A-Level Economics A: Chains of Reasoning PAPER 3

Question 1

1.2.3 Price, income and cross elasticities of demand

Explain what is a normal good.

Answer 1

1. Normal goods are goods whose demand shows a direct relationship with a consumer’s income.
2. This means that the demand for normal goods increases alongside the expansion of consumers’ income.

Question 2

1.2.3 Price, income and cross elasticities of demand

Explain what is a luxury good.

Answer 2

1. A luxury good is characterised by high-income elasticity of demand, the responsiveness of demand to a change in income.
2. This means when an increase in demand causes a bigger percentage increase in demand (in comparison with normal goods).

Question 3

1.2.3 Price, income and cross elasticities of demand

Explain what is an inferior good.

Answer 3

1. A inferior good is characterised by low-income elasticity of demand, the responsiveness of demand to a change in income.
2. This means an increase in income causes a fall in demand.

Question 4

1.2.3 Price, income and cross elasticities of demand

Q. Explain what is a substitute good.

Answer 4

1. A substitute in economics refers to a product that consumers see as essentially the same to another product.
2. Substitutes are characterised by a positive cross elasticity of demand, the percentage change in quantity demand for a good after the change in the price of another.
3. This means if the price of one good increases, then the demand for the substitute is likely to rise due to this positive cross elasticity of demand.

Question 5

1.2.3 Price, income and cross elasticities of demand

Q. Explain what is a complementary good.

Answer 5

1. Complementary goods are products which are used together.
2. Complementary goods are characterised by a negative cross elasticity of demand, the percentage change in quantity demand for a good after the change in the price of another.
3. This means If the price of one good increases, demand for both complementary goods will fall.

Question 6

1.2.3 Price, income and cross elasticities of demand

[POINT: TIME]

Q. Examine two possible reasons for the change in price elasticity of demand for a good over time.

Answer 6

1. The price elasticity of demand varies directly with the time period.
2. This means the elasticity for a shorter time period is always low or it can be even inelastic.
3. The reason stated for this is the redundant human nature to change habits. We generally stick to a commodity and respond very late to the price changes.
4. However, the elasticity of demand is high over a longer time period as our habit changes over time. We can substitute the original product if its price changes in the long run.

Question 7

1.2.3 Price, income and cross elasticities of demand

[POINT: SUBSTITUTES]

Q. Examine two possible reasons for the change in price elasticity of demand for a good over time.

Answer 7

1. If a product has a lot of substitutes, people will switch to other products when prices go up.
2. Therefore, the price elasticity of demand will be elastic.
3. Similarly, if a market loses the availability of substitutes, the demand curve will remain inelastic.
4. As a result, people will still have to buy that good if there are no alternatives.

Question 8

1.2.3 Price, income and cross elasticities of demand

[POINT: FALL IN PROFITS]
[FACTOR: NECESSITY]

Q. Assess the likely effects on inelastic (demand) good retailers if the consumption of that good becomes more elastic.

Answer 8

1. If a good is a demand inelastic when a change in price occurs, there is a small change in demand.
2. A factor in why these goods are inelastic is due to their sense of necessity, the need to keep buying regardless of price.
3. However, if consumer behaviour changes its perception of necessities (such as tobacco products) the good will becomes more elastic.
4. On the retailer’s end, they can no longer charge higher prices based on elasticity since the price now affects a greater percentage change in demand.

Question 9

1.2.3 Price, income and cross elasticities of demand

[CB: FALL IN PROFITS]
[FACTOR: NECESSITY/ADDICTIVENESS]

Q. Assess the likely effects on inelastic (demand) good retailers if the consumption of that good becomes more elastic.

Answer 9

1. However, there are other factors that help retain product elasticity such as addictiveness.
2. This means retailers can continue to charge higher prices based on their good’s addictive properties.
3. Because of these properties, it leads to consumers treating those goods as necessary for their own purposes.
4. As a result, retailers can still charge prices based on elasticity to some degree.

