AQA Micro Answer Guide
AQA Micro Answer Guide
AQA Micro Answer Guide
Answer Guide
Question 1 – Pg 3-4
Question 2 – Pg 5-6
Question 3 – Pg 7-10
Question 4 – Pg 11-21
Context 2
Question 5 – Pg 22-23
Question 6 – Pg 24-25
Question 7 – Pg 26-29
Question 8 – Pg 30-41
Section B
Essay 1
Question 9 – Pg 42-47
Question 10 – Pg 48-61
Essay 2
Question 11 – Pg 62-67
Question 12 – Pg 68-85
Essay 3
Question 13 – Pg 86-91
Question 14 – Pg 92-104
The question asks about the average price of a single ticket from London to
Exeter. Identifying the correct row allows us to pick out the values we need to
answer the question.
A summary sentence can often be useful to highlight the answer you have
given. For example:
“The average price of a single ticket from London to Exeter increased by 205.3%
between 1995 and 2013.”
Explain how the data in Extract A show how UK rail passengers have suffered
due to the lack of ‘on-rail’ competition in the UK rail industry. [4 marks]
A clear explanation
why that evidence
Evidence (data) from
shows that passengers
Extract A
have suffered due to a
lack of competition
Having provided some evidence, your answer needs to explain why this
evidence shows that UK rail passengers have suffered from a lack of ‘on-rail’
competition. To achieve top marks, this explanation needs to be clear and
logical.
Extract B, (lines 15-17) explains that an increase in passenger demand will put
further pressure on an industry already at capacity.
With the help of a diagram, explain how increased passenger demand in the UK
rail industry could affect the rail fares paid by passengers. [9 marks]
Written explanation
An accurate and inclduing knowledge,
appropriate diagram application and
analysis
Step 1: Introduction
Beginning by introducing the context and setting the scene for the diagram to
follow allows you to display important knowledge and application skills
alongside.
“Extract B predicts that “Over the next 30 years, passenger demand for rail will
more than double”. Demand for rail is the amount consumers are willing and
able to pay to make rail journeys at a given price. Increased passenger demand
for rail is likely to, assuming ceteris paribus, increase the rail fares paid by
passengers. This can be explained by looking at a supply/demand diagram.”
Axes correctly
labelled
Government Regulation
• Many train ticket prices in the UK are regulated by the government.
The government might not allow train fares to increase due to the
increased passenger demand.
Subsidies
• If the government intervenes by providing subsidies to the rail
industry (above the level it currently provides), then this is likely to
reduce the increase in ticket prices caused by increased passenger
demand.
In your answer, you would not be expected to discuss many of these issues. A
good strategy might be to attempt to introduce one issue with a clear chain of
reasoning. This question does not examine your skills of evaluation, so you
should focus upon using these issues briefly to push your analysis up to the top
end! Your answer should take you no longer than 14 minutes.
This question is marked on a levels basis. The overall quality of your response,
including your diagram will be considered when deciding upon which level the
answer is.
Level 1 [1 – 3 Marks] – Poor or no diagram alongside a brief and/or incoherent
written explanation.
Level 2 [4 – 6 Marks] – Reasonable response which may include a diagram
Level 3 [7 – 9 Marks] – Organised and coherent response with an accurate and
appropriate diagram.
In Extract C, (lines 12-16) the Competition and Markets Authority argues that
‘increased rail competition on selected routes will create additional consumer
benefits’.
Using the data in the extracts and your own economic knowledge, assess the
impact of introducing more competition on rail lines in the UK rail industry.
[25 marks]
The different
Essay
assessment
Structure
objectives
As essay structure is a more general skill, we will focus on showcasing how to
hit the different assessment objectives required for this specific question.
However, hopefully the following discourse will provide some assistance with
regards to essay structure.
AO1: Knowledge
Being able to display accurate knowledge is judged to be the most basic
requirement. It is still important to be able to demonstrate accurate
knowledge throughout your essay. You can signpost this by including accurate
definitions. For example, in your introduction you might want to provide a
definition of competition. For example:
“The amount of competition within a given market is the extent to which there
are rival suppliers of the same good, each attempting to attract consumers in
the face of each other’s presence.”
Being able to apply your knowledge is particularly important for essays within
data response questions. In this case the question particularly asks about the
impact of introducing competition within the UK rail industry. Utilising the data
extracts can provide some helpful angles to use in order to demonstrate that
you are applying economic theory to this particular market. Some examples
are:
Extract C - 17-22
• This provides the example of the East Coast mainline which has been
opened up to increased 'on-rail' competition.
• This can be used to support the conventional theory that competition
leads to lower prices and better services. :
You are only expected to use some of these application examples in your
essay. You can also introduce application via your own knowledge of the UK
rail market. Some examples are:
Inelastic PED
• Many rail passengers in the UK are commuters who have little or no
alternative method of travelling to work. This lack of substitutability is
likely to mean that PED in this market is inelastic, especilly for peak-
time tickets.
Inelastic PES in short-run
• Increasing the supply of trains may be very difficult in the short-run as
it would require building more trains and/or laying more tracks, both
of which require significant long-run investment. This is likely to mean
that supply is inelastic, at least in the short-run.
Government Subsidies
• The government currently intervenes in the market by providing
significant subsidies and funding the operation of Network Rail, the
public sector organisation in charge of improving and repairing the
UK's tracks.
Regulated Prices
• Some ticket prices are heavily regulated by the government with a
quasi-maximum price being set.
As ever, you only need to include some of these issues. Indeed, some of these
application examples are quite high-level and would only be expected of highly
sophisticated answers.
AO3: Analysis
The core of top-level essays consists of well-constructed, relevant analysis of
the topic. This should be presented using logical chains of reasoning, and
where appropriate, clear diagrams.
There are lots of analytical routes you could go down with a question like this.
The core analysis will involve an explanation of the theory of competitive
markets, in comparison to uncompetitive markets. A good (but not the only)
approach would be to consider the traditional theory of monopoly markets
and then consider the outcomes of a perfectly competitive market. The
argument can then be made that introducing ‘on-rail’ competition will shift the
market along the spectrum from a monopoly towards perfectly competitive
outcomes.
Monopoly Markets
In the absence of ‘on-rail’ competition, the UK rail industry can be argued to be
a monopoly market, with only one Train Operating Company (TOC) available to
a passenger travelling on a particular route. The following is a good example of
a chain of reasoning which attempts to explain the implications of this:
“In the absence of competition on the particular routes they serve, Train
Operating Companies (TOCs) are likely to hold some monopoly power. This will
allow them to act as ‘price makers’ rather than ‘price takers’, setting the price
which will maximise profits. This is likely to be above the price which would be
set by a perfectly competitive market, leading to higher ticket prices for
consumers and higher (supernormal) profits for firms.”
Other relevant results about perfect competition include the facts that firms
are both productively and allocative efficient and that consumers have a wide
range of firms to choose from.
The typical perfect competition diagram (see below) could be used here to
support the analysis, although if the monopoly diagram is also included in your
essay you may decide to omit it in order to avoid spending too long on your
answer to this question.
This results of this shift can largely be analysed by comparing the results of the
monopoly market and the perfectly competitive market.
Lower Prices
• Passengers are likely to face lower prices, increasing their consumer
surplus.
