IB ECONOMICS HL

ASP_Answering Solution Pack 2025

BIS HCM pastpaper model answer

Question 1A [10 marks]

Explain two reasons why a government might set a price ceiling (maximum price) on a good.

Model Answer:
A price ceiling is a legally imposed maximum price below the market equilibrium price. Governments may implement price
ceilings for several reasons, primarily to increase affordability and promote equity.

1. To protect low-income consumers from unaffordable prices

Governments may set a price ceiling to ensure that essential goods remain accessible to the general public. For example, in
many countries, rent control is used to prevent landlords from charging excessive prices, especially in urban areas where
housing demand is high. This policy is aimed at protecting low-income households from homelessness and housing insecurity.

2. To prevent exploitation in times of crisis

In emergencies such as natural disasters or pandemics, price ceilings can prevent firms from exploiting consumers by charging
excessively high prices for necessities. For instance, during the COVID-19 pandemic, some governments imposed price
ceilings on face masks and hand sanitizers to prevent price gouging and ensure basic access to health products.

In conclusion, price ceilings are used primarily to improve affordability and equity, especially when market forces would
otherwise lead to high and potentially exploitative prices for essential goods.

Question 1B [15 marks]

Using real-world examples, discuss the consequences of a price ceiling on stakeholders.
Model Answer:
Price ceilings affect various stakeholders including consumers, producers, and the government. A price ceiling set below the
market equilibrium price leads to excess demand and creates both positive and negative consequences.

1. Consumers
A price ceiling can benefit consumers by lowering the price of essential goods, increasing affordability. For instance, rent
control in New York helps low-income tenants remain housed in expensive areas. However, the resulting shortage may mean
some consumers cannot access the good at all, and quality might decline due to reduced producer incentives.

2. Producers
Firms face reduced revenue and profits, which may lead to lower investment or exit from the market. For example, in
Venezuela, price controls on food discouraged farmers from producing enough, leading to widespread shortages. Producers
also have less incentive to improve quality, since they receive lower returns.

3. Government
The government may need to intervene through rationing or subsidies to manage shortages. Administrative costs may rise. In
some cases, black markets develop, undermining policy goals. For example, in India, price caps on medicines led to parallel
markets where products were sold illegally at higher prices.

Conclusion:
While price ceilings aim to protect consumers, they often lead to unintended consequences such as shortages, quality
reductions, and inefficiency. Stakeholders are affected unevenly, and long-term benefits depend on how well the policy is
implemented alongside other support measures.

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Question 2A [10 marks]

Explain how a decrease in the price of travelling by train might affect the price and output of its substitutes and of its
complements.
Model Answer:
When the price of travelling by train falls, this has different effects on substitutes and complements due to the principles of
cross-price elasticity of demand (XED).

1. Effect on substitutes (e.g., intercity buses, domestic flights)

Substitutes are goods that can replace each other. A decrease in train ticket prices makes train travel more attractive, so demand
for substitute modes of transport decreases. Consequently, the demand curve for substitutes shifts left, leading to lower
equilibrium prices and lower output.
For example, in the UK, when train fares are reduced on certain routes, National Express (bus service) sees a decline in
passengers.

2. Effect on complements (e.g., train station parking, in-train food services)

Complements are goods consumed together. As train travel becomes cheaper and demand increases, the demand for
complementary goods rises. The demand curve for parking services or station cafés shifts right, increasing their equilibrium
price and quantity.
As shown in the diagram left, When the price of train
travel falls, the demand for substitutes (e.g., intercity
buses) decreases, shifting the demand curve to the left,
reducing both price and quantity. In contrast, the demand
for complements (e.g., parking at train stations)
increases, shifting the demand curve to the right,
increasing both price and quantity

Conclusion:
A price decrease in train travel reduces demand for substitutes while increasing demand for complements, shifting resource
allocation in related markets.

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Question 2B [15 marks]

Using real-world examples, evaluate the view that the government should never provide subsidies to firms.

Model Answer:
Subsidies are financial support from the government to firms to reduce costs of production and encourage output. While some
argue that subsidies distort markets and should not be used, others highlight their role in correcting market failures and
promoting societal goals.

Arguments against subsidies:

1. Market distortion and inefficiency
Subsidies can lead to overproduction and inefficiency. For example, in the EU, the Common Agricultural Policy (CAP) has
been criticized for encouraging overproduction and environmental degradation. It distorts market prices and global trade.

2. Fiscal burden and opportunity cost

Subsidies are funded by taxpayers, potentially diverting funds from essential services such as healthcare or education. In
developing countries, indiscriminate energy subsidies have strained budgets without significantly benefiting the poor.

Arguments in favor of subsidies:

1. Correcting market failures
Subsidies help address positive externalities. For instance, governments often subsidize renewable energy firms to encourage
clean energy adoption and reduce carbon emissions. In Denmark, wind energy subsidies have supported the growth of a
globally competitive green industry.

2. Supporting strategic industries or employment

Governments may use subsidies to protect industries vital for national security or economic stability. During the COVID-19
pandemic, many governments subsidized airlines and small businesses to prevent mass unemployment.
Conclusion:
While subsidies can distort markets if misused, they are powerful tools for correcting market failures and supporting public
policy goals. Rather than being banned entirely, subsidies should be targeted, transparent, and regularly reviewed for
effectiveness.

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Question 3A [10 marks]

Explain the difference between price elasticity of demand and income elasticity of demand.

Model Answer:
Price elasticity of demand (PED) measures the responsiveness of quantity demanded to a change in price, calculated as:
PED = %∆ / %∆P

Income elasticity of demand (YED) measures the responsiveness of quantity demanded to a change in consumer income:
YED = %∆ / %∆Y
The Engel curve shows the relationship between income and quantity demanded,
holding price constant.

•For a normal good, the curve slopes upward: as income increases, demand also
increases.
•For a luxury good, the slope is steeper (YED > 1).
•For an inferior good, the Engel curve bends backward or slopes downward at
higher income levels (YED < 0).
This shows that income elasticity of demand reflects how sensitive demand is to
income changes, not price.

Key differences:
• PED is always negative due to the inverse price-demand relationship, whereas YED can be positive or negