1.1 The market system

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1.1.1 The economic problem

Scarcity is the basic economic problem: human wants are unlimited, but the resources available to satisfy them are finite. Resources therefore cannot produce every desired good and service, so choices must be made.

Part of the problem	Economic meaning
unlimited wants	when one want is satisfied, people can still desire other goods, services or improvements
finite resources	land, labour, capital and enterprise are available in limited quantities at a particular time
competing uses	the same worker, machine, budget or site can often be used for different purposes
choice	consumers, firms and governments must decide which wants to satisfy and which to leave unmet

A government budget cannot fund every hospital, school, road and environmental project requested. Even a wealthy economy faces scarcity because resources and time remain limited relative to all possible wants.

Scarcity does not mean a resource is completely absent, and it is not the same as a temporary shortage. A resource is scarce when its available quantity is insufficient to satisfy every competing want at a zero price.

Opportunity cost is the next best alternative given up when a choice is made. It is the value of the best rejected option, not every possible alternative and not necessarily the money paid.

Economic agent	Choice	Possible opportunity cost
consumer	buy a television with limited savings	the next-best phone or holiday that can no longer be bought
producer	purchase a delivery vehicle	the next-best machine, marketing campaign or staff training forgone
government	fund a new hospital	the next-best school, road or other public service that the same resources could have provided

The effect depends on what is forgone: a consumer loses satisfaction, a producer may lose future revenue or productivity, and a government gives up benefits to another group or policy objective. Context identifies which alternative is genuinely next best.

The purchase price is an accounting cost; opportunity cost is the best alternative use of those resources. If no alternative is named and linked to the decision, the opportunity cost has not been identified.

A production possibility curve or frontier (PPC/PPF) shows the maximum combinations of two goods or categories an economy or firm can produce with its current resources and technology when those resources are fully employed.

Diagram feature	What it represents
horizontal axis	quantity of one product, such as tables
vertical axis	quantity of the other product, such as chairs
intercepts	maximum output of one product when none of the other is produced
downward-sloping frontier	producing more of one product requires giving up some of the other
movement along the frontier	a reallocation of existing resources, not a change in productive capacity

To show a firm producing more tables and fewer chairs, mark a second point farther right and lower on the same frontier. Guide lines can make both output changes visible, and both axes must be labelled.

A movement along one PPC changes the output mix. A shift of the whole PPC changes productive potential; do not draw a new frontier merely because production moves from one attainable combination to another.

A PPC separates combinations that current resources can produce from those they cannot, while its position and movements reveal resource use, opportunity cost and changes in maximum productive potential.

Position or change	Interpretation
point on the frontier	maximum productive potential with resources fully employed and used efficiently
point inside the frontier	possible output with unemployed or inefficiently used resources
point outside the frontier	currently unobtainable with existing resources and technology
movement along the frontier	opportunity cost: gaining one output requires sacrificing some of the other
outward shift	positive economic growth; more of one or both categories can potentially be produced
inward shift	negative economic growth; productive potential has fallen

If moving from B to A raises consumer goods from 130 million to 160 million units while capital goods fall from 450 million to 350 million, the opportunity cost of the extra 30 million consumer goods is 100 million capital goods.

An inside point does not prove the economy lacks resources; it shows current resources are not fully or efficiently employed. Economic growth shifts potential output, but actual production can remain inside the new frontier.

Positive economic growth is an increase in an economy's maximum productive potential, shown by an outward PPC shift. Negative growth reduces that potential and shifts the PPC inward.

Change in productive capacity	Causal route	PPC effect
more or better capital	investment adds machinery, infrastructure or productive buildings	outward
larger or more skilled labour force	population growth, migration, education or training raises available effective labour	outward
technological advance or greater efficiency	each unit of resource can produce more output	outward
discovery or improved access to natural resources	more usable inputs become available	outward
destruction or loss of resources	war, natural disaster, capital deterioration, emigration or resource depletion removes productive inputs	inward
lower productivity	loss of skills, technology or institutional effectiveness reduces output from existing inputs	inward

A change that benefits both categories can shift the whole curve. A sector-specific resource or technology improvement may expand productive potential more strongly toward one axis, so the shift need not be perfectly parallel.

