AS Paper 4: Markets and the Macroeconomy
Covers Demand, Supply and Price Determination, Elasticity of Demand and Supply, Market Failure and Externalities, Government Intervention in Markets, Measuring Economic Performance, Aggregate Demand and Aggregate Supply and Fiscal and Monetary Policy.
Questions
Question 1 [2 marks]
Measuring Economic Performance
Define "real GDP" and explain why it is generally considered a better measure of a country's output than nominal GDP.
Question 2 [2 marks]
Fiscal and Monetary Policy
Define "expansionary fiscal policy" and give one example of a specific action a government could take to implement it.
Question 3 [2 marks]
Elasticity of Demand and Supply
Define price elasticity of demand (PED), and state whether a PED value of -0.4 represents elastic or inelastic demand.
Question 4 [2 marks]
Aggregate Demand and Aggregate Supply
State one reason why the aggregate demand (AD) curve slopes downward from left to right, and briefly explain it.
Question 5 [3 marks]
Market Failure and Externalities
A power station generates electricity with a private marginal cost of 40 pounds per megawatt hour. Each megawatt hour produced also creates an external cost of 15 pounds from carbon emissions.
Calculate the social marginal cost per megawatt hour, and state whether the private marginal cost overstates or understates this figure.
Question 6 [3 marks]
Demand, Supply and Price Determination
Define "composite demand" and explain, using an example, why an increase in demand for one use of a resource can create a shortage in its other use.
Question 7 [3 marks]
Aggregate Demand and Aggregate Supply
Define "short-run aggregate supply" (SRAS), state one factor that could cause it to shift left, and explain why.
Question 8 [4 marks]
Government Intervention in Markets
A city council imposes a maximum rent of 800 pounds per month on privately rented one-bedroom flats, below the free-market equilibrium rent of 1100 pounds per month.
Using a diagram in words, explain the effect of this maximum rent on the quantity of flats supplied and demanded, and identify the resulting problem in the market.
Question 9 [5 marks]
Measuring Economic Performance
Explain two limitations of using real GDP growth alone as a measure of a country's economic wellbeing.
Question 10 [5 marks]
Government Intervention in Markets
The government sets a minimum wage of 11.50 pounds per hour in a labour market where the equilibrium wage would otherwise have been 10 pounds per hour. At 11.50 pounds, 900,000 workers are willing to work but firms only wish to employ 800,000.
Calculate the size of the resulting excess supply of labour, and briefly evaluate one labour-market condition under which a minimum wage set above the free-market equilibrium wage would be less likely to cause unemployment of this kind.
Question 11 [5 marks]
Fiscal and Monetary Policy
A government currently spends 820 billion pounds and raises 760 billion pounds in tax revenue in a given year. National debt at the start of the year was 2100 billion pounds.
Calculate the size of the budget deficit for the year, and the resulting national debt at the end of the year, assuming no other changes to the debt.
Question 12 [4 marks]
Government Intervention in Markets
Explain, using the concept of price elasticity of demand, why the incidence of an indirect tax on a good with highly inelastic demand falls mostly on consumers rather than producers.
Question 13 [5 marks]
Fiscal and Monetary Policy
In a recession, a country's tax revenue falls from 480 billion pounds to 440 billion pounds, while government spending on unemployment benefits rises from 60 billion pounds to 85 billion pounds, with all other government spending of 400 billion pounds unchanged.
Calculate the government's budget balance before and during the recession, and state whether the position has moved toward a larger deficit or a smaller deficit or surplus.
Question 14 [5 marks]
Elasticity of Demand and Supply
Explain why the supply of strawberries is likely to be more price inelastic in the short run than the supply of factory-made toys.
Question 15 [6 marks]
Market Failure and Externalities
A council estimates that a new incinerator has a private marginal cost of production of 60 pounds per tonne of waste processed. It generates an external cost of 25 pounds per tonne from air pollution, rising to 40 pounds per tonne once processing exceeds 500 tonnes per week, as local air quality worsens further.
