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WORKBOOK ANSWERS

Pearson Edexcel A-level Economics A Theme 3 Business behaviour and the labour market

This Answers document provides suggestions for some of the possible answers that might be given for the questions asked in the workbook. They are not exhaustive and other answers may be acceptable, but they are intended as a guide to give teachers and students feedback.

The student responses (green text) for the longer essay-style questions are intended to give some idea about how the exam questions might be answered. The examiner comments (blue text) have been added to give you some sense of what is rewarded in the exam and which areas can be developed. Again, these are not the only ways to answer such questions, but they can be treated as one way of approaching questions of these types.

The abbreviation KAA stands for Knowledge, Analysis and Application, and EV stands for Evaluation.

Topic 1Business growth and objectives

Sizes and types of firm1 Possible answers include the following, up to 2 marks:

Where the owners of a company are unable to control the business directly (1 mark).

For example, shareholders own the company but appoint directors/managers to run the business on a day-to-day basis (1 mark).

This is an example of the principal–agent problem (1 mark).

2 Possible answers include the following, up to 2 marks for a developed point:

A public-sector organisation is owned and run by the government (or state) (1 mark), whereas a private-sector organisation is not/is run by individuals (1 mark).

Edexcel Economics A Theme 3 Business behaviour and the labour market

© Peter Davis 2019 Hodder Education

TOPIC 1 Business growth and objectives

A public-sector organisation often provides services for the public, such as the NHS, that are free at the point of use (1 mark), whereas the private sector will provide goods and services, including for-profit businesses (1 mark).

3

a 2 marks for the following:

Economies of scale are a reason for companies to grow (1 mark).

Any reason for gaining economies of scale (1 mark):

– e.g. by growing a firm can increase quantity and gain lower long-run average

costs

– e.g. operating on a larger scale can provide a barrier to entry/allow limit pricing

b 2 marks for the following:

Targeting niche markets is a reason why firms stay small (1 mark).

Any reason for targeting niche markets (1 mark):

– e.g. a business may still be able to be profitable on a small scale by targeting a

small market (possibly unreached by larger rivals)

– example of niche markets, such as Fairtrade chocolate

4 Possible answers include the following, up to 3 marks per point identified, explained and applied to Oxfam:

Reduced donations/reduced income

(e.g. people will switch donations to other charities)

Need to reduce costs

(e.g. examples of cost cutting at Oxfam)

Damage to brand image

(e.g. long-term damage to brand affecting donations)

Reduced ability to pursue social aims

(e.g. due to lower profits / ban from operating in Haiti)

Issues of recruitment

(e.g. may not be able to recruit the best staff following the scandal)

Business growth5 1 mark for correct type of growth and 1 mark for brief explanation.





Conglomerate integration (1 mark)

This is because Google and YouTube are in totally different industries (1 mark).

NB Accept a clear explanation of external growth for up to 2 marks.


Organic growth (1 mark) or internal growth (1 mark)

This is because IKEA is expanding itself (via more stores) rather than taking over another firm (1 mark).

c 2 marks for the following:

Vertical backwards integration (1 mark)

This is because Amazon is taking over publishers that are in the same industry but at a previous stage of the chain of production (1 mark).

NB Accept a clear explanation of external growth for up to 2 marks.

6

a 2 marks for any of the following (1 mark for identification and 1 mark for development):

Lack of synergy (1 mark): firms do not gain the expected benefits from working as a larger company (1 mark).

Diseconomies of scale (1 mark): if the firm has grown too large, the long-run average costs may rise, such as due to poor communication/coordination (1 mark).

Loss of focus (1 mark): some businesses may be focused on too many markets and become less focused on their core business, which they predominantly get profits from (1 mark).

Selling off unprofitable businesses (1 mark): this could be to cut the losses of that business or to boost the share price of the remaining firm(s) (1 mark).

To raise finance (1 mark): this could then be used to reinvest into the remaining part of the business, such as product development (1 mark).

b 2 marks for any of the following (1 mark for identification and 1 mark for development):

Improved product quality (1 mark):

– e.g. due to improved focus/reinvesting funds from the demerger (1 mark).

– e.g. due to greater competition as more firms in the market (1 mark).

Lower prices/increased consumer surplus (1 mark):




– e.g. due to cost savings from greater efficiency/fewer diseconomies of scale

(1 mark)

– e.g. due to greater competition driving down prices (1 mark)

Greater choice of products (1 mark):

– e.g. as more firms in the market after the demerger (1 mark)

– e.g. due to greater levels of competition/funds available to widen product range

(1 mark)

7 2 marks for correct type of integration and accurate definition:

Identification of horizontal integration (1 mark)

This is where a firm takes over/merges with a firm in the same industry and at the same stage of production (1 mark).

8 Two benefits explained in the context of ASDA/Sainsbury’s for 2 marks; analysis = 6 marks:

Less competition/more market power/higher profits (1 mark): e.g. ASDA and Sainsbury’s would gain a greater combined market share of over 30% (1 mark) and therefore they may be able to raise prices (1 mark).

Cost savings/ability to compete on price (1 mark): e.g. if they merged, ASDA and Sainsbury’s would be able to reduce costs that are duplicated between the firms (1 mark), which could boost profitability/allow them to compete with low-cost supermarkets (1 mark).

Greater monopsony power (1 mark): e.g. ASDA and Sainsbury’s would become a more powerful buyer (1 mark) and therefore would be able to negotiate lower prices from suppliers (1 mark).

Economies of scale (1 mark): e.g. ASDA and Sainsbury’s would have a greater ability to gain better deals from the bank (1 mark) due to lower risks because the combined firm is likely to be more profitable/larger (1 mark).

NB Economies of scale can count as more than one point if different types are explained.

Evaluation = 2 marks for one point developed or two points identified, such as:

The merger has been blocked and therefore the benefits are only theoretical.

Possibility of diseconomies of scale increasing long-run average costs due to large-scale operation.

Job losses/fear of job losses could impact on productivity and morale.

Will the merger be successful or lead to a clash of cultures?

Greater dependence on the supermarket industry.

Cost of the merger or takeover.




Prioritisation/significance of arguments (with justification).

Conclusion: would it have been beneficial for the supermarkets overall (with justification)?

9 Analysis = 6 marks; possible answers include:

The CMA is blocking the merger to prevent a reduction in competition that could hurt customers and lead to:

higher prices and lower consumer surplus: e.g. increases in petrol prices due to lack of competition/greater market power

reduced customer service/inefficiency: e.g. longer checkout queues for shoppers

less choice: e.g. fewer major supermarkets for shoppers to switch between.

Evaluation = 4 marks; possible answers include:

Potential benefits to customers:

– e.g. £1 billion lower prices due to cost savings/economies of scale

– e.g. long-term reinvestment of profits, which could be used to improve stores

Long-term vs short-term impact on customers:

– e.g. longer-term benefits of reinvesting profits

– e.g. will supermarkets suffer X-inefficiency/diseconomies of scale in the long

term?

Supermarkets were going to sell off stores and petrol stations, limiting impact on competition.

Difficulty assessing future costs and benefits for customers due to information gaps.

It depends: e.g. on the extent to which prices are lowered/profits are reinvested for the benefit of customers.

Magnitude arguments:

– e.g. 30% market share as high monopoly power

– e.g. magnitude of £1 billion cost savings

Prioritisation and significance of arguments: e.g. significance of CMA verdict as it aims to protect consumer interests.

10 6 marks for two developed points, such as:

Size of market (1 mark): supermarkets have a limited number of consumers in the UK market and this will limit how much their total revenue can grow (1 mark), e.g. there may be only a certain number of food shops done each week in the UK (1 mark).




Access to finance (1 mark): supermarkets may find it difficult to access finance from banks, especially with greater regulation on bank lending since the financial crisis(1 mark) and therefore supermarkets cannot fund future expansions/mergers to grow the firm (1 mark).

Owner objectives (1 mark): the owners may not be looking to pursue a growth/revenue maximisation strategy (1 mark) and therefore even if there were market opportunities they may not be targeted by the owners, if for example they do not maximise short-term profits (1 mark).

Business objectives11 2 marks for the following:

Profit satisficing is making sufficient profits to satisfy shareholders (1 mark).

Profit maximisation is trying to gain the largest difference between total revenue and total cost or setting marginal cost equal to marginal revenue (1 mark).

12 Possible answers include the following, up to 3 marks:

Explanation of the principal–agent problem (up to 2 marks):

– Definition: the conflict of interest that arises when a principal hires an agent to

perform duties for them that are in the interest of the principal but not the agent

(1 mark).

– Application: here the principal is the shareholders and the manager is the agent

(1 mark).

Reason why managers can pursue alternative objectives (up to 2 marks):

– This is due to shareholders not being able to observe perfectly whether

managers are profit maximising (1 mark) and therefore can pursue objectives

that maximise their welfare, such as reduced effort (1 mark).

– This is an example of information failure/moral hazard (1 mark).

13 1 mark for identifying correct quantity and 3 marks for one reason explained, such as:

a

Q4 (1 mark)

Higher growth (1 mark): by increasing sales revenue the firm should increase market share (1 mark) and this could improve the status/prestige/perceived success of managers (1 mark).

Sales-related pay (1 mark): some managers may be paid on commission (1 mark), therefore by increasing total revenue they will increase their own financial remuneration (1 mark).




b

Q5 (1 mark)

Entry deterrence (1 mark): by only making normal profits (1 mark) there is less incentive for other firms to enter the market/may limit potential competition (1 mark).

Social/ethical reasons (1 mark): managers may wish to sell as much as they can of the product to benefit society/local community (1 mark) such as charities or goods with external benefits (1 mark).

Exam-style questions (multiple choice and short answer)

1

a B (1 mark)

b Knowledge (1 mark):

Identification of one reason for Whitbread’s demerger of Costa Coffee (1 mark), such as:

– Reducing diseconomies of scale

– Greater focus on Premier Inn/raising finance for other businesses

– Creating shareholder value

Analysis (1 mark):

Linked development of reason for demerger in the context of Whitbread (1 mark).

Here the student scores full marks for one reason identified and explained in context:

One reason for the demerger of Costa Coffee by Whitbread is to allow greater focus on its other businesses, such as Premier Inn (1 mark). By focusing more on Premier Inn it could help to improve the customer experience at the hotels and therefore increase sales and profits (1 mark).

c Knowledge (1 mark):

Identification of one benefit of Coca-Cola buying Costa Coffee (1 mark), such as:

– Higher profits

– Growth of the business

– Diversification into new market

– Greater control of supply chains

Analysis (1 mark):

Linked development of benefit in the context of Coca-Cola (1 mark)

Here the student scores full marks for one benefit identified and explained in context:




One benefit for Coca-Cola buying Costa Coffee could be greater diversification (1 mark). This will reduce risk for Coca-Cola as if sales fall for sugary drinks, due to healthier consumer tastes or the sugar tax, they will hopefully still have sales from coffee in Costa Coffee (1 mark).

2

a D (1 mark)

b Knowledge (2 marks):

Definition/understanding of organic growth (1 mark)

Identification of one constraint on growth (1 mark):

– Size of market (i.e. not enough customers to grow)

– Access to finance (i.e. cannot access funds to finance expansion)

– Owner objectives (i.e. owners’ objectives may not be revenue/growth

maximisation)

– Regulation (i.e. more scrutiny from competition authorities)

Application (1 mark):

Application to a high-street book store (1 mark):

– Application of organic growth to a high-street book store

– Application of constraint of growth to a book store

Analysis (1 mark):

Linked development of constraint of growth (1 mark)

Here the student scores full marks:

Organic growth is where a firm achieves growth by increasing output of the firm via internal growth rather than mergers and takeovers (1 mark). For example, this would mean the high-street book store opening more stores, possibly in new towns, rather than taking over a firm like Waterstone’s (1 mark). One constraint on this growth could be access to finance (1 mark); this may be true because high-street book retailers may seem a risky option given competition from online retailers. Therefore, the high-street book store may not be able to gain a loan in order to finance buying more stores, books and sales staff needed to expand (1 mark).

The student clearly understands the concept of organic growth and has explained one constraint on it (finance). There is clear application throughout to gain the final mark, but it is worth noting that one piece of clear application will suffice, such as in the second sentence.

Exam-style question (data response)




3

a Knowledge (1 mark), analysis (3 marks):

Identification of reason (1 mark) with clear explanation (3 marks); points may include:

– successful organic growth (rising online sales, new stores)

– consumer tastes becoming more discerning/growing market

– quality of chocolate produced by Hotel Chocolat

– benefits of vertical integration (cost control, quality supplies)


Quote/figure from Extract 1 (1 mark)

Application to the chocolate market/Hotel Chocolat (1 mark)

Here the student scores full marks for a well-explained answer, with clear reference to the extract:

One reason why Hotel Chocolat’s profits are rising could be due to changes in consumer tastes (1 mark). According to Extract 1, consumers are ‘becoming increasingly discerning’ in their tastes and are switching to premium brands (1

mark). This means that consumers may switch away from rival brands, such as Mars, towards Hotel Chocolat, which offers higher-quality chocolate (1 mark), in part due to its excellence in sourcing good raw materials and controlling them through vertical integration (1 mark). Therefore, sales are likely to have risen for their products and this will have seen a percentage increase in profits (1 mark).

b Knowledge (2 marks), analysis (2 marks):

Productive efficiency (1 mark) achieved due to ability to control costs of suppliers (1 mark).

