SUGGESTED ANSWERS

AQA
Economics
Advanced Level
Suggested Answers and
Examiner Commentary for:

PAPER 1
2019
IMPORTANT NOTICE
These suggested answers have been prepared solely to help students
develop their exam technique for future exam sittings. These answers
are not endorsed by AQA. These answers were not written under exam
conditions and were prepared with knowledge of the relevant mark
schemes. The examiner commentary provided is written by experienced
examiners but is not endorsed by AQA. The answers provide just one
way to approach each question – other equally valid approaches and
responses are possible.
AQA Economics
Paper 1 June 2019

Context 1

Suggested answer – 2 marks Examiner

commentary
1 (126-110)/100*100 = 14.5 % to 1 dp Following the
precise
instructions is
crucial – in this
case, giving the
answer to 1dp

Suggested answer – 4 marks Examiner

commentary
2 For the expansion in the global sand market to be leading to increasing real prices of construction The first
sand, the change in the price of construction sand would need to be above the general price sentence
increase and positively associated with expansion in the global sand market. indicates that the
candidate clearly
Figure 2 clearly shows the global sand market is growing, expanding from demand of 180 millions understands the
of tons in 2010 to 244 millions of tons in 2015. Over the same period, the index of US producer concept of ‘real’
prices of construction sand increased from an index value of 100 in 2010 to an index value of 115 in data and has
2015. This is a 15% increase. At the same time the consumer price index increased from 100 to identified what
around 109. For 2010 – 2015, the data shows a clear correlation and the theory of demand they need to do.
suggests this is likely to be causality. It should be noted though that there were significant periods The data is then
of time when the price of construction sand did not rise in real terms, for example 2011 – 2013. accurately
quoted with
correct units and
some
“manipulation”
i.e. 15% increase.

Suggested answer – 9 marks Examiner

commentary

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3 One of the costs of production for sand is transportation. When transport becomes cheaper, all The question
else equal, this will lead to an increase in supply. This means that at each price, profit maximising clearly asks
firms will be willing to supply more. On the diagram, the industry supply curve shifts from S to S1. candidates to
If this is accompanied as well by a construction boom in East Asia, there will also be an increase in consider the
demand. This is because “sand is mostly used in the construction industry to make concrete and impact of both
asphalt” - Extract B lines 2 -3. China (which is in East Asia) has a rapid pace of construction and the construction
the impact is therefore likely to be large. On the diagram this is shown by the shift in the demand boom and
curve from D to D1. This means cheaper
that at each price, consumers are transport – this
willing to demand more. Initially candidate has
the market was in equilibrium at considered both,
P,Q, but the increase in both and therefore
supply and demand throw the made two shifts
market into disequilibrium. The on the diagram.
impact depends on the relative
size of the shifts of two curves, The second part
but as drawn, at the original price of the
P there is a now shortage, candidate’s
specifically of Q1 to Q2. answer shows a
very strong
If economic agents are rational, understanding
there is an incentive for dissatisfied consumers to increase the price they are willing to pay and this of how new
sends a signal and provides an incentive for even more resources to be allocated to this market. equilibrium
While the higher price means that some consumers will now ration, the overall effect is to increase points are
the equilibrium quantity. The market for sand has grown from Q to Q3. reached in
markets, using
relevant price
mechanism
terminology

Suggested answer – 25 marks Examiner

commentary
4 “Critics argue that the international community needs to treat sand like a resource on a par with The use of
clean air, biodiversity and other natural endowments” – Extract C lines 2 to 3. This suggests that relevant quotes
sand may be a common access resource where significant market failure is possible. On the other from the data to
hand, “substitutes for sand do exist” – Extract C line 10, and “in some rich countries a shift towards illustrate both
these alternative production processes is already underway as sand prices rise” – Extract C lines 11 sides of the
– 12. This suggests that the market may, in some cases at least, be functioning well. Should the argument
scarcity of sand be solved by government intervention or is it a problem best solved by market presented in the
forces? Three factors will be considered. First, the view that the existence of market failure question is really
provides an argument in favour of government intervention. Next, another argument in favour of helpful.
government intervention that effective policy options exist and finally, the arguments against Outlining the
intervention. structure will
also help to
prevent the
essay from
drifting off track.

