Edexcel A Level economics

Theme 1
markets and
market failure
Study book

Student Name:
About this study book
The tutor2u Edexcel A Level Economics Study Book provides a comprehensive set of essential
study notes on Theme 1 (Markets and Market Failure) for Edexcel A Level Economics.
We've broken down each section into:
• What you need to know
• Complete, concise notes on each topic
• Exam gold - advice from experienced examiners about common student misconceptions
and what to focus on in your revision
Make this Study Book your own. Highlight key points. Add your own comments and examples
to make the notes invaluable for your exam revision.

CONTENTS
1.1.1 Economics as a social science Page 3
1.1.2 Positive and Normative Statements Page 4
1.1.3 The Economic Problem Page 4
1.1.4 Production Possibility Frontiers Page 7
1.1.5 Specialisation and the Division of Labour Page 10
1.1.6 Free market economies, mixed economy and command economy Page 12

1.2.1 Rational Decision Making Page 17

1.2.2 Demand Page 17
1.2.3 Price, income and cross elasticities of demand Page 20
1.2.4 Supply Page 27
1.2.5 Elasticity of supply Page 30
1.2.6 Price determination Page 31
1.2.7 Price mechanism Page 34
1.2.8 Consumer and producer surplus Page 36
1.2.9 Indirect taxes and subsidies Page 39
1.2.10 Alternative views of consumer behaviour Page 43

1.3.1 Types of market failure Page 46

1.3.2 Externalities Page 47
1.3.3 Public Goods Page 52
1.3.4 Information Gaps Page 55

1.4.1 Government Intervention in Markets Page 58

1.4.2 Government failure Page 68

2 Edexcel A Level Economics Theme 1 Study Book

1.1.1 Economics as a social science
What you need to know

Thinking like an economist: the process of developing models in economics, including the need to make
assumptions
The use of the ceteris paribus assumption in building models
The inability in economics to make scientific experiments

Models in Economics
Economists develop models and theories to help explain the multiple choices we make in our daily lives. These
models are built on assumptions that can help to simplify analysis, and allow us to think about links between one
variable and another. However, many of the assumptions that economists make risk being criticised for not being
sufficiently realistic – the real world is far more complex than most economic models suggest.
What are assumptions?
Assumptions are initial or prior conditions made before a micro or macroeconomic analysis is built. Sometimes
assumptions are used for simplification of a theoretical idea or an economic relationship.
Ceteris paribus assumption
To simplify analysis, economists isolate the relationship between two variables by assuming ceteris paribus – i.e. all
other influencing factors are held constant. For example, “an increase in real income will cause an increase in demand,
ceteris paribus.” Here we keep constant all other factors that might lead to a change in demand for a product.
Other assumptions
Most of the economics that we study is based on a “neo-classical” approach. Neo-classical economists make a number
of key assumptions in their analysis, including:
• people are rational;
• people (e.g. workers, business owners etc) aim to maximise their “utility” i.e. their ‘satisfaction’. For businesses,
this means aiming to maximise their profit;
• people act independently of each other when making their decisions;
• the information needed to make decisions is always accurate and complete.

Exam Tip Try to note down at least one assumption when you are writing analysis points in exam answers.
This then allows you to critique and evaluate your analysis later in your answer by simply questioning the
assumptions that you have made. For example:
“An increase in real income should cause an increase in demand for products, assuming that they are normal
goods and have a positive income elasticity of demand. However, some goods and services are classified as
inferior goods and have a negative income elasticity of demand, so demand for them will fall when income
rises.”

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1.1.2 Positive and Normative Statements
What you need to know

Distinction between positive and normative economic statements

The role of value judgements in influencing economic decision-making and policy

Positive statements
Positive statements are objective statements that can be tested, amended or rejected by referring to the available
evidence. Positive economics deals with objective explanation and the testing and rejection of theories. For example:
• If the government raises the tax on beer, this will then lead to a fall in profits of brewers
• A fall in the cost of generating solar energy may cause a contraction of demand for coal

Normative statements
Normative statements are subjective statements – i.e. they carry value judgements. For example:
• High unemployment is more harmful to a country such as the UK than high rates of inflation
• The retirement age in Britain should be raised to 70 to combat the effects of an ageing population

The role of value judgements

Most economic decisions and policy are influenced by “value judgements”. These vary from person to person, from
company to company, from government to government, and from country to country. Value judgements help us to
explain why economic policies vary from place to place, and from time to time.