Allocative efficiency achieved (1 mark) due to ability to control quality of supplies, allowing products to meet consumer needs (1 mark).

Dynamic efficiency could be achieved (1 mark) due to more profit being earned due to vertical integration and this can be invested in research and development (1 mark).

Application (2 marks): e.g. two references to Hotel Chocolat, cocoa farmers or luxury chocolate industry (1 + 1 mark).

Evaluation (2 marks for one or two points):

Possibility of inefficiency (e.g. X-inefficiency) if the firm becomes more dominant.

Possibility of diseconomies of scale impacting on costs and ability to achieve productive efficiency.

Firms may not invest profits in research and development, or it may not be successful.




The firm may lack the expertise in supply chain management to control costs and quality in order to improve efficiency.

Long-term arguments: e.g. short-term higher costs to control the supply chain and lack of expertise but could gain efficiency savings over time.

Other factors impacting on economic efficiency:

– e.g. amount of competition in the market may be low, meaning high prices

– e.g. other costs could be rising (rent, wages), causing higher average costs

On 8-mark questions the best technique is to provide two analysis points relating to the context and then one developed evaluation point (or two in less detail).

Vertical backwards integration could help productive efficiency (1 mark). By controlling the cocoa farmers who supply Hotel Chocolat’s key raw material (1 mark), they will also have more control over their supply chain and can therefore control costs, helping minimise average costs and improving productive efficiency (1 mark).

Hotel Chocolat could also benefit from allocative efficiency (1 mark) as it can now control the quality of the cocoa used in its chocolate, its primary ingredient (1 mark). This should help maintain the quality of the chocolate it sells, hence meeting customer needs in the luxury chocolate market (1 mark).

Full marks for analysis for two points developed and clearly in context = 6/6 KAA marks.

However, it may be the case that Hotel Chocolat does not have enough expertise in cocoa farming. This means that it may not be able to lower costs to gain productive efficiency or improve quality to achieve allocative efficiency (2e marks).

Furthermore, if Hotel Chocolat uses vertical backwards integration to dominate the chocolate market it will gain more market power. This could lead to X-inefficiency as there would be less incentive to cut costs but an incentive to increase prices instead, hurting productive and allocative efficiency (2e marks).

Full marks for evaluation would be gained by either of these points = 2e/2e marks. Here the student scores 8/8.

c KAA = 8 marks:

Application to chocolate manufacturing industry/Hotel Chocolat/other larger chocolate brands (e.g. Cadbury, Nestlé)/use of extract

Benefits of niche marketing

Ability to meet specific customer needs/reference to discerning chocolate connoisseurs

More personal service can be given




Benefits of gaining higher quality/specialist ingredients

Lack of expertise to expand

Lack of motivation to expand

Low barriers to entry allowing too much competition

Avoiding unwanted attention from the regulator/rival firms

Avoiding diseconomies of scale

Barriers to growth, e.g. lack of finance, market power of rivals, such as from branding

Evaluation (4 marks):

Reasons why chocolate manufacturers may attempt to grow:

– e.g. higher revenue/profit

– e.g. market share increase

– e.g. market power

– e.g. ability to gain economies of scale (can count as more than one point)

Some firms may remain large due to significant barriers to entry, e.g. branding (can count as more than one point)

Long-term arguments, e.g. are firms likely to remain small in the long term or will they attempt to grow?

Prioritisation/significance of arguments with justification

On a 12-mark question the best technique is to ensure you cover two KAA points, which are both well developed and effectively applied to the context. This will access top-level KAA. Then, it is best to develop two evaluation points in context to achieve level 2 evaluation.

Here the student scores 12/12 marks:

One reason why a chocolate manufacturer may remain small is in order to meet customer needs more specifically. The extract mentions that chocolate consumers are becoming more discerning and therefore by remaining small a firm could tailor its chocolate to these different needs, such as high cocoa content or special/unique flavours. This is what companies like Hotel Chocolat and Willie Cocoa have done in order to differentiate themselves from the mass market brands, such as Mars and Cadbury. By remaining small they can continue to target these customers more specifically with premium chocolate products, gain higher prices and gain a share of the $109.5 billion global market for chocolate. As Extract 1 states, even a niche market can be profitable given the size of the market. L3 KAA

However, some chocolate manufacturers have grown substantially in recent decades and have benefited from this, such as multinational brands like Mars.




They can therefore gain purchasing economies of scale, which will allow them to lower their long-run average costs due to bulk buying discounts on ingredients, such as cocoa. This allows them to keep prices competitive and helps them maintain a large market share, compared with firms like Hotel Chocolat, and remain a large dominant player in the market. L2 EV

Furthermore, small chocolate firms may face barriers to growth. This could be in the form of a lack of finance to expand. Small firms may find it more difficult to gain external finance from the banks as they are seen as a riskier option and retained profits may be limited. This could constrain their ability to expand production of their chocolate bars. There may also be a limit to how many customers these niche providers can gain due to the high degree of brand loyalty in the market. Some customers will continue to purchase their favourite chocolate bars due to brand loyalty and habitual behaviour, making it difficult for smaller firms with less brand awareness to succeed. Therefore, small chocolate manufacturers may continue to operate on a small scale, even if there is a desire by the owners to expand. L3 KAA

The main barrier to growth of firms is competition and brand loyalty. Although small chocolatiers can be seen as risky, the growing nature of the market and strong sales of firms like Hotel Chocolat show that retained profits and debt finance should be available. However, the strength of brand loyalty and unwillingness of consumers to switch is more significant as many people will have engaged in habitual behaviour for years and this could well continue into the future as well. L2 EV

Exam-style question (essay)

4 Knowledge (4 marks), application (4 marks), analysis (8 marks):

Understanding/definition of conglomerate integration

Application to Virgin (or other companies)

Diagrammatic analysis (e.g. cost/revenue diagram)

Benefits of conglomerate integration:

– Reduced risk

– Diversification

– Expand into new markets

– Potential increased profit and revenue

– Economies of scale (different types can count as more than one point)

– Synergy benefits





Problems of conglomerate integration:

– Diseconomies of scale

– Lack of synergy

– Lack of expertise in the new industry

– Loss of focus on core business(es)

– Risk to brand image

– Cost of the takeover

– Lack of potential target companies?

Would other forms of integration be more beneficial? E.g. horizontal may allow them to focus on their core businesses.

Long-term vs short-term effects, e.g. short-term costs of takeovers vs longer-term benefits (e.g. less risk)

Magnitude arguments, e.g. Virgin already a large conglomerate and implications of this

Prioritisation of arguments, with justification

Conclusion, with justification

For 25-mark essays the best technique is to provide two extremely well-developed paragraphs of analysis, in the context of the industry given/chosen and using diagrammatical analysis where possible. This should allow two level 4 KAA paragraphs and therefore access to the highest mark. Two evaluation points are needed as well, in context and with development. This, along with an informed judgement (often in an overall conclusion), gets a response into top-level evaluation.

Here the student scores 25/25:

Conglomerate integration is where a firm takes over or merges with a firm in a different industry. This can be related conglomerate integration, when the industries are similar or unrelated. For several years, Virgin has widened the industries it operates in either via external growth (taking over firms in other industries) or internally (by expanding itself into those industries, with a Virgin business). This essay will focus on Virgin specifically and whether further conglomerate integration would be beneficial.

The first benefit of further conglomerate integration could be entering new profitable markets. For example, Virgin could take over a cinema chain, such as Vue. This would mean that Virgin would be gaining increased cinema sales and related items such as food and snacks. This higher demand for Virgin will lead to an increase in average revenue (from AR1 to AR2) and therefore profit increases from P1ACC1 to P2BDC2, as shown in the diagram below:




By diversifying into the cinema industry, this should allow Virgin to diversify its risk. This would be advantageous as if some of Virgin’s business suffers a fall in profits it would be offset by these profits earned in the cinema industry. This could happen if it faces fierce competition in an industry (like home entertainment and Virgin Media) or if there are uncertainties about a totally new venture (like Virgin Galactic). This should allow Virgin to make profits overall, despite rises and falls in particular industries, and lower its risk. L4 KAA

However, conglomerate integration is not without risk. Virgin may not succeed in a new market due to a lack of expertise in these new areas, and this could have damaging effects on its brand image overall. For example, if Virgin Cinema had a scandal where it sold out-of-date produce to consumers, they may not only boycott the Virgin Cinema but also other businesses like Virgin Atlantic and Virgin Media. This would significantly reduce Virgin’s profits and may have long-term impacts on its reputation and brand image, which could take years to recover from. The more it ventures into other industries, especially totally new ones, the greater the chances of this happening. L3 EV

A second benefit could be that the larger Virgin firm could benefit from significant economies of scale. This would lower its long-run average costs across its businesses and allow it to be more price competitive and create a barrier to entry. This is shown by a movement from Q1 to Q2 on Virgin’s long-run average cost curve and reducing long-run average costs from C1 to C2, as shown in the diagram below:




Virgin could then use its cost advantage to limit price in the home entertainment business to deter entry and still gain profits, as it has lower long-run average costs than potential entrants. There is a variety of economies of scale it could benefit from. For example, as it spreads its risk over more businesses it may get lower rates of interest from banks, gaining financial economies of scale. It could also gain from marketing economies of scale, where the cost of advertising the Virgin brand image could be spread across more units and more businesses. If it decided to sponsor a Premiership football team then this could promote Virgin Media, Virgin Atlantic and Virgin Galactic all at the same time, while only paying for the yearly sponsorship fee. This combination of types of economies of scale should allow Virgin to boost its profitability in the long term. L4 KAA

However, it could be argued that Virgin is already gaining from economies of scale and therefore any of the benefits of lower long-run average costs may have already been gained and will not be altered by buying a cinema or supermarket. Furthermore, if the conglomerate gets too large it may suffer from diseconomies of scale where long-run average costs rise as output increases, beyond Q2 on the diagram above. This could be due to communication problems between the different Virgin businesses, bureaucracy increasing and possible coordination problems that could occur from running a multinational business across a wide variety of sectors. All these inefficiencies could outweigh the gains of lower long-run average costs or certainly minimise their benefits. However, arguably in recent years with developments in technology the chances of Virgin being able to succeed on a global basis may have become easier and so long-run average costs may still remain low. L3 EV

In conclusion, conglomerate integration has been fundamental to Virgin’s success, as this is really its business model that has provided profits over its history. The growth of its business into a variety of different areas has seemed to only strengthen its brand image rather than cause any harm. There is still certainly a risk but I doubt this would undermine the brand to such an extent that conglomerate integration would be costly for the business. Informed judgement: L3+ EV



TOPIC 2 Revenues, costs and profits

Topic 2Revenues, costs and profits

Revenue1 1 mark for definition or formula:

The additional revenue gained by selling one more unit of output (1 mark)

ΔTR/ΔQ (1 mark)

2


Change in total revenue = £14.8m – £10m = £4.8m (1 mark)

Change in quantity = 3.7m – 2m = 1.7m (1 mark)

MR = £4.8m/1.7m = £2.82


Change in total revenue = £7.4m – £12m = –£4.6m (1 mark)

Change in quantity = 7.4m – 6m = 1.4m (1 mark)

MR = –£4.6m/1.4m = –£3.29 (1 mark)

3 3 marks for each part, such as:

a Initially positive (1 mark) but falling (1 mark) and then turns negative (1 mark).

b Total revenue is rising (1 mark), peaks (when MR = 0) (1 mark) and then falls (1 mark).

c PED is initially elastic (1 mark), then unitary (when MR = 0) (1 mark) and then becomes inelastic (1 mark).

4 5 marks; possible answers include:

The firm is a price taker/firm has no market power/its price is determined by the world market (1 mark).

Application: each small wheat farm must set the same price based on world demand and supply of wheat (1 mark).

Average revenue (or price) will also be constant (1 mark).




Therefore, each unit will add the same amount to total revenue (1 mark).

Marginal revenue is constant (1 mark).

Total revenue will be a straight line through the origin (or similar description) (1 mark).

5 Possible answers include:


Growing popularity/increasing downloads of Fortnite game (1 mark) aided by celebrity players using the game (1 mark), allowing greater revenue from in-game purchases, despite the game being free (1 mark).

Reference to figures (1 mark), e.g. 45 million playing the game/30 million downloads by March/$296m from in-game purchases in April alone.


Greater demand for headsets (1 mark) from Fortnite players (1 mark). This is an example of complementary products/joint demand (1 mark).

Reference to figures (1 mark), e.g. annual sales have been increasing by 185%.

c 3 marks for the following:

Greater advertising revenue for Facebook (1 mark) from streaming Fortnite games on its website (1 mark). This is particularly lucrative as it targets the key target market of young viewers (1 mark).