The accurate use

of terminology
here is a great
way to build
strong
knowledge
marks

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First, one argument for government intervention in the market for sand is the view that sand
should be viewed as a common access resource. This means that it is a good which is rival (when
one person uses it another person cannot) but which is non-excludable. It shares very similar Excellent use of
characteristics to common land. The result is that no individual has an incentive to conserve the the data and
resource, since the lack of excludability means they cannot confine the benefit to themselves. context
Consumption can therefore be thought of as being associated with negative externalities since the throughout this
rational behaviour leads to adverse impacts on others. An example of this would be the erasure answer
of over 20 islands in Indonesia since 2005 and the impact more generally on biodiversity. On the
diagram, the market would reach
equilibrium at PQ since market
participants have no incentive to
take account of their actions on
others. However, the negative
externality means that the socially
optimal equilibrium lies at Q1P1. In
order for this to be an effective
argument for government
intervention, the market failure
(shown by the shaded deadweight
loss triangle) needs to be significant.
All markets fail to some extent, so
market failure itself is not a reason
for governments to act. Again, linking to
the data
Those who link the problem to clean air and biodiversity presumably think the welfare loss is provided is
sizeable. Furthermore, the fact that some governments have imposed restrictions (US, Indonesia, highly effective
Malaysia and Cambodia for example) suggests that they too view the problem as significant. In
the case of the developing countries, the restriction takes the form of an export ban that is
especially costly. All in all, market failure seems to provide reasonable grounds for supporting the Immediate
view that increasing scarcity of sand should be solved through government intervention. evaluation of the
argument is a
Another argument in favour of government intervention would be if effective policy options exist good way to
to correct the market failure. There are a number of options that could be used, but the specific structure the
one mentioned in the extract is regulation. In the case of the US for example, there are essay
“restrictions on where sand can be mined…” – Extract C line 4. This reduces the size of any
negative externality. On the diagram, MSC would, as a consequence, lie closer to MPC and the
welfare triangle would be reduced, possibly eliminated. In theory, this provides a strong argument
for government intervention. However, in reality it seems that there are significant problems with
enforcing regulation “there is a particular problem of ineffective enforcement in India, with
organised criminal networks ignoring rules and conducting sand mining” – Extract C lines 7 – 9.
Not only does this suggest government intervention might be ineffective, but by providing
revenue for criminal networks it is possible that externalities more generally would increase and
the result would be government failure, where the unintended consequence actually increases the
welfare loss. While effective in some cases, there do seem to be particular problems with
regulation in some areas of the world.

Finally, there are important arguments against intervention. In theory at least there are theoretical
cases where externalities can be solved by the market. The Coase Theorem provides such
circumstances. This requires that numbers affected and negotiation costs are low and this is not Conclusions
the case here, since sand is a global market. As mentioned earlier, excess demand for sand leads which link theory
to rising prices and this should lead to some consumers rationing their demand for this item and and evidence
using substitutes instead. This is possible since “substitutes for sand do exist” – Extract C line 10. are nearly
“In the UK, sand demand is 25% less than 2007” evidences that this is happening in some always highly
circumstances. The difficulty though is that without effective regulation, rising prices only make effective.
illegal mining (and the associated) externalities more profitable.

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 In conclusion, while there is compelling evidence that market failure exists, regulation does seem
beset with problems and in some areas of the world at least the risk of government failure is
present. India is such a large country that widespread failure here cannot be ignored. It is in the
areas where regulation is more effective (developing countries) where market forces are having an
impact, but the common access resource nature of sand suggests that leaving matters entirely to
market forces is unlikely for the time being to be the best solution to the problem of the scarcity
of sand. This view can be held with some certainty since it is supported by both theory and
empirical evidence.

Context 2

Suggested answer – 2 marks Examiner

commentary
5 73p The answer is
correct and
would therefore
be awarded
both marks, but
it is advisable to
always show
workings

Suggested answer – 4 marks Examiner

commentary
6 For changes in the demand for rail travel to have contributed to changes in the price of rail travel, It is vital for 4-
the data would need to show a positive correlation. The index of passenger kilometres is an mark questions
indicator of the demand for rail travel and this increased by 62% from an index of 100 in 2004 to to quote and
an index of 162 in 2017. At the same time, the index of ticket prices rose by 68% from an index of use as much
100 in 2004 to an index of 168 in 2017. Furthermore, the change in the retail price index was relevant data as
considerably lower, showing an increase of around 44% for the period in question. This suggests possible –
very strongly that the increase in rail ticket prices did not simply reflect general inflationary remember that
pressure and the positive correlation with the index of passenger kilometres suggests that the data must be
changes in the demand for rail travel very likely contributed to changes in the price of rail travel. interpreted (as is
shown here)
rather than just
stated

Suggested answer – 9 marks Examiner

commentary
7 A natural monopoly exists when minimum efficient scale is so high relative to industry demand An excellent
that the productively efficient outcome is for there to be only one firm in the industry. This is understanding
because sunk costs (and other fixed costs) are extremely high. Minimum efficient scale is the of natural
lowest level of output where all economies of scale are achieved. Economies of scale are savings monopoly is
in long run average total cost as scale of production increases. shown
immediately

The diagram is
carefully
labelled, and
referred to in the
detailed written
analysis

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 On the diagram, if output
Q represents maximum
industry demand,
maximum economies of
scale are not achieved at
this point. This would be
typical of a natural
monopoly. Economies of
scale arise from a number
of factors. Technical
economies will be present
such as indivisibilities
(specialist pieces of capital
equipment that are
uneconomic at smaller
scale), economies of
massed resources, marketing, financial and management economies and network economies will
be especially important for an industry such as this. Breaking the industry into smaller parts, for
example consistent with scale of output Q1 means that while some economies of scale can still be
achieved (the LRATC curve is still sloping downwards), they are not achieved to such a degree.
LRATC at this level of output C1, as drawn, are multiples of their level C when there is one firm in
the industry.

Given the nature of the break-up of British Rail, the scale of output may in fact be even lower than
this and the vertical disintegration as a result of privatisation may also mean there are increasing
costs arising from this source. Economies of scale suggests that breaking up the natural
monopoly may increase LRATC. It may be though that greater competition and greater private
sector efficiency may lead to greater dynamic efficiency and lower ATC curves due especially to
process innovation. X-inefficiency (where lack of competition reduces the incentive to be
technically efficient and negotiate the lowest possible prices for factors of production) may also be
reduced.

Suggested answer – 25 marks Examiner

commentary
8 The Labour party has proposed rail renationalisation of the entire UK network” – Extract F line 7.
Renationalisation occurs when an industry has previously been privatised (transferred from the
public sector to the private sector) and is returned once again to the public sector. What would
be the case for such a move for the railways in the UK? This essay considers three factors. First
what are the arguments on grounds of abuse of monopoly power? Next, what can be said
regarding cost and finally what other alternatives are there to renationalisation to achieve
improvements in the rail network?

Starting
paragraphs by
stating the main
point of the
paragraph helps

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First, one argument in favour of renationalising railways in the UK is that it would reduce the with an effective
likelihood of abuse of monopoly power. Monopoly power exists whenever a firm is able to restrict structure
output in order to raise price. All firms outside of perfect competition have some degree of
monopoly power, but in concentrated markets with high barriers to entry, they have the most and
when PED is low they have a high incentive to use this power in order to increase revenue and
maximise profit. While rail has been split into “no less than 100 pieces” – Extract E lines 10 – 11,
most firms still operate in
concentrated markets, in
some cases monopolies. The argument
This impact of this may be builds very well
analysed using the in this
diagram below. If firms paragraph, with
are highly competitive (as theory
in perfect competition) presented in
then equilibrium will be detail before
achieved through market linking with the
forces at P,Q. where specific context
supply equals demand. In (rail) in which
contrast, if a firm with data has been
significant market power chosen
is willing and able to effectively
restrict output, then the
profit maximising level of output will be achieved at Q1 where MC = MR. There is a welfare loss of
consumer and producer surplus shown by the shaded triangle. If this is how rail firms behave in
the private sector, this would be strong grounds for renationalisation. One piece of evidence
supporting that this may be the case is that “ticket prices are now 25% higher in real terms than in Immediate
1995 and 30% higher than in France, Sweden and Switzerland” – Extract E lines 18 – 19. evaluation of the
previous
On the other hand, “profits are about 3.4% across the industry” - Extract F line 17. While this analytical point
aggregated figure may hide some divergence, in considering the impact, much depends on the is a good way to
use to which any extra profit is put. Even if monopoly power is being used to maximise profit, if develop a strong
the result is greater allocative or productive efficiency as a result of product and process argument
innovation, there may still be welfare gains. Investment may have increased around 4 times in real
terms but “the data on service quality are mixed”. All in all there does seem to be some merit in
the view that in the private sector there may be some abuse of monopoly power and this would
be an argument in favour of renationalisation.

Considering the
assumptions
made in analysis
is another
effective method
for developing
arguments – it

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Another argument concerns cost. The diagram above assumes that firms in competitive markets shows excellent
and firms in concentrated markets face the same cost structure. This is highly unlikely, in part understanding
because of economies of scale, but as already discussed, the argument is far from simple. If of theory, and
renationalising results in improvements to LRATC through economies of scale AND there is no an ability to
abuse of monopoly power, then the result in theory can be a very good one. On the diagram, evaluate and
economies of scale lead to considerably lower costs (MC1) and assuming the government is acting critique
altruistically, equilibrium would be reached at P2, Q2. Equilibrium output is considerably higher
(Q2) than where abuse of monopoly power is assumed ( Q1) and consumers pay much lower
prices meaning that consumer surplus increases significantly. Excellent use of
an integrated
On the other hand, there are reasons to suppose a renationalised firm might be less efficient. This diagram
was a key reason for privatisation in the first place. Economic theory suggests that not only might
the lack of profit motive and
lack of competition mean
that there is less incentive to
innovate and be cost
conscious, but lower profits
and constraints placed by
macroeconomic fiscal
considerations might limit
investment. There is also
the risk of moral hazard if
rail decision makers think
government if necessary will
bail them out. As things
stand though, this appears
to be a feature of a
privatised rail service. The argument for renationalisation from a cost point of view is far from
clear.