Producing more by moving from inside the PPC toward it uses spare capacity but does not itself prove the frontier has shifted. A PPC shift requires a change in the quantity or productivity of resources or technology.

1.1.2 Economic assumptions

Economic models often begin with two simplifying assumptions: consumers aim to maximise their benefit from consumption, while businesses aim to maximise profit. These assumptions predict the objective each decision-maker is trying to achieve; they do not claim that every real decision succeeds.

Decision-maker	Assumed objective	Meaning in a decision
consumer	maximise benefit	choose the affordable option expected to provide the greatest satisfaction or usefulness
business	maximise profit	choose the output, price or method expected to make the largest difference between total revenue and total cost

If two affordable products differ in expected usefulness, the consumer assumption predicts selection of the higher-benefit one. If two production plans differ in expected revenue and cost, the business assumption predicts the higher-profit plan.

Benefit is the consumer's gain from consumption, not the firm's profit. Profit is total revenue minus total cost, not simply sales revenue. An assumption is a model starting point, not proof that consumers calculate perfectly or that every business has only one objective.

Consumers may choose an option that gives less benefit because calculation is difficult, habits persist, or other people's behaviour influences the choice. A strong explanation names the cause and traces how it changes the decision.

Reason	Decision mechanism	Possible result
poor calculation	the consumer cannot accurately compare all costs, risks and future benefits	an option that looks attractive now may provide lower overall benefit
hard-to-give-up habit	repeated behaviour makes switching costly or uncomfortable even when a better option exists	brand loyalty or continued consumption overrides the calculated alternative
copying others	social approval, fashion or group behaviour becomes part of the decision	the consumer follows friends or a trend rather than choosing the personally highest-benefit option

For sugary drinks, a consumer may underestimate long-term health costs, keep buying a familiar brand, or copy friends. Each route can sustain consumption even after the price rises or information suggests another choice would offer greater benefit.

A choice that an observer dislikes is not automatically irrational. To show failure to maximise benefit, explain why the consumer's calculation, habit or social influence leads away from the option that would provide that consumer greater overall benefit.

A producer may accept less profit when managers pursue revenue or sales, when the business prioritises customer care, or when it undertakes charitable work. The alternative objective changes the decision criterion, so the most profitable option is not always selected.

Alternative priority	Likely decision	Why maximum profit may be forgone
revenue maximisation	seek the greatest sales income, possibly by changing price or output	higher total revenue can come with costs that prevent the largest profit
sales maximisation	use discounts or promotion to sell the greatest quantity	lower margins or higher selling costs can reduce profit
caring for customers	improve service, quality, access or affordability	extra cost or a lower price may benefit customers while reducing current profit
charitable work	donate money, provide free services or charge a subsidised price	resources are directed to a social aim instead of their most profitable use

If a shop manager offers a bulk discount to increase the number of sales, the manager may meet a sales target even though revenue per unit falls and the owner's profit is not maximised. This also shows how managers and owners can pursue different objectives.

Revenue maximisation, sales maximisation and profit maximisation are distinct: revenue concerns sales income, sales concerns quantity sold, and profit concerns revenue after costs. Customer care or charity can later improve reputation and profit, but the immediate decision can still sacrifice maximum current profit.

1.1.3 Demand, supply and market equilibrium

Demand is the quantity of a good or service that consumers are willing and able to buy at a given price over a given period of time.

Element	Why it matters
quantity	demand is measurable in units
willing and able	desire alone is not demand; purchasing power is also required
given price	quantity demanded is linked to a particular price
time period	100 units per day differs from 100 units per year

Other things equal, a lower price normally leads to a greater quantity demanded and a higher price to a smaller quantity demanded. The demand curve therefore usually slopes downward.

Demand is the whole price–quantity relationship; quantity demanded is one amount at one price. Do not define demand as simply wanting a product.