Reference to extract (1 mark), e.g. Facebook could stream Michael Baty’s Fortnite games on its site.

Costs6 1 mark for each clear definition/formula.

a

Marginal cost is the additional cost of producing one more unit of output (1 mark).

Accept marginal cost formula = ∆TC/∆Q (1 mark)

b Average cost is equal to total cost divided by quantity (1 mark).

c Fixed costs are costs that do not vary with output (in the short run) (1 mark).

7 1 mark per completed column (6 marks):

Total output

TC (£) TFC (£) TVC (£)

AVC (£) AFC (£) AC (£) MC (£)

0 100 100 0 – – – –3 150 100 50 16.67 33.3 50 16.67

10 200 100 100 10 10 20 7.1424 250 100 150 6.25 4.16 10.42 3.57




36 300 100 200 5.56 2.78 8.33 4.1640 350 100 250 6.25 2.5 8.75 12.542 400 100 300 7.14 2.38 9.52 25

8 4 marks; possible answers include:

When a firm continues to add more variable factors to a fixed factor (1 mark) marginal productivity (or marginal product) will eventually fall (1 mark).

This means marginal cost will rise (1 mark), which is the cost of producing an additional unit (1 mark).

Explanation of rising marginal costs:

– e.g. the farm will continue to add more workers, which increases total costs but each

worker will increase total output by less (2 marks)

– e.g. numerical example (2 marks)

Example: farmers getting in each other’s way as more are added (1 mark).

9

a 1 mark for workings, 1 mark for correct answer:

= (($70 – £54.90)/$54.90) 100 (1 mark) = 27.5% (1 mark)

NB 2 marks if correct answer given, even without workings or different rounding

b 1 mark for workings, 1 mark for correct answer:

= $38 billion 0.88 (1 mark) = $33.44 billion (1 mark)


10 1 mark per point, up to 3 marks:

Cost of fuel is a variable cost (1 mark).

Variable costs vary with output (1 mark).

This is because more fuel is needed to fly an increasing number of planes (1 mark).

11 4 marks for a clear diagram showing:

original marginal cost and average cost curves (1 mark)

shift inwards of marginal cost (1 mark)

shift upwards of average cost (1 mark)

marginal cost hitting average cost at its minimum (1 mark)




Economies and diseconomies of scale12

a 1 mark for a clear definition, such as:

The output level at which the (internal) economies of scale have been fully exploited (1 mark).

The scale/quantity at which long-run average cost is minimised (1 mark).

b 3 marks for a clear diagram, showing:

U-shaped LRAC curve (1 mark) with labelled axes and curve (1 mark)

clear annotation of MES at the bottom of the LRAC curve (1 mark)

13 Possible answers include the following:

a Up to 3 marks:

Diseconomies of scale are factors that cause long-run average cost to rise as the firm’s output increases (1 mark).

Examples of diseconomies of scale (2 marks); either one explained or two identified:

– e.g. communication problems due to the size of the organisation

– e.g. coordination problems when managing a large firm

– e.g. bureaucracy and form filling needed in large firms

– e.g. morale issues as workers feel isolated or do not have a significant impact on firm

performance

b Up to 3 marks

External economies of scale are factors that cause long-run average cost to fall as the size of the industry increases (1 mark).

Examples of external economies of scale (2 marks); either one explained or two identified:

– e.g. skilled labour attracted to the area

– e.g. suppliers locating nearby

– e.g. benefits of better infrastructure

– e.g. shared innovation


The long-run average cost curve is derived from the short-run average cost curve (1 mark).

The LRAC curve is a combination (or envelope curve) of all the various SRAC curves (1 mark), with each SRAC curve tangential (or just touching) the LRAC curve (1 mark).




Each short-run average cost curve represents a different scale (1 mark); the scale can only be varied in the long run when all factors are variable (1 mark).

15 2 marks for clear definition, including:

Factors that cause long-run average cost to fall (1 mark) as the size of the firm’s output increases (1 mark).

NB If no reference to long run, maximum 1 mark

16 2 marks for two types identified and applied to McDonald’s:

Financial (1 mark) as McDonald’s can gain lower interest rates due to having a lower risk of failure (1 mark).

Marketing (1 mark) as McDonald’s can spread advertising cost over more units (1 mark).

Managerial (1 mark) as McDonald’s can afford to employ specialist managers and spread the costs over more units (1 mark).

Technical (1 mark) as McDonald’s can afford specialist equipment and can spread the cost over more units (1 mark).

Normal profit, supernormal profit and losses17 1 mark for any of the following:

Normal profit is where average cost = average revenue (1 mark).

Normal profit is where total revenue = total cost (1 mark).

Normal profit is just enough profit to stay operating in the industry and not switch to the next best alternative (1 mark).

18 1 mark for each column completed:

Quantity Price (£) Total revenue (£) Total cost (£) Total profit (£)150 5 750 300 450300 4 1,200 450 750450 3 1,350 600 750

19

a 1 mark per correct annotation:

Short-run shut-down point annotated at minimum AVC (1 mark)

Long-run shut-down point annotated at minimum AC (1 mark)

b Possible answers include the following, up to 3 marks:

It should continue in the short run as it is covering average variable costs (1 mark) and so the firm is still making a contribution to paying back fixed costs (1 mark), which will minimise its losses (1 mark).




In the long run the firm should shut down as it is making a loss (1 mark). Firms need to cover all costs to continue operating in the long run (1 mark).

20 2 marks for identifying two factors and 2 marks for briefly explaining them:

Lack of sales/revenue (1 mark) due to low consumer confidence (1 mark)

Lower prices (1 mark) without significant rise in sales volume/inelastic PED (1 mark)

Lower profit margins (1 mark) falling from 4% to 2%, meaning less profit per unit (1 mark)

NB Accept any other likely reasons not mentioned in the extract.

Exam-style questions (multiple choice and short answer)1

a

Knowledge (2 marks):

Identification that total cost will be rising (1 mark).

Identification that the gradient of total cost will fall or will rise at a slowing rate (1 mark).

Diagram illustrating the firm’s MC curve (1 mark) and the related TC curve (1 mark).


Application to US car manufacturing (link to car manufacturing).

Analysis (1 mark):

Explanation of link between marginal cost and total cost:

– MC being positive but falling means each unit produced adds less to total cost than the

last.

– MC is a gradient of TC and so the gradient must also be positive and falling.

When the car manufacturer’s marginal cost curve is positive but falling this means that total cost will be rising (1 mark) but at a slowing rate (1 mark). This is because producing an extra car will increase the firm’s total cost as the marginal cost of the car is positive, but as marginal cost is falling, less will be added to total cost as the next car is produced (2 marks).

Here the student scores 4/4 marks. There is clear identification of the impact on total cost (rising/at a slowing rate) and the final sentence provides a clear explanation, in the context of car manufacturing.

b C (1 mark)

2

a Application (2 marks):

1 mark for application of the formula = £70/10 (1 mark)




1 mark for correct answer = £7 (1 mark)

NB If the correct answer of £7 is given, award 2 marks.

Marginal revenue = ∆TR/∆Q

= (£330 – £260)/(30 – 20)

= £70/10

= £7 (2 marks)

Here the student clearly gains full marks and shows very clear workings, so if a mistake was made in the final calculation they could still gain a mark.

b Application (2 marks):

1 mark for application of the formula = 50%/–15.4%

1 mark for correct answer = –3.22 (3 s.f.)

NB If the correct answer of –3.22 (or with different rounding) is given, award 2 marks

Price elasticity of demand = 50%/–15.4%

= –3.22 (2 marks)

Here the student gains full marks. Note that full marks can be gained without stating the formula/full workings. However, it is recommended that you do so.

c A (1 mark)



TOPIC 3 Market structure

Topic 3Market structure

Economic efficiency1 1 mark for a clear definition, such as:

Dynamic efficiency is achieving economic efficiency over time (1 mark).


Productive efficiency explanation (1 mark):

– e.g. producing at minimum average cost (MC = AC)

– e.g. producing where there is minimum wastage of resources by producers

Allocative efficiency explanation (1 mark):

– e.g. pricing at marginal cost

– e.g. producing goods and services that match the changing needs and wants of

consumers


Definition (1 mark), i.e. the lack of incentives/competitive pressures leading to a monopolistic firm neglecting the minimisation of average cost.

Here Network Rail is a pure/natural monopoly (1 mark) and therefore has little incentive to lower average costs because it faces no competition/no other firm can maintain the railways even if it is inefficient (1 mark), hence costs are £2 billion too high (1 mark).


Definition of productive efficiency (1 mark), e.g. minimising average cost

Definition of allocative efficiency (1 mark), e.g. pricing at marginal cost

By cutting costs (to achieve productive efficiency) by £2 billion (1 mark) Network Rail may have fewer funds for investment/improvements in rail network (1 mark), meaning a possibility of more delays, which is against the public/train customers’ interests (i.e. reducing allocative efficiency) (1 mark).

Perfect competition5 1 mark for any explanation:




A firm that can alter its rate of production and sales without significantly affecting the market price of its product (1 mark).

A firm that has no market power and therefore must set the market price (1 mark).

A firm that must set average revenue equal to marginal revenue (1 mark).

6 1 mark per assumption, up to a maximum of 3 marks:

Large number of buyers and sellers (1 mark)

Homogeneous product (1 mark)

Low barriers to entry and exit (or freedom of exit and entry) (1 mark)

Perfect information (1 mark)

7


= 25,000 £2.50 (1 mark) = £62,500

NB 2 marks if correct answer given, but only 1 mark for 62.5 as incorrect units

b 1 mark for workings, 1 mark for correct answer:

= 25,000 (£3.50 – £2) (1 mark) = £37,500


c 1 mark for workings, 1 mark for correct answer:

= 25,000 £3.50 (1 mark) = £87,500


d 1 mark for workings, 1 mark for correct answer:

= 25,000 (3.50 – £2.50) (1 mark) = £25,000 loss or –£25,000 (1 mark)

NB 2 marks if correct answer given, but only 1 mark for –25 or 25 loss as incorrect units

8 1 mark for each of the following points, up to 6 marks:

Definition of normal profits (1 mark), e.g. where AC = AR

Definition of the long run (1 mark), e.g. where all factors are variable

Firms will exit the market (1 mark) due to making losses (1 mark) and barriers to exit being low (1 mark). This will decrease industry supply (1 mark).

The firm will see price/demand rise (1 mark) until AC = AR (1 mark), and there is no incentive for firms to exit the market (1 mark) as they are now making normal profits rather than losses (1 mark).

9 4 marks for completing the table, showing:




productively efficient in the long run (1 mark) but not the short run (1 mark)

allocatively efficient in the short run (1 mark) and long run (1 mark)

10 2 marks for each reason (1 for identification and 1 for explanation):

Low profits being earned by steelmakers (1 mark):

– e.g. shows high degree of competition/many firms/low barriers to entry (1 mark)

– e.g. profits competed away in perfect competition (in the long run) (1 mark)

Steel is a homogeneous product (1 mark):

– e.g. steel produced to an industry standard (1 mark)

– e.g. steel similar to other commodities, such as wheat or copper (1 mark)

– e.g. steel firms will be price takers for standard steel (1 mark)

Large number of steel makers (1 mark):

– e.g. 60 firms producing over 5 million tonnes (1 mark)

– e.g. even the market leader only has 6% market share (1 mark)

– e.g. showing a high degree of competition/low barriers to entry (1 mark)

Perfect information (1 mark):

– e.g. production process for steel easy to find out (1 mark)

– e.g. world price of steel available for consumers (1 mark)

– e.g. industry standards for steel known for production (1 mark)

Low barriers to entry (1 mark):

– e.g. no significant branding as steel is a homogeneous product (1 mark)

– e.g. only real barrier to entry is start-up costs (1 mark)


Allocative efficiency is where firms price at marginal cost (or are meeting customer needs and wants) (1 mark).

Perfectly competitive firms are price takers (1 mark) because they have no market power/produce homogeneous products, so cannot price above marginal cost (1 mark) — if they did the firm would gain no revenue as consumers would switch to the large number of rival firms (1 mark).

Diagram showing perfect competition to illustrate pricing at marginal cost (1 mark), with explanation (1 mark).




Monopolistic competition12 1 mark each, possible answers include:

a

Differentiated products (1 mark)

Firms being price makers (1 mark)

b

Low barriers to entry/exit (1 mark)

Large number of firms in the market (1 mark)

Each firm having a relatively small market share (1 mark)

13 1 mark for each relevant example; possible answers include:

Local hairdressers

Local takeaways

Taxi companies

14 4 marks for a diagram showing monopolistic competition in the long run:

Downward sloping and relatively elastic AR/MR curves (1 mark)

Profit-maximising price and quantity shown (1 mark)

Normal profits being made (1 mark)

All curves and axes labelled correctly (1 mark)

15


Productively inefficient (1 mark) and annotation of diagram showing the firm not producing at minimum AC (1 mark).


Allocatively inefficient (1 mark) and annotation of deadweight loss triangle or that price is above marginal cost (1 mark).