Finally, an argument against renationalisation would be if there were alternative and better ways
of improving rail performance. There are a number of possibilities here but one perhaps worthy
of consideration is the franchising process itself and the means by which subsequent problems are
handled. The process is very expensive and this must itself reduce competition. Best outcomes
are likely to be achieved the more contestable the market. While rail cannot be especially
contestable in the usual sense, if large profits attracted significant competition in the next franchise
bidding process, this might moderate significant abuse of monopoly power. It seems essential too
that once companies have taken on a franchise moral hazard should be avoided. The evidence
from Stage Coach and Virgin in 2018 that led to them leaving the very important East Coast
mainline contract 3 years early suggests this is a very significant problem.

It seems that renationalisation could be done at little cost as franchises would simply not be
renewed. This is a consideration but perhaps not the most important one. It seems pretty clear
though that something must be done. While UK trains are reasonably punctual and reliable, it is a
concern that “UK trains and tracks are more intensively used than in any other European market” –
Extract E lines 5 -6 and that ticket prices are higher than in much of Europe. Of particular note is
that “the costs of running the UK’s railways is 40% higher than in the rest of Europe” – Extract E –
lines 13 – 14. Certainly from a theoretical point of view there is no compelling case that
renationalisation is the answer but the experience when National Express gave up the East Coast
franchise in 2009 does suggest otherwise. The case for renationalising the railways, for the
reasons given, seems pretty evenly balanced.

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Section B
Essay 1

Suggested answer – 15 marks Examiner

commentary
9 Irrationality occurs when consumers (or producers for that matter) make decisions that are biased. Explaining key
Biased means they are subject to systematic errors. Rules of thumb, or heuristics, is a way of terms at the start
reducing the cognitive load of decision-making. Behavioural economics is the branch of can really help
economics that analyses the impact of irrationality, and especially predictable irrationality. A to ensure that
Human is an economic agent affected by irrationality and bias. An Econ is not. the essay is built
on a firm base.
Irrationality and rules of thumb will have no impact at all on consumers’ demand for goods and
services if they are Econs. Econs are assumed to have clearly defined preferences and the
cognitive ability to consider all of the possibilities when making decisions. Choices are made
according to the utility provided and while there might be errors (for example a film which did not
yield the expected utility), they will not be systematic. Irrationality is avoided by ranking options
according to the marginal utility gained and the opportunity cost is the next best alternative
forgone. Limitless cognitive ability removes the need for rules of thumb.

In contrast, Humans experience bounded rationality and this is one way in which rules of thumb
and irrationality affect their demand for goods and services. Consumers face an incredible array
of choice. Against this background, even if attempts are made to adopt maximising behaviour,
there are limits to the rationality that will be shown. Rationality may be limited by the complexity
of the decisions that need to be taken, their familiarity and the time available for example. In Very good use
order to reduce cognitive load, consumers may adopt simple rules of thumb. Examples of such of technical
behaviour include inertia, default choice, and herd behaviour. The result is some degree of terminology
irrationality. Consumers are unlikely to be wholly irrational but in the case of demerit goods for
instance the irrational component may be large. An example of a demerit good is smoking. The use of an
Consumers receive some immediate utility from consumption because it is addictive but are example helps to
irrational in their failure to take proper account of the longer-term disadvantages. Partly as a support the
result their self-control is bounded and the impact on their demand for goods and services is that argument and
it is above their private optimum and well above the socially optimal level. convince
examiners that
Consumers’ demand for goods and services may also be affected because supermarkets and the topic is well
other commercial firms are adept at using choice architecture and framing techniques to exploit understood
the rules of thumb that irrational consumers adopt. One example of this is anchoring. In a sale
for example, rather than considering the utility to be gained from a purchase, irrational consumers
will consider the sale price with reference to the original price. The original price is the anchor on
which decisions are based. The bigger the discount, the more likely the consumer is to make the
purchase. Default choice is an example of choice architecture, where consumers are more likely
to accept the default since they assume it contains some element of social norm.