A change in the product's own price causes a movement along the existing demand curve. A non-price determinant changes demand at every price and shifts the whole curve.

Cause	Diagram action	Economic statement
own price falls	move down and right along D	extension: quantity demanded rises
own price rises	move up and left along D	contraction: quantity demanded falls
non-price factor raises demand	shift D right	more is demanded at every price
non-price factor lowers demand	shift D left	less is demanded at every price

Keep the axes labelled price and quantity. For a movement, mark two points on one curve; for a shift, draw and label a second curve such as D1.

Never shift demand because the product's own price changed. Price changes quantity demanded; advertising, income, tastes, related-good prices or population can change demand.

A demand determinant shifts the curve only when it changes how much consumers are willing and able to buy at each possible price. Identify the factor, explain the consumer response, then state left or right.

Change	Typical demand effect	Reason
more effective advertising or favourable fashion	right	more consumers want the product
income rises for a normal good	right	purchasing power increases
price of a substitute rises	right	consumers switch toward this product
price of a complement rises	left	joint consumption becomes more expensive
target population grows	right	more potential buyers enter the market
reverse of these changes	opposite shift	willingness or ability moves in the opposite direction

The direction must fit the relationship: if bananas and apples are substitutes, cheaper bananas reduce demand for apples; if rackets and tennis balls are complements, cheaper rackets raise demand for tennis balls.

Income does not always shift every product the same way: the usual rightward result assumes a normal good. Also distinguish a related good's price, which can shift demand, from this product's own price, which causes movement along D.

Supply is the quantity of a good or service that producers are willing and able to offer for sale at a given price over a given period of time.

Element	Why it matters
quantity	supply is measured in units offered for sale
willing and able	productive capacity without willingness, or willingness without capacity, is insufficient
given price	quantity supplied is tied to a particular market price
time period	producers can often adjust more over a longer period

Other things equal, a higher price normally increases the reward from selling and leads to a greater quantity supplied, so the supply curve usually slopes upward.

Supply means units offered for sale, not the total stock that exists. Supply is the whole curve; quantity supplied is one amount at one price.

A change in the product's own price causes movement along the existing supply curve. A non-price determinant changes supply at every price and shifts the whole curve.

Cause	Diagram action	Economic statement
own price rises	move up and right along S	extension: quantity supplied rises
own price falls	move down and left along S	contraction: quantity supplied falls
non-price factor raises supply	shift S right	more is supplied at every price
non-price factor lowers supply	shift S left	less is supplied at every price

Use two points on one curve to show a price movement. Use a second labelled curve, such as S1, only when production conditions change.

A higher product price does not shift supply. It changes quantity supplied along S; costs, technology, taxes, subsidies and natural factors can shift S.

Supply shifts when a production condition changes the quantity firms can profitably offer at each price. Trace the change through unit cost or productive capacity before choosing the shift direction.

Change	Cost/capacity route	Shift
production costs rise	each unit is less profitable to produce	left
technology or productivity improves	more output can be made from given inputs	right
indirect tax increases	cost per unit rises	left
subsidy increases	effective production cost falls	right
favourable weather for crops	yield and available output rise	right
disaster or adverse weather	capacity or yield falls	left

A rise in raw-material costs shifts car supply left, raising equilibrium price and lowering quantity. A productivity improvement shifts smartphone supply right, lowering equilibrium price and raising quantity, assuming demand is unchanged.

Do not treat every government payment as demand. A subsidy to producers changes their costs and shifts supply; the product's own market price still causes movement along the curve.

Market equilibrium occurs where quantity demanded equals quantity supplied. The intersection of D and S determines both the equilibrium price, Pe, and equilibrium quantity, Qe.

At a candidate price	Comparison	Market condition
Qd = Qs	planned purchases equal planned sales	equilibrium
Qd > Qs	buyers want more than firms offer	excess demand
Qs > Qd	firms offer more than buyers want	excess supply

Demand represents buyers' decisions and supply represents sellers' decisions. Only at their intersection are the two plans mutually consistent, so there is no pressure from unsold goods or unmet orders for price to change.