Exam Tip Deciding whether a statement is positive or normative is a common multiple-choice question.
Examiners may include words such as ‘should’ in statements that are actually positive (this is done to make
students think that they are normative). The rule-of-thumb is that you should always consider whether the
statement can be tested. If it can be tested, then it is a positive statement.

1.1.3 The Economic Problem

What you need to know

The problem of scarcity – where there are unlimited wants and finite resources
The distinction between renewable and non-renewable resources
The importance of opportunity costs to economic agents (consumers, producers and government)

What is the basic economic problem?

The main purpose of economic activity is the production of goods and services to satisfy the needs and wants of consumers.
The basic economic problem is about scarcity and choice i.e. economics is about coming up with ways to meet
infinite wants when faced with finite resources. Each society must decide:
• What goods and services to produce? Does the economy use its resources to build more hospitals, roads,
schools or luxury hotels? Can the National Health Service afford free IVF treatment for childless couples or offer
new but expensive cancer treatments? How should we source our energy in the years to come?

4 Edexcel A Level Economics Theme 1 Study Book

 • How best to produce goods and services? What is the best use of our scarce resources? Should government land be
sold off to provide more land for affordable housing? Should we subsidise the electric vehicles as a strategy to
reduce carbon emissions from transport?
• Who is to receive goods and services? Who will get hospital treatment - and who not? Which areas get the go-
ahead for major transport infrastructure projects such as new airport runways, Freeports, CrossRail, HS2 and HS3
and which regions might miss out?
Scarcity
We are always uncovering new wants and needs. Because of scarcity / finite resources, all consumers, businesses
and governments must make choices. For example, five million people travel into London each day, they make
decisions about when to travel and whether to use the bus, tube, walk or cycle or work from home. Their time and
money is scarce.
Factors of production
Economics is concerned with converting inputs to outputs; in other words, the resources that we need to use to be
able to produce the goods and services that we want. Economists call these inputs “factors of production”. The four
main categories of factors of production are land, labour, capital and enterprise (also known as entrepreneurship). You
can remember the four main categories by using the acronym CELL.
• Capital: goods made by people that are used to supply other products e.g. machines, technology, factories, plant
and software.
• Enterprise: entrepreneurs organise factors of production and also take risks when seeking to exploit market
opportunities.
• Land: the stock of natural (environmental) factor resources available for production. Remember that this is any
natural resource so this could, for example, include the sea or oil.
• Labour: the quantity and quality of the human input into the production process.
What are capital goods?
These are goods that are used to make consumer goods and services. Capital inputs include plant and machinery,
hardware, software, new factories and other buildings. Capital also includes working capital e.g. stocks of finished
products and component parts (intermediate products). Capital is often used to replace labour; this is known as
capital-labour substitution. There have been many recent examples, for example robots in Amazon warehouses
and grocery suppliers such as Ocado, that carry out “picking and packing”.

Working capital Transport Bulky units of Digital platforms Servers for Air traffic control
Infrastructure capital enable such as Instagram cloud computing systems
mass production networks
to happen

Exam Tip Many students struggle with the concept of ‘capital’ in economics, especially in relation to the term
‘investment’ (which you will also meet in your macroeconomics). Investment, for an economist, is the purchase
of capital, or the addition to an economy’s capital stock. Investment is not about saving money in a bank or
buying shares/stocks. The term is often used in a different way in the media, so do be careful!

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Renewable and non-renewable resources
What are non-renewable resources?
• Non-renewable resources are finite in supply
• With crude oil, coal, natural gas and other fossil fuels, no mechanisms exist at present to replenish them at a rate
that is faster than the rate of consumption
• The rate of extraction of finite resources depends in part on the current market price
What are renewable resources?
• Renewables are replaceable if the rate of extraction is less than the natural rate at which a resource renews
• Examples of renewable resources are solar energy, tidal power, oxygen, biomass, fish stocks and forestry