Suggested answer – 25 marks Examiner

commentary
10 Market failures arise when the market left to its own devices, fails to achieve the best allocation of
resources. Markets can fail totally in the case of public goods or partially in the case of
externalities or inequalities. Traditional economic policies are based on the assumption that Whilst outlining
economic agents are rational – i.e. unbiased in their decision-making. In contrast nudges are the structure of
policies based on behavioural economic theory that makes use of predictable irrationality to the essay is
influence behaviour. This essay will consider three types of market failure and the ability to tackle certainly not
them using behavioural approaches: public goods, demerit and merit goods and finally essential it can
inequality. help to prevent
an essay from
drifting off track

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Public goods will lead to complete market failure. A pure public good is non-rival and non-
excludable. A good example is nuclear defence. Providing defence to one person does not limit This is a very
the protection to the next person, and the only way to prevent one person benefitting from efficiently written
protection is to remove it from all. The result is a strong incentive to free ride and as a result piece of analysis
consumption cannot be linked to payment and profit cannot be made. The market is missing. on traditional
Traditional economic policies would require government provision (or government organised approaches to
provision) with funding collected centrally through some sort of tax. In theory, some sort of public goods
behavioural approach based on altruism might be successful in these circumstances because
economic agents would now have to take the impact of their actions on third parties into account,
but it is very unlikely to provide a good solution, especially when not all would agree that nuclear
defence offered benefit. It is more likely that altruism might be successful for public goods such as Very clear mini-
lighthouses and streetlights where the cost is smaller and the gain clearer and less contentious. judgement at
Generally though with public goods, the biggest gains in terms of correcting market failure seem the end of the
to be coming from technological advances that improve excludability and remove the need for paragraph
state intervention at all. An example would be the growth of streaming services compared with
terrestrial TV. Where public goods are concerned, behavioural economic based policies do not
seem very useful.

In the case of a merit good the individual concerned may not be making an accurate assessment
of their own marginal private benefit (and especially taking accurate account of the long term It is clear from
benefits), there will be externalities (impacts on third parties) and these are goods which society the use of
judges an individual should have access to irrespective of their ability to pay. An example would technical
be education or healthcare. Demerit goods such as smoking or alcohol are the opposite. The language,
diagram shows these features of a demerit good, with D being the incorrect estimate the interesting and
individual puts on their MPB, D1 the correct evaluation according to society and MSB the impact accurate
including the effect diagram and its
of the negative accompanying
consumption analysis, that this
externality. The topic is very well
result is a market understood
failure, which
certainly in the case
of alcohol or
smoking is
significant as
evidenced by the
sizeable impact on
NHS services that
are paid for by
taxpayers.
Traditional theory
would suggest that Good use of
one solution would be an indirect tax of the distance P2 to P4. In theory this would work but the traditional and
tax would need to be very large given the size of the market failure. Another possibility is to behavioural
attempt to reduce the information failure and close the gap between D and D1. Traditional theory approaches,
would suggest an information campaign but experience suggests these have not been especially with real-world
successful. Behavioural theory suggests instead particular types of campaigns (specifically images contexts
of health impacts on packets) that exploit availability bias. In other areas (the organ donor register
and work place pensions), choice architecture has been shown to be very effective in achieving
better outcomes and this may suggest a behavioural approach will work well with some aspects
demerit goods. Given the size of the problem it is likely though that behavioural and traditional
approach would need to work hand in hand.

Inequality is a particular type of market failure where allocative efficiency is compromised because
not all have an equal ability to express their demand for goods and services. Traditional economic
theory suggests a number of approaches such as improving earnings ability through supply side
or labour market approaches (this would affect original income) or tax and benefits to affect final

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 income. Tax and benefit changes have particular issues concerning incentives though, with a
possible link between benefit payments and frictional unemployment and higher tax rates
impacting risk taking and entrepreneurship. An alternative approach relies on the charitable
sector. All charitable giving is altruistic. Behavioural theory is at work here but usually where the
charities are concerned, again exploiting availability bias. For governments, the approach is
almost entirely traditional.

It seems that the effectiveness of behavioural soljutions depends very much on the type of market
failure in question. For public goods and inequality, it seems as though behavioural policies are of
very little help where the government is concerned. It is a different matter though for charities
themselves. For merit and demerit goods though, behavioural is an exciting field which seems to
offer benefit especially where bounded self-control is an issue. Evidence from the trials of the
“Nudge” unit bear this out. There is very little evidence though of behavioural approaches
replacing traditional. Behavioural approaches only work where an individual is irrational. There
may be many examples of predictable irrationality but it seems likely that much behaviour is still
rational and this therefore calls for traditional policies in the main in many cases.