Question 10

1.2.3 Price, income and cross elasticities of demand

[POINT: FALL IN PROFITS]
[FACTOR: SUBSTITUTES]

Q. Assess the likely effects on inelastic (demand) good retailers if the consumption of that good becomes more elastic.

Answer 10

1. If a good is a demand inelastic when a change in price occurs, there is a small change in demand.
2. A factor in why these goods are inelastic is due to the availability of substitutes, people will have to buy a good if there are no alternatives.
3. However, if a market gains more substitutes, then the price elasticity of demand will be more elastic.
4. Retailers who now face competition from other retailers can no longer charge higher prices based on elasticity.

Question 11

1.2.3 Price, income and cross elasticities of demand

[CB: FALL IN PROFITS]
[FACTOR: BRAND LOYALTY]

Q. Assess the likely effects on inelastic (demand) good retailers if the consumption of that good becomes more elastic.

Answer 11

1. However, there are other factors that help retain product elasticity such as brand loyalty.
2. The attraction of brand loyalty makes demand more inelastic.
3. This is because there is less time for consumers to think about what to buy and they can safely guarantee minimum standards.
4. As a result, regardless of new substitutes changing elasticity, it can be argued that brand loyalty can still help enable retailers to charge higher prices to some degree.

Question 12

1.3.2 Externalities

Q. Explain one measure government could use to reduce the impacts of negative externalities.

Answer 12

1. Indirect taxes are taxes levied on goods and services rather than on income or profits.
2. Taxes are put on goods with negative externalities to increase their price. This is done to reduce the external costs of externalities.
3. As a result, it moves production closer to being socially optimum.

Question 13

1.3.2 Externalities

Q. Explain what a negative production externality is.

Answer 13

1. Negative externalities of production occur when social costs are greater than private costs.
2. The market left to operate freely will ignore the external costs involved in producing a good. It will produce where MPB=MPC, the market equilibrium, at Q1P1.
3. At Q1, the costs to the society are higher than the benefits to society resulting in the loss of welfare equal to the shaded area.
4. As highlighted by the shaded region, there is a net welfare loss.

Question 14

1.3.2 Externalities

Q. Explain what a negative consumption externality is.

Answer 14

1. Negative externalities of consumption occur when social benefit is less than private benefit.
2. In a free market, we get Q1 output. But at this output, the social marginal cost is greater than the social marginal benefit.
3. Social efficiency occurs at a lower output (Q2). where social marginal benefit = social marginal cost.

Question 15

1.3.2 Externalities

Q. Explain what is social efficiency.

Answer 15

1. In a free market, consumers ignore the external costs of consumption. Therefore, the free market equilibrium is at Q1 (where S=D).
2. Social efficiency occurs at an output where Marginal Social Benefit (MSB) = Marginal Social Cost (MSC).
3. If the output is reduced from Q1 to Q2, society is in a better position. At Q2, the marginal social cost = the marginal social benefit. This is said to be socially efficient

Question 16

1.3.2 Externalities

[POINT: ENABLES GREATER SOCIAL EFFICIENCY]

Q. Assess the likely benefits of an increased subsidy on positive externalities.

Answer 16

1. In a free market, there is an under consumption of goods with positive externalities.
2. To increase consumption and production, the government can offer a subsidy to reduce the price and increase the quantity.
3. The supply curve should expand, decreasing prices.
4. The output will then be socially efficient because Social marginal cost (SMC) equals Social marginal benefit (SMB).

Question 17

1.3.2 Externalities

[CB: ENABLES GREATER SOCIAL EFFICIENCY]

Q. Assess the likely benefits of an increased subsidy on positive externalities.

Answer 17

1. However, the cost will have to be met through taxation.
2. Some taxation, e.g. income tax, may reduce incentives to work.
3. The most efficient way to raise revenue for subsidising positive externalities would be to tax goods with negative externalities, however, this may not always be the case.

Question 18

1.3.2 Externalities

[POINT]

Q. Explain how externalities impact economic agents? (negative consumption)

Answer 18

1. In a free market, we get Q1 output. But at this output, the social marginal cost is greater than the social marginal benefit.
2. Social efficiency occurs at a lower output (Q2) where social marginal benefit = social marginal cost.
3. As a result, the shaded triangle which represents the dead-weight welfare loss, highlights the net loss of welfare/utility derived from the consumption of a good.
4. This occurs because consuming a tobacco causes a harmful effect to a third party. In this case, the social benefit is less than the private benefit.