16

a 1 mark per point, to a maximum of 3 marks:

In monopolistic competition firms have differentiated products (1 mark).




Example of firm differentiating products, such as quality of haircuts between local salons (1 mark).

This gives firms some market power (1 mark) and price-making ability (1 mark), as illustrated with a downward-sloping demand curve.

Only perfectly competitive firms do not have a downward-sloping demand curve, where they sell homogeneous products (1 mark).

b 1 mark per point to a maximum of 3 marks:

In monopolistic competition there are low barriers to entry and exit (1 mark).

Example of firm with low barriers to entry, such as local hairdressers just needing basic equipment to start up (1 mark).

When profits are made in the short run there is an incentive for firms to enter the market (1 mark). This reduces demand and profits for existing firms (1 mark) and will continue until normal profits are made (1 made)

17 Analysis = 6 marks for two reasons explained in context; possible answers include the following:

Low barriers to entry and exit (1 mark):

– e.g. low start-up costs (1 mark), such as renting a car and getting a licence (1 mark)

– e.g. customers not very brand loyal (1 mark) — may take next taxi available whatever the

company (1 mark)

Differentiated product (1 mark):

– e.g. examples of differentiating taxis, such as customer service (1 mark) or cars (1 mark)

– e.g. Pink Taxi example (1 mark), with development (1 mark)

Large number of small firms in the market (1 mark):

– e.g. no firm with dominant market share in UK taxi industry (1 mark)

– e.g. over 18,000 taxi firms operating in the UK (1 mark)

Evaluation (2 marks for one point explained or 1 mark per evaluation point identified):

Question the assumptions:

– e.g. how differentiated can a taxi journey be? Is it nearly homogeneous?

– e.g. there are still some start-up costs and possibly some brand loyalty

– e.g. in a local area firms may have more local market power

Long term vs short term: e.g. what impact will taxi phone apps have on the industry in the long term?

Significance and prioritisation of reasons, with justification.




Oligopoly18


= 20.9% + 15.8% + 12.1% (1 mark) = 48.8% (1 mark)


b 1 mark for a characteristic and 2 marks for an explanation in context, such as:

Interdependence (1 mark): this means the strategies of one firm depend on the actions of the others (1 mark). For example, Apple may develop a new phone after Samsung releases one (1 mark).

High barriers to entry (1 mark): for example, there may be brand loyalty (1 mark) — some Apple customers are very loyal to the iPhone, making it hard for new phone manufacturers to become established in the market (1 mark).

Product differentiation (1 mark): each firm will produce different products from one another, such as different/better features on the phones, e.g. a high-definition camera (1 mark), giving them market power/providing a barrier to entry via brand loyalty (1 mark).

c 2 marks for difference between pricing strategies and 2 marks for application, such as:

Explanation of difference between limit pricing and predatory pricing (2 marks):

– e.g. limit pricing is used to deter entry into a market (1 mark) whereas predatory pricing is

attempting to put existing firms out of business (1 mark)

– e.g. limit pricing involves pricing below the potential entrant’s average cost (1 mark),

whereas predatory pricing is pricing below average variable cost (1 mark)

Application to smartphone industry (2 marks): e.g. Samsung could limit price in order to stop new mobile firms entering the market (1 mark) or use predatory pricing to eliminate smaller smartphone manufacturers in the market, such as Oppo (1 mark).

19 Up to 3 marks for the following:

Identification that the truck manufacturers are using overt collusion (1 mark).

Overt collusion involves forming a cartel/firms agreeing to restrict competition using a formal agreement (1 mark).

Application to extract (1 mark), such as meetings/phone calls/emails.


Game theory matrix (up to 2 marks):

– Accurate game theory matrix (1 mark), applied to truck manufacturers (1 mark).




Explanation of impact on profits (up to 3 marks):

– Definition of profits (1 mark) or collusion (1 mark).

– Identification of higher profits (1 mark) due to higher prices (1 mark) set by all members

of the cartel (1 mark), so consumers have no choice but to pay the higher prices (1

mark).

– Reference to game theory matrix to show profits before (1 mark) and after (1 mark)

collusion taking place (1 mark).

21 Analysis = 6 marks:

Explanation of one pricing strategy in the context of truck manufacturers (3 marks):

– e.g. predatory pricing

– e.g. limit pricing

– e.g. price war/undercutting rivals

– e.g. sales or revenue maximisation

Explanation of one non-pricing strategy in the context of truck manufacturers (3 marks):

– e.g. research and development

– e.g. improved trucks, such as fuel efficiency/reduced environmental damage

– e.g. better distribution

– e.g. after-sales service

Evaluation = 2 marks, for two identified points or one developed point. Possible points include:

Limitations of strategies (e.g. cost of strategies, whether strategies are legal or effective).

Depends on rival response (e.g. rivals truck manufacturers may also reduce price/improve trucks).

Short-term vs long-term impacts (e.g. short-term costs of non-price strategies, but longer-term benefits).

Prioritisation/conclusions (with justification) on the best method(s).

Monopoly22 2 marks for two clear definitions, such as:

Natural monopoly (1 mark):

– e.g. an industry in which it is most efficient (involving the lowest long-run average cost)

for production to be permanently concentrated in a single firm rather than contested

competitively




– e.g. an industry with one firm that exists as a result of the high fixed or start-up costs of

operation or significant economies of scale

Pure monopoly (1 mark):

– e.g. one firms controls the entire market

– e.g. there is only one firm in the market

– e.g. one firm has 100% market share

23

a Price OC or C (1 mark); quantity OG or G (1 mark)

b CDEB (1 mark)


Not productively efficient as not producing at minimum AC (1 mark).

Reference to diagram (1 mark), e.g. producing at E not K on average cost curve.

Not allocatively efficient as price above MC (1 mark).

Reference to diagram (1 mark), e.g. deadweight loss is DIF or price (C) is above MC (A).

25 2 marks for each benefit identified and explained; possible answers include:

Benefits for consumers:

– e.g. lower prices/higher consumer surplus (1 mark) if monopolies are able to gain

economies of scale and pass these onto consumers in the form of lower prices (1 mark)

– e.g. higher quality/choice (1 mark) if monopolies invest supernormal profits into areas

such as R&D

Benefits to employees:

– e.g. higher wages (1 mark) if firm has higher profits and passes some of these onto

workers in the form of higher wages (1 mark)

– e.g. job security (1 mark) if the firm is less likely to go out of business due to being a

dominant firm in the market (1 mark)


Diagram (2 marks), showing:

– increase in AR and MR on the monopoly diagram (1 mark)

– higher profits annotated on the diagram (1 mark)

Reason for higher profits (2 marks):




– Higher demand identified (1 mark).

– One reason for higher demand explained (1 mark), e.g. due to successful blockbuster

films, higher ticket and refreshment sales, successful expansion into the USA.


Definition of price discrimination (1 mark) or conditions of price discrimination (1 mark).

Use of Figure 6 (up to 2 marks):

– e.g. price discrimination by time (weekend vs weekday) (1 mark)

– e.g. price discrimination by income (student vs adult) (1 mark)

Explanation of how price discrimination can boost profits (up to 4 marks):

– e.g. application of elastic and inelastic customers (2 marks)

– e.g. link between prices, PED and TR increasing (2 marks)

Three-part diagram showing price discrimination increasing profits (up to 2 marks).

NB Cap at 4/6 marks if no use of Figure 6.

Evaluation = 2 marks, for one developed point or two points identified. Possible answers include:

Magnitude of price discrimination (refer to figures)

Counter-points/use of conditions:

– e.g. ability to determine price depends on degree of market power

– e.g. profits are reduced (slightly) by cost of reducing arbitrage

Other factors determine profitability/better strategies may be available: e.g. quality of films offered/effectiveness of advertising/economic climate.

Monopsony28 Up to 2 marks for the following:

A pure monopsony is a market where there is a single buyer (1 mark).

Application to British Sugar (1 mark), e.g. British Sugar purchases all the sugar beet grown in the UK.


Definition of monopsony power (1 mark), e.g. where firms have significant buying power/market dominated by a few buyers.

Identification that monopsony power will decrease (1 mark).




Explanation of why monopsony power decreases (up to 3 marks):

– Improved negotiating power of the farmers (1 mark) when selling sugar beet to British

Sugar (1 mark).

– The trade union will negotiate collectively on behalf of all farmers (1 mark) rather than

having to negotiate individually (1 mark).

– Farmers will have more monopoly power (1 mark), with reference to countervailing power

(1 mark).


Definition of monopsony power (1 mark), e.g. where there are a few dominant/powerful buyers.

Application (1 mark), e.g. few dominant supermarkets in the UK that purchase milk from smaller dairy farmers.

Explanation of two effects in the context of supermarkets (3 marks + 3 marks), such as:

– possible effects on supermarkets (e.g. higher profits/lower costs for supermarkets)

– possible effects on suppliers (e.g. lower prices/profits/business failure)

– possible impact on workers (e.g. improved job security and wages for supermarket

workers, or lower wages and job security for dairy farmer workers)

– possible impact on supermarket customers (e.g. lower costs passed on in the form of

lower supermarket prices, or improvements to supermarkets if profits reinvested)

Evaluation = 4 marks, for two developed points. Possible answers include:

Depends on size of dairy farmers/countervailing power arguments:

– Mega-dairies are gaining huge economies of scale, so can cope with lower prices or may

be able to negotiate better deals due to their size.

– Will dairy farmers negotiate/collude together to gain better deals?

Long-term arguments:

– e.g. dairy farmers that survive will have more selling power in the long term

– e.g. long-term benefits to customers from reinvested profits

– e.g. short-term suppliers may make reduced profits, but longer term may fail

– e.g. future mergers, such as ASDA–Sainsbury’s, would increase monopsony power

Counter-points:

– e.g. will supermarkets pass on lower costs to supermarket customers?

– e.g. some supermarkets, such as Morrisons, are increasing prices for some dairy

farmers




Magnitude of monopsony power of supermarkets (e.g. supermarkets not a pure monopsony but have significant monopsony power).

Significance and prioritisation/conclusions of impacts (with justification).

Contestability 31 1 mark for definition, 1 mark for an example:

Sunk costs are costs that have already been incurred and cannot be recovered (1 mark), e.g. advertising (1 mark), R&D (1 mark), depreciation of capital equipment (1 mark).

32 2 marks for explanation, 1 mark for application:

a

Economies of scale are factors that cause long-run average cost to fall as output increases (1 mark).

Therefore, the existing firm can be more competitive on price than the entrant due to lower costs (1 mark).

Ability to limit price below the entrant’s average cost to deter entry, as the entrant would make a loss (1 mark).

Application (1 mark) — examples of economies of scale:

– e.g. bulk buying chemicals for medicines

– e.g. financial economies of scale from being a global, reputable pharmaceutical firm

b

Brand loyalty is the tendency of customers to continue to buy the same brands rather than competing brands (1 mark).

Customers continue to trust the existing firm and continue to buy from it even when new entrants arrive (1 mark).

This means that the new pharmaceutical firm will not be able to make enough revenue to cover its costs (1 mark).


– e.g. examples of brands in the pharmaceutical industry

– e.g. need to trust brands in an industry such as pharmaceuticals

c

Patents are licences that give sole rights to producers for a set period of time (1 mark).

This means that the new firm will be unable to copy the products of the existing firm (1 mark).




The new firm will need to develop its own product, which will mean high levels of costs, such as R&D (1 mark).


– e.g. allowing exclusive rights to the drug for 20 years

– e.g. needed to give incentive for medical companies to innovate where R&D costs are so

significant


Understanding of ‘more contestable’, i.e. lower barriers to entry and exit (1 mark).

Pricing will be reduced by the current firm (1 mark).

Reasons for lower prices:

– Firms need to limit price as they face the threat of competition (1 mark) and to prevent

hit-and-run competition occurring (1 mark).

– Lower price will act as a barrier to entry for the current firm (1 mark) because entrants

will not be able to enter profitably/only normal profits are being made (1 mark).

34 2 marks for a clear definition:

A contestable market is one with low/no barriers to entry (1 mark) and low/no barriers to exit (or sunk costs) (1 mark).

35 Analysis = 6 marks, for two reasons explaining why the industry may be contestable, such as:

Large entry of new firms (reference to thousands of new apps launched each day)

Many app creators likely to be making low/no profits — an indication of contestability

Arguably easy/cheap to set up an app (e.g. online, from home)

Many different (niche) markets that apps can target to compete

Evaluation = 2 marks, for one developed point or two points identified, such as:

High concentration/revenue for top developers

Profits being earned by top developers in the market — an indication of non-contestability

Existence of well-known brands, as a barrier to entry (e.g. Disney, EA, Angry Birds)

Need for R&D/advertising could incur sunk costs

Might it become more contestable over time?

Prioritisation of reasons, with justification

Exam-style questions (multiple choice and short answer)1Edexcel Economics A Theme 3 Business behaviour and the labour market




1 mark for application of profit formula (profit margin quantity):

= £0.75 6,000

1 mark for calculating supernormal profits:

= £4,500

or

1 mark for application of profit formula (TR – TC):

= £12,000 – £7,500

1 mark for calculating supernormal profits:

= £4,500

NB If the correct answer of £4,500 is given, award 2 marks.