Calculate the social marginal cost per tonne at outputs of 400 tonnes and 600 tonnes, and analyse why a single uniform per-tonne tax might not fully correct this market failure.
Question 16 [6 marks]
Elasticity of Demand and Supply
A company sells razor handles, which have a PED of -2.2, alongside replacement blades that are in joint use with the handles and have a PED of -0.3. The company is considering pricing the razor handles very cheaply as a "loss leader" while charging a higher margin on the blades.
Using the concept of price elasticity of demand, evaluate whether this pricing strategy is likely to be effective in maximising the company's overall profit.
Question 17 [6 marks]
Government Intervention in Markets
The UK government is considering replacing a system of tradable pollution permits with a fixed per-unit carbon tax for heavy industry.
Analyse the relative merits of a system of tradable permits compared with a carbon tax as methods of reducing carbon emissions.
Question 18 [6 marks]
Fiscal and Monetary Policy
A government's actual budget deficit is 60 billion pounds in a year when the economy is operating with an output gap of -2% of GDP, below potential output. Economists estimate that if the economy were operating exactly at potential output, tax revenue would be 25 billion pounds higher and spending on benefits would be 10 billion pounds lower, with no other changes.
Calculate the government's estimated structural budget deficit, and explain the difference between a structural deficit and a cyclical deficit.
Question 19 [6 marks]
Market Failure and Externalities
A government issues 500 tradable pollution permits, each covering one tonne of carbon emissions, to a steel plant. The market price of a permit is 45 pounds. The plant currently emits 650 tonnes per year.
Calculate the cost to the plant of buying enough extra permits to cover its current emissions, and analyse how this cost is likely to affect the plant's incentives regarding future emissions.
Model solutions
| Question 1[2 marks] | |
|---|---|
| Answer or working | Marks |
| a correct definition of real GDP as the value of output or national income adjusted for inflation | 1 |
| explaining it is a better measure because it strips out the effect of price changes, allowing genuine changes in output to be compared over time | 1 |
| Final answer: Real GDP is GDP adjusted for inflation; it is a better measure because it isolates true changes in output from price changes. | |
| Question 2[2 marks] | |
|---|---|
| Answer or working | Marks |
| a correct definition, e.g. a deliberate increase in government spending and/or cut in taxation designed to raise aggregate demand | 1 |
| a valid example, e.g. increasing spending on infrastructure projects, or cutting income tax rates | 1 |
| Final answer: Expansionary fiscal policy raises AD through higher government spending and/or lower taxes, e.g. cutting income tax rates. | |
| Question 3[2 marks] | |
|---|---|
| Answer or working | Marks |
| a correct definition of PED as the responsiveness of quantity demanded to a change in price | 1 |
| correctly identifying -0.4 as inelastic demand, since its magnitude is less than 1 | 1 |
| Final answer: PED measures the responsiveness of quantity demanded to price changes; a PED of -0.4 is inelastic because its magnitude is below 1. | |
| Question 4[2 marks] | |
|---|---|
| Answer or working | Marks |
| identifying a valid reason, e.g. the real balance (wealth) effect | 1 |
| a brief but correct explanation, e.g. as the price level falls, the real value of household savings and other fixed-value assets rises, making consumers feel wealthier and increasing consumption, so a lower price level is associated with higher real aggregate demand | 1 |
| Final answer: One reason is the real balance effect: as the price level falls, the real value of savings rises, making households feel wealthier and spend more, so a lower price level is associated with higher aggregate demand. | |
| Question 5[3 marks] | |
|---|---|
| Answer or working | Marks |
| identifying social marginal cost = private marginal cost + external cost | M1 |
| social marginal cost = 40 + 15 = 55 pounds per megawatt hour | A1 |
| correctly stating the private marginal cost understates the social marginal cost | 1 |
| Final answer: Social marginal cost = 55 pounds per MWh; private marginal cost understates this by 15 pounds. | |
| Question 6[3 marks] | |
|---|---|
| Answer or working | Marks |