Equilibrium is not the highest price or output a firm prefers. It is the market price–quantity combination where the quantities demanded and supplied are equal.

Begin with D and S intersecting at Pe and Qe. Shift only the curve whose determinant changed; its new intersection gives the new equilibrium price and quantity. At a controlled or non-equilibrium price, horizontal quantities reveal excess demand or supply.

Curve change, other curve fixed	New equilibrium price	New equilibrium quantity
demand shifts right	higher	higher
demand shifts left	lower	lower
supply shifts right	lower	higher
supply shifts left	higher	lower

At a price below equilibrium, Qd is normally greater than Qs: excess demand. At a price above equilibrium, Qs is normally greater than Qd: excess supply. Measure both quantities at the same price line.

A movement to a new equilibrium after a curve shifts includes movements along the unchanged curve. Do not shift both curves unless the context gives separate determinants for both.

Excess demand is the amount by which quantity demanded exceeds quantity supplied at a given price. Excess supply is the amount by which quantity supplied exceeds quantity demanded at a given price.

Condition	Calculation	Diagram
Qd > Qs	excess demand = Qd − Qs	horizontal gap from Qs to Qd below Pe
Qs > Qd	excess supply = Qs − Qd	horizontal gap from Qd to Qs above Pe
Qd = Qs	excess = 0	the price line passes through equilibrium

If 1,870 sunglasses are demanded and 1,350 are supplied, excess demand is 1,870 − 1,350 = 520 pairs. State the unit and the price or context to which the calculation applies.

Subtract the smaller quantity from the larger only after naming which quantity is larger. Excess demand and supply are quantities, not price differences, and both readings must come from the same market price.

Market forces remove imbalance through price changes that alter both quantity demanded and quantity supplied along their curves, moving the market toward the intersection.

Initial imbalance	Price response	Buyer response	Seller response	Result
excess demand: Qd > Qs	price rises	quantity demanded contracts	quantity supplied extends	gap narrows toward equilibrium
excess supply: Qs > Qd	price falls	quantity demanded extends	quantity supplied contracts	gap narrows toward equilibrium

With excess demand for tickets at 1,500 krona, buyers compete for too few tickets and sellers can raise price. The higher price discourages some buyers and encourages more supply until Qd equals Qs at the equilibrium price.

The adjustment is movement along existing curves when determinants are unchanged. A shortage does not itself shift demand or supply; it creates price pressure that changes quantities demanded and supplied.

1.1.4 Elasticity

Price elasticity of demand (PED) measures how responsive quantity demanded is to a change in price.

PED compares percentage changes so responsiveness can be compared across products measured in different units. Demand is more price responsive when a given percentage price change produces a larger percentage change in quantity demanded.

PED concerns movement along a demand curve caused by the product's own price. It does not measure a demand-curve shift caused by income, tastes or related-good prices.

$\mathrm{PED}=\frac{\%\ \mathrm{change\ in\ quantity\ demanded}}{\%\ \mathrm{change\ in\ price}}$

Use percentage changes for both numerator and denominator. Because price and quantity demanded usually move in opposite directions, PED is normally negative.

The same relationship can be rearranged: percentage change in quantity demanded = PED × percentage change in price. For PED = −1.9 and a 10% price fall, the quantity change is (−1.9) × (−10%) = +19%.

Do not mix an absolute quantity change with a percentage price change; both parts of the ratio must be percentages.

$\mathrm{PED}=\frac{-2.1\%}{+1.6\%}=-1.3125\approx -1.31$

First assign signs from direction: the price rose by 1.6%, while quantity demanded fell by 2.1%. Divide the percentage change in quantity demanded by the percentage change in price, then round only the final result.

The magnitude is greater than 1, so demand is price elastic: quantity demanded changed proportionally more than price.

Classification uses the absolute magnitude, but retain the negative sign when reporting PED unless the question or convention explicitly uses magnitude only.

A price-elastic demand curve shows a proportionally large quantity response to a price change; a price-inelastic curve shows a proportionally small quantity response.