Opportunity cost
Even if we are not asked to pay money for something, scarce resources are normally used up in production and there
is an opportunity cost involved. Opportunity costs describe the unavoidable trade-offs resulting from scarcity: satisfying
one objective more means satisfying other objectives less.
Opportunity cost is the “cost of the alternative that is given up / foregone, when a choice is made”
• Work-leisure choices: the opportunity cost of deciding not to work an extra 10 hours is the lost wages foregone.
If you are being paid £8 per hour to work in a shop, if you take a day off you could lose £80 of income before tax.
• Government spending priorities: the opportunity cost of the government spending nearly £10 billion on
investment in the National Health Service might be that £10 billion less is available for spending on education or
improvements to the road and rail transport network.
• Investing today for consumption tomorrow: the opportunity cost of an economy investing resources in capital
goods is the production of consumer goods given up for today. Living standards may fall in the short term in order
to allow long term living standards to rise.
• Making use of scarce farming land: the opportunity cost of using farmland to grow corn for bio-fuel means
that there is less corn available for food production causing food prices to rise and increasing the risks of food
poverty and malnutrition for world’s most vulnerable people.

Exam Tip Students frequently use the concept of opportunity cost as part of their evaluation – but you
won’t get much credit for it unless you give a sensible application of what might have been ‘given up’. For
example, it is better to write “Should the government choose to increase spending on higher education, then
the opportunity cost may be that there is less money available to spend on primary or secondary education,
assuming that the government doesn’t borrow more” than writing “Should the government choose to increase
spending on higher education then there might be an opportunity cost”.

6 Edexcel A Level Economics Theme 1 Study Book

1.1.4 Production Possibility Frontiers
What you need to know

The use of production possibility frontiers to depict:

• the maximum productive potential of an economy; opportunity cost (through marginal analysis);
economic growth or decline; efficient or inefficient allocation of resources; possible and unobtainable
production
The distinction between movements along and shifts in production possibility curves, considering the possible
causes for such changes
The distinction between capital and consumer goods

What is a production possibility frontier?

We usually use production possibility frontiers (PPFs) to show the maximum potential output combinations of two
goods that an economy can achieve when all its resources are fully and efficiently employed. We can also use them
to show the maximum potential output combinations of two goods that a firm can achieve, when it uses all of its
resources (i.e. “factors of production”) efficiently.
PPF’s are drawn An economy's PPF A firm's PPF
like this: i.e. macroeconomic version i.e. microeconomic version
Capital Good Y
goods

Consumer goods Good X

• We normally draw a PPF as concave to the origin (in other words, bowed outwards)
• This is because when we move down along the PPF, as more resources are allocated towards Consumer Goods
(on the macroeconomic version) or Good X (on the microeconomic version), then the output of Capital Goods /
Good Y we lose gets larger. You can see this diagrammatically on the following PPF diagram:

Good Y
A
Equal falls B
in output of
C
Good Y
D

Good X
Diminishing increases
in output of Good X

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This occurs because not all factor inputs (such as land and labour) are equally suited to producing different goods
and services leading to lower productivity. Initially, firms will move workers (and other factors of production) towards
producing Good X if the firm thinks that the workers will be really good at producing Good X (i.e. they have the ‘right’
skills for the job). As output of Good X rises, though, firms will have to resort to moving workers to production of Good
X even if they are better suited to producing Good Y.

Exam Tip Explaining the shape of a PPF is a reasonably frequent low-mark or multiple-choice question, but
many students struggle to gain the marks because it is such a small part of the syllabus covered so early in the
course that they have simply forgotten it! Always make sure that you review the topics you covered early in the
course.

The PPF and economic efficiency Potatoes

Combinations A, B and C are all
efficient output combinations -
Any point on the PPF represents a productively efficient A
they are on the PPF
Product combination
allocation of scarce resources – all factors of production B D is not possible
in this farm - it lies
are being used in their most efficient way. Points inside C outside the PPF
the PPF represent an inefficient allocation of resources D
since it is possible to produce more of one good without
sacrificing any of the other. This is illustrated on the E
F
diagram, which shows a PPF for a small farm,
Combinations E and F are achievable
which can grow just potatoes and carrots. but inefficient - not all factors of
production are being used

Carrots

Combinations of goods lying inside the PPF happen when there are unemployed resources or when resources are
used inefficiently. This is the case with combinations E and F.
Combinations beyond the PPF are unattainable. A country or firm would require an increase in factor resources, an
increase in productivity or an improvement in technology to reach this combination i.e. they would need more
factors of production. Combination D is unattainable on this farm at the moment.
Specialisation, trade and exchange between countries allows nations to consume beyond their own PPF. Producing
more of both goods would be an improvement in allocative efficiency (i.e. more likely to satisfy consumer wants and
needs). You will cover trade and efficiency in more detail in Theme 3.
The PPF and opportunity cost
Reallocating resources from producing one good to producing a different good will involve an opportunity cost.