Question 19

1.3.2 Externalities

[POINT]

Q. Explain how externalities impact economic agents? (negative production)

Answer 19

1. In a market without environmental regulation, producers ignore the external costs to others.
2. Therefore output will be at Q1 (where Demand = Supply). This makes production at a socially inefficient level because since social marginal costs outweigh social marginal benefit.
3. Since social efficiency occurs at Q2, where social marginal cost = social marginal benefit, the shaded triangle highlights the deadweight welfare loss.
4. This highlights the net loss of welfare/utility derived from the production of a good since pollution causes a harmful impacts to a third party as highlighted by the example of Bangladesh.

Question 20

1.3.2 Externalities

[POINT]

Q. Explain how externalities impact economic agents? (positive consumption)

Answer 20

1. Even people that are not paying for your positive externalities will get some positive benefit from it.
2. In this case, the social marginal benefit of consumption is greater than the private marginal benefit.
3. Consumption will initially be at Q1 because private benefit equals private cost, however, this is socially inefficient due to Q1 having social marginal cost being less than social marginal benefit.
4. Therefore, social efficiency would occur at Q2 where social cost equaled social benefit.

Question 21

1.3.2 Externalities

[POINT]

Q. Explain how externalities impact economic agents? (positive production)

Answer 21

1. Initially, the social marginal cost of production is less than the private marginal cost of production. However, the socially efficient after improvements in public transport the level will be at Q2 (where social marginal cost = social marginal benefit).
2. This is because of reduced transport costs it enables businesses to connect with a larger pool of people. This has major implications.
3. Firstly, it enables connection with finding potential customers, enabling them to sell to wider market.
4. Lastly, a larger pool of people imply a wider pool of talent. This allows skills to be better matched to employment opportunities for both individuals and businesses.

Question 22

1.3.2 Externalities

[CB]

Q. Explain how externalities impact economic agents? (negative consumption)

Answer 22

1. Demand is very inelastic for cigarettes; this is due to cigarettes having addictive properties.
2. Therefore, increasing price will only cause a small fall in demand and mean a large proportion of smokers will continue to smoke regardless of price.
3. As a result, the government can be argued to have failed in reducing the negative externalities caused by the consumption of tobacco products.

Question 23

1.3.2 Externalities

[CB]

Q. Explain how externalities impact economic agents? (negative production)

Answer 23

1. Firstly, It may be socially inefficient to ban everything.
2. For example, you could introduce environmental laws polluting industries must abide by.
3. This would reduce pollution but could have adverse economic effects on business.
4. This implies that the socially efficient level of pollution is not zero since zero business too hurts economic agents.

Question 24

1.3.2 Externalities

[CB]

Q. Explain how externalities impact economic agents? (positive consumption)

Answer 24

1. Innovation and production of new products can result in the pollution via the means of transportation and manufacturing of said product.
2. Since most firms still rely on fossil fuels as a source of energy for operations, emissions will cause to some degree negative externalities.

Question 25

1.3.2 Externalities

[CB]

Q. Explain how externalities impact economic agents? (positive production)

Answer 25

1. In the government sector, there may be poor information and a lack of incentives, which leads to a misallocation of resources.
2. Therefore, bigger government expenditure in certain sectors could lead to a less efficient economy and little benefit returned forever pound spent on public transport.

Question 26

2.6.2 Demand-side policies

[POINT: INTEREST RATES]

Q. To what extent might monetary policy help the UK government achieve its macroeconomic objectives?

Answer 26

1. Firstly, interest rates can be increased when demand is too high.
2. An increase in interest rates will make borrowing more expensive as more has to be paid back in loans.
3. This will decrease
   consumption, as borrowing has become more expensive since banks will raise their interest rates as they know that if they have to borrow money from the central bank, they will need to pay higher rates.
4. Moreover, it will encourage people to save which will decrease consumption.

Question 27

2.6.2 Demand-side policies

[CB: INTEREST RATES, ECON GROWTH AND TRADE BALANCE]

Q. To what extent might monetary policy help the UK government achieve its macroeconomic objectives?

Answer 27

1. However, this will also increase the value of the pound due to increased demand for sterling for foreigners who want to invest.
2. Therefore, exports will become expensive and imports cheap as there may be a current account deficit and a fall in net trade.
3. Since AD is made up of (X-M), lower export demand and greater spending on imports would expect a fall in AD, causing lower economic growth and worsening the trade balance by causing a bigger deficit.
4. This hurts two of the UK’s main objectives, positive economic growth and trade balance.