Higher Output
• Lower prices will cause a movement down the demand curve,
inducing more journeys to be taken by rail.
Non-Price Competition
• In addition to competition putting downward pressure on prices, it is
likely to also encourage firms to improve their levels of service.
More Efficient
• The market is likely to be more allocatively and productively efficent,
ensuring a better overall utilisation of economic resources.
Smaller Profits
• Firms no longer earn supernormal profits, instead being restricted (in
the long-run) to normal profits in the extreme case of perfect
competition.
Including accurate and relevant evaluation in your essay is the most important
thing to ensure you achieve top marks. Evaluation is the art of making
supported judgements, of deciding which factors are most important and
providing a counterargument against some of the analytical points made in the
essay.
There a huge number of evaluative angles you could take within this essay.
Here we will showcase some useful examples. You would not be expected to
include all of these examples – there simply is not enough time!
Government Intervention
• The extent to which increased competition would deliver the
theorised consumer and efficiency benefits depends upon the extent
and nature of government intervention in the market. If, for example,
the government continued the practice of implementing price controls
(through regulated fares) then the ability of market competition to
reduce prices might be limited.
Inelastic PED
• This increases the incentive for monopolists to exercise their
monopoly power and set high prices as doing so results in few
passengars lost.
Externalities of Substitutes
• An increase in competition is likely to increase the output (number of
journeys) of the market. This might have a higher social benefit than
first imagined as a common substitute to train travel is to drive.
Driving produces negative externalities including increased emissions
and congestion.
The concluding paragraph of your essay is often a very good place to make
clear what your overall reasoned judgement of the question is. Some people
also like to include a similar judgement in their introduction, to signpost clearly
to the examiner that they will be making an evaluative judgement in their
essay.
“Overall, the case for introducing more competition into the UK rail industry is
persuasive. Despite the fact that the arguments regarding the potential
dynamic efficiency benefits of monopolist earning supernormal profits deserve
consideration, the current market failure of productive and allocative
inefficiency should take priority. This is especially so because long-suffering
commuters often have few privately or socially appealing substitutes to train
travel and thus their demand is likely to be price inelastic, making the likelihood
of monopoly pricing more likely and more important to act against.”
“On balance, introducing more competition into the UK rail industry would not
be beneficial to the market. The allure of introducing more competition
revolves around increasing static efficiency and increasing consumer here and
now. Despite the importance of these factors, the most pressing issue for the
UK rail industry is its future. Its ability to accommodate increasing demand is a
matter of vital importance and can only be guaranteed by incentivising firms to
invest in more trains and improving services through the prospect of enjoying
supernormal profits as a monopolist now and in the future.”
The question asks about the average annual price of a barrel of oil in 2013 and
2016. We can identify these pieces of data from the table in Extract D.
Explain how the data in Extract D show how the OPEC cartel’s market power in
the oil market has decreased. [4 marks]
A good answer needs to include two key elements.
A clear explanation
why that evidence
Evidence (data) from
shows that OPEC's
Extract D
market power has
decreased
evidence shows that OPEC’s market power has decreased. To achieve top
marks, this explanation needs to be clear and logical.
If your evidence has effectively identified the fact that world oil supply
increased faster than world oil demand over the period considered, then an
effective explanatory chain of reasoning might look like:
“When the world oil price falls, you would expect the OPEC cartel to restrict
supply in order to stabilise prices and avoid lower prices impacting upon their
revenues. The fact that over the period between 2013 to 2016, world oil supply
increased faster than world oil demand in face of falling world oil prices
suggests that OPEC were unable to exert significant control over supply to
prevent the oil price continually falling. This may be the result of a decrease in
OPEC’s market power as a result of alternative supplies of oil including the
fracking industry in the US.”
There are other ways of achieving a good explanation. You would expect them
to include:
1. Why OPEC would want to prevent the world oil price continuously
falling.
2. Why supply and demand data suggest that they haven’t been able to
achieve this.
3. Why this suggests that OPEC’s market power has fallen.
It is important to be aware that the command work in this question is ‘Explain’
and therefore detailed analysis and evaluation is not required. This question
should take no longer than 6 minutes to answer.
Extract E, (lines 18-179) states that world oil supply has increased above oil
demand creating a ‘supply glut’ in the market. With the help of a diagram,
explain how the increase in world oil supply has put pressure on world oil
prices to fall. [9 marks]
Written explanation
An accurate and inclduing knowledge,
appropriate diagram application and
analysis
Step 1: Introduction
Beginning by introducing the context and setting the scene for the diagram to
follow allows you to display important knowledge and application skills
alongside.
“Extract E details that the downward pressure on oil prices can be partially
explained by increased supply from the US and Russia. The world supply of oil
can be defined as the combined quantity of oil all of the produces around the
world are willing and able to produce at a given price. Increased supply of oil is
likely to, assuming ceteris paribus, reduce the world oil price. This can be
explained by looking at a supply/demand diagram.”
The first thing your written explanation needs to do is to clearly explain what
your diagram shows. To assist clarity, it helps to refer to the labels you have
given on your diagram. Where possible, the results of the diagram should be
applied to the context of the question. For example:
“In the diagram above, the world market for oil is depicted at an initial
equilibrium of (Q1, P1) formed at the intersection of the original demand curve
(D) and the supply curve (S1). The increase in oil supply results in a shift of the
supply curve from S1 to S2. At the original price level of P1, there is now excess
supply in the market which places a downwards pressure on prices. As a result,
the market price decreases until the market reaches a new equilibrium at (Q2,
P2).
This new equilibrium results in more oil being consumed as represented by the
quantity increasing from Q1 to Q2 and the price paid per barrel for oil falling
from P1 to P2.”
To achieve maximum marks, your answer needs to expand a little (but only a
little) further than the accurate but basic analysis thus far offered. There are a
variety of relevant issues which can be analysed including:
In your answer, you would not be expected to discuss many of these issues. A
good strategy might be to attempt to introduce one issue with a clear chain of
reasoning. This question does not examine your skills of evaluation, so you
should focus upon using these issues briefly to push your analysis up to the top
end! Your answer should take you no longer than 14 minutes.
This question is marked on a levels basis. The overall quality of your response,
including your diagram will be considered when deciding upon which level the
answer is.
Level 1 [1 – 3 Marks] – Poor or no diagram alongside a brief and/or incoherent
written explanation.
Level 2 [4 – 6 Marks] – Reasonable response which may include a diagram
Level 3 [7 – 9 Marks] – Organised and coherent response with an accurate and
appropriate diagram.
In Extract F, (lines 12-15) concerns were raised over how effective OPEC’s
production quota would be in correcting the disequilibrium in the world oil
market.
Using the data and your own economic knowledge, evaluate how effective OPEC’s
production cut is likely to be at raising the worldwide market price of oil.
[25 marks]
The different
Essay
assessment
Structure
objectives
As essay structure is a more general skill, we will focus on showcasing how to
hit the different assessment objectives required for this specific question.
However, hopefully the following discourse will provide some assistance with
regards to essay structure.
