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
| Concept | Formula | Interpretation | Typical determinants |
|---|
| Price Elasticity of Demand (PED) | %ΔQd ÷ %ΔP | - Elastic (PED > 1) – quantity responds strongly to price change.
- Inelastic (PED < 1) – quantity responds weakly.
- Unit‑elastic (PED = 1).
| Availability of substitutes, proportion of income spent, necessity vs. luxury, time‑period. |
| Price Elasticity of Supply (PES) | %ΔQs ÷ %ΔP | - Elastic (PES > 1) – producers can increase output quickly.
- Inelastic (PES < 1) – output changes little.
| Production flexibility, spare capacity, time‑period, storage possibilities. |
Diagram tip: Show a steep (inelastic) vs. flat (elastic) demand curve and label the corresponding PED values.
2.3 Price Determination (The Price Mechanism)
- What to produce? – Rising demand raises price; higher price signals profit opportunity, attracting producers to increase output of that good.
- 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).
- 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
| Failure | Why the market fails | Typical government response |
|---|
| Public goods | Non‑rival & non‑excludable → free‑rider problem → under‑provision. | Direct provision (e.g., street lighting) or financing through taxation. |
| Merit & demerit goods | Consumers undervalue benefits (merit) or costs (demerit) → over‑ or under‑consumption. | Subsidies for merit goods; taxes, price ceilings or bans for demerit goods. |
| Externalities | Third‑party costs or benefits not reflected in market price. | Taxes or regulations for negative externalities; subsidies or permits for positive externalities. |
| Monopoly / imperfect competition | Single seller can set price above marginal cost → under‑production, higher price. | Price regulation, anti‑trust legislation, or public ownership. |
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
| Aspect | Market Economy | Planned Economy | Mixed Economy |
|---|
| Resource ownership | Predominantly private | State owned | Both private and state |
| Decision‑makers | Households & firms (self‑interest) | Central planners | Consumers, firms, and government |
| Price determination | Supply & demand (price mechanism) | Set by planners | Market forces with selective regulation |
| Role of profit | Primary driver of production | Irrelevant | Important but may be moderated by policy |
| Typical government role | Legal framework, correction of market failure | Extensive – directs all activity | Selective – provide public goods, regulate, redistribute |
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)
| Market type | Number of buyers | Number of sellers | Price‑setting power | Examples |
|---|
| Perfect competition | Many | Many | Price takers | Fresh fruit markets, wheat market. |
| Monopoly | Many | One | Price maker | Water supply in a town, rail infrastructure. |
| Monopolistic competition | Many | Many (differentiated products) | Some price‑setting ability | Restaurants, clothing retailers. |
| Oligopoly | Many | Few | Inter‑dependent price setting | Airlines, mobile‑phone networks. |
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
- Scarcity forces societies to decide what, how, and for whom to produce.
- In a market economy these decisions are made by the price mechanism – interaction of demand and supply.
- Key advantages: efficiency, innovation, consumer choice.
- Key disadvantages: inequality, market failures, environmental damage.
- Government corrects failures with taxes, subsidies, regulation, public provision, price controls, privatisation, nationalisation, and quotas.
- A mixed economy seeks a balance: retain market efficiency while using state intervention to achieve equity, stability, and sustainability.
- Understanding elasticity, the labour market, firm cost structures, and different market types is essential for AO2 (application) and AO3 (analysis) exam questions.