Question 28

2.6.2 Demand-side policies

[POINT: QUANTITATIVE EASING]

Q. To what extent might monetary policy help the UK government achieve its macroeconomic objectives?

Answer 28

1. Moreover, quantitative easing can be used to affect money supply. The central bank can inject money into the economy by buying assets from private firms.
2. This encourages firms to spend more, as they have more money, and pushes prices up as demand for goods rises.
3. This can lead to a positive wealth effect as if the price of people’s assets rise, they are likely to increase consumption.
4. On the whole, AD will expand from AD1 to AD2. This is usually done when the economy is at very low output. As a result, it increases employment and economic growth without having a negative effect on inflation.

Question 29

2.6.2 Demand-side policies

[CB: QUANTITATIVE EASING, INFLATION]

Q. To what extent might monetary policy help the UK government achieve its macroeconomic objectives?

Answer 29

1. If it was done at a different time, it may push inflation up without increasing economic growth/employment at all this would be when the economy is at full output.
2. The increase in the money supply too quickly will cause inflation. The flood of cash in the market may encourage reckless financial behaviour and increased prices.
3. This occurs when an increase in the money supply does not correlate with the volume of goods available for sale.
4. The increased AD could then cause a further impact on the balance of payments deficit if consumers’ needs cannot be met by the country, so imports are increased.

Question 30

2.6.2 Demand-side policies

[POINT]

Q. Discuss ‘looser fiscal policy’ that may be used by governments to increase economic growth.

Answer 30

1. This can encourage growth in a number of ways. Firstly, the government can increase spending which will increase AD, since government spending is one component of AD.
2. As a result, this will lead to a rise in growth from Y1 to Y2. On top of this, they could reduce direct taxes which will increase disposable increase and thus increase consumption, leading to higher AD. Again, growth will rise from P1 to P2.
3. The effect of both of these will depend on the multiplier. If the multiplier is high, there will be an even larger increase in AD, which will further increase growth.
4. Furthermore, tax cuts enable higher levels of consumption since more disposable income is available since fewer taxes on personal income apply to consumers.

Question 31

2.6.2 Demand-side policies

[CB]

Q. Discuss ‘looser fiscal policy’ that may be used by governments to increase economic growth.

Answer 31

1. There are two main problems with these policies: their effects on inflation and on the budget.
2. The rise in AD will lead to price increases from P1 to P2. This will depend on where the economy is producing
3. The bigger problem will be the budget. Some countries run high budget deficits, when expenses exceed revenue, which they are trying to reduce and so this will cause conflicting objectives.
4. According to the laffer curve, a fall in tax rates will lead to a fall in tax revenue. As a result, fiscal policy poses a problem for both inflation and a balanced budget.

Question 32

2.6.2 Demand-side policies

Q. Explain the likely effect of a rise in the value of the pound on aggregate demand.

Answer 32

1. A rise in the value of the pound is likely to mean AD will fall. A strong pound makes imports cheap and exports dear.
2. As a result, more people will buy imports and fewer people will buy UK exports, causing net trade to fall.
3. Net trade is a component of AD and so a fall in net trade will cause AD to fall.
4. Furthermore a rise in the value of the pound can be caused by a rise in interest rates and so therefore the effect of a rise in interest rates will cause AD to fall even further.

Question 33

2.6.2 Demand-side policies

Q. Explain the likely effect of a fall in the value of the pound on aggregate demand.

Answer 33

1. A fall in the value of the pound is likely to mean AD will increase. A weaker pound makes exports cheap and imports dear.
2. As a result, more people will buy exports and fewer people will import, causing net trade to rise.
3. Net trade is a component of AD and so a rise in net trade will cause AD to rise.
4. Furthermore a fall in the value of the pound can be caused by a fall in interest rates and so therefore the effect of a fall in interest rates can cause AD to rise even further.