Same proportional price change	Quantity response	Diagram appearance in a like-for-like sketch
elastic demand,	PED	> 1
inelastic demand,	PED	< 1

Label price vertically and quantity horizontally, draw one downward-sloping D curve, and mark two price and quantity readings so the relative percentage changes are visible.

Steepness is reliable only when axes and scales are comparable. Elasticity is defined by percentage responsiveness, not angle alone.

PED magnitude	Classification	Quantity response to a price change
0	perfectly price inelastic	quantity demanded does not change
between 0 and 1	price inelastic	proportionally smaller
1	unitary price elastic	same proportion
greater than 1	price elastic	proportionally larger
infinity	perfectly price elastic	any price rise reduces demand to zero in the model

PED is usually negative; classification normally uses |PED|. Thus −0.5 is inelastic and −1.5 is elastic.

A positive PED value is not the standard downward-sloping demand relationship. Do not call +1 perfectly elastic; perfect elasticity is represented by an infinite magnitude.

Factor	More elastic when…	Why
substitutes	close alternatives are available	consumers can switch after a price rise
necessity	the product is less necessary	consumption is easier to postpone or avoid
share of income	spending takes a larger share	the price change matters more to the budget
time	consumers have longer to adjust	they can search, switch or change habits

Demand for a soft drink may become more elastic over six months as consumers discover substitutes and have time to alter routines.

These factors influence responsiveness rather than shifting demand by themselves in the PED calculation. State the causal route, not just a memorised factor.

$\mathrm{Total\ revenue}=\mathrm{price}\times\mathrm{quantity\ sold}$

Demand type	Price rises	Price falls
elastic,	PED	> 1
inelastic,	PED	< 1
unitary,	PED	= 1

If an inelastic product sells 50 units at $3,000, total revenue is$ 150,000. A price rise would normally increase total revenue because the percentage quantity loss is smaller than the percentage price gain.

This relationship concerns total revenue, not profit. Costs may change, so higher revenue does not guarantee higher profit.

Price elasticity of supply (PES) measures how responsive quantity supplied is to a change in price.

PES asks how strongly producers adjust output offered for sale when the product's own price changes. A larger percentage output response means more elastic supply.

PES describes movement along a supply curve. A change in costs, technology, taxes, subsidies or weather shifts supply and is not itself the price change measured by PES.

$\mathrm{PES}=\frac{\%\ \mathrm{change\ in\ quantity\ supplied}}{\%\ \mathrm{change\ in\ price}}$

Quantity supplied and price normally move in the same direction, so PES is normally positive. Use percentage changes so responsiveness is independent of the units used.

Percentage change in quantity supplied = PES × percentage change in price. If PES is 1.5 and price rises by 12%, quantity supplied rises by 18%.

Use quantity supplied, not quantity demanded, in the numerator.

$\mathrm{PES}=\frac{+2.7\%}{+4.9\%}=0.551\ldots\approx 0.55$

Record the percentage change in quantity supplied, divide by the percentage change in price, and round at the end. Both changes are positive here because higher price encourages greater quantity supplied.

PES = 0.55 is price inelastic: quantity supplied changes proportionally less than price.

If both price and quantity supplied fall, dividing two negative changes still gives a positive PES. Do not classify it as negative elasticity.

Price-elastic supply shows a proportionally large output response to a price change; price-inelastic supply shows a proportionally small output response.

Same proportional price change	Quantity response	Like-for-like sketch
elastic supply, PES > 1	larger proportional change	relatively flatter S
inelastic supply, PES < 1	smaller proportional change	relatively steeper S

Label price and quantity axes, draw an upward-sloping S curve, and mark P1, P2, Q1 and Q2 so the relative changes can be compared.

Curve angle alone is not a universal elasticity test because scale matters; compare percentage changes or diagrams with identical axes and scales.

PES	Classification	Quantity response
0	perfectly price inelastic	no response; vertical supply
between 0 and 1	price inelastic	proportionally smaller
1	unitary price elastic	same proportion
greater than 1	price elastic	proportionally larger
infinity	perfectly price elastic	horizontal supply in the model

A PES of 1.5 is price elastic; a PES of 0.5 is inelastic.