AO1: Knowledge
Being able to display accurate knowledge is judged to be the most basic
requirement. It is still important to be able to demonstrate accurate
knowledge throughout your essay. You can signpost this by including accurate
definitions. For example, in your introduction you might want to provide a
definition of a production quota in the context of the OPEC cartel. For
example:
“OPEC producers act as a cartel, in the sense that given their large market
share of the oil market they can influence the price of oil by coordinating
production decisions and managing the supply of oil to stabilise the market
price. One way this can be achieved is through a production quota.
AO2: Application
Being able to apply your knowledge is particularly important for essays within
data response questions. In this case the question asks about the effectiveness
of an oil production cut in raising world oil prices. Utilising the data extracts
can provide some helpful angles to use in order to demonstrate that you are
applying economic theory to this particular market. Some examples are:
You are only expected to use some of these application examples in your
essay. You can also introduce application via your own knowledge of the world
oil market. Some examples are:
Inelastic PED
• Traditionally the demand for oil has been relatively inelastic as oil has
very few close and direct substitutes available to consumers. It also
remains a key commodity required to support the production process
of many goods produced in the manufacturing and construction
industries. This explains why even during periods when oil prices were
high, demand was still increasing.
Interrelationships between markets
• Derived demand is when the demand for one good or service is
dependent on the demand for another good or service. The demand for
oil is largely derived from the demand for products which can be
produced only from oil, like petrol and diesel. As a result, when
considering the oil market, ther markets from where oil derives its
demand may also have to be considered.
As ever, you only need to include some of these issues. Indeed, some of these
application examples are quite high-level and would only be expected of highly
sophisticated answers.
There are lots of analytical routes you could go down with a question like this.
The core analysis will involve an explanation of the theoretical impact a
production cut would have on the world oil market if honoured by all firms. A
good (but not the only) approach would then be to consider the impact that
higher oil prices will have on firms’ shut-down decisions and therefore the
future course of direction for oil prices. The argument can then be made that
higher oil prices could in fact force higher cost US shale producers back into
the market and oil prices could then be liable to fall once again.
In this question, it may help to first set the scene regarding the downward
movement of oil prices over time. The focus here should be on the existing
strategy that OPEC producers have taken. An example of this is:
“In the absence of a production cut, oil prices have continued to decline and fell
as low as $27 at the start of 2016, due to a combination of increasing global
supply by the major oil producing countries and weakening global demand for
commodities from the global economy. The increased production from US shale
producers, because of the increased development of the fracking industry, has
resulted in the market share of OPEC producers to diminish over time.
The falling market share of OPEC producers has not only limited the ability of
OPEC producers to stabilise market prices but has also reduced their
profitability from the sale of oil on the world market. Therefore, to protect their
market share, OPEC producers have taken the surprising but controversial
production decision to continue to increase the supply of oil to protect their
market share and to induce the exit of high cost US shale producers over time,
as these firms do not have a large cash reserves to fall back on.
This is a change in strategy for OPEC producers, as since the 1960s they have
effectively run as a cartel to use their market position to ensure that oil prices
are stable and the market provides stability in supply for oil consumers,
consistent and steady income for producers and a decent return to investors in
energy companies.”
“The decision for OPEC to announce their first oil production cut in 8 years is a
signal that the strategy stance taken to induce the exit of unconventional US
shale producers out of the market has not been a successful one – it has
contributed to the fall in world oil prices and actually eroded the market
position for all oil producing firms involved.
The production cut will aim to reduce OPEC oil production by 1.2 million barrels
a day and help encourage a collaborative approach towards maintaining stable
oil prices for all. Assuming ceteris paribus, the production cut will contribute
towards removing the excess supply of 1.6 million barrels a day and the price of
oil should, as a result, rise.”
The production cut by OPEC creates an inward supply curve shift to S3, as at
every given price OPEC will be supplying less oil to the market. Assuming
ceteris paribus, this creates a movement up the demand curve and a new
equilibrium is reached (3) where oil prices are higher (P3) and the number of
barrels of oil produced are lower (Q3).
Here the inwards shift in the supply curve caused by OPEC’s tighter quota is
represented as being smaller than the previous outwards shift in order to
illustrate that the quota does not affect non-OPEC producers and as such is
unlikely to be as significant.
Having discussed the theoretical results of a production cut using a supply and
demand diagram, this gives you a brief opportunity to talk about some of the
wider impacts that this will have.
Higher Profits
• All oil producers in the market will make higher supernormal profits as
the margin on each barrel of oil sold increases.
Higher Prices
• Because oil is a commodity used in the production process of a lot of
goods, if the price of oil increases this is likely to increase the cost of
producing goods and services and therefore consumers will have to
pay higher prices e.g. petrol and diesel prices.
A useful angle to consider is the impact that high oil prices will have on the
unconventional US shale producers. This is important because a growing
contributor to the initial excess supply of oil was the increased market
presence of US shale producers, who have been able to participate in the
market due to the traditionally high oil price.
All other things being equal, the marginal cost of production for OPEC
producers is lower than US shale producers. This because the extraction costs
that result from fracking are currently higher than the extraction costs of using
traditional oil wells and refineries. Therefore, the lower oil price has caused
significant stresses upon companies operating the new US shale methods.
Receiving lower average revenue moves these firms closer to their shut-down
points.
However, if OPEC production cut causes the oil price to increase, this will
relieve the pressure on US shale producers and potentially encourage more US
shale firms to enter the market and existing shale producers to increase
investment and expand their capacity. This may perversely result in a higher
world supply within the next few years, which ultimately could reverse any rise
in the oil price caused by OPEC’s decision.
AO4: Evaluation
Including accurate and relevant evaluation in your essay is the most important
thing to ensure you achieve top marks. Evaluation is the art of making
supported judgements, of deciding which factors are most important and
providing a counterargument against some of the analytical points made in the
essay.
There a huge number of evaluative angles you could take within this essay.
Here we will showcase some useful examples. You would not be expected to
include all of these examples – there simply is not enough time!
Corruption
• Even if an agreement between OPEC producers has been made to
control supply and stabilise the world oil market, if there is no
effective enforcement of this agreement, in terms of punishment for
cheating behaviour, then this agreement is likely to unravel. Many oil
producing countries' budgets depend signficantly on oil revenues and
the domestic pressures on firms to 'cheat' on agreements are high.
This particular agreement is vulnerable to cheating behaviour as it is
not legally binding.
• When we refer to cheating behaviour we are focusing on acts by firms
within the agreement that break the rules of that agreement such as:
undercutting rival firms, payment of bribes to increase quota
allocation or concelaed actions to exceed a quota limit.
Oil Price settled at a new 'normal' level
• It could be argued that the price of oil has settled at a new lower level
and oil prices may never consistently hit the high levels seen in 2014.
This can be explained by the fact that, as a result of high supernormal
profits in the industry being earned and the subsequent investment
these profits incentivised, the industry has seen a high pace of
innovation. This innovation has not only increased the world oil
reserves which are obtainable by producers, but also made oil
production more efficient, reducing costs.
The concluding paragraph of your essay is often a very good place to make
clear what your overall reasoned judgement of the question is. Some people
also like to include a similar judgement in their introduction, to signpost clearly
to the examiner that they will be making an evaluative judgement in their
essay.
Here is a good example of an attempt to argue that a production cut will lead
to desired effects in the world oil market:
“Overall, if firms within the oil industry agree to stick to a production quota to
restrict supply, it is likely to bring balance to the world oil market and stabilise
prices. It is important to bear in mind that the production cut will require a
concerted effort and commitment by all firms in the industry – OPEC and non-
OPEC producers alike. However, if this quota can be effectively enforced within
the market, it is likely to bring back higher prices for oil and higher supernormal
profits to firms, as they take advantage of the inelastic demand curve for oil.
There is always a distinct possibility that higher prices may entice more firms to
begin scaling up production and that can result in a greater supply of oil in the
long-run. However, there is great uncertainty about the true productive
capacity of new production techniques and therefore any future destabilising
increase in supply, if it arises at all, is likely to be far away in the long-run. The
short-term effectiveness of this policy cannot and should not be overlooked.”
Alternatively, it would be just as valid to argue that the price cut may not be
effective:
“On balance, a production cut by OPEC to stabilise the oil market is unlikely to
be effective and successful. The short-run durability of the agreement may
result in a slight temporary recovery in the oil price but the long-term allure of
higher prices to high-cost shale producers will be too tempting to resist. In fact,
with new techniques like fracking, already up and running, the ‘long-run’ may
not actually be too far away. There is also a note of caution to emphasise
regarding the short-run effectiveness of this policy. Many OPEC production
agreements in the past have ended up being broken due to the incentive for
Essays are marked on a levels basis. The overall quality of your essay will be
considered when deciding upon which level the answer is.
Level 1 [1 – 5 Marks] – Very weak response which includes little relevant
content.
Level 2 [6 – 10 Marks] – Weak response which shows some understanding but
undeveloped analysis.
Level 3 [11 – 15 Marks] – Reasonable analysis but poor evaluation, which is
usually unsupported.
Level 4 [16 – 20 Marks] – A well organised response with good analysis and
some reasonable evaluation.
Level 5 [21 – 25 Marks] – A well organised response with good analysis and
supported evaluation throughout and in a final conclusion.
Explain why firms in the pharmaceutical industry can charge different prices for
the same drug in different countries.
[15 marks]
The key to answering this 15-mark question effectively is to realise that there
are no marks available for evaluation. This question is focused upon examining
your ability to present structured analysis, relying heavily upon well-written
chains of reasoning. It is important to ensure that your response answers the
question and provides a relevant and technically correct explanation.
Step 1: Introduction
The introduction provides an opportunity to demonstrate that you understand
what topic the question is asking about and structure your response. It is also a
good opportunity to demonstrate some knowledge (AO1) by providing
definitions of the key terms and some application (AO2) by making a clear link
with the context.
Step 2: Analysis
There are several forms of price discrimination. The form alluded to in this
context is 3rd degree price discrimination. This is where firms charge different
prices to different groups of consumers. In this example, consumers are
grouped depending on the country in which they live.
To demonstrate relevant knowledge and application (AO1 & AO2) skills,
beginning the heart of your response with a discussion of what form of price
discrimination is being implemented would be useful. A good example is:
“Price discrimination can be implemented in three main forms. In the example
of the pharmaceutical industry, it appears that it is third-degree price
discrimination that is being utilised. This involves firms segregating consumers
into different groups, based on their willingness and ability to pay, and
charging these groups of consumer’s different prices. Here, consumers are
separated geographically with consumers living in developing countries being
charged lower prices than those in developed countries.”
This initial discussion of what form of price discrimination is being
implemented would be well supported by a standard third-degree price
discrimination diagram.
This is a complex diagram that involves drawing three separate diagrams – a
diagram representing developing country consumers, a diagram representing
developed country consumers and a diagram representing the combined
market.
Transportation Costs
• In addition to the regulatory difficulties of importing and exporting
drugs, many drugs require specialist expensive transportation. This
provides an additional reason why the pharmaceutical industry is able
to successfully keep the sub-markets separate.
Fairness (Equity)
• The use of government regulation to keep markets separate in the
pharmaceutical industry might be intended to improve the fairness of
access to medicine. By allowing price discrimination to take place,
governments are (whether intentionally or not) allowing consumers in
developing countries to access drugs at a more affordable price.
Imperfect Information
• Firms who believe that consumers have different demand curves may
be more willing than it is feasible to engage in price discrimination. For
example, firms may be underestimating the price consumers in
developing countries are willing and able to pay and as a result may
charge a price that is too low, reducing the effectiveness of price
discrimination.
Product Diferentiation
• Differentiating products by using branding and promotional activities
may allow firms to utilise price discrimination more effectively. It may
be that the same drug is being sold in both developing and developed
countries, but under different brands. The emphasis on branding in
the developed countries leads to demand being greater in those
countires, encouraging the implementation of price discrimination.
This question is marked on a levels basis. The overall quality of your response,
including your diagram will be considered when deciding upon which level the
answer is.
Level 1 [1 – 5 Marks] – Weak response which shows limited knowledge,
application and unfocused analysis.
Level 2 [6 – 10 Marks] – Reasonable response that shows satisfactory
knowledge and application with analysis which is reasonable but not fully
coherent and/or fully developed.
Level 3 [11 – 15 Marks] – Organised and coherent response which
demonstrates sound knowledge and application as well as strong analysis.
The different
Essay
assessment
Structure
objectives
AO1: Knowledge
Other relevant definitions here MAY include defining the specific forms of
price discrimination that firms can use to extract consumer surplus from the
market:
Be careful in your essay not to worry too much about spending significant time
explaining the differences and divergences between the different forms of
price discrimination. This essay focuses upon assessing the results of price
discrimination, and qualitatively each form delivers the same results. You may,
however, wish to use the distinction as an evaluative tool (see later on).
AO2: Application
Being able to apply your knowledge to the subject matter of the essay is
particularly important in essay questions without a data extract, as it
showcases to the examiner that you have a detailed and developed
understanding of the related economic concepts in the essay. You are only
expected to use some of these application examples in your essay:
As ever, you only need to include some of these issues. Indeed, some of
these application examples are quite high-level and would only be expected
of highly sophisticated answers.
There are lots of analytical routes you could go down with a question like this.
The core analysis will involve an explanation of the reasons and objectives of
firms engaging in price discrimination and then via a set of diagrams the effects
this pricing strategy has on society – both desirable and undesirable. A good
(but not the only) approach would be to consider the impact of firms engaging
in a specific form of price discrimination such as third-degree price
discrimination (other forms of price discrimination could also be used). The
analysis provided by the diagrams can put forward the intuitive reasons why
firms wish to engage in price discrimination and the net effect that this has on
them and other economic agents.
The diagram shows how pharmaceutical firms have identified two different
sub-markets to sell their products to - developing countries and developed
countries. The market segments have been classified based on their marginal
willingness to pay for the product i.e. the elasticity of demand. The distinction
between the two is represented by the different price elasticities for the drugs
in each sub-market. Developing countries face a more elastic demand curve for
drugs, reflecting the low income levels within those countries (lower
willingness and ability to pay), whilst developed countries face a relatively
inelastic demand curve because of the high income levels in those countries
(higher willingness to pay).
When the market is separated, the price and output in developing countries is
at PA and QA, higher output but at a lower price. Whereas, in developed
countries, because of the inelastic demand curve, the price will be higher at PB
and the quantity sold is slightly lower at QB. As the firm is catering for two
The prices are set in each sub-market for the firm to maximise profits. Profit
maximisation for the firm will occur when MC=MR. This point leads to the
number of drugs being sold to the UK and US to be Q (= QUK + QUS).
The marginal cost of producing goods is transferred to each market segment as
the marginal cost of producing the drug is the same regardless of the location
sold. This means that the total profits made through this pricing strategy is
represented by the sum of the red shaded areas in the sub-market diagrams.
As the profit from separating the market into segments is greater than setting
a uniform price across countries, it is optimal for the pharmaceutical firm to
consider a more complex pricing strategy within the market
The firm is neither productively efficient, as it does not produce at the
minimum point of the AC curve, nor is it allocatively efficient as the prices
charged for consumers does not equate the marginal cost of production.
A form of price discrimination in which all consumers are charged their maximum willingness to pay for the good
and therefore each unit of output is sold at a different price so that all the consumer surplus in the market is
captured by firms and converted into producer surplus.
This form of price discrimination perfectly segregates the market into individual consumers rather than broader
sub-markets under third-degree price discrimination. This is done by charging each consumer the price that they
are willing to and able to pay.
Price discrimination means more goods are sold in total; but unlike under a normal demand curve firms have not
had to decrease the price for all consumers as they have been able to perfectly segregate the market based on the
willingness to pay.
This pricing strategy is occasionally referred to as ‘optimal pricing’ as all firms would like to adopt this pricing
strategy, because it extracts the entire consumer surplus under the demand curve and convert this into extra
revenue for the firm. However, this form of price discrimination requires detailed knowledge about the
preferences of each individual consumer, which is almost impossible for any firm in the real world to obtain.
A form of price discrimination in which consumers are charged a different price based on the quantity of
goods that are consumed. This is a pricing strategy used by firms to sell off excess capacity of stock that
they hold in their inventories.
The strategy works by firms charging a higher price for small quantities of the product, but a lower price is
introduced when the consumer purchases a higher quantity of the product, as this extra quantity represents
additional units consumed which are of less value and importance to consumers purchasing.
This form of pricing strategy increases sales revenue by the shaded green region (B). It could be argued that
this is a pricing strategy used by the pharmaceutical industry as certain firms may charge lower prices when
products are bought in bulk by organisations like the NHS, compared to small quantity purchases.
Higher Profits
• By using price discrimination, firms can increase their overall level of profits
(the extent of this depends on the degree of price discrimination used).
This is achieved by converting consumer surplus into producer surplus by
raising prices for consumers who value the good the most) and encouraging
consumers who value the good the least to purchase the product by
advertising an enticing price. The combination of more products being sold
in the elastic market and a higher margin established in the inelastic market
means that overall revenue and profits are higher than under a single
uniform pricing strategy.
Economies of Scale
• If sales are higher under price discrimination than under a single price,
it means that the producer will have to produce more of the product.
When the output of a firm increases this may move them further
down the LR average cost curve and generate economies of scale for
the firm. This will improve the firm's profit margins.
Affordability of Products
• Price discrimination can result in some products becoming more
affordable to certain groups of consumers than under a uniform
pricing strategy. Those who value the good below the original price
may now be able to consume at the lower price made available
through price discrimination to them.
AO4: Evaluation
Including accurate and relevant evaluation in your essay is the most important thing to
ensure you achieve top marks. Evaluation is the art of making supported judgements, of
deciding which factors are most important and of explaining in the circumstances in which
factors assume importance or otherwise.
There are a huge number of evaluative angles you could take within this essay. Here we will
showcase some useful examples. You would not be expected to include all of these
examples – there simply is not enough time!
It is particularly crucial in this type of essay question as you need to evaluate whether price
discrimination ‘always’ creates undesirable results for society. Critiquing this element of the
question phrasing is a sure-fire way to demonstrate some good evaluation skills.
Lessening of Competition
• Price discrimination may benefit incumbent firms (existing market
players) but the low prices set in elastic markets may force competitiors
out of the market and deter new firms from entering. Firms can set
extremely low prices in elastic markets, as they can use the profit
earned on high margins within inelastic markets to cancel out any
losses made from low prices, granting them the opportunity to
undercut their rival firms in the elastic market. The low prices also act
as a barrier to entry, as new firms realise the profit potential is not very
high within elastic markets. This reduces competition in the long-run
and can create efficiency problems for the market.
Missing Information
• It is assumed that firms know the shape and location of their cost and
demand curves, which then allows them to decide upon the profit-
maximising price and quantity to reach their desired objective.
However, in the real world firms will not always be aware of the exact
shape of their costs and revenue curves which limits the effectiveness
of price discrimination and therefore the theoretical benefits of price
discrimination for economic agents may not be fully realised.
Government Intervention
• The extent to which price discrimination would deliver the theorised
benefits to producers and consumers depends upon the extent and
nature of government intervention in the market. If, for example, the
government was going to intervene and prevent some pharmaceutical
firms from charging higher prices in certain market segments by setting
a maximum price, then this will reduce the effectiveness of price
discrimination converting consumer surplus into producer surplus.
Market Structure
• Price discrimination involves market segmentation and firms setting
their own prices which can only occur in markets where firms have
significant market power. But if the firm is not a monopolist and there
is interdepency in the market, then the firm will need to gauge the
reaction of other rival firms in the market and therefore price
discrimination may not be feasible or the effects may be limited in
magnitude.
The concluding paragraph of your essay is often a very good place to make
clear what your overall reasoned judgement of the question is. Some people
also like to include a similar judgement in their introduction, to signpost clearly
to the examiner that they will be making an evaluative judgement in their
essay.
Here is a good example of an attempt to, in one paragraph, argue that price
discrimination does not always lead to undesirable results for society:
Using economic theory, explain why pay differentials exist between such
professions. [15 marks]
The key to answering this 15-mark question effectively is to realise that there
are no marks available for evaluation. This question is focused upon examining
your ability to present structured analysis, relying heavily upon well-written
chains of reasoning. It is important to ensure that your response, answers the
question and provides a relevant and technically correct explanation.
Step 1: Introduction
The introduction provides an opportunity to demonstrate that you understand
what topic the question is asking about and structure your response. It is also a
good opportunity to demonstrate some knowledge (AO1) by providing
definitions of the key terms and some application (AO2) by making a clear link
with the context.
Despite not being explicitly mentioned, the question focuses upon labour
market equilibria within the context of comparing the wage rate paid to elite
footballers and nurses:
Step 2: Analysis
Having already alluded to the importance of equilibrium in the labour market,
the opportunity is available to plough ahead and explain that the market for
labour within a particular industry can be modelled like every other industry:
with the fundamentals of demand and supply.
To further demonstrate relevant knowledge and application (AO1 & AO2) skills,
beginning the heart of your response with a discussion of the key factors that
the demand and supply of labour each depend upon would be a strong start. A
good example is:
“Labour markets for an individual profession can be examined with the help of
demand and supply analysis. The demand for labour represents the value that
firms place on employing workers within that industry. More technically, the
wage rate a firm is willing to pay a worker will be equal to the marginal
revenue product of that worker - the value of the output each worker produces.