Output of wheat
(tonnes)

A
200
B
160
When cotton
productions rises
by 100 tonnes, then
wheat production
falls by 40 tonnes

Output
300 400 of cotton
The opportunity cost of increasing (tonnes)
the output of cotton is given in terms
of the amount of wheat given up

8 Edexcel A Level Economics Theme 1 Study Book

If we increase our output of cotton (i.e. moving along Output of wheat
(tonnes)
the PPF from point A to point B) fewer resources are
available to produce wheat – there is an opportunity When cotton 200
A
cost of 40 tonnes of wheat. productions rises
by a further 100 B
tonnes, then wheat 160
Because the PPF is concave, this means that the production falls by
opportunity cost of expanding output of cotton 100 tonnes
measured in terms of lost units of wheat is
60 C
increasing i.e. each extra tonne of cotton that
we produce, we give up even more wheat.
Output
300 400 500 of cotton
(tonnes)

Shifts in the PPF

A PPF will shift outwards if the firm, or economy, gains more factors of production, or the quality of those factors of
production improves (e.g. the economy has the same number of workers but they have received more training and
education, so are more productive). If we draw a macroeconomic PPF and it shifts outwards, then we can say that
there is economic growth.
A straight line PPF is an indication of perfect substitutability of resources such as labour or capital – we sometimes
make this assumption to make our analysis look a little tidier. Examples are given below. In the PPF on the left, the
economy has experienced an improvement in the technology available for producing capital goods but not consumer
goods – there is growth but it is not ‘balanced’, as the economy’s PPF moves from A to B. In the PPF on the right,
the economy has experienced an increase in the factors of production available to make all types of goods – there is
‘balanced growth’ as the PPF moves from A to C.
Capital Capital
goods goods

B C
A A
Consumer goods Consumer goods

Cause of an outward shift in the PPF Brief comment on the cause of the shift in the PPF
Higher productivity / efficiency of factor inputs This increases the output per unit of an input used in
production
Better management of factor inputs Improved management reduces waste and also
improves quality
Increase in the stock of capital and labour supply e.g. from inward labour migration / increased capital
investment

Innovation and invention of new products and resources Improved production processes help to lift efficiency
Discovery / extraction of new natural resources (land) Discovery of commercially viable land drives extraction

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Inwards shifts of a production possibility frontier
This is caused by a fall in the productive potential of a country i.e. something that causes a decrease in the factors of
production. This could perhaps be due to:
1 The damaging effects of severe natural disasters such as a tsunami, floods, persistent drought and other
extreme weather events
2 The economic damage caused by war and other types of conflict for example in failing states
3 Large scale net migration of people out of a country e.g. when there is very high unemployment
4 A long-term fall in productivity of labour

Extension idea: resource depletion

This is a decline in the total stock of resources available, for example arising in the long run from the effects of
de-population, climate change and low rates of investment in new capital inputs.

Machinery Skills Decline Buildings Basic Infrastructure

Extension idea: resource depreciation

This is when the productivity / efficiency of resources diminishes with age and also with repeated use when producing
goods and services.

Exam Tip Questions relating to the short-run and long-run impacts on PPFs of an economy producing more
capital goods are reasonably common. In the short-run, there will be a movement along the PPF so that more
capital goods are produced and fewer consumer goods are given up. However, in the long-run, the economy
now has more capital goods and so can produce more of everything – this causes a shift outwards of the PPF.

1.1.5 Specialisation and the Division of Labour

What you need to know

Specialisation and the division of labour: reference to Adam Smith

Advantages and disadvantages of specialisation and the division of labour in organising production
Advantages and disadvantages of specialising in the production of goods and services to trade
Functions of money

What is specialisation?
Specialisation is when we concentrate on producing a specific product or task. Specialisation happens at all levels:
1 Specialisation of tasks within extended families in many of the world’s poorest countries
2 Within businesses and organisations, for example, specialist buyers employed by supermarkets
3 In a country – Bangladesh is a major producer and exporter of textiles; Norway is a leading oil and gas
exporter; Ghana is one of the biggest global producers of cocoa.
4 In a region of a country – for many years the West Midlands has been a centre for motor car assembly,
there has been huge investment in recent years by JLR in Castle Bromwich and Solihull

10 Edexcel A Level Economics Theme 1 Study Book