Answers to exam-style questions (data response)

01 A negative externality is a public bad which stems from either the production or consumption of a good or service and which is dumped on third parties without their consent. The negative externality is delivered outside of the price mechanism. (5 out of 5 marks)

Although this answer earns full marks, the fact that the word ‘externalities’ in the question is in the plural might have prompted the candidate to give two examples of negative externalities.

02 The first significant feature is that in every age group shown in Extract A more people choose not to smoke than to smoke. The 21–25 year age group are the most likely to smoke with 41.2% of people smoking, whereas the 12–13 year age group are the least likely to smoke with only 2.4% smoking.

The second significant feature is that after the age of 25 there is a gradual reduction in the percentage of people in each age group smoking. In the age group 21–25 as many as 41.2% of the people smoke but this figure falls and in the 65+ age group only 10% of people smoke. (8 out of 8 marks)

Two significant features of the data are correctly identified, with identification backed up in each case with evidence from the data. Mark schemes for part 02 and 06 questions award 2 marks for each point of identification (provided the examiner deems it to be significant) and 2 marks for statistical back-up. With the latter, it is important to include accurate units of measurement (in this case % signs).

03 The diagram below depicts the marginal private, external and social costs and benefits incurred and received in a free market for tobacco products such as cigarettes.

Tobacco is a demerit good, which means that is it over-produced and over-consumed if provided in a free market. This occurs for two reasons.

First, when smoked tobacco dumps harmful negative externalities into the immediate atmosphere. Non-smokers do not choose to breath in this passive smoke but could suffer severe health effects such as lung cancer (Extract B, line 5). The market has no mechanism for charging smokers for the harm that they are inflicting on the health of non-smokers. Hence the true price of smoking is not reflected in the price. When left to the free market, smoking is under-priced and over-consumed. Over-consumption is shown by Q₂–Q₁ on the diagram.

Second, when people start smoking they fail to appreciate the true health effects of smoking. This is known as the information problem because humans cannot appreciate the long-term costs of smoking, which may take over 30 years to appear. Teenagers who start smoking often ‘ignore and downplay information’ about how addictions may be dangerous but they only fully comprehend the actual consequences of their actions in later life. As a result they over-consume tobacco because they make decisions based on short-term benefits but ignore long-term costs. This effect is not shown on the diagram. (12 out of 12 marks)

More often than not, part 03 and 07 questions ask for inclusion of an ‘appropriate diagram’. For questions on a market, such as the Topic 2 question on the gold market, the ‘appropriate diagram’ is almost always a supply and demand diagram. For questions on a market failure, including this question, the appropriate diagram is likely to be a marginal private, external and social cost and benefit diagram.

04 The justification for raising taxation on tobacco is that tobacco is a demerit good which is under-priced by the free market, hence its price is too low and it is over-consumed.

By increasing the level of taxation the government will be increasing the costs of production of firms supplying tobacco in the market. This is illustrated in the diagram below, as supply shifts to the left from S₁ to S₂. The suppliers will in turn pass the cost of the tax increase onto consumers. The government hopes that the higher price will create a disincentive for consumers not to buy tobacco.

The main problem with this argument is that most smokers develop an addiction to cigarettes when they are young (Extract B, line 9). Once smokers are addicted to tobacco their demand is often inelastic, as can be seen in the diagram. This means that the increase in the level of taxation on tobacco is ineffective at reducing demand.

Anti-smoking campaigners argue that even if the tax increase is ineffective it is still justified on the grounds that it will raise revenues for the government worth billions of pounds each year that can be used to treat people with smoking-related diseases. This is a powerful argument. Smoking tobacco is harmful for both the individual who chooses to consume cigarettes and third parties who unintentionally passive smoke. Hence, increased taxation can be used to help correct the immense damage caused by smoking.

The tobacco industry disputes part of this argument. As can be seen in Extract C, tobacco firms warn that excessive taxation actually reduces government tax revenues because it leads to higher levels of smuggling (line 5) which deprives the UK exchequer of £3 billion per year.

Although this is a strong argument it is not a reason for not taxing tobacco heavily. The government should use the police and revenue and customs agencies to enforce the law and prevent illegal smuggling. However, if the government really wants to decrease the level of smoking it needs a policy that discourages young people from starting smoking. Taxation can be effective by making cigarettes expensive but to be truly effective an educational government policy is needed to make young smokers fully aware of the long-term cost of smoking. (19 out of 25 marks)

This answer reaches Level 4, for which the descriptor is:

AS LEVELS OF RESPONSE	AO1 KNOWLEDGE and UNDERSTANDING of theories, concepts and terminology	AO2 APPLICATION of theories, concepts and terminology	AO3 ANALYSIS of economic problems and issues	AO4 EVALUATION of economic arguments and evidence, making informed judgements
Level 4 17–21 marks (mid-point 19) Good analysis but limited evaluation or Reasonable analysis and reasonable evaluation	Good throughout the answer with few errors and weaknesses Good throughout much of the answer with few errors and weaknesses	Good application to issues Good use of data to support answer Some good application to issues Some good application to issues Some good use of data to support answer	Relevant and precise with a clear and logical chain of reasoning Largely relevant and well organised with reasonable logic and coherence	Limited but showing some appreciation of alternative points of view Reasonable, showing an appreciation of alternative points of view

To reach Level 5, a winding-up concluding paragraph is necessary, linking back to, but not merely repeating, arguments stated earlier in the answer. It is often a good idea to ‘save’ one important argument until the conclusion and then to use it as the ‘killer’ argument which sways you in favour of either ‘the case for’ or ‘the case against’.