The supply of labour represents the wage rate workers would have to receive to
be willing to accept a job in that industry. The level of labour supply in a
particular industry depends on a number of factors, including the available pool
of people who have the necessary skills and ability to perform the role and how
enjoyable and fulfilling the role will be to perform.”
This initial discussion leads nicely on to applying labour market equilibrium
theory to the specific example being considered with the assistance of
demand/supply diagrams. You might consider introducing two diagrams, one
for each of the professions.
Use a ruler and ensure the diagrams are neat and tidy.
Here the labour market diagram for elite footballers has been drawn with a
demand curve out to the right (representing a large demand) and a supply
curve out to the left (representing a low supply). The labour market
Non-Monetary Factors
• The supply of labour often differs between industries due to the
different levels of appeal each role has. Roles which are more
enjoyable to perform are likely to encourage a higher supply of labour
which will result in a lower equilibrium real wage rate.
Alternative Employment
• The level of the supply of labour for a given industry is partially
dependent upon the other employment options that are available to
prospective workers. In industries where workers have appealing and
readily available substitute work, the supply of labour is likely to be
lower resulting in a higher equilibrium real wage rate.
This question is marked on a levels basis. The overall quality of your response,
including your diagram will be considered when deciding upon which level the
answer is.
Level 1 [1 – 5 Marks] – Weak response which shows limited knowledge,
application and unfocused analysis.
Level 2 [6 – 10 Marks] – Reasonable response that shows satisfactory
knowledge and application with analysis which is reasonable but not fully
coherent and/or fully developed.
Level 3 [11 – 15 Marks] – Organised and coherent response which
demonstrates sound knowledge and application as well as strong analysis.
Assess the case for government intervention in labour markets to improve pay
differentials and achieve a fairer distribution of income.
[25 marks]
The different
Essay
assessment
Structure
objectives
As essay structure is a more general skill, we will focus on showcasing how to
hit the different assessment objectives required for this specific question.
However, hopefully the following discourse will provide some assistance with
regards to essay structure.
AO1: Knowledge
Being able to display accurate knowledge is judged to be the most basic
requirement. It is still important to be able to demonstrate accurate
knowledge throughout your essay. You can signpost this by including accurate
definitions. For example, in your introduction you might want to provide a
definition of the distribution of income. For example:
AO2: Application
UK Inequality
• The UK's inequality levels, as measured by statstics like the Gini
coefficient, are higher than those of most European countries, but
lower than some other developed economies, like the USA. More
attention has been brought to bear on the topic of the distribution of
income in the wake of stagnent real wages for most of the distribution
following the 2008 financial crisis.
High-Level Taxation
• In 2013, the highest taxation rate in the UK was reduced from 50% to
45% on earnings over £150,000. Critics argue that this has
exacerbated income inequality, whilst supporters claim that reducing
the taxation rate has in fact resulted in the government raising more
revenue than before.
• There has been a lot of focus upon the utilisation of dubious tax
avoidance schemes by some of the richest individuals in the UK. Critics
suggest that the government should do more to stop such schemes
being abused.
Low-Level Taxation and Benefits
• The income threshold below which individuals pay no tax has been
steadily increased over the previous few years. This amounts to an
effective cut in the amount of tax paid by the lowest earners in
society.
• Alongside this, benefit payments have been squeezed as a
consequence of the emphasis upon economic austerity.
AO3: Analysis
There are lots of analytical routes you could go down with a question like this.
The heart of the analysis will discuss some possible government interventions
in the labour market and their likely effects upon pay differentials and the
distribution of income. One (of many) possible structure of the analysis is to
begin by explaining why an unequal distribution of income is potentially a
problem, then detail some of the possible government interventions and their
likely impacts.
Inequality
Where an economy is subject to inequalities in the distribution of income and
wealth, there are two main arguments why society might view this as a
negative phenomenon and want the government to intervene.
The first is a consideration of the fairness of pay differentials. This relates the
concept of inequality to the concept of inequity (unfairness). Whilst a
contentious view, there are many who believe that severe pay differentials are
inherently unfair and for honest labour, the divergences in wages should be
reduced. Much economic thinking assumes that the government is interested
in the overall welfare of society as a whole (the sum of all individuals), in which
case there is an argument to be made that if the government can intervene to
reduce income inequality and inequity then they will have a positive effect
upon society’s overall welfare.
“Pay differentials and the unequal distribution of income that results are
arguably very damaging to the overall welfare of society. The concept of the
equity of different wage rates has been a long-discussed topic in economies
around the world. Socialists have often argued that wide pay differentials are
simply unfair and that governments should implement policies to increase the
fairness of labour markets. Furthermore, many argue that an unequal
distribution of income is an example of market failure, as it can impose costs
upon society. The inability of those subject to poverty to engage in essential
consumption decisions may restrict their ability to effectively participate and
progress in the workforce.”
There are lots of possible examples that could be used. There is simply not
enough time to attempt to detail every one of them. You should focus on two
or maybe three of what you consider to be the most important or illuminating
examples. Possible examples include:
“The diagram showcases the impact that a minimum wage would have upon a
low-paying labour market. This labour market is at an initial equilibrium
formed by the intersection of the supply of labour (SL) and demand for labour
(DL) curves, where L* workers are employed at a real wage rate of W*. The
introduction of the minimum wage (WMin) at a higher real wage rate than the
initial equilibrium (W*) moves the market out of equilibrium.
The upshot of this is that workers who remain employed within the industry
receive an increased real wage rate. Increasing the wages of these low-paid
workers is likely to, in isolation, make the distribution of income more equal.
However, as firms are now forced to pay each worker the minimum wage, they
demand fewer workers (LDMin). This in contrast to the impact upon the supply of
labour. The higher wage being offered encourages more people to be willing to
take up roles in the industry. The disequilibrium, therefore, results in classical
unemployment to the extent of LSMin – LDMin.”
The increase in
unemployment
increasing the costs
of benefits provision.
The diagram shows the effect of this subsidy is to shift the supply of labour
curve outwards from SL to SLBenefits. The incidence of the subsidy is split between
workers and firms, with the real wage rate paid by firms falling from W* to
W1Firm, but importantly with the effective real wage rate paid to workers
This increase in the real wage rate received by workers in low-paying jobs is
likely to decrease the inequality of the distribution of income. Another helpful
effect is that the provision of in-work benefits encourages an increase in the
quantity labour employed in these industries, from L* to L*1, potentially
resulting in a fall in unemployment. As the unemployed are prime candidates to
be at the very bottom of the distribution of income, this is likely to also improve
inequality.”
The two interventions considered so far have both been aimed at lifting the
incomes of those at the bottom of the distribution of income. The next
possible intervention looks at the dragging down the incomes of those situated
at the very top of the distribution.
A maximum wage cap would operate as a maximum price within the labour
market. In practice, it might manifest itself as a 100% (or close to) marginal
taxation rate above a certain threshold. This policy is not unheard of – during
the second world war, the highest marginal taxation rate in the UK was
99.25%.
A diagram of a high-paying labour market (perhaps the market for CEOs) with a
maximum wage is, unsurprisingly, helpful to illustrate this analytical thread:
“In high-paying labour markets, a maximum wage cap which is set below the
initial equilibrium real wage rate (W*) will influence the market by pushing it
into a state of disequilibrium. Here a wage cap of WMax has caused the demand
for labour (LDMax) to be higher than the supply of labour (LSMax), resulting in
classical unemployment. By reducing the number of those employed in a high-
paying industry, the distribution of income is favourably affected.