Perfectly inelastic supply is PES = 0, not a very large number. Perfectly elastic supply is the infinite limiting case.

Factor	More elastic when…	Why output can adjust
factors of production	inputs are mobile and easy to obtain	firms can expand production quickly
stocks	finished stocks are available	firms can release goods without waiting for production
spare capacity	unused labour or machinery exists	output can rise without new facilities
time	producers have longer to respond	capacity, labour and inputs can be changed

Supply becomes more inelastic when inputs are specialised, stocks are perishable or absent, capacity is full, or the response period is short.

A factor must change the ease or speed of output adjustment. It does not automatically change the current quantity supplied unless price changes.

Product type	Likely PES	Main reason
manufactured product with stocks and spare factory capacity	more elastic	stock can be released and output expanded relatively quickly
primary agricultural product in the short run	more inelastic	growing seasons, weather, land and biological production times limit rapid response
either product over a longer period	usually more elastic	firms can change capacity, inputs or production plans

A textile factory operating below capacity can raise shirt output after a price increase more readily than an avocado grower can produce a new crop immediately.

Product category is a guide, not a guarantee. Stocks, perishability, spare capacity and time can make a particular manufactured or primary product differ from the usual pattern.

Income elasticity of demand (YED) measures how responsive quantity demanded is to a change in consumer income.

YED compares percentage changes in demand and income. Its sign reveals whether demand moves with income or against it, while its magnitude shows the strength of the response.

YED concerns an income-driven shift of the demand curve. It is not PED, which measures movement along demand caused by the product's own price.

$\mathrm{YED}=\frac{\%\ \mathrm{change\ in\ quantity\ demanded}}{\%\ \mathrm{change\ in\ income}}$

Keep the direction signs: demand rising with income gives positive YED; demand falling as income rises gives negative YED.

Percentage change in quantity demanded = YED × percentage change in income. This helps businesses forecast demand after an expected income change.

The denominator is percentage change in income, not price.

$\mathrm{YED}=\frac{+11\%}{+7\%}=1.571\ldots\approx 1.57$

Assign signs, divide the percentage change in quantity demanded by the percentage change in income, and round only the final answer.

The result is positive and greater than 1, so the product is a luxury good in the YED classification: demand rises proportionally more than income.

Do not remove a negative sign before classification; it distinguishes inferior goods from normal goods.

YED value	Classification	Response when income rises
greater than 1	luxury good	demand rises proportionally more
between 0 and 1	normal necessity	demand rises proportionally less
less than 0	inferior good	demand falls as consumers switch away

YED = 0.7 identifies a normal good; YED = 1.6 identifies a luxury; YED = −0.9 identifies an inferior good.

In this classification, 'inferior' describes the direction of demand after an income change, not poor quality. A YED of exactly 1 is positive unit income elasticity, not greater-than-one luxury responsiveness.

Decision	Relevant elasticity	How it informs the decision
business changes price	PED	predicts quantity and total-revenue response
business forecasts income growth or recession	YED	predicts which products gain or lose demand
government imposes an indirect tax	PED	inelastic demand sustains quantity and tax revenue more strongly; consumers may bear more of the price rise
government subsidises a product	PED	predicts how strongly lower prices may expand consumption

Transport operators can use YED to forecast how rising incomes affect bus or rail demand; government can use PED when judging whether a tax will sharply reduce consumption or mainly raise revenue.

Elasticity is evidence for a decision, not the whole decision. Costs, objectives, distributional effects, time horizon and the reliability of estimates may change the final choice.

1.1.5 The mixed economy

A mixed economy is an economic system in which both the private sector and the public sector own resources and provide goods and services.

Markets and private enterprise make many allocation decisions through prices and profit incentives, while government owns some organisations, provides services, regulates activity and can redistribute resources.

Mixed does not mean that the two sectors are equal in size. Every mixed economy can choose a different balance between market decisions and government involvement.