Topic 5 Government intervention in the market

1 An example of a market functioning inefficiently is the international airline industry. International air flights do not pay fuel duty but they emit carbon dioxide emissions, which are negative externalities, into the atmosphere. This is a market failure because the airlines do not pay the full costs of production. This is inefficient because the market price does not reflect the true costs of air travel. As a result the free market price is too low, too many people travel by air and resource misallocation occurs. (5 marks)

2 Fuel taxation could be used to raise the price of air travel. The revenues raised could be used to correct the damage caused by the negative externalities. The higher price will discourage consumption. (2 marks)

3 The word ‘equitable’ means ‘fair’ or ‘just’ and the word ‘inequitable’ means ‘unfair’ or ‘unjust’. Many, though not all, economists believe that a highly unequal distribution of income should be deemed a market failure, on the ground of inequity. However, inequity and equity are normative words, so not all economists agree. Make sure that you do not confuse inequity with inequality (a positive word). Some say the market for bank workers is inequitable as the pay of top bankers is hundreds per cent higher than the pay of bank cashiers. (6 marks)

4 Progressive taxation could make the market for bank workers function more equitably. An income tax is progressive if a progressively larger proportion of income is paid in tax as income increases. (2 marks)

5

The diagram above is nearly identical to the diagram drawn in the answer to part 04 of the data response question on tobacco as a demerit good in Topic 4 (see page 31). In this case, however, the demand curve has been drawn elastic, showing a more than proportionate fall in demand following the increase in price that results from the imposition of the indirect tax. Given this assumption about the elasticity of demand (which may be unrealistic), the indirect tax successfully reduces demand for alcoholic drink from Q₁ to Q₂. (8 marks)

6 Imposing a price ceiling on the fees universities can charge for higher education would keep the price down, but it could leave to excess demand and too few higher education places being made available by the universities. This means, to be successful, the price ceiling would need to be supported by another policy such as granting subsidies to universities. (4 marks)

7 A tradable market in permits to pollute in the electricity market works in the following way. Coal-burning power stations able to reduce pollution by more than the law requires sell their ‘spare’ permits to other power stations which, for technical or other reasons, decide not to, or cannot, reduce pollution below the maximum limit. The latter still comply with the law, even when exceeding the maximum emission limit, because they buy the ‘spare’ permits sold by the former group of power stations. In the long run, even power stations that find it difficult to comply with the law, have an incentive to reduce pollution, so as to avoid the extra cost of production created by the need to buy pollution permits. (8 marks)

8 The issue here is ‘fairer for whom’? Government provision of healthcare is certainly fairer for poor people who could not afford to buy market-provided healthcare but who now receive free state-provided healthcare. But is it fairer for somebody who in the current system lives in a part of the UK where local NHS hospitals are poor. Is it fairer for people whose health deteriorates while languishing on NHS waiting lists, or who suffer from a ‘postcode lottery’ in which similarly ill people living 50 miles away are prescribed expensive drugs denied to them.

Neither the current NHS provision nor market provision is fair, though arguably state provision is fairer. Hospital care could be provided through a state-guaranteed private insurance system. Healthy people never know whether they will be ill in the future and will require expensive hospital treatment many years ahead. But while an individual seldom knows whether a future operation will be required, insurers can predict, using the ‘law of large numbers’, how many people in an age group are likely to suffer a serious disease in the future. Private but state-backed health insurance, which forces everybody to pay insurance premiums and insurance companies to accept contributions from everybody, is the way forward. (10 marks)

9 The passage mentions three forms of rationing healthcare other than rationing through prices. These are: quantity rationing, which results in queues and waiting lists; rationing by lottery; and rationing through the notion of blame. This answer is going to evaluate the first of these, quantity rationing. Rationing by queues and by waiting lists occurs when the price of a good is set below the market-clearing price, which creates excess demand and a shortage. This can happen if the government introduces a maximum price law, or, in the case of events such as football matches, rock concerts and art exhibitions when the promoter of the event sets admission prices that are too low. Rationing by queues and waiting lists leads to black markets. Some economists believe that black markets perform a useful economic function, bringing together buyers and sellers, with the black market price clearing the market. Others argue that black markets lead to criminal behaviour and racketeering.

In the health service, quantity rationing has the adverse effect of patients dying while they wait several weeks or even months for treatment. It also leads to queue jumping when patients who can afford to choose private treatment instead, often in NHS hospitals. However, defenders of the system argue that this frees scarce resources within the NHS, which can be used to treat patients who cannot afford to queue jump. (10 marks)

10 Market failure occurs when markets function badly or unsatisfactorily. Market failure occurs when banks function inequitably or inefficiently, and in the latter case, when one of the three functions prices perform in a market breaks down. In an extreme case, when all three functions (signalling, incentive and rationing) break down, a market ceases to function at all. In this situation, there is a ‘missing market’.

Government failure, by contrast, occurs when government intervention in the economy, sometimes to correct market failure, is ineffective. In extreme cases, government intervention may create new problems worse than those the intervention was supposed to cure. For example, government intervention through high taxation to make incomes more equal may reduce incentives to work hard and this may harm economic growth. (10 marks)