The reduction in
Potential for multi-
incentives for workers
national firms to
to succeed and the
relocate to other
reduction in
countries
innovation/effort
The progressiveness of taxation details the extent to which the marginal rate
of taxation paid by workers increases as their labour market incomes increase.
For example, a highly progressive taxation system would have very low
marginal taxation rates for low earners but very high marginal taxation rates
for high levels of earnings.
“In the diagrams above, the government has implemented a highly progressive
taxation system. For industries where earnings are high, represented by the
diagram on the left, the taxation system results in a large inwards shift in the
supply curve from SL to SLTax.
This causes a large fall in employment from LHigh* to LHighTax. Firms must also pay
a significantly higher wage rate, (WHighFirm rather than WHigh*). Despite this, the
The effects of taxation in the low-paying industry are all the same in terms of
direction, however because the rate of taxation is significantly lower, the size of
each of the effects are consequently also lower. Overall, therefore, the
progressive taxation has a far greater dampening effect upon the wages
received by high earners than that of those receive by lower earners, helping to
make the distribution of income more equal.”
Again, this is most easily and effectively explained with the help of a diagram:
The effect of this upon pay differentials is two-fold. Firstly, the real wage rate
received by these low-earners increases from W* to W1*. Secondly, the amount
The impact of
The time frame of the
education and training
effects coming
on the supply of
through.
labour curve
There are a variety of other potential interventions you could analyse including
(but not limited to):
“It is clear that ‘free lunches’ are hard to come by. Acting to curb pay
differentials and therefore improve the distribution of income rarely can be
achieved without negatively affecting other economic factors. As a result,
effective policies should consider the trade-offs which arise on an intervention-
by-intervention basis.”
AO4: Evaluation
Including accurate and relevant evaluation in your essay is the most important
thing to ensure you achieve top marks. Evaluation is the art of making
supported judgements, of deciding which factors are most important and of
explaining in what circumstances particular factors assume the most
importance.
There are many evaluative angles you could take within this essay. The points
you effectively make will be dictated by the particular interventions you have
focused on in your essay. Here we will showcase some useful general examples
which could be adapted and applied to individual interventions or evaluate the
overall premise of the question. You would not be expected to include all of
these examples – there simply is not enough time!
Time Frame
• Some interventions may only result in improvements in the
distribution of income over a lengthy time period (i.e. in the long-run).
Alternatively, practicalities might mean that a particular intervention
has to be inplemented gradually. This lack of an instant result may
distort the trade-off between using the intervention to improve the
distribution of income and other economic factors.
• Any changes to the incentives for workers to work hard and be
successful may have long-term consequences for the productive
capacity of the economy which are hard to predict. It may reduce the
incentive to promote innovation and invention and may mean creative
destruction occurs.
Government Failure
• Any government intervention runs the risk of causing unintended
consequences. Interventions in the labour market may run a
particularly high risk of resulting in government failure as they affect
the incentives on offer to workers and firms. Organisations and
individuals are often capable of ingenious ways to get round the
intended results of a government intervention.
The concluding paragraph of your essay is often a very good place to make
clear what your overall reasoned judgement of the question is. Some people
also like to include a similar judgement in their introduction, to signpost clearly
to the examiner that they will be making an evaluative judgement in their
essay.
Essays are marked on a levels basis. The overall quality of your essay will be
considered when deciding upon which level the answer is.
Level 1 [1 – 5 Marks] – Very weak response which includes little relevant
content.
Level 2 [6 – 10 Marks] – Weak response which shows some understanding but
undeveloped analysis.
Level 3 [11 – 15 Marks] – Reasonable analysis but poor evaluation, which is
usually unsupported.
Level 4 [16 – 20 Marks] – A well organised response with good analysis and
some reasonable evaluation.
Level 5 [21 – 25 Marks] – A well organised response with good analysis and
supported evaluation throughout and in a final conclusion.
Explain how the development of fracking sites in the UK can result in the
production of negative externalities for society.
[15 marks]
The key to answering this 15-mark question effectively is to realise that there
are no marks available for evaluation. This question is focused upon examining
your ability to present structured analysis, relying heavily upon well-written
chains of reasoning. It is important to ensure that your response answers the
question and provides a relevant and technically correct explanation.
Step 1: Introduction
The introduction provides an opportunity to demonstrate that you understand
what topic the question is asking you about and structure your response
accordingly. It is also a good opportunity to demonstrate some knowledge
(AO1) by providing definitions of the key terms and some application (AO2) by
making a clear link with the context.
The question focuses upon market failure within the context of the UK shale
gas industry
Step 2: Analysis
To further demonstrate relevant knowledge and application (AO1 & AO2) skills,
beginning the heart of your response with a discussion of the logical chain of
reasoning behind how a negative externality damages society’s welfare is
important:
“The externality produced in this type of market is a negative production
externality because it results in external costs being imposed on society by the
increased production of shale gas. This means there is a cost to society that is
not considered in the process of making a production decision by the firm. This
Use a ruler and ensure the diagrams are neat and tidy.
Regulation
• Regulation introduced by the government can help to manage the
market and ensure that the production of externalities is kept within
acceptable levels.
Producer Incentives
• Firms that contribute to the environmental pressures from fracking
have no incentive to take action to reduce the costs they have
imposed on others as it does not directly impact their own costs. This
is why effective government intervention in markets with negative
prodution externalities involves the government imposing the external
cost onto the firm e.g. through taxation.
Allocative Efficiency
• You may also make reference to the fact that the overproduction of
the good is a sign that the market is allocatively inefficient as there is a
misallocation of scarce resources. Due to the nature of scarcity, if too
many economic resources are being diverted towards the fracking
industry, then it is the case that too few resources are being diverted
towards other industries, resulting in market failure elsewhere.
This question does not examine your skills of evaluation, so you should focus
upon using these issues briefly to push your analysis up to the top end! Your
answer should take you no longer than 23 minutes. There is a lot of content
you could potentially cover and therefore you should be aware that the
priority is to effectively explain how negative externalities are produced by the
development of fracking activities.
Assess the view that taxation is the most effective form of government
intervention in markets that are affected by negative production externalities
[25 marks]
The different
Essay
assessment
Structure
objectives
As essay structure is a more general skill, we will focus on showcasing how to
hit the different assessment objectives required for this specific question.
However, hopefully the following discourse will provide some assistance with
regards to essay structure.
AO1: Knowledge
Being able to display accurate knowledge is judged to be the most basic
requirement. It is still important to be able to demonstrate accurate
knowledge throughout your essay. You can signpost this by including accurate
definitions. For example, in your introduction you might want to provide a
definition of government intervention in the context of a market that produces
negative externalities. For example:
The government can help rectify the market situation by affecting the
incentives behind decisions made by individuals and firms. This can help move
the market outcome closer to the social optimum so that welfare in the market
is maximised. Indirect taxation is one appropriate way of dealing with markets
AO2: Application
Enviromental Concerns
• Fracking creates environmental pressures such as: a greater number of
pollutants released into the atmosphere, contamination of local water
supplies, destruction of protected local areas, noise pollution from the
construction and maintenance of fracking sites and respiratory
problems created because of higher pollution.