Sector	Definition	Typical ownership
public	organisations and activities owned or controlled by government	central, regional or local government
private	organisations owned by private individuals or groups rather than government	entrepreneurs, shareholders, partnerships or other private owners

Either sector can produce goods or services. The distinction is ownership and control, not whether the output is physical or whether consumers pay directly.

A service used by the public is not automatically in the public sector; a privately owned bus company remains private sector even though many people use it.

Feature	Public sector	Private sector
ownership	government on behalf of the public	private individuals or shareholders
control	ministers, public bodies or local authorities, subject to public rules	owners and managers, subject to law and regulation
common aims	access, public service, equity or policy outcomes	profit, growth, survival, sales or owner objectives

Public organisations may accept low or no profit to meet a service objective. Private organisations usually need sufficient revenue and profit to survive, though they can also pursue customer or social aims.

These are typical aims, not absolute rules. A public enterprise may be required to earn revenue, and a private social enterprise may prioritise a social objective.

Allocation question	Market contribution	Government contribution
what to produce	consumer demand and expected profit signal desired output	budgets and policy choose public services and priorities
how to produce	firms compare productive methods and costs	regulation, public ownership and standards influence methods
for whom to produce	income and prices determine purchasing power	taxes, benefits, subsidies and public provision alter access

A mixed economy uses both routes at once: market prices coordinate many private choices, while government changes or replaces market outcomes where policy objectives or market failure justify intervention.

Government does not make every production decision, and prices do not determine every person's access. The defining feature is the combination.

Market failure occurs when the market mechanism allocates resources inefficiently, so the pattern or quantity of production and consumption does not maximise overall economic welfare.

Source of failure	Allocation problem
external costs or benefits	market decisions ignore effects on third parties
public goods and free riders	firms cannot reliably charge all beneficiaries, causing under-provision
imperfect information	choices are based on incomplete or misleading knowledge
weak competition or market power	price and output can depart from a competitive allocation

Market failure does not mean that no market exists or that every firm has failed financially. It is a failure of resource allocation.

Government may intervene when an unregulated market produces too much, too little, poor access or harmful effects because private decisions do not capture all social costs and benefits.

Market-failure concern	Possible intervention purpose
external costs	discourage harmful production or consumption
external benefits	encourage beneficial consumption or provision
public good	fund or provide output that free riders leave under-supplied
poor information	require disclosure, standards or consumer protection
lack of competition	regulate conduct or protect competition

Flood defences can protect many properties and areas, including people who cannot easily be charged individually; public provision can therefore address under-provision.

Intervention has costs and may not improve the outcome automatically. The objective here is why intervention may be needed, not a claim that every policy succeeds.

Characteristic	Meaning	Consequence
non-excludable	people cannot feasibly be prevented from benefiting	non-payers can still consume the benefit
non-rival	one person's use does not reduce the amount available to others	serving an extra user need not remove another user's benefit

Because exclusion is difficult, individuals can wait for others to pay and still benefit. This is the free-rider problem. If many act this way, a private firm cannot collect enough revenue, so the market may under-provide or not provide the public good.

Street lighting benefits people throughout the lit area, including those who did not pay directly, so government funding through taxation can overcome the payment problem.

A good is not a public good merely because government supplies it. The defining test is non-excludability and non-rivalry.

Public-sector role	Private-sector role
provide public goods and selected merit or essential services	respond to consumer demand through privately owned firms
own or operate activities judged strategically or socially important	innovate, invest and compete for revenue and profit
regulate, tax, subsidise or purchase output	supply goods and services within the legal and policy framework

The sectors can coexist in one industry: government may provide roads while private firms manufacture vehicles, or public hospitals and private clinics may both supply healthcare.

Role is not fixed forever. Contracting, nationalisation, privatisation and policy change can alter who produces a service while the economy remains mixed.

The relative importance of the public and private sectors is the share of economic activity, ownership or employment associated with each sector; it differs across economies and over time.