Supernormal profit = (£2.00 – £1.25) 6,000

= £4,500 (2 marks)

The student gains full marks here for getting £4,500. Different approaches can be used to get full marks, as long as supernormal profit is calculated accurately.

b Application (2 marks):

1 mark for application of total revenue formula (price quantity)

= £1.05 5,500

1 mark for calculating long-run total revenue

= £5,775

Total revenue = price quantity = £1.05 5,500 = £5,775 (2 marks)

The student gains 2/2 marks for the calculation and has shown good exam technique by including a clear formula and workings.

c B (1 mark)

2

a B (1 mark)


Identification of reason for breakdown of collusive agreement:

– To gain short-term profits (i.e. by undercutting/reference to matrix).

– To avoid fines (i.e. gaining immunity from being a whistleblower).




– To gain reputational benefits (i.e. from stopping collusion or damaging rival business).

Analysis (1 mark):

Linked explanation of the reason in context.

One reason for the breakdown of the collusive agreement could be a firm trying to gain short-term profits from undercutting its rival (1 mark). For example, by Fizz lowering its price to £1 it could increase its profits by £60 million (1 mark).

The student scores 2 marks for a clear reason identified in context.

c Application (2 marks):

1 mark for application of figures from matrix into a ratio:

(Fizz) £360m : £90m (Sparkli)

1 mark for simplification of ratio:

Fizz 4 : 1 Sparkli

The ratio between the profits is £360m (Fizz) : £90m (Sparkli), which is a ratio of 4 : 1.

The student gains 2/2 for clearly stating the 4 : 1 ratio of profits between Fizz and Sparkli.

3

a C (1 mark)

b Knowledge (2 marks):

Monopoly diagram with profit-maximising price and quantity (at MC = MR) (1 mark).

Correct upwards shift in average cost only (1 mark).

Application (2 marks):

Original profit area shaded/annotated (1 mark).

New profit area shaded/annotated (1 mark).




Profits have fallen on the diagram (2 marks) from C1ZXP (1 mark) to C2YXP (1 mark).

Here the student gets full marks for a clear diagram that shows the correct shift in AC and then clearly identifying the profit box before and after the change in fixed costs.

This style of question only requires a diagram with no explanation to gain full marks. However, using letters on your microeconomics diagrams can ensure precision when illustrating changes.

Exam-style questions (data response)4 a Knowledge (1 mark), analysis (3 marks):

Definition/understanding of monopsony power (1 mark)

Explanation of the benefit of monopsony, such as:

– ability to negotiate better deals with suppliers (1 mark)

– lower (variable) costs (1 mark) and higher profits (1 mark)

– ability to lower prices to compete with rivals (1 mark)

– maintaining profit margins even with lower prices (1 mark)


Application to Extract 1, referring to Lidl’s monopsony power

5-mark questions require only knowledge, application and analysis. The key here is to provide a developed answer, with use of the information provided to show context.

Here the student scores full marks, with a clear explanation of the benefit of monopsony power, in the context of Lidl and the extract:

Monopsony power is where there are a few dominant or powerful buyers (1 mark). Here Lidl has significant buying power over their suppliers as they are buying ‘middle aisle’ products for over 10,000 stores across Europe (1 mark). This is beneficial as it will allow Lidl to reduce its variable costs (1 mark) due to its strong negotiating position relative to suppliers allowing them to negotiate better deals (1 mark). This could allow Lidl to lower its prices to compete with other discount stores, such as Aldi (1 mark).




b KAA = 6 marks:

Definition/understanding of contestable markets.

Application to Extract 1 and Figure 8.

Explanation of reasons why the market has low contestability, such as:

– high concentration/dominated by strong brands

– high barriers to entry, such as economies of scale, start-up costs, locations

– high sunk costs, such as advertising

Evaluation (4 marks)

Arguments that the market is contestable:

– successful entry of Aldi/Lidl into the market

– reduced brand loyalty, with customers becoming more price sensitive

– many barriers can be overcome by a dominant firm like Amazon, with a strong brand and

large finances

Long term vs short term (e.g. entry of Amazon in the long term could show increasing contestability)

Magnitude of arguments

Significance and prioritisation of arguments, with justification

For 10-mark questions there are 6 marks for KAA and 4 marks for evaluation. The best technique for analysis is to cover one or two issues in context, depending on the question, and then provide two applied and developed evaluation points.


A contestable market is one where there are low barriers to entry and exit (i.e. low sunk costs).

The UK supermarket can be argued to have low contestability due to having high barriers to entry and exit. The industry is clearly dominated by a few dominant supermarkets, with the top four firms controlling 58.1% of the market. These supermarkets are all very well-known brands, such as Tesco and ASDA. This makes it difficult for new supermarkets to set up in the market successfully as shoppers are likely to be brand loyal to one of the major supermarkets, which will therefore limit the number of customers switching to the entrant. This is made even more likely because a new entrant may not be able to gain the economies of scale, such as purchasing economies from bulk buying stock for the stores, to drive down long-run average costs and therefore be able to enter and compete on price with existing supermarkets.




New entrants also face high start-up costs of setting up a supermarket, such as the stores, recruitment, stock and advertising. The new entrant may not have the finances to afford these costs and therefore be unable to enter the market, even if customers were willing to switch to them. Advertising is also a sunk cost — a barrier to exit — because it is unrecoverable and will make it unprofitable to leave the market until it has covered this cost with higher revenue. Therefore, barriers to both entry and exit are increased due to high costs and this makes the supermarket industry less contestable as new firms cannot enter and exit the market. L3 KAA

However, the market is to some extent contestable, as shown by the entry of Lidl/Aldi. The entry of firms into the market shows that to some extent firms are able to overcome barriers to entry in the supermarket industry. These discount supermarkets have been able to compete on price, to some extent due to buying a limited range of products in store at low cost, despite the brand loyalty and larger scale of supermarkets like Tesco and ASDA. L2 EV

The contestability of the UK supermarket market could change over time. Extract 1 mentioned that Amazon could enter the market, showing that further entry is possible into the industry due to its strong brand and finances, and therefore contestability may increase in the long term. However, the extent to which further entry could happen will depend on the real incomes of consumers, as this was a driving factor in the success of Lidl and Aldi and the reduction in brand loyalty. If the UK was to fall into a recession post Brexit, this could increase contestability as Amazon and others could enter with lower-priced groceries to compete with the big four. L2 EV

c KAA = 9 marks:

Understanding/definition of market share

Use of game theory:

– suitable and applied pay-off matrix or use of kinked-demand theory

– explanation of interdependent firms, basing their decisions on likely reactions of others

– explanation of best strategies available

– use of the prisoner’s dilemma

Application to Lidl/Extract 1

Possible strategies to increase market share include:

– pricing strategies (e.g. price war, predatory pricing, limit pricing)

– non-pricing strategies (e.g. online deliveries, changes to product range, increased

coverage of stores)

– horizontal integration (e.g. taking over rival supermarkets, such as Aldi)

NB Maximum level 2 KAA if no use of game theory (maximum 6 marks)





Limitations of strategies:

– e.g. cost of non-price strategies

– e.g. legality of predatory pricing

– e.g. effectiveness of strategies aimed at boosting market share

Reaction of other companies may reduce effectiveness

Critique/evaluation of game theory

Long-term vs short-term ways of boosting market share

Prioritisation/conclusions (with justification) — relative merit of strategies

On this 15-mark question you need to cover two points, in detail and context, to score 9/9 for KAA and then two very well-developed evaluation points to gain 6/6 for evaluation. On this question you specifically need to link strategies specifically to market share and use game theory to gain top-level analysis.

Here the student scores 15/15 marks:

Market share is defined as the percentage of total revenue controlled by a single firm in the market. Lidl has the seventh highest market share in the UK supermarket industry and is looking to continue to increase this.

Firstly, Aldi could use pricing strategies in order to increase their market share, with consumers ‘worried about real incomes’. The game theory matrix below shows the revenue for milk at different prices between Aldi and Lidl.

Aldi @ 50p Aldi @ 25pLidl @ 50p Both earn £200,000 Lidl earns £50,000

Aldi earns £300,000Lidl @ 25p Lidl earns £300,000

Aldi earns £50,000Both earn £120,000

Assuming that both Aldi and Lidl are setting a price of 50p per pint of milk, they will earn £200,000 revenue each. Therefore, in order to increase their market share Lidl could undercut Aldi with a price of 25p per pint. This would lead to Lidl earning £300,000 and Aldi only £50,000. Therefore, Lidl will be gaining higher revenue relative to Aldi and therefore increasing its market share overall. Lidl could go further and price many products below average variable cost in order to try to force smaller firms, like Iceland, out of the market. Forcing Iceland to price below average variable cost will mean making a loss and, assuming Lidl has greater retained profits than Iceland, it could survive making a loss longer. If Iceland left the market then Lidl could potentially gain some of Iceland’s customers and market share. L3 KAA




However, there are issues with using pricing strategies in order to boost market share in the longer term. Although in the short term Lidl could gain market share by lowering price, this will probably lead to a price war in the long term, with firms like Aldi following suit with lower prices. If Aldi cut its price to 25p per pint as well, then they will both earn £120,000 and Lidl will not have gained market share against its rival. If, as in the case of predatory pricing against Iceland, the price war forces price below AVC then this may not be effective as it is illegal, so this could lead to fines and reputational damage, which could reduce Lidl’s market share in the long term. L3 EV

Secondly, Lidl could use non-pricing strategies in order to boost market share. One way to do this would be to make changes to its product range. Many British shoppers are brand loyal to certain brands and therefore if Lidl could offer these recognisable British brands this could lead to supermarket shoppers being more willing to shop at Lidl compared with other rival supermarkets as they now feel they can do their entire weekly shop in store. They could also be enticed in by a greater range of middle aisle offers, which could be changed more regularly or improved to meet customer needs following market research. These changes to Lidl’s product range could therefore lead to an increase in demand (from AR1 to AR2) for groceries at Lidl and therefore an increase in total revenue from P1AQ1O to P2BQ2O, as shown in the diagram below:

Therefore, as Lidl is gaining customers and revenue at the expense of other supermarkets, it will see a further increase in its market share. L3 KAA

However, widening its product range may not boost its market share. Although providing more branded and higher-quality products could attract customers, there is no guarantee of this. Many customers will continue to be brand loyal to other supermarkets, who will also have these products too, and may still consider Lidl as the ‘poor man’s shop’, even if improvements are made to its range. It can take a long-time for customer perceptions to change about a brand. If Lidl is really going to gain significant market share growth in the coming years then it will need to target more middle-income consumers, many of whom may take a long time to switch their attitudes and their weekly shop to the discount supermarket. There may therefore be a limit to how much market share Lidl can get, with discount supermarkets only forecast to take up 20% of the British market according to Extract 1. L3 EV




5 KAA = 16

Understanding of price discrimination (e.g. definition, conditions of price discrimination)

Application to pharmaceuticals (e.g. LEDCs elastic PED and MEDCs inelastic PED)

Diagrammatic analysis (e.g. three-part diagram, appropriating consumer surplus diagram, external benefit diagram)

Possible economic effects on producers:

– higher revenue/profit

– appropriation of consumer surplus

– entry deterrence

– dynamic efficiency arguments

– cross-subsidisation

– benefits of customer loyalty in future

– economies of scale as output increases

Possible economic effects on consumers:

– impact on price for consumers and consumer surplus (e.g. lower prices and higher

consumer surplus in LEDCs)

– private and external benefits of medical drugs/living standards (e.g. greater access in

LEDCs)

– benefits from improved product development (e.g. due to firms reinvesting)


Counter-points

– e.g. higher prices in MEDCs whereas lower prices in LEDCs

– e.g. higher costs to prevent arbitrage/smuggling

– e.g. greater scrutiny on firms as profits and market share rise

– e.g. more dynamic efficiency but less static efficiency?

It depends:

– e.g. on whether firms invest in R&D or pay dividends to shareholders

– e.g. on how well the conditions of price discrimination are met, such as arbitrage

– e.g. the ability to raise price depends on level of competition in MEDCs

Long-term vs short term:

– e.g. long-term impact of dynamic efficiency

– e.g. development of customer loyalty over time in elastic markets




– e.g. market power could be lost as patents expire in future

Significance of arguments (e.g. of arbitrage for the success of price discrimination).

Conclusion/informed judgement (e.g. will consumers or producers benefit more, with justification?).

For 25-mark essays the best technique is to provide two extremely well-developed paragraphs of analysis, in the context of the industry given/chosen and using diagrammatical analysis where possible. This should allow two level 4 KAA paragraphs and therefore access to the highest mark. Two evaluation points are needed as well, in context and with development. This, along with an informed judgement (often in an overall conclusion), gets a response into top level for evaluation.


Price discrimination means setting different prices for different customers/markets for the same product. Here pharmaceutical companies are discriminating by charging different prices for pharmaceuticals to different countries.

