Quantitative easing (QE) is the unconventional tool: the Bank creates new money electronically to buy government bonds (gilts), pushing down long-term interest rates and boosting the money supply when Bank Rate is already near zero. Quantitative tightening (QT) reverses this by selling bonds back.

Fiscal policy

Controlled by the Treasury via the Chancellor's Budget. Expansionary fiscal policy means higher government spending and/or lower taxes to boost aggregate demand, usually financed by borrowing (widening the budget deficit). Contractionary (or 'austerity') fiscal policy cuts spending or raises taxes to reduce a deficit. The UK's fiscal rules (as set by the Chancellor) typically require the current budget to balance or be in surplus within a rolling period, and for debt as a share of GDP to be falling by the final year of the forecast. Automatic stabilisers (like unemployment benefits and progressive income tax) work without any new decisions being made.

Supply-side policy

Aims to shift long-run aggregate supply (LRAS) rightwards, raising the economy's productive potential without triggering inflation. Market-based measures include deregulation, privatisation, cutting income tax to boost work incentives, and reducing trade union power. Interventionist measures include government spending on education, training, infrastructure, and R&D subsidies.

Common mistakes

• Don't confuse fiscal policy (government/Treasury) with monetary policy (Bank of England) — examiners love this trip-up.
• QE is not 'printing physical money' — it's a central bank asset-purchase programme.
• A budget deficit (annual borrowing) is different from the national debt (total accumulated borrowing).
• Supply-side policies work over the long run; monetary and fiscal policy affect demand in the short run.
• Time lags matter: fiscal policy can take months to implement (recognition, decision, and implementation lags); monetary policy changes take around 18-24 months to fully feed through the economy.

Why countries trade

Comparative advantage (Ricardo) says a country should specialise in producing goods where its opportunity cost is lowest, even if another country is better at making everything (absolute advantage). Trade lets both sides consume beyond their own production possibility frontier.

• Assumptions behind the theory: no transport costs, perfect factor mobility, constant returns to scale - all unrealistic, so real-world gains are smaller than the simple model suggests.
• Terms of trade = index of export prices divided by import prices, x100. A rise means a country can buy more imports per unit of exports (usually seen as favourable).

Trade patterns and the WTO

The World Trade Organization (WTO) sets global trade rules and runs a dispute settlement system; it promotes trade liberalisation through rounds of negotiation (the Doha round has stalled since 2001). The UK trades mostly with the EU and under WTO terms with the rest of the world since leaving the EU customs union in 2021.

Protectionism - the tools and their effects

• Tariffs: a tax on imports, raises price to consumers, raises government revenue, creates a welfare loss (deadweight loss triangles).
• Import quotas: a physical limit on quantity imported; raises domestic price without raising government revenue (unless quota licences are auctioned).
• Subsidies to domestic producers: lowers their costs so they can compete with cheaper imports, but costs taxpayers and can breach WTO rules.
• Non-tariff barriers: technical standards, health and safety rules, red tape - harder to measure but very effective at restricting trade.

Arguments FOR protectionism: infant industry protection, protecting jobs, national security (e.g. steel, food), anti-dumping (selling below cost to destroy rivals), correcting a large trade deficit.

Arguments AGAINST: raises prices for consumers, reduces choice, invites retaliation (trade wars), reduces efficiency (loses comparative advantage gains), can prop up inefficient 'zombie' firms indefinitely.

Trading blocs and common mistakes

• Free trade area: members remove tariffs between themselves but set their own external tariffs (e.g. old EFTA).
• Customs union: free trade area plus a common external tariff (the EU is a customs union and single market).
• Common mistake: students confuse a customs union with a single market - a single market also removes non-tariff barriers and allows free movement of labour and capital, not just goods.
• Trade creation (switching from a high-cost domestic producer to a low-cost partner) is welfare-improving; trade diversion (switching from a low-cost non-member to a higher-cost member because of the tariff) is welfare-reducing. Do not mix these up.

Economic development

Development is broader than growth - measured by the Human Development Index (HDI), which combines income (GNI per capita), life expectancy and education, not just GDP. Barriers to development include debt, poor infrastructure, primary product dependency, corruption and civil conflict. Strategies include trade liberalisation, aid, debt relief, FDI, and diversifying away from primary commodities (the Prebisch-Singer hypothesis says primary product prices fall relative to manufactured goods over time).