| a correct definition of composite demand as demand for a good that has more than one use | 1 |
| a valid example, e.g. milk is demanded both for drinking and for making cheese | 1 |
| explaining that a rise in demand for one use (e.g. cheese) leaves less of the good available for the other use (e.g. drinking milk), raising its price and creating a shortage there | 1 |
| Final answer: Composite demand is demand for a good with more than one use, e.g. milk for drinking and for cheese; a rise in demand for one use leaves less available (and raises price) for the other. | |
| Question 7[3 marks] | |
|---|---|
| Answer or working | Marks |
| a correct definition of SRAS as the total output producers are willing and able to supply at a given price level in the short run, when at least one factor of production is fixed | 1 |
| a valid factor causing a leftward shift, e.g. a rise in the cost of raw materials, energy or wages | 1 |
| explaining that higher production costs reduce firms' profitability at each price level, so they supply less at every price, shifting SRAS left | 1 |
| Final answer: SRAS is the total output firms are willing to supply at each price level in the short run; a rise in costs such as energy or wages raises production costs and shifts SRAS to the left. | |
| Question 8[4 marks] | |
|---|---|
| Answer or working | Marks |
| explaining that at a rent of 800 pounds, below the equilibrium of 1100 pounds, quantity demanded for flats rises above the free-market equilibrium quantity | 1 |
| explaining that quantity supplied of flats falls below the free-market equilibrium quantity, since landlords receive a lower rent than before | 1 |
| identifying that quantity demanded now exceeds quantity supplied at the maximum rent, creating a shortage of rental flats | 1 |
| a developed point, e.g. this shortage might lead to non-price rationing methods, such as long waiting lists or landlords being more selective about tenants | 1 |
| Final answer: At 800 pounds, below the 1100 pound equilibrium, quantity demanded rises and quantity supplied falls, creating a shortage of flats; landlords may then ration flats by other means, such as waiting lists or tenant selection, rather than by price. | |
| Question 9[5 marks] | |
|---|---|
| Answer or working | Marks |
| identifying a limitation, e.g. GDP does not directly measure income distribution, so growth could accompany rising inequality with many people no better off | 1 |
| explaining the consequence, e.g. average GDP per capita could rise while median living standards stagnate if gains are concentrated among a few | 1 |
| identifying a second limitation, e.g. GDP excludes non-market activity such as unpaid housework or caring, and does not subtract negative externalities such as pollution | 1 |
| explaining the consequence, e.g. GDP growth could overstate genuine wellbeing if it comes with worse environmental quality or a decline in valuable unmeasured activity | 1 |
| a further valid point, e.g. GDP does not capture leisure time, so growth achieved through very long working hours may not represent a genuine improvement in wellbeing | 1 |
| Final answer: Real GDP growth does not show how gains are distributed, so it can rise alongside worsening inequality, and it excludes non-market activity, environmental damage and leisure time, all of which affect true economic wellbeing. | |
| Question 10[5 marks] | |
|---|---|
| Answer or working | Marks |
| identifying that a minimum wage above equilibrium creates excess supply of labour | M1 |
| calculating excess supply = 900,000 - 800,000 = 100,000 workers | A1 |
| a valid evaluation point, e.g. if the labour market is monopsonistic, a minimum wage up to a certain level can raise both wages and employment | 1 |
| developing this evaluation, e.g. explaining a monopsony employer would otherwise restrict employment below the competitive level to keep wages down | 1 |
| a further evaluation point, such as firms absorbing the cost through lower profits or higher productivity rather than cutting jobs | 1 |
| Final answer: Excess supply (unemployment) = 100,000 workers; in a monopsonistic labour market a correctly set minimum wage can raise employment rather than reduce it. | |
| Question 11[5 marks] | |
|---|---|
| Answer or working | Marks |
| identifying the budget deficit as government spending minus tax revenue | M1 |
| a budget deficit of 820 - 760 = 60 billion pounds | A1 |
| adding the deficit to the starting national debt | M1 |
| national debt at the end of the year = 2100 + 60 = 2160 billion pounds | A1 |