Indicator	A larger public-sector value suggests…
share of employment	government bodies employ more of the workforce
share of output or provision	public organisations produce more goods and services
ownership of major industries	the state controls more productive assets

Political priorities, development strategy, market institutions, privatisation or nationalisation, and the chosen role of government can change the balance. Cuba's high state ownership and employment imply greater public-sector importance than in a more privatised economy.

Importance cannot be inferred from one public service alone; use a stated measure and comparison.

Privatisation is the transfer or sale of an enterprise or activity owned or controlled by government to private-sector ownership or control.

After privatisation, private owners and managers make the organisation's decisions and usually face stronger commercial objectives, although government can continue to regulate the industry.

Privatisation is not the same as deregulation. Ownership can become private while rules remain; deregulation reduces rules without necessarily changing ownership.

Stakeholder	Possible benefit	Possible cost
consumers	efficiency, innovation, choice or lower prices from competition	higher prices, reduced access or weaker service if market power remains
workers	investment and growth may create opportunities	cost cutting may reduce jobs, pay or conditions
business	greater autonomy, profit incentives and access to private finance	commercial risk and pressure from owners or competitors
government	sale revenue and lower operating/subsidy burden	loss of future profit, control and responsibility for universal provision

The result depends on competition, regulation, the firm's starting efficiency, public-service obligations and the time horizon. A private monopoly may not deliver the same consumer gains as several competing firms.

Privatisation does not guarantee efficiency or harm. Link each claimed effect to the stakeholder and the mechanism that makes it plausible.

1.1.6 Externalities

An external cost is a negative effect of production or consumption imposed on a third party who is not directly involved in the market transaction.

The buyer and seller consider their own private costs, but an outside person or community bears an additional loss. Because this loss is not fully included in the market price, too many resources may be allocated to the harmful activity.

A producer's wage, fuel or rent payment is a private cost, not an external cost. The defining question is whether the cost falls on an uninvolved third party.

Activity and effect	Third party	External cost
factory emissions create air pollution	nearby residents	poorer health, cleaning costs or reduced quality of life
extra road journeys increase congestion	other road users and residents	longer travel times, noise and additional pollution
production damages land, water or habitats	local communities and future users	lost environmental quality or productive resources

A complete example links the activity to a harmful spillover and names who bears it. Brick production, for instance, may create dust or emissions that harm nearby residents even though they did not buy or sell the bricks.

The firm's own production expense is private. Environmental damage becomes an external cost when its burden is shifted to others rather than paid by the decision-maker.

An external benefit is a positive effect of production or consumption enjoyed by a third party who is not directly involved in the market transaction.

The consumer or producer receives a private benefit, while other people gain an additional spillover benefit. Because the decision-maker does not receive all of this wider gain, the market may allocate too few resources to the beneficial activity.

The direct satisfaction received by the purchaser is a private benefit. An external benefit must accrue to someone outside the transaction.

Activity	Private benefit	External benefit to others
education	learner gains knowledge, skills and earnings potential	employers and society gain a more productive, informed population
healthcare	patient gains improved health	reduced transmission and less pressure on families or services
vaccination	vaccinated person lowers their own infection risk	lower transmission protects other people, including vulnerable groups

The spillover must reach someone beyond the direct consumer. Vaccination can therefore create external benefit by reducing the chance that an infected person passes disease to others.

Government provision or payment is not what makes a benefit external. The test is whether third parties receive a positive effect.

$\mathrm{Social\ costs}=\mathrm{private\ costs}+\mathrm{external\ costs}$

$\mathrm{Social\ benefits}=\mathrm{private\ benefits}+\mathrm{external\ benefits}$

Term	Whose effect is counted?
private cost or benefit	buyer, seller, producer or consumer directly involved
external cost or benefit	third parties outside the transaction
social total	both direct and third-party effects

If production imposes $60 of private cost and$ 25 of pollution cost on residents, social cost is $85. If vaccination gives$ 40 of private benefit and $30 of protection to others, social benefit is$ 70.

Add like effects: costs to costs and benefits to benefits. Do not calculate social cost using benefits or social benefit using costs.