Question 34

2.6.3 Supply-side policies

Q. What are the benefits of Supply-side policy?

Answer 34

1. Lower Inflation
2. Lower Unemployment
3. Improved Economic Growth
4. Improved Trade and Balance of Payments

Question 35

2.6.3 Supply-side policies

Q. Explain what happens when a Supply-side policy is applied.

Answer 35

1. The LRAS curve shifts to the right, to show the increase in the productive potential of the economy.
2. In other words, the maximum output of the economy at full employment has increased.
3. This leads to a fall in the average price level, from P1 to P2, and an increase in national output, from Y1 to Y2.

Question 36

2.6.3 Supply-side policies

Q. What is the strength of Supply-side policies?

Answer 36

Supply-side policies are the only policies which can deal with structural unemployment, because the labour market can be directly improved with education and training.

Question 37

2.6.3 Supply-side policies

Q. What is the weakness of Supply-side policies?

Answer 37

1. There are significant time lags associated with supply-side policies and not all policies will be successful.
2. There may be negative impacts on the government budget due to higher government expenditure or lower taxes.

Question 38

2.6.3 Supply-side policies

[POINT: PRIVATISATION, CURRENT ACCOUNT]

Q. Evaluate the effectiveness of market-based supply-side policies such as privatisation and deregulation.

Answer 38

1. Supply-side policies such as privatisation can help reduce current account deficits. A private firm has the incentive to maximise profits instead of social welfare.
2. So the private firm may cut average costs, reduce X-inefficiency as it now has an incentive to cut costs and in doing so, increase productivity.
3. This means the LRAS shifts right from LRAS to LRAS1 and the SRAS shifts right from SRAS to SRAS1 reducing the price level from PL to PL1.
4. A lower price level increases export competitiveness, so export demand increases and import demand decreases, so the balance of trade improves and so does the current account.

Question 39

2.6.3 Supply-side policies

[CB: PRIVATISATION, UNEMPLOYMENT]

Q. Evaluate the effectiveness of market-based supply-side policies such as privatisation and deregulation.

Answer 39

1. Firms may choose to fire workers to cut costs and increase profits, increasing the rate of unemployment.
2. Royal Mail cut 1600 jobs after the privatisation. Higher unemployment would generate costs for the unemployed individuals, forcing some into poverty.
3. Particularly if the firm’s activity is concentrated in a particular area, higher unemployment could also mean lower spending in local shops, causing a negative multiplier effect.
4. This could harm the level of local economic activity and national activity since the government business works on a national scale.

Question 40

2.6.3 Supply-side policies

[POINT: DEREGULATION, REMOVING BARRIERS TO ENTRY]

Q. Evaluate the effectiveness of market-based supply-side policies such as privatisation and deregulation.

Answer 40

1. Deregulation may remove barriers to entry, allowing more firms to enter markets and increasing short-run and long-run aggregate supply.
2. Hence the productive potential of the economy improves and so does real GDP.
3. This will also increase employment, as labour demand is derived demand from demand for goods and services.
4. Since more labour and enterprise are both factors of LRAS, this will reflect a bigger expansion in LRAS.

Question 41

2.6.3 Supply-side policies

[CB: DEREGULATION, UNINTENDED CONSEQUENCES]

Q. Evaluate the effectiveness of market-based supply-side policies such as privatisation and deregulation.

Answer 41

1. However the success of deregulation depends on the reason for the regulation in the first instance. For example deregulation of health and safety may increase the harm to self-employed workers.
2. This could lead to higher accident rates, more time off work and hence lower productivity.
3. It could also cause higher government spending on NHS care for those who have accidents at work because of deregulation.
4. Because of the number of workers affected (800,000) a significant bill for the NHS could even worsen the government budget deficit.

Question 42

3.1.2 Business growth

What are the main objectives of growth?

Answer 42

• Economies of scale
• Increased market share
• Increased profitability

Question 43

3.1.2 Business growth

Why do businesses pursue economies of scale as a means of growth?

Answer 43

1. As a business grows, its output will increase.
2. As a result of this, their costs will be spread over more items.
3. This is likely to result in a decrease in the average costs of the business.
4. As a result, the business’s profit margins will increase causing an increase in the overall profit the business makes.

Question 44

3.1.2 Business growth

Why do businesses pursue increased market share as a means of growth?