The first economic effect is on pharmaceutical companies in the form of higher profits. By using price discrimination, the companies will be charging higher prices for drugs in MEDCs because they have higher incomes and therefore more price inelastic demand, as the cost of medicines will be a smaller percentage of people’s income. This will lead to higher total revenue for the companies as there will be a less than proportionate fall in quantity demanded following the increase in price. In contrast, lower prices will be charged in LEDCs where there are lower incomes and more price elastic demand, as medicines will take up a larger percentage of incomes. This again will lead to higher total revenue, this time because there will be a more than proportionate increase in quantity demanded following the decrease in price. This can be shown on the three-part price discrimination diagram below:

The higher price of Pa in MEDCs and lower price of Pb in LEDCs will lead to a higher total profit combined than in the industry diagram (on the right) where there is no price discrimination. Therefore, assuming costs of serving both markets are the same, then total profit will increase as a result of price discrimination. L4 KAA

However, although many of the conditions for price discrimination hold for this example, the possibility of arbitrage may reduce the chance of making increased profits. For price discrimination to be successful it must not be possible for reselling to take place between the two markets (i.e. no arbitrage can take place). In this case it would mean medicinal




drugs being bought at a low price in LEDCs and then resold at a price lower than set in the MEDCs. This can be highly profitable for firms to do given the scale of the pharmaceutical industry. In effect this would mean that the pharmaceutical companies would be selling all drugs at the lower price, as there would be no incentive for those in the MEDC to purchase at the higher price. Whilst measures could be put in place to stop this taking place, it would be hugely costly and almost impossible to ensure that no drugs were resold. L3 EV

Secondly, there could be an effect on consumer welfare in LEDCs. As can be seen from the price discrimination diagram, the price of drugs sold in LEDCs is Pb and is a much lower price than without price discrimination. This will lead to higher consumer surplus for these customers as there will be a larger difference between the market price and their maximum willingness and ability to pay. It will also increase the consumption of life-saving drugs. A higher consumption of healthcare will improve the private benefit directly to consumers in terms of higher life expectancy and quality of life. It will also lead to external benefits (positive third-party effects) as there will be less spread of disease to others in local communities and a larger, more productive workforce for firms in LEDCs. This should allow an increase in profits and employment, as well as an increase in economic growth and tax revenue for the benefit of the economy as a whole. In effect, the LEDC is moving towards the social optimum shown in the diagram below:

The market equilibrium is Qfm, where MPC = MPB and the social optimum is Qs, where MSC = MSB. Currently there is underconsumption of (Qs – Qfm). The lower price of drugs should increase quantity from the market equilibrium towards the social optimum and the country will be benefiting from part of the welfare gain (XYZ). Therefore, this is reducing the market failure associated with underconsumption of healthcare. L4 KAA

However, consumers in MEDCs will certainly be losing out in terms of welfare. These consumers will be facing higher prices for medicine and healthcare in general. Therefore, there consumer surplus will fall compared with a situation of no price discrimination. Whilst, on average, incomes are higher in MEDCs, there is still significant income inequality. For countries like the US where there is no equivalent to the NHS, this could mean severely damaging effects on those in poverty and increased inequality in the




country. Even countries with state healthcare, like the UK with its NHS, will see higher costs of drugs at a time when healthcare budgets are already stretched. This could lead to worse provision, which is relied upon more by those at the bottom of the income distribution. L4 KAA

Overall, the benefits of price discrimination in pharmaceuticals would be mainly gained by citizens of LEDCs where they desperately need cheaper medicine to improve living standards. However, in reality, this policy is unlikely to be put into practice because the profits from doing so would be low or even negative, due to the significant logistical difficulties of preventing reselling. This is in contrast to other markets, where businesses find it very profitable to price discriminate, such as in the travel and cinema industries. Informed judgement L3+ EV



TOPIC 4 Labour market

Topic 4Labour market

Demand and supply of labour1 1 mark for definition, 1 mark for application to builders:

a

Definition (1 mark): when something is demanded only because it is needed for the production of other goods.

Application to builders (1 mark), e.g. builders demanded in order to build houses.

b

Definition (1 mark): where a change in the wage leads to a more than proportionate change in the quantity of labour supplied.

Application to builders (1 mark), e.g. easy for workers to join the building professions when builders’ wages rise.

Wage determination2 Possible answers include the following, up to 3 marks each:

a

Builders’ wages lower than under a perfectly competitive labour market (1 mark).

Application to diagram, i.e. wage falls from W1 to W2 (1 mark).

Reason for fall in wage (1 mark), e.g. monopsonist uses its buying power to exploit workers and lower wages as workers have few options for where to work.

b

Number of builders employed will be lower than under a perfectly competitive labour market (1 mark).

Application to diagram, i.e. employment falls from Q1 to Q2.

Reason why employment falls (1 mark), e.g. monopsonist lowering wage means it can employ fewer workers because there is less incentive to work at a lower wage (or they switch to another occupation).

3 Analysis = 6 marks, with 3 marks for the diagram:




Diagram showing higher wages for engineers (up to 3 marks):

– Original demand and supply, with equilibrium wage (1 mark)

– Increased demand for labour (1 mark)

– New equilibrium wage (1 mark)

Explanation of higher wages for engineers (up to 3 marks):

– Higher derived demand for engineers (1 mark) leading to a higher wage.

– Expansion of engineering firms leads to more demand for engineers (1 mark).

– Reference to wage inelastic supply of engineers increasing the impact of higher demand

on the wage of engineers (1 mark).

– Application to extract (1 mark), e.g. above-inflation wage increase, £53,913 average

salary in oil/gas sector 2018, 200,000 engineers needed each year by 2024.

NB Accept arguments based on ‘skills shortage’/excess demand driving up wages.

Evaluation = 2 marks, for one developed point or two points identified. Possible answers include:

Short term vs long term:

– e.g. longer-term supply of engineers should increase due to T-levels and lower wages

– e.g. demand for engineers a long-term issue, until at least 2024

Magnitude issues, e.g. large increase in demand for engineers of 200,000 a year.

It depends on PES of labour, e.g. the more inelastic labour supply is, the greater the impact of demand on wages.

Other factors may be significant in determining engineering wages.

Labour market failure and government intervention


Market failure is where the price mechanism fails to allocate resources efficiently and leads to a misallocation of resources (1 mark).

Geographic immobility is the inability of workers to move areas to take available work (1 mark).

Example of cause of geographic immobility (1 mark), e.g. house price differentials/social ties/differences in cost of living.

Reason(s) why this is an example of market failure, such as:




– It leads to structural unemployment because workers are unable to move to areas where

jobs are available (1 mark) and leads to unemployed resources/inefficiency/operating

inside the PPF (1 mark).

– It can lead to rising inequality/poverty because workers are unable to find employment (1

mark), as well as between regions in the UK (1 mark).

5 1 mark per correct box completed. Possible answers include:

Causes of geographic immobility: house price differences/cost of living differences/social ties/rental cost differences/language barriers

Government intervention: relocation subsidies (or similar)

Causes of occupational immobility: skills mismatch/lack of transferable skills/lack of training/lack of qualifications/lack of education/demotivation from long-term unemployment

Government intervention: government training schemes (or similar)

6 4 marks for a diagram showing:

demand and supply of labour (1 mark)

axis labels applied to labour market (i.e. wage, employment) (1 mark)

minimum wage line (1 mark)

unemployment (1 mark)


Public-sector wage setting is where wages are set by the government for their workers (in the public sector) (1 mark).

Application (up to 2 marks):

– Government scrapping 1% pay cap for public-sector workers (1 mark).

– Wages are set by the government for teachers/police/armed forces (1 mark).

– Example of wage increase, such as 2% rise for the police (1 mark).

8 Analysis = 6 marks. Possible answers include:

Definition of a maximum wage, i.e. a legal wage which they cannot rise above (1 mark)

Diagram (up to 3 marks) showing:

– original equilibrium (1 mark) with maximum wage, set below equilibrium (1 mark)

– excess demand annotated on diagram (1 mark)

Explanation of economic effects of a maximum wage (up to 3 marks per point), such as:




– Reduced income inequality (1 mark): wages of the top earners will be reduced and

therefore reduce income inequality (1 mark), which currently sees executives earn 150

times as much as the average worker (1 mark).

– Skills shortages (1 mark), as there will be a contraction in the supply of labour and an

expansion in demand for labour (1 mark); this will lead to some employers being unable

to find the staff they require (1 mark).

– Reduced costs for firms (1 mark) because top earners are no longer being paid higher

salaries, reducing fixed/total costs (1 mark), with knock-on effects (e.g. higher profit,

more chance of reinvestment) (1 mark).

– Reduced incentive to work/earn/train (1 mark) — if wages are capped then top earners

may decide not to work as much and substitute for leisure (1 mark), with knock-on effects

on tax revenue, growth, etc.

– UK workers leaving country (1 mark) as wages capped in UK, and can earn more abroad

(1 mark), with knock-on effects, e.g. loss of tax revenue, brain drain, impact on future

economic growth (1 mark).

– Moral/fairness arguments (1 mark): some will argue it is not fair for some workers to earn

so much more than others (1 mark), and therefore it is morally right to restrict the wages

of those at the top, such as elite footballers (1 mark).

NB if no appropriate diagram, maximum 4/6 for KAA

Evaluation = 4 marks, for two developed points, such as:

Depends on the magnitude of the maximum wage — if set too high then it may have little impact on wage differentials, as it will be above the equilibrium wage for many professions. However, if set too low then it could cause major restrictions in the incentive to work and skills shortages in the UK.

Depends on the PED/PES of labour — if PED and PES of labour are inelastic then any skills shortage will be minimal and wages can be reduced without major disruption.

Counter-points:

– There are likely to be other factors keeping workers in the UK even if maximum wages

introduced (e.g. family/social ties).

– Moral/fairness judgements are a normative concept and therefore require value

judgement. What is fair? According to whom?

May be ineffective if top executives paid in non-wage alternatives

Critical consideration of alternatives to maximum wages (e.g. income tax rises)

Prioritisation/conclusions with justification

Exam-style questions (multiple choice and short answer)




1

a C (1 mark)


Identification of one issue faced by former coal miners gaining employment in the service sector (1 mark), such as:

– underemployment

– zero hours contracts

– part-time rather than full-time work

– low wage rates

Analysis (1 mark):

Linked development of the issue, in the context of coal miners (1 mark).

Here the student scores full marks for one reason identified and explained in context:

One issue faced by former coal miners when gaining employment in the service sector is being on zero hours contracts (1 mark). Therefore, the job in the service sector may get a low number of hours a week, leading to low and uncertain wages for the former coal miners compared to the regular wage they received from coal mining (1 mark).


Identification of one factor that will determine the wage elasticity of demand for service-sector workers (1 mark), such as:

– labour as a percentage of total costs

– availability of capital as a substitute

– PED for final product

– time period

Analysis (1 mark):

Linked development of factor, in the context of the service sector (1 mark)

Here the student scores full marks for one factor identified and explained in context:

One factor could be the ability of employers in the service sector to substitute labour for capital (1 mark). For example, demand for labour may be more wage inelastic in supermarkets if managers can replace checkout staff with self-checkout if wages rise (1 mark).

2


1 mark for application of percentage change formula




= ((£8.21 – £7.83)/£7.38) 100

1 mark for correct answer; accept other rounding:

= 4.85%

= (£0.38/£7.38) 100 = 4.9%

The student gains 2/2 for a correct answer. They would have scored full marks for 4.9% on its own, but it is good exam technique to show your working in case you make a numerical error.

b C (1 mark)


Identification that the national minimum wage is likely to be below the equilibrium wage/what the worker is currently earning in that profession (1 mark).

or

Diagram showing national minimum wage set below equilibrium (1 mark).

Analysis (1 mark):

The high earners will still be paid the equilibrium wage as it will be above what the legal minimum is (1 mark).

Numerical example (which could be explained with reference to a diagram) (1 mark).

High earners are unlikely to be affected by an increase in the NMW as it is likely to be below their current equilibrium wage (1 mark). For example, if a builder is earning £8 an hour they will still be paid this as it is above £6.50 (1 mark).

The student has identified the issue that the NMW will be set below the equilibrium wage for high earners, and gets a second mark for a clear numerical example. A diagram is another way to gain these marks.

Exam-style question (data response)3

a Knowledge (1 mark):

Demand and supply diagram, showing the original equilibrium wage and employment (1 mark).


Reference to Extract 1 (1 mark):

– e.g. 30% increase in wage of engineers at mining firms

– e.g. BHP/Rio Tinto/Fortescue Metals Group all expanding

Analysis (3 marks):




Outward shift in the demand curve (1 mark).

Higher equilibrium wage shown (1 mark).

Explanation of why wages rose in Australian mining firms (1 mark), e.g. linked to derived demand for workers in expanding Australian mining firms.

This is a 5-mark question that requires a brief explanation of the answer linked to a fully labelled diagram.

The following answer scores 5/5, for a fully labelled diagram and an explanation.