| correctly distinguishing the deficit, a flow measured over the year, from the debt, a stock measured at a point in time | 1 |
| Final answer: Budget deficit = 60 billion pounds; national debt rises to 2160 billion pounds. | |
| Question 12[4 marks] | |
|---|---|
| Answer or working | Marks |
| identifying that inelastic demand means quantity demanded barely falls as price rises | 1 |
| explaining that producers can therefore pass most of the tax on to consumers through a higher price without losing many sales | 1 |
| explaining that if demand were elastic, raising price would cause a large fall in quantity demanded, discouraging producers from passing on the tax | 1 |
| concluding that the more inelastic the demand, the greater the consumer's share of the tax burden | 1 |
| Final answer: Inelastic demand allows producers to raise price with little loss of sales, so most of the tax is passed on to consumers. | |
| Question 13[5 marks] | |
|---|---|
| Answer or working | Marks |
| total spending before = 400 + 60 = 460 billion pounds, and balance = revenue - spending = 480 - 460 | M1 |
| the balance before the recession = a surplus of 20 billion pounds | A1 |
| total spending during the recession = 400 + 85 = 485 billion pounds, and balance = 440 - 485 | M1 |
| the balance during the recession = a deficit of 45 billion pounds | A1 |
| identifying that the budget position has moved from a 20 billion pound surplus to a 45 billion pound deficit, a swing driven automatically by falling tax revenue and rising benefit spending | 1 |
| Final answer: Before the recession the budget was in a 20 billion pound surplus (480 - 460); during the recession it moves to a 45 billion pound deficit (440 - 485), a 65 billion pound swing driven by automatic stabilisers. | |
| Question 14[5 marks] | |
|---|---|
| Answer or working | Marks |
| identifying that strawberries take a fixed growing season to produce, limiting how quickly farmers can respond to a price change | 1 |
| explaining that this makes strawberry supply price inelastic in the short run, since quantity supplied cannot increase much even if price rises | 1 |
| identifying that toy manufacturers can use spare factory capacity to raise output relatively quickly | 1 |
| explaining that this allows a faster supply response to a price change, making toy supply more price elastic | 1 |
| a further valid point, e.g. toy producers may hold stocks of materials or finished goods, whereas strawberries are perishable and cannot be stockpiled | 1 |
| Final answer: Strawberry supply is fixed by a growing season and cannot be stockpiled, making it inelastic in the short run; toy manufacturers can use spare capacity and stocks to respond quickly to a price change, making their supply more elastic. | |
| Question 15[6 marks] | |
|---|---|
| Answer or working | Marks |
| calculating social marginal cost at 400 tonnes, 60 + 25 = 85 pounds per tonne | M1 |
| calculating social marginal cost at 600 tonnes, 60 + 40 = 100 pounds per tonne | A1 |
| identifying that the external cost rises at higher output, so the marginal externality is not constant | 1 |
| explaining that a single, uniform tax rate is normally set equal to the external cost at one chosen output level | 1 |
| analysing that a uniform tax based on the lower external cost would under-correct the market failure once output exceeds 500 tonnes | 1 |
| a valid alternative or refinement, such as a rising or tiered tax rate, or a cap-and-trade style quantity limit | 1 |
| Final answer: SMC = 85 pounds/tonne at 400 tonnes and 100 pounds/tonne at 600 tonnes; because the external cost rises with output, a single uniform tax cannot fully correct the externality at both output levels. | |
| Question 16[6 marks] | |
|---|---|
| Answer or working | Marks |
| identifying that razor handles have elastic demand (PED = -2.2), so a low price on handles should generate a large percentage increase in quantity demanded | 1 |
| identifying that blades have inelastic demand (PED = -0.3), so a higher price on blades causes only a small fall in quantity demanded of blades | 1 |
| explaining that because handles and blades are in joint use (complements), selling more handles cheaply increases the customer base who will need to buy blades repeatedly | 1 |
| explaining that charging a higher price on the inelastically demanded blades allows the company to earn a high revenue and profit margin on repeat blade purchases | 1 |
