Definition of the market economic system

Market Economic System – Cambridge IGCSE 0455

1. The Basic Economic Problem

• Scarcity – limited resources, unlimited wants.
• Economic goods vs. free goods
  • Economic goods: scarce, have a price (e.g., a laptop).
  • Free goods: abundant, no price (e.g., air).
• Factors of production
  • Land (natural resources)
  • Labour (human effort)
  • Capital (machinery, buildings, money used to produce)
  • Enterprise (risk‑taking, organisation)
• Opportunity cost – the value of the next best alternative fore‑gone.
  Example: If a farmer uses 1 ha of land to grow wheat instead of corn, the opportunity cost is the profit that could have been earned from corn.
• Production Possibility Curve (PPC)
  • Shows maximum output combinations of two goods when resources are fully and efficiently used.
  • Key points to label: points on the curve (efficient), inside the curve (inefficient), outside the curve (currently unattainable).
  • Shifts:
    • Outward shift – increase in resources or technology.
    • Inward shift – loss of resources, natural disaster, war.

  Diagram description: Axes labelled “Good A” (horizontal) and “Good B” (vertical); curve bowed outwards; point A on curve, point B inside, point C outside; arrows showing outward shift.

2. Allocation of Resources – Core Concepts

2.1 Demand and Supply

• Demand – quantity of a good that consumers are willing and able to buy at each price.
  • Law of demand: price ↑ → quantity demanded ↓ (ceteris paribus).
  • Movement along the demand curve = change in price.
  • Shift of the demand curve = change in any non‑price factor (income, tastes, price of related goods, expectations, number of buyers).
• Supply – quantity of a good that producers are willing and able to sell at each price.
  • Law of supply: price ↑ → quantity supplied ↑.
  • Movement along the supply curve = change in price.
  • Shift of the supply curve = change in any non‑price factor (technology, input prices, taxes/subsidies, expectations, number of sellers).
• Equilibrium – point where quantity demanded = quantity supplied (E). At this price the market “clears”.

2.2 Price Elasticity

Diagram tip: Show a steep (inelastic) vs. flat (elastic) demand curve and label the corresponding PED values.

2.3 Price Determination (The Price Mechanism)

1. What to produce? – Rising demand raises price; higher price signals profit opportunity, attracting producers to increase output of that good.
2. How to produce? – Higher product price raises the potential profit from each factor of production. Firms adopt the cheapest technique that maximises profit (e.g., automation, cheaper labour).
3. For whom to produce? – The market price determines purchasing power. Those with higher incomes can afford more; goods are allocated to those willing to pay the most.

2.4 Diagram – The Price Mechanism (Three‑step)

• Start with an initial equilibrium E₀ (P₀, Q₀).
• Right‑ward shift of demand → new equilibrium E₁ (P₁ > P₀, Q₁ > Q₀) – illustrates “what to produce”.
• Right‑ward shift of supply (due to more efficient technique) → new equilibrium E₂ (P₂ < P₁, Q₂ > Q₁) – illustrates “how to produce”.
• Price level at each equilibrium shows “for whom” – higher price limits quantity purchased to higher‑income consumers.

3. Market Failure & Government Intervention

3.1 Types of Market Failure

3.2 Government Intervention Tools (Cambridge 2.9)

• Price ceiling (maximum price) – set below equilibrium to protect consumers (e.g., rent control).
• Price floor (minimum price) – set above equilibrium to protect producers (e.g., agricultural price support).
• Tax – raises price, reduces quantity demanded; used to correct negative externalities or demerit goods.
• Subsidy – lowers effective price, increases quantity demanded; used for merit goods or positive externalities.
• Regulation – standards, licences, bans (e.g., emission limits, safety rules).
• Privatisation – transfer of state‑owned firms to private ownership to introduce competition.
• Nationalisation – transfer of private firms to state ownership to control essential services.
• Direct provision – government produces the good/service (e.g., NHS, public education).
• Quotas – limit quantity produced or imported (e.g., fishing quotas, import licences).

4. Market Systems – Comparison

4.1 Arguments For a Mixed Economy (2.10)

• Efficiency – markets allocate most resources efficiently.
• Equity – state can redistribute income and provide services to reduce poverty.
• Market‑failure correction – government can supply public goods, internalise externalities, and control monopolies.
• Economic stability – fiscal and monetary policies can smooth business cycles.

4.2 Arguments Against a Mixed Economy

• Distortion of price signals – taxes, subsidies or price controls can lead to inefficiency.
• Reduced incentives – high taxes or extensive welfare may discourage work and investment.
• Bureaucratic inefficiency – government may lack the information needed for effective allocation.
• Risk of policy errors – inflation, deficits, or crowding‑out of private sector.

5. Microeconomic Decision‑Makers (Cambridge 3)

5.1 Money & Banking

• Functions of money – medium of exchange, unit of account, store of value.
• Banking system
  • Commercial banks – accept deposits, provide loans, create money through the multiplier effect.
  • Central bank (e.g., Bank of England) – issues currency, sets interest rates, controls money supply.
• Interest rate – price of borrowing; influences consumer spending, business investment, and exchange rates.

5.2 Households

• Decisions on spending, saving, borrowing are influenced by income, age, culture, expectations, and interest rates.
• Household consumption pattern determines demand curves for many goods.

5.3 Workers (Labour Market)

• Demand for labour – derived from firms’ demand for the output they produce; downward‑sloping.
• Supply of labour – households offering work; upward‑sloping.
• Equilibrium wage and employment determined where the two curves intersect.
• Government interventions: minimum wage (price floor), training programmes, unemployment benefits.

5.4 Firms

• Goal: maximise profit = total revenue – total cost.
• Production – relationship between inputs and output illustrated by the Production Function (short‑run: one fixed factor, long‑run: all variable).
• Costs
  • Fixed Cost (FC) – does not vary with output.
  • Variable Cost (VC) – varies with output.
  • Total Cost (TC) = FC + VC.
  • Average Cost (AC) = TC ÷ Q; Marginal Cost (MC) = ΔTC ÷ ΔQ.
• Short‑run equilibrium where MC = MR (marginal revenue). In perfect competition MR = price.

5.5 Market Types (Cambridge 3.4)

6. Sustainability & the Market Economy (2024 syllabus update)

• Negative externalities – e.g., carbon emissions, plastic waste. Market price does not reflect environmental cost.
• Government tools for sustainability
  • Environmental taxes (carbon tax, landfill tax).
  • Regulations – emission standards, bans on single‑use plastics.
  • Subsidies for renewable energy, electric vehicles, public transport.
  • Cap‑and‑trade schemes – allocate permits for emissions.
• Market can also encourage “green” merit goods through consumer demand for sustainable products (e.g., organic food, eco‑tourism).

7. Quick‑Recall Summary

1. Scarcity forces societies to decide what, how, and for whom to produce.
2. In a market economy these decisions are made by the price mechanism – interaction of demand and supply.
3. Key advantages: efficiency, innovation, consumer choice.
4. Key disadvantages: inequality, market failures, environmental damage.
5. Government corrects failures with taxes, subsidies, regulation, public provision, price controls, privatisation, nationalisation, and quotas.
6. A mixed economy seeks a balance: retain market efficiency while using state intervention to achieve equity, stability, and sustainability.
7. Understanding elasticity, the labour market, firm cost structures, and different market types is essential for AO2 (application) and AO3 (analysis) exam questions.