Essay 2

Suggested answer – 15 marks Examiner

commentary
11 Profit is the difference between revenue and cost. The short run is a situation where at least one
factor of production is variable and the long run is when all factors of production are variable. A
firm experiences a number of costs during the production process – fixed costs and variable costs.
In the short run, variable costs (such as labour and raw materials) vary with output but fix costs do
not. In the long run all
costs are variable.

The diagram shows a It is simply not

firm operating in possible in a 15-
monopolistic mark exam essay
competition. (This is question to
chosen as an example.) cover all possible
Monopolistic market
competition is similar to structures –
perfect competition narrowing it
except that products are down to one is a
differentiated. A firm will sensible
continue to operate in a approach
market all the time that
profit is greater or equal
to normal. On the
diagram, the firm in
question is earning below normal profit because at the profit maximising level of output
(MR=MRC) AR is below ATC. The firm will leave the market and allocate its resources to a market
where normal profit can be earned. (Barriers to entry and exist do not exist in the long run in
monopolistic competition and there are therefore no sunk costs.) Whether the firm shuts down in Good use of
the short run or long run depends on which of its costs it is able to cover with revenue. Providing technical theory.
variable costs are being covered, which they are at Q in the diagram (and they are being covered Costs and shut-
by a reasonable amount) the firm will stay in the market in the short run and attempt to pay down down points are
some of its fixed costs. An example of fixed costs is premises and machinery. In contrast, if often
variable costs were not being covered, the firm would shut down immediately and exit the market. misunderstood,
so its good to
In the long run though any firm not making normal profit will shut down and leave the market. In see them
the case of monopolistic competition, it may be that the lack of barriers to entry means that other accurately
firms exit the market and as demand switches from these substitutes, revenue for this firm explained here

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 increases enough to allow it to again earn normal profit. If this is the case, it will stay. In the case
of monopoly though, where there is only one firm in the market, the firm would exit the market in
the long run unless costs could be reduced or revenue increased through product development
and/ or advertising sufficient to return the firm to normal profit. Firms such as Homebase and
House of Fraser which are not monopolies but operate in concentrated markets can be seen to be
adopting cost saving strategies of this sort. House of Fraser has attempted to renegotiate rents
for example.

Suggested answer – 25 marks Examiner

commentary
12 At the heart of traditional economic theory lies the assumption that rational economic agents
adopt maximising behaviour. In the case of firms this means they will be profit maximising. Profit
maximisation occurs when output takes place at the point where MC=MR. How valid though is
this assumption, especially where firms such as Spotify have “never made a profit in any year since
it was founded”? This essay will consider three aspects of this quite complex question. First –
what can be said of the circumstances where profit maximisation may be a realistic assumption?
Next, is profit satisficing a better assumption and finally is the main objective (as suggested for
Spotify), maximising market share?

Profit is the reward to risk taking and must therefore be an important consideration for most firms.
For small firms though it is likely to be critically important. In the case of perfect competition for Comparing
example, where products are homogenous, information is perfect and firms are price takers, any theory to
firm failing to maximise profit will earn below normal profit and will be forced to exit the market in practice is a
the long run. In the real world though, perfect competition is an unrealistic market structure, but great way to
for any small firm, profit is likely to be very important, as it is the basis of their means of finance. approach
Small firms will not have access to the capital market (through bonds and share issues) and will economics exam
either need to use retained profits to grow or will need to demonstrate an ability to earn profits in questions.
order to obtain bank borrowing. However, even if a small firm wishes to maximise profit it may be Similarly, noting
in reality be quite difficult for them to do so. It is likely that managers of firms will experience that all firms are
bounded rationality in considering all of the cost and revenue information necessary to equate MR different e.g.
and MC and will instead adopt heuristics or simple rules of thumb to reduce cognitive load. One small v large, is
such example is cost plus pricing. The result may be that they are profit seeking as oppose to effective
profit maximising. Bounded rationality will be even greater for larger firms, even though they may
have the benefit of specialised managers. In theory profit maximisation may be a valid
assumption for small firms in particular but the practical difficulties of achieving it bring the
assumption into question.