The wage for workers in Australian mining firms has increased, for example those for engineers in mining firms have risen to $120,000 (1 mark). This is because of a higher derived demand for workers in mining firms following the expansion of three major mining firms (1 mark). This is shown on the diagram below, with the wage rising from W1 to W2 (3 marks):

b KAA = 6 marks

Definition/understanding of labour immobility

Definition/understanding of occupational and geographic immobility

Application to Extract 1, such as:

– ‘38% of professionals switching jobs this year’

– ‘Lack of engineers qualifying from university’

– ‘Engineers are moving from South Australia to Western Australia’

Explanation of factors affecting labour mobility, such as:

– geographic immobility, e.g. cost of housing/renting/living, social ties, transport links

– occupational immobility, e.g. level of skills/qualification, cost and availability of training

and education




Evaluation = 4 marks:

Counter-points:

– e.g. government policy could be used to reduce occupational and geographic immobility

– e.g. higher wages can overcome the cost of relocation and geographic immobility

It depends:

– e.g. geographic immobility depends on the wage increase relative to the cost of

relocation

– e.g. occupational immobility depends on the skills required for different jobs in the mining

sector

Long term vs short term:

– e.g. more switching of jobs now occurring in Australia, up to 38%

– e.g. occupational mobility could become less of an issue in the long term as more

workers are attracted to becoming qualified, such as in engineering, to earn the high

wages

Magnitude of labour immobility:

– e.g. 38% now switching jobs

– e.g. magnitude of wage increase, $15,000 higher

Significance and prioritisation of reasons:

– e.g. Extract 1 suggests the issue is more occupational than geographic

– e.g. significance of social ties as difficult to overcome with government policy

For 10-mark questions there are 6 marks for KAA and 4 marks for evaluation. The best technique for analysis is to cover one or two issues in context, depending on the question, and then provide two applied and developed evaluation points.


Labour immobility can be both geographic and occupational. Geographic immobility means the inability of workers to move areas in order to gain available work, whereas occupational immobility is the inability of workers to change professions to take this work.

Firstly, geographic immobility could prevent workers in the Australian mining industry from taking available work. For example, there could be factors limiting the ability of engineers currently working in South Australia to take a new engineering job in Western Australia. This could be because of social ties to the area, such as not wanting their children to switch schools, as well as significantly higher costs of accommodation, such




as due to house price differentials or a generally higher cost of living in Western Australia. This would mean that, despite a wage $15,000 higher, workers may be unwilling or unable to afford relocation to a new area to get a new engineering job. L3 KAA

However, higher costs of accommodation and living can be overcome through government intervention. For example, the Australian government could provide relocation subsidies for workers who are unable to afford relocation with the higher wage alone. Therefore, social and family ties to an area may prove a more significant barrier to geographic mobility. This is because these cannot be easily overcome with increased finance from a higher wage or relocation subsidies. L2 EV

Secondly, occupational immobility could prevent workers who currently work in a different profession from switching to the Australian mining sector. As stated in Extract 1, there is a ‘lack of engineers qualifying from university’. This shows that, currently, there is a lack of Australians who are able to transfer to an engineering job due to a lack of qualification. It will also take time to train to become an engineer, as it requires a university degree. Therefore, workers cannot quickly take up jobs coming up in the mining sector. L3 KAA

However, the level of occupational immobility will depend on the mining jobs that need to be filled. Whilst the issue of occupational immobility seems to be a significant and long-term issue, this may not be the case for more manual and office jobs. Given the rising wages in the mining sector, workers are more likely to have the transferable skills to take up these jobs, or it will take a much shorter time to become trained and qualified. L2 EV



TOPIC 5 Government intervention

Topic 5Government intervention

Controlling monopolies and mergers1 Up to 3 marks for one developed point. Possible answers include the following:

The competition authorities believe the merger is against the public interest (1 mark) because firms are now facing less competition following the merger (1 mark) and therefore have less incentive to act in consumers’ interests, e.g. low-priced, quality goods (1 mark).

Prices may rise after the merger (1 mark) because the new firm will face less competition/have more market power to raise prices (1 mark) and therefore reduce consumer welfare/surplus (1 mark).

Less choice after the merger (1 mark) because there are fewer firms in the market following the merger, restricting the choice of firms (1 mark), and firms may have less incentive to innovate and provide new products due to their market power/lack of competition (1 mark).

Quality of products may suffer (1 mark). Because firms now face less competition they may become complacent/inefficient (1 mark) and therefore not strive to innovate/create quality products in the long term (1 mark).

2 3 marks for one method explained. Possible answers include the following:

Price capping (1 mark):

– e.g. could improve productive efficiency (1 mark) as firms have the incentive to minimise

average cost to compensate for lower prices or an explanation via RPI – X formula (1

mark)

– e.g. could improve allocative efficiency (1 mark) as firms are forced to reduce prices

nearer to marginal cost or explanation via RPI – X formula (1 mark)

– e.g. could improve dynamic efficiency (1 mark) if firms are allowed to increase prices and

can then use profits to reinvest into better service or explanation via RPI + K formula (1

mark)

Performance targeting (1 mark):

– e.g. could improve allocative efficiency (1 mark) as the needs and wants of consumers

are being met/consumer welfare promoted via targets, such as fewer leaks (1 mark)

– e.g. could improve dynamic efficiency (1 mark) as targets could aim to improve

consumer welfare in the long term, such as via investment in new infrastructure/water

treatment (1 mark)




Quality standards (1 mark): e.g. water companies could be encouraged to be more allocatively efficient (1 mark) as they must provide water that meets quality standards, which are in the consumers’ interest (1 mark).

Profit regulation (1 mark): e.g. firms may have an incentive to be more allocatively efficient (1 mark) because there is less incentive to increase prices as profit/rate of return is capped by regulators (1 mark).

Competition policy/regulating market power (1 mark): e.g. if water companies are exploiting their market power then OFWAT could sanction anti-competitive practices, such as via fines (1 mark), and therefore efficiency should improve as regulators are a surrogate for competition (1 mark).

3 Analysis = 6 marks, for explaining two reasons why railway regulations are currently effective, such as:

Rail companies being allowed to increase prices/use of RPI + K could be effective as they should allow:

– long-term investment in the railways (improvements in dynamic efficiency), with the

highest investment ‘since the Victorian era’ and ‘98p out of every pound spent on tickets

being reinvested’

– reduction in the cost of running the railways over time (improvements in productive

efficiency)

– better service over time (improvements in consumer welfare and allocative efficiency)

– lower fares/a return to RPI – X in future once investment has been completed

Performance targets could be effective because:

– they make train companies meet targets that are in the public interest, such as

punctuality of trains (improvements in consumer welfare and allocative efficiency)

– regulators are making performance targets more stringent, such as punctuality targets

Evaluation (4 marks) for two points developed, such as:

Downsides of current regulatory system:

– Use of RPI + K has increased fares for consumers/reduced their welfare and consumer

surplus/especially when real incomes are stagnating.

– Performance targets not being met, such as Southern Rail.

– Possible conflict with productive efficiency as prices are rising substantially and more

costs may have to be incurred to attempt to meet performance targets.

– Downsides of regulation in general: imperfect information arguments (e.g. hard to set the

correct level of K or predict amount of investment needed/set correct targets and monitor

them effectively), regulatory capture arguments, cost of enforcing and monitoring

regulations.




Would other systems be better? For example, nationalisation, greater use of deregulation, price capping to reduce fares, covering investment via taxation rather than rail fares.

Long-term vs short-term arguments: e.g. railway regulation is being designed to make the UK rail industry effective over a number of years, but this has some short-term costs, such as higher fares.

Prioritisation/conclusions with justification: are current rail regulations effective?

Promoting competition and contestability4 Possible answers include the following, up to 2 marks each:

a

Privatisation involves the sale of public-sector businesses/assets to the private sector (1 mark).

Deregulation involves opening up markets by reducing barriers to entry, with the aim of promoting competition/contestability (1 mark).

b

Competitive tendering introduces competition among private-sector firms, which put in bids for work that is contracted out by the public sector (1 mark).

Therefore, this competition between the bidders hopefully leads to lower-cost bids for the government/increased efficiency/more innovative solutions (1 mark).


Identification of aim of the CMA to promote competition/promote the public interest (1 mark)

Application of encouraging entry to the banking sector (1 mark):

– e.g. 30 licences granted to new banks since 2013, some on a restricted basis

– e.g. CMA forcing RBS to provide £425 million to build up rival capability and £350 million

to promote customer switching

Benefits to banking customers from higher competition (up to 3 marks per point):

– Lower prices (e.g. lower-priced foreign exchange offered by Revolut)

– Improved customer experience (e.g. improved apps released by Monzo)

– Improved product range (e.g. ability to get cryptocurrencies through Revolut)

– Improved choice (e.g. customers can switch to get better deals/service at

Monzo/Revolut)

Evaluation = 2 marks, for one developed point or two identified points, such as:

Long-term vs short term:




– e.g. will new banks be able to survive in the long term and provide these benefits?

Counter-points:

– e.g. too much choice for consumers, and will they be able to find the best deals?

– e.g. will too much competition lead to lower profits to reinvest/economies of scale?

It depends:

– e.g. on the extent to which customers switch banks to take advantage

– e.g. on whether the increased competition is significant enough to force existing rivals to

compete, such as improving their apps

Significance and prioritisation of benefits to customers

Protecting employees and suppliers 6

a 1 mark for a clear definition, such as:

The process of taking a private-sector industry/asset into public ownership by a government (1 mark).

b Up to 3 marks for one impact explained, such as:

Lower prices/economies of scale (1 mark): e.g. by running the renewable energy industry as a state monopoly the government should be able to exploit large economies of scale and reduce long-run average cost (1 mark), and therefore be able to pass this lower cost onto consumers of renewable energy in the form of lower prices for consumers (1 mark).

Greater equity (1 mark): e.g. the government may provide renewable energy at a low cost/price, whereas a private-sector firm is aiming to make profits (1 mark) — this will help those on low incomes to afford renewable energy, aiding their consumer welfare/surplus (1 mark).

Higher social benefit (1 mark): e.g. renewable energy has many external benefits and would probably be underprovided by the free market (1 mark) — therefore, by nationalising the government could aim to provide it at the socially optimum level, increasing social benefits (1 mark).

Greater investment (1 mark): e.g. the government may invest long term in renewable energy, when the private-sector firms may not provide it if it is unprofitable in the short term (1 mark) — this could lead to further innovative breakthroughs in the long term (1 mark).

7 3 marks each for two policies explained. Possible answers include the following:




Minimum wage (1 mark): e.g. minimum wage means that even if employers have monopsony power, they cannot legally pay below it (1 mark) — this should mean that the wage is nearer to the competitive equilibrium (1 mark).

Fining firms that exploit suppliers (1 mark): e.g. a fine for firms will significantly increase their costs/damage their reputation (1 mark) — therefore, this provides a deterrent against firms engaging in exploitation of suppliers in future (1 mark).

Forming producer organisations (1 mark): e.g. by farmers being organised into producer organisations they have more negotiating power against monopsony suppliers or have countervailing power (1 mark) — therefore, the price they are offered should be fairer/nearer the competitive level, reducing exploitation (1 mark).

Minimum price scheme (1 mark): e.g. minimum price means that there is a legal minimum that dominant buyers have to pay suppliers (1 mark) — this should mean that the price they get is nearer to the competitive equilibrium (1 mark).

The impact of government intervention8 1 mark per point to a maximum of 3 marks:

Regulatory capture means that the regulators are not aiming to promote the public interest (1 mark) but instead are trying to promote the interests of the industry they are regulating (1 mark).

This could happen due to regulators becoming too close to the industry they are regulating (1 mark).

Any example of a policy (1 mark), e.g. they may set less strict environmental regulations.

9

a 2 marks for a clear definition, such as:

Where one party has more information than another (2 marks).

NB A definition of imperfect information scores only 1 mark.

b Analysis (6 marks). Possible answers include:

The Competition and Markets Authority (CMA) aims to promote the public interest/promote competition (1 mark).

Collusion is where firms restrict competition in order to increase profits (1 mark).

Here there is asymmetric information because the CMA has less information (1 mark) than the firms that are colluding (1 mark) — this is because the firms know if they have colluded but the CMA does not (1 mark).

The CMA may be unable to detect evidence of collusion (1 mark), such as phone calls/e-mails (1 mark) and therefore cannot prove that collusion occurred (1 mark).




This is especially true if collusion is tacit because there will be no formal agreement to find (1 mark), and other evidence will be needed to prove that collusion has occurred (1 mark).

Exam-style questions (multiple choice and short answer)1

a Knowledge (2 marks):

Definition/understanding of key terms (1 mark), such as:

– monopsony power (1 mark), i.e. power from being a dominant buyer

– horizontal integration (1 mark), i.e. where two firms combine from the same industry and

at the same stage of production

Identification of why monopsony power reduces (1 mark):

– merger reduces the number of sellers for the buyer

– increased importance of larger merged firm for the buyer


Application of monopsony power to Amazon (1 mark)

Application to the merger between Penguin and Random House (1 mark)

Analysis (1 mark):

Explanations relating to increased negotiating power/countervailing power (1 mark)

Explanation of impact of reduced monopsony power (1 mark), i.e. higher prices, higher profit for publishers

Diagrammatical analysis using demand and supply or monopsony diagram (1 mark)

Monopsony power is where there is a single or powerful buyer (1 mark). Amazon has monopsony power because it is a dominant buyer of books from publishers, such as Penguin and Random House (1 mark). However, following the merger there are fewer firms for Amazon to buy from (1 mark), which means that the remaining firms have more negotiating power with Amazon and can therefore try to increase the price they gain for their books (1 mark).