| an evaluative point, e.g. the strategy's success depends on customers being unable or unwilling to switch to cheaper generic blades from a rival firm, which would undermine the inelastic demand assumption for the company's own blades | 1 |
| a reasoned overall judgement, e.g. the strategy is likely to be profitable only if the company can prevent close substitute blades entering the market, otherwise the elastic demand for handles will not be offset by durable profit on blades | 1 |
| Final answer: Selling handles cheaply exploits their elastic demand to build a large customer base, while inelastic demand for blades lets the company profit from repeat purchases at a higher margin; the strategy works only if rival firms cannot supply cheaper substitute blades, since this would undermine the inelastic pricing power on blades. | |
| Question 17[6 marks] | |
|---|---|
| Answer or working | Marks |
| explaining that tradable permits set a fixed quantity of allowed pollution (a cap) and let the market determine the price | 1 |
| explaining that a carbon tax fixes the price of polluting and lets the market determine the resulting quantity of emissions | 1 |
| analysing that permits therefore give certainty over the total quantity of emissions, which a tax does not guarantee | 1 |
| analysing that a tax gives firms cost certainty, which may be preferable for business investment planning, compared with a potentially volatile permit price | 1 |
| a further comparative point, e.g. permits can create their own market failure if over-allocated or if a black market emerges, or the two differ in administrative and monitoring costs | 1 |
| a reasoned overall judgement, e.g. permits are preferable where an absolute emissions target must be met, while a tax may suit administrative simplicity and revenue certainty | 1 |
| Final answer: Permits guarantee the quantity of emissions reduced but with an uncertain price; a tax gives price and cost certainty but an uncertain quantity outcome, so the better choice depends on the government's priority. | |
| Question 18[6 marks] | |
|---|---|
| Answer or working | Marks |
| calculating the total improvement in the budget balance if the economy were at potential output, 25 + 10 | M1 |
| a total improvement of 35 billion pounds | A1 |
| subtracting this from the actual deficit, 60 - 35 | M1 |
| a structural deficit of 25 billion pounds | A1 |
| explaining that a cyclical deficit is the part of the deficit caused by the economy currently operating below potential output, e.g. lower tax revenue and higher benefit spending than would occur at full employment | 1 |
| explaining that a structural deficit is the part of the deficit that would remain even if the economy were operating exactly at its potential output, reflecting an underlying imbalance between government spending and revenue rather than the state of the economic cycle | 1 |
| Final answer: The structural deficit is estimated at 25 billion pounds, the 60 billion pound actual deficit minus the 35 billion pound cyclical improvement that would occur at potential output. The cyclical deficit is the part caused by the economy currently operating below potential output, while the structural deficit is the part that would remain even at full potential output, reflecting an underlying gap between spending and revenue. | |
| Question 19[6 marks] | |
|---|---|
| Answer or working | Marks |
| identifying the shortfall in permits, 650 - 500 = 150 permits | M1 |
| the cost of buying extra permits, 150 x 45 = 6750 pounds | A1 |
| explaining that this cost creates a financial incentive for the plant to reduce emissions, e.g. by investing in cleaner technology, to avoid buying further permits | 1 |
| explaining that if the plant instead reduces emissions below its allocation, it could sell spare permits for extra revenue, reinforcing the incentive to cut emissions | 1 |
| a developed point on the market mechanism, e.g. the permit price itself may rise if many firms need extra permits, strengthening the incentive to invest in abatement | 1 |
| a valid evaluative caveat, e.g. the strength of the incentive depends on the permit price remaining high relative to the plant's own cost of reducing emissions | 1 |
| Final answer: The plant must buy 150 extra permits at a cost of 6750 pounds; this cost gives it a financial incentive to invest in lower emissions, since cutting emissions below its allocation would let it avoid these costs or even sell spare permits, though the strength of the incentive depends on the permit price relative to abatement costs. | |