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Is profit satisficing a more valid assumption? Any firm, but especially larger firms, will have a
number of stakeholders. A stakeholder is anyone with an interest in the business. Examples of
stakeholders include employees, shareholders, customers, possibly the government in some cases, Again, excellent
the competition authorities, but there are many more. Shareholders will have a particular interest use of
in maximising profit since it is likely that dividends (their reward for taking the risk of buying terminology
shares) will be greatest when profits are high. Employees though will not want to see wages shows very
pushed to the lowest level consistent with productive efficiency. Recent strike threats from BA strong
pilots evidences this understanding
fact. Customers too will of the topic
want prices to be
reasonable, and in most
real world markets,
profit maximisation
requires output to be
restricted in order to
elevate price. Instead, Including
the firm may profit diagrams is
satisfice. This means nearly always an
firms will attempt to effective
choose a level of profit approach –
that satisfies all of its especially when
stakeholders. On the they are
diagram, the profit accompanied by
satisficing level of profit detailed written
lies between profit analysis
maximising at Q and in the long run normal profit at Q1. Depending on the strength of each of
the stakeholder groups, a firm will aim at a profit point within this range. If a firm has
shareholders, it will be difficult and risky to move too far from profit maximisation in the long run. “depending on”
It may also be that even shareholders wish to profit maximise the divorce between ownership and statements are
control and the different incentives and asymmetry of knowledge means that this is not the useful for
outcome. Certainly for larger firms, while in the long run profit may be an important objective, the introducing
validity of this assumption in the shorter run seems more questionable. evaluation
comments
Finally, is expanding market share a more valid assumption for the main objective of firms? A firm
might seek to maximise its market share for a number of reasons, but a key one is to consolidate
its position in an uncertain, interdependent oligopolistic market. A firm adopting such a strategy
might revenue maximise (operating where MR=0 at Q2 on the diagram), where normal profit is Making
being earned (Q1) or as in the case of Spotify actually earn a loss. These firms though are not reference to a
ignoring the profit maximisation objective altogether, they are pursuing it in the long run rather diagram that has
than the short run. Spotify is not the only example of this type of behaviour. It took Amazon, for already been
example, many years to make profit and Uber has yet to make a profit. These are large, high used is a very
profile companies and this suggests expanding market share is an important objective. efficient
technique in a
time-pressured
What then can be said of the validity of the traditional economic assumption that the main exam
objective of firms is to maximise profits? Certainly there are examples where firms for a period at
least are choosing other objectives, such as Spotify, but the valuation of $27 billion suggests that
at some point this strategy will pay off in terms of profit. Profit seeking or profit satisficing,
depending on the circumstances might be a closer assumption to reality, especially given the
difficulty of actually achieving true profit maximisation. The purpose of an assumption though is
to provide a useful approximation to reality to allow analysis to take place and against this
background, there is some validly to the traditional assumption that the main objective of firms is
profit maximisation since it allows clear outcomes to be established.

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Essay 3

Suggested answer – 15 marks Examiner

commentary
13 Price elasticity refers to the proportionate responsiveness of quantity (demanded or supplied) to Good accurate
the proportionate change in price. A minimum price is a legal floor to the amount that may be definitions help
charged for a good. Minimum prices are usually imposed on goods or services where there is a to prevent
market failure such as a demerit good. An example would be a minimum price for alcohol in errors
Scotland.

The diagram shows the

impact of a minimum
price for a good or
service of price PM. First
of all, in order to have
any impact at all, the
minimum price must lay
above the market
equilibrium, in this case
P and a key aspect of
the impact will be how
far above the equilibrium
it lies. In this case the
minimum price is above
the equilibrium, and the
impact of the higher
price is to move the market into disequilibrium. The higher price sends a signal and provides an
incentive for firms to allocate more resources to this market but at the same time the higher price
provides an incentive for consumers to ration their consumption. Quantity supplied increases to
Q2 and quantity demanded falls to Q1. There is excess supply of Q2 to Q1. Ordinarily the
dissatisfied party (in this case firms) would have an incentive to change their behaviour and
specifically lower the price they are willing to accept. In this case, the minimum price prevents this
from happening unless black markets develop. The specific impact of the price elasticity of
demand and price elasticity of supply is to influence how responsive quantity is to any given
proportionate change in price. For instance if PED is -0.8 and the minimum price causes the price The use of
to rise above the equilibrium by 10% the quantity demanded will fall by 8%. If PED was instead - numerical
1.5, the fall in quantity would be 15%. The more price elastic the good in question, the greater will examples is a
be the fall in quantity demanded. The same (in reverse) will be true for quantity supplied. The nice approach
more price elastic it is, the greater will be the increase in supply. Where price elasticity is high, all
else equal, excess supply will be greater than if goods or services are price inelastic.

If excess supply is particularly great then the incentives for black markets to develop in response to
the minimum price may be stronger. If this is the case then the impact of the minimum price in
terms of reducing consumption will be less and could also generate unintended consequences in
terms of greater crime etc. This will depend though on the effectiveness of regulation and the
severity of any sanctions. In the case of most demerit goods, certainly demand is likely to be price
inelastic (since they are addictive) although supply may be more variable.