Emerging Industry
• The UK fracking industry is an emerging industry where firms and
governments are discovering the potential and problems that fracking
shale gas and oil has on the UK economy. This means the level of
uncertainty in this market is higher compared to more conventional
markets.
AO3: Analysis
The core of top-level essays consists of well-constructed, relevant analysis of
the topic. This should be presented using logical chains of reasoning, and
where appropriate, clear diagrams.
There are lots of analytical routes you could go down with a question like this.
The core analysis will involve an explanation of the advantages and
disadvantages of using taxation to specifically deal with markets that fail due
to the production of negative externalities. This analysis will be aided by using
a diagram to show the impact that an indirect tax can have on internalising the
externality. A good (but not the only) approach would be to consider the
impact of an indirect tax being placed on a market where the good is over-
produced and then discuss the alternative forms of government intervention
which may or may not be as effective. This is because the phrasing of the
question using ‘most effective’ is prompting you to talk about other means
that are available.
Indirect Taxation
Taxation is one method of intervention that can be used to correct the market
failure. Indirect taxes are taxes that are imposed on the producers of goods
and services and these taxes can be passed onto the consumer. In this case,
the tax is intended to make UK shale producers pay the full social cost of the
materials they are fracking from the ground at fracking sites. If the tax is equal
to the external cost of production (negative externality), then the tax will
effectively increase producer’s private costs so the private costs of production
equals the social costs of production.
Effects of Taxation
Having discussed the results of imposing an indirect tax on a market that fails
because of the production of negative externalities, the question itself can now
be answered by explaining the relative advantages and disadvantages of using
this form of government intervention to create an efficient allocation of
resources. The advantages include:
Corrects Incentives
• The tax aims to correct the incentives of the producer by imposing the
full cost of the negative externality they produce onto their own costs.
If the tax is significant enough it will encourage shale producers to try
and develop more energy efficient alternatives or an energy friendly
production process towards extracting the materials that they require.
This may in fact slow down the development of the fracking industry
and reduce the negative externalities produced in this industry over a
longer period of time.
Internalises Externality
• If the tax imposed is set at the right level (equal to the external cost)
then it will be effective in removing the deadweight loss triangle in the
market. This is because producer costs will be equal to social costs and
if a producer faces higher costs it will be incentivised to cut
production.
Sustainability
It can be argued that the imposition of taxes on firms in the fracking
industry may not actually be an effective solution to the problem of
pollution. This is because unlike production limits or bans this does
not actually guarantee a reduction in pollution as taxes only aim to
affect the firms incentives.
Significance and Size of Tax
• It is often difficult for governments to be able to accurately quantify
the size of the externality being created and therefore it is difficult to
set the right tax on firms. This is particularly the case for the UK
fracking industry as there are lots of different environmental
pressures created, which makes it difficult for governments to
accurately place a value on the overall external costs that fracking
imposes on the enviornment.
Tax Evasion
• It may be the case that even if UK shale producers have an indirect tax
imposed on them to change their incentives, they may find a loophole
in the tax system to avoid paying this tax. If so, this may prevent
certain firms from taking into account the external costs, which
causes the market to still have an inefficient allocation of resources.
Administration Costs
• It can be very costly in terms of time, resources and money to not
only administer taxes on firms but also to monitor the behaviour of
firms ex-post to ensure that taxation has in fact altered the incentives
of firms.
• Introducing a less government-involved solution such as tradeable
pollution permits might be a less costly solution to administer.
The question is asking you to assess whether taxation is the ‘most effective’
form of government intervention towards tackling negative production
externalities. Therefore, some alternatives should be discussed. This will
enable you to talk about the relative advantages and disadvantages of these
forms of intervention have over taxation. Here are some examples of
alternative forms of government intervention:
Subsidies
• The government may provide subsidies to firms, as a reward for
keeping their pollution levels below a certain level.
• Despite this being an alternative strategy it is unlikely to be effective in
the fracking industry as the enviornmental effects of fracking are often
disputed and not easily measured, which means providing subsidies is
not only a costly solution but one that is difficult to adminster as well.
Compensation
• Firms that pollute could be required to pay compensation to local
residents that are negatively affected by the production of UK shale
gas and oil. The compensation payments will increase the private cost
of production for firms and will incentivise firms to reduce production.
Of course, you are only expected to propose and introduce some of these
alternative solutions to taxation and not all of these, as otherwise you will not
have time to develop enough evaluation points within your essay.
Including accurate and relevant evaluation in your essay is the most important
thing to ensure you achieve top marks. Evaluation is the art of making
supported judgements, of deciding which factors are most important and of
explaining
There a huge number of evaluative angles you could take within this essay.
Here we will showcase some useful examples. You would not be expected to
include all of these examples – there simply is not enough time!
Unintended Consequences
• Some forms of government intervention could create unexpected
side-effects which damage the efficiency and welfare of the market in
the long-term. For instance, imposing sticter environmental standards
on firms in the UK shale gas and oil industry may create job losses and
ultimately lessen competition in the market, because it is not
appropriate to universally apply environmental standards to all firms
within the market. Some some emerging firms may not have the
resources to invest, which could lead to a lessening in competiton in
the long-run. This is a particuarly important issue to consider in the UK
fracking industry as it is a upcoming and devloping industry where lots
of new firms have recently taken up a position in the industry.
Equity Concerns?
• When deciding upon imposing a tax on firms that operate in the UK
shale gas and oil industry, there may be concerns regarding whether
the form of government intervention is in fact equitable or not. This is
because it can often be difficult for the government to identify not
only what firms are polluting but more importantly to what extent
each firm is responsible for the enviornmental damage and pressures
created.
Cost of Administration
• It is important to take into account the cost of planning, setting and
policing forms of legislation in the market to correct negative
externalities. This is because if the cost of administration exceeds the
cost of pollution itself to society, then it is debatable whether in fact it
is beneficial to intervene in a market that produces negative
externalities.
The concluding paragraph of your essay is often a very good place to make
clear what your overall reasoned judgement of the question is. Some people
also like to include a similar judgement in their introduction, to signpost clearly
to the examiner that they will be making an evaluative judgement in their
essay.
Here is a good example of an attempt to, in one paragraph, argue that taxation
is the most effective form of government intervention:
“Overall, the case for using taxation as a way to rectify the market failure in
industries exhibiting negative production externalities is persuasive. Whilst
there are some concerns about how effectively a government can establish
what the right level of the tax should be and how to effectively implement the
intervention, in today’s modern society this concerns should be diminished.
Governments are able to use a variety of techniques to ensure their estimates
are good and their interventions will be successful. Moreover, done right,
taxation can ensure a complete solution to this market failure by forcing the
producers to fully internalise the externality.”
“On balance, indirect taxation should not be considered to be the best solution
when trying to rectify negative production externalities. The uncertainty
present in many industries means that any intervention by a government, at
best an arms-length away from the production practicalities, is likely to mis-
estimate and produce government failure. Far better to introduce a market-
based solution like tradeable pollution permits, which incentivises firms to
adapt and change their ways but provides flexibility for those who struggle
initially.”