Here the student scores 4/4 marks. There is clear application throughout and the student has explained the concept of monopsony power and how the merger would affect this.

b B (1 mark)

2

a Knowledge (2 marks), analysis (1 mark):




Definition/understanding of deregulation (1 mark), e.g. opening up markets by lowering barriers to entry to promote competition.

Identification of benefit of deregulation for customers (1 mark), such as:

– lower prices/cost savings

– more choice

– improved service


Application of deregulation to the water industry (1 mark), e.g. business customers can now switch to water suppliers outside their local area.

Analysis (1 mark):

Linked development of benefit (1 mark).

Deregulation means opening up of markets by reducing barriers to entry, with the aim of promoting competition and contestability (1 mark). Here policymakers are allowing businesses to get water from any area of the country, not just their local supplier (1 mark). One potential benefit for customers is lower water bills (1 mark). This is because water providers now face competition from the other regional water companies and may need to lower prices in order to retain or attract customers (1 mark).

Here the student clearly understands deregulation, applying their answer throughout when explaining the benefit of the policy to customers. This answer gains 4/4.

b A (1 mark)

Exam-style question (data response)3 a Knowledge (1 mark):

Definition/understanding of competitive tendering (1 mark), e.g. introducing competition among private-sector firms, which put in bids for work that is contracted out by the public sector.

Definition of one type of economic efficiency (1 mark), e.g. productive efficiency is where MC = AC, allocative efficiency is where P = MC.


Use of Extract 1 (1 mark), such as:

– only three companies operating private prisons in Britain (1 mark)

– contract to develop a London hospital only had one bidder (1 mark)

– bidding process complicated/bureaucratic, discouraging small firms (1 mark)

Analysis (3 marks):




Lack of competition in the bidding process/collusive tendering meaning less incentive for bidders to compete with one another to win the contract (1 mark).

Productive inefficiency (1 mark), because firms do not need to minimise average cost in order to win the contract (1 mark).

X-inefficiency (1 mark) due to the market power of firms, leading to rising average costs (1 mark).

Allocative inefficiency (1 mark), because firms may not provide low-price/high-quality projects (1 mark).

5-mark questions require only knowledge, application and analysis. The key here is to provide a developed answer, with use of the information provided to give context.

Here the student scores full marks, with a clear explanation of why competitive tendering may not improve economic efficiency:

Competitive tendering is where private-sector firms compete in order to win public-sector contracts (1 mark). There is a lack of competition for many bids — for example, only two firms recently bid to develop a London hospital (1 mark). This means that firms bidding on the contract may not need to compete with rivals as aggressively in order to win the contract (1 mark). This could lead to productive inefficiency (1 mark), as there is less incentive for firms to minimise average cost in order to lower their price to gain the contract from the government (1 mark).

b KAA (8 marks):

Definition/understanding of nationalisation, e.g. the transfer of assets or firms from the private sector to the public sector.

Application to Extract 1/UK railways:

– government taking control of railway franchises over time

– ‘lower ticket prices due to lower financing costs’

– ‘significant cost for the government’

Explanation of the potential economic effects of nationalising the UK railways, such as the effect on:

– passenger welfare, e.g. possible economies of scale/lower financing costs reducing

prices, government acting in the public interest, loss of benefits of competition for

consumers, such as choice

– economic efficiency, e.g. reinvestment by the government/dynamic efficiency/external

benefits, lower prices by the government could improve allocative efficiency, central

planning/lack of profit motive/moral hazard could reduce efficiency

– government finances, e.g. cost of nationalising and running the railways/budget deficit,

revenue gained from running railways, which can be reinvested





Counter-points:

– e.g. cost of nationalising could be offset by gaining revenue

– e.g. lower prices for consumers, but a lack of choice of railways may reduce welfare

– e.g. improvements may not occur, as shown by previous experience of British Rail

Other factors determining the success of the UK railways:

– e.g. infrastructure may be more important than the debate between privatisation and

nationalisation of railways

– e.g. growth in demand may make it difficult to provide an effective service, whether it is

nationalised or not

Long term vs short term:

– e.g. significant short-term cost of nationalisation, but benefits likely to be seen over time

– e.g. time lag for benefits of reinvestment into the railways

Significance and prioritisation of economic effects, with justification

On a 12-mark question the best technique is to cover two issues in detail and with reference to the context in order to achieve level 3 KAA. Two developed evaluation points, again in context, are needed to achieve top-level evaluation. Here the student scores 12/12 marks:

Nationalisation is the transfer of assets or firms from the private sector to the public sector.

The first economic effect could be a reduction in rail fares for UK passengers as, according to Extract 1, Labour claims there will be ‘lower ticket prices’ following nationalisation. This is in part due to the ‘lower borrowing costs’ of the government due to the public sector being a lower risk debtor than the private sector, and is likely to be offered lower interest rates. The government as a monopoly provider will also be able to gain significant economies of scale, such as bulk buying fuel for the entire UK railways network and therefore a reduction in long-run average costs. As the government should be aiming to protect the public interest and not exploit their monopoly power over the railways, these cost savings are likely to be passed onto passengers in the form of lower fares, such as for season tickets. This will therefore increase the consumer surplus of rail passengers and improve their welfare. L3 KAA

However, there is no guarantee that costs will be lower under state ownership than privatisation. One reason for this could be the economic efficiency of government due to a lack of a profit motive to encourage the minimisation of average costs, as well as the potential failure of large-scale government planning of the entire UK railway. This could therefore lead to the need to increase prices or an inefficiently run railway system, with more delays. As John Vickers says, previous nationalisation ‘was not exactly glorious in terms of efficiency’ and ‘customer service’. L2 EV




The second effect of the nationalisation of the UK railways is on the government. The government’s nationalising of the railways will ‘involve taking control of the railway franchises’, which will incur a significant up-front cost. There are also the running costs of the railways, such as fuel and employing staff, which will now be the job of the government. This will have an opportunity cost for the government, as this spending could have been allocated to other areas like the NHS and education. These areas of government could provide more significant external benefits to the UK economy, in terms of improvements in productivity and improved growth. To avoid spending cuts the government’s only alternative is higher borrowing (due to a rising budget deficit) or increases in taxes (like higher income tax, which Labour suggested in the 2017 election). L3 KAA

To many this increase in government spending makes nationalisation a non-viable option due to these short-term costs and at a time when national debt is historically high. However, in the longer term the government will also be earning revenue from the sale of tickets and this could lead to the railways providing a positive boost to the government’s budget. This could allow greater reinvestment in the railways and long-term improvements to the railway network, which are crucial to its success. L2 EV

Exam-style question (essay)4 KAA (16 marks):

Understanding of the role and nature of UK competition authorities

Application to an industry in the UK

Possible policies linked to economic efficiency, such as:

– price capping (RPI – X, RPI + K)

– performance targets

– profit capping

– promoting small business

– deregulation

– privatisation

– competitive tendering (e.g. in PFI)

– competition policy


Limitations of policies:

– RPI – X may lower profits to improve dynamic efficiency.

– RPI – X could encourage cost cutting and productive efficiency at the expense of

customer needs and allocative efficiency.

– RPI + K could lead to higher prices and losses in productive/allocative efficiency.




– Problems setting the correct X and K values in price capping.

– Meeting performance targets may conflict with cutting costs and productive efficiency.

– Will there be enough competition to gain economic efficiency following

privatisation/deregulation/the promotion of small firms?

– Possibility of collusive tendering in bidding processes and monopoly power afterwards.

– Cost implications of some policies (e.g. monitoring/implementing).

Limitations of competition policy in general:

– regulatory capture

– imperfect information issues

Which policies will work best and in which combination depends on the industry

Long-term vs short-term approaches to promoting competition

Magnitude/significance of arguments/policies

Prioritisation of policies, with justification

Conclusions, with justification

For 25-mark essays the best technique is to provide two extremely well-developed paragraphs of analysis, in context of the industry given/chosen and using diagrammatical analysis where possible. This should allow two level 4 KAA paragraphs and therefore accessing the highest mark. Two evaluation points are needed as well, in context and with development. This, along with an informed judgement (often in an overall conclusion), gets a response into top-level evaluation.


In the UK, the role of the competition authorities is to promote the public interest. This is done by the Competition and Markets Authority (CMA), as well as regulators, such as OFWAT for the UK water industry. The focus of this essay will be to evaluate the policies these organisations can use in the UK water industry to promote economic efficiency, such as by productive efficiency (minimising average costs), allocative efficiency (by meeting customer needs and pricing at marginal cost) and dynamic efficiency (over time).

Firstly, policymakers can use price capping regulation to improve economic efficiency. Price capping involves putting a limit on price (usually in comparison to inflation), by using an RPI – X formula or an RPI + K formula.

An RPI – X approach is where firms can increase their prices by inflation (RPI being the retail price index) minus an X value, which is the perceived efficiency gains that firms are forecast to be able to make. So, if RPI was 2% and X was 0.5% water companies could put their prices up by 1.5% (a 0.5% cut in real terms). This will result in a real terms cut in water prices and encourage water boards to cut costs (by 0.5% or more) in order to maintain or improve profitability. Therefore, the market should become more




productively efficient, assuming water companies respond by cutting average cost, and more allocatively efficient as water bills will be nearer marginal cost. This has been applied by OFWAT in the past to cut water prices significantly and prevent water firms from exploiting their local monopoly power. The water industry has also used an RPI + K approach in recent years. OFWAT has allowed water companies to put their prices up above the rate of inflation (RPI) by a factor of K. This K was the amount estimated as being needed to fund improvements in the water industry, such as infrastructure or water treatment or to meet environmental standards. This would hopefully boost economic efficiency in the long term and promote dynamic efficiency. OFWAT therefore allowed water companies to earn higher profits, from higher prices, in exchange for longer-term improvements in the water industry and to promote the public interest. L4 KAA

However, as with any regulations, there are limitations. OFWAT has price reviews every five years and during this time they will need to estimate the values of X and K that will maximise economic efficiency in the industry. This can be difficult due to imperfect information, as it is difficult to estimate accurately the perceived efficiency gains (X value) or how much it will be necessary to reinvest to make longer-term improvements (K value). OFWAT will consult water companies to try to gain this information but there may be incentives to give the wrong values and, even if the correct values are known, they may not be implemented if regulatory capture has become an issue in the industry. Therefore, it is unlikely that these values will be set to optimise economic efficiency in the water industry. L3 EV

Secondly, policymakers can take a more market-orientated approach by putting in place measures to promote competition in markets. In the water industry this has come in the form of privatisation in previous decades and, more recently, in terms of deregulation.

Following the privatisation of the water industry in 1989, private-sector firms were set up to run water services for businesses and households in their local area. This would introduce the profit motive into the provision of water in UK markets in an attempt to improve economic efficiency. These water companies were in effect local monopolies and this was the reason for the price capping regulation discussed earlier, to act as a surrogate for competition. This situation was changed in April 2018 with the deregulation of the water industry, initially for business customers in the UK. This meant that businesses no longer had to use their local water provider and could instead choose any of the companies across the country, in a similar way to which they choose their energy suppliers. This has, for the first time, effectively created competition in the market for water as firms will need to compete with one another to gain business customers and, soon, household customers. This could have a dramatic effect on economic efficiency. There is now an incentive to minimise average costs and gain productive efficiency, as this will allow water companies to either lower their prices to gain clients or improve their profit margins. Should prices drop, this will also improve allocative efficiency, as prices will be set nearer to marginal cost. In a broader sense, if water companies provide a better customer service/experience then this will also improve allocative efficiency by




meeting customer needs and maximising social welfare. This could come in the form of better call centres, quicker responses to issues with a client’s water supply or better tracking of water usage through smart meters and apps. L4 KAA

However, the effectiveness of these policies depends fundamentally on whether they can promote genuine competition between firms. Historically, households have not switched despite better deals being available for them, for example due to computational difficulties, inertia or habitual behaviour. If this happens following water deregulation then there is little incentive for water companies to drop the price of water bills or to improve their service, and therefore productive and allocative efficiency will not improve. However, in the long term there will be every effort by policymakers to ensure that this does happen, such as by developing and promoting comparison sites, as well as more time for customers to start switching to get the best deals. L3 EV

In my opinion, the best way to ensure economic efficiency in the water industry is to let the market work through deregulation. More interventionist solutions, such as regulation, will always be an imperfect way of providing a surrogate for competition and to artificially incentivise economic efficiency. It will be up to water regulators to ensure that a genuine market for water is implemented, and in the long term it will be possible. Informed judgement: E3+ EV



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