Suggested answer – 25 marks Examiner

commentary
14 A minimum wage is a legal floor to the amount that may be paid to labour. A national minimum
wage applies equally across a country (although there are usually different rates applied to young
workers). The UK for instance has operated a minimum wage for a number of years and now has
a legal living wage that is a statutory minimum for those aged over 25. “Each time the

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Government imposes a minimum price or wage, the result is almost always excess supply”.
Ordinarily excess supply would be at odds with the fundamental economic problem of achieving
the best allocation of scarce resources in the face of infinite wants, but overall is the NMW
beneficial for an economy? This essay will consider three factors. First, whether a minimum wage
will always result in excess supply – unemployment in other words. Next, does the impact change
if there are monopsony employers and finally what can be said of the impact on inequality?

The diagram analyses the impact of the imposition of a minimum wage. Assuming the minimum
wage is above the equilibrium (which it may be for some industries and not others, and the impact
may even differ within industries) then the market will now be in disequilibrium for the reasons Not only is there
discussed earlier. Depending on the extent to which the minimum wage is above the equilibrium good theory
and the wage elasticities then there will be some unemployment. E1 to E workers who were shown here, but
employed at the old wage rate will be unemployed now and E to E2 workers were not offering evaluation
their labour at the equilibrium wage but are at W min. The group of workers who remain comments are
employed though have ‘built in’ e.g.
benefitted and are different
receiving W to Wmin industries,
additional earnings. “depending on”
The greater the statements etc
minimum wage above
the equilibrium then the
greater will be the
benefit to the worker
employed, but equally
the greater will be
unemployment. The
more wage elastic
supply and demand
then the greater the
impact will be on
unemployment. In low wage industries where NMW is most likely to be above the equilibrium
then there is reason to think supply and demand may be more elastic. Jobs tend to be less skilled
and this increases supply elasticity. On the demand side, it does vary but employment is likely to A range of
be associated with goods and services which are price elastic (restaurant chains, retail etc) and this economic
will mean demand for labour is more wage elastic. There is some evidence though that being impacts are
paid a “fair” wage is important in motivating labour and that the NMW may have led to considered here
productivity improvements. If this is the case, MRP will rise and hence the demand for labour.
This will reduce excess supply. There are a number of estimates that suggest the NMW has not
increased unemployment at all (and productivity is one reason given) but the same cannot be said
of the higher NLW. There seems to be some evidence that the NMW is beneficial for some
workers but perhaps less so for the over 25s.

Thinking about
the impact of
assumptions that
have been made
is a great way to
develop an
argument

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This analysis though has assumed a competitive labour market. Is a national minimum wage more
beneficial for an economy
if monopsony employers Thinking about
are considered instead? different types of
A monopsony employer firm/employer
is where one firm shows
employs all the labour in consideration of
a particular industry. The a range of
NHS and some perspectives and
government departments helps to support
would be examples, but strong analysis
also some of the gig and evaluation
economy firms also have marks
considerable monopsony
power. On the diagram,
a profit maximising
monopsony employer will
employ labour to the point where MC=MRP at a wage rate W1. This is considerably below the
competitive market wage rate of w and level of employment E. A NMW (for example at wmin)
reduces MC across the relevant employment range and as a result increases both the wage rate
and employment levels. However, while this might be beneficial for those workers concerned,
monopsony firms certainly in a country like the UK do not in fact employ the majority of workers.
Furthermore many of the workers for firms such as Uber are self-employed and are therefore not
covered by minimum wage legislation at all. All in all, the monopsony argument does not seem
sufficiently widespread to support the view that a national minimum wage is beneficial for an
economy.

Finally, what of the impact on inequality? This is possibly the key reason why governments
introduce minimum wages. There is some evidence (from Wilkinson’s Spirit Level analysis) that
developed economies have much to gain if inequality is reduced. These benefits come in the
main from reduced social exclusion. Certainly those who remain in employment are likely to see
their incomes improved and also those who work for monopsony employers. The unemployed
though are likely to be worse off and this may widen rather than narrow inequality. There is also
some evidence that employers offset NMW by reducing non-wage benefits and this may mean
that welfare does not improve at all. It is unlikely that an economy will see benefits if the welfare
of its workforce is unchanged.

Overall, it certainly seems to be a complex picture, as evidenced by the discussion above, and
much will depend on the circumstances in question. In the case of the UK there does seem to be
some evidence that the national minimum wage has not caused considerable unemployment but
equally there seems to be evidence that some employers have managed to introduce offsetting
changes minimising the overall gain. Where the NLW is concerned though, the unemployment
impacts do seem greater and since this covers the majority of those in the working age
population, this does bring into question the view that a national minimum wage is overall
beneficial for an economy.

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