Answer 44

1. As market share increases so will sales.
2. As a result of this, more people are likely to recognise the brand of the business.
3. Building up a good brand image will help to reduce the business’s customer’s PED as well as attract more sales.

Question 45

3.1.2 Business growth

What are some of the problems that may arise from growth?

Answer 45

• Diseconomies of scale
• Internal communication
• Overtrading

Question 46

3.1.2 Business growth

How might growth cause problems in internal communication?

Answer 46

1. As a business grows, their average costs may raise.
2. This is due to the problems of growing such as worse communication and co-ordination.
3. Communication is harder due to the operation hierarchy increasing.
4. This will result in businesses being unable to react quickly to changes in the market.

Question 47

3.1.2 Business growth

How might growth cause overtrading?

Answer 47

1. When a business tries to grow too quickly they can often end up with liquidity problems.
2. This is due to the fact that most of the business growth will often be done through loans.
3. As a result of this, both their current and non-current liabilities are likely to increase.
4. This will result in a lack of working capital to pay off current liabilities.

Question 48

3.1.2 Business growth

What are the advantages of organic growth?

Answer 48

• Integration is expensive, time-consuming and high risk. Firms often pay too much for takeovers and integration is often poorly managed with many key workers tending to leave after the change.
• The firm is able to keep control over its business.

Question 49

3.1.2 Business growth

What are the disadvantages of organic growth?

Answer 49

• Sometimes another firm has a market or an asset which the company would be unable to gain through organic growth. For example, integration would allow a European company to expand into the Asian market which it has no expertise in.
• Organic growth may be too slow for directors who wish to maximise their salaries.
• It will be more difficult for firms to get new ideas

Question 50

3.1.2 Business growth

What are the advantages of forward and backwards integration?

Answer 50

• There will be fewer risks as suppliers do not have to worry about buyers not buying their goods and buyers do not have to worry about suppliers not supplying the goods.
• With backward integration, businesses can control the quality of supplies and ensure delivery is reliable. Moreover, they don’t have to worry about being charged high prices for supplies, keeping costs low and allowing lower prices for consumers. This can increase competitiveness and sales.

Question 51

3.1.2 Business growth

What are the disadvantages of forward and backwards integration?

Answer 51

Firms may have no expertise in the industry they took over, for example a car manufacturing company would have deep knowledge of car manufacturing but little knowledge of selling cars and vice versa.

Question 52

3.1.2 Business growth

What is an example of vertical integration in the UK?

Answer 52

Tesco’s £3.7bn takeovers of Booker in 2018 is an example of vertical integration. It has led to an increase in sales for Tesco.

Question 53

3.1.2 Business growth

What are the advantages of horizontal integration?

Answer 53

• This helps to reduce competition as a competitor is taken out and increases market share, giving firms more power to influence markets.
• The business is able to grow in a market where it already has the expertise, which is more likely to make the merger successful.

Question 54

3.1.2 Business growth

What are the disadvantages of horizontal integration?

Answer 54

The problem is that it will increase the risk for the business as if that particular market fails, they have nothing to fall back on and will have invested a lot of money into that area. They are ‘placing all their eggs in one basket.

Question 55

3.1.2 Business growth

What is a medical example of horizontal integration?

Answer 55

In 2015, AstraZeneca acquired ZS Pharma for $2.7bn. It gave them access to new compounds and was a long term deal intended to strengthen a specific sector of their business.

Question 56

3.1.2 Business growth

What are the advantages of conglomerate integration?

Answer 56

• The range of products reduces the risk for firms and if a whole industry fails, they will still survive due to the other parts of the business.
• It will make it easier for each individual part of the business to expand than if they were on their own as finance can be easily obtained and managers can be transferred from company to company within the firm.

Question 57

3.1.2 Business growth

What are the disadvantages of conglomerate integration?

Answer 57

The problem with this is that firms are going into markets in which they have no expertise. It can often be damaging for the business.

Question 58

3.1.2 Business growth

What is an example of conglomerate integration?

Answer 58

General Electric was founded as a lighting business and is now involved in aircraft, water, oil and gas, financial, healthcare, energy, aviation, rail and software.

Question 59

3.1.2 Business growth

What are the main constraints on business growth?

Answer 59

• Size of the market
• Access to finance
• Owner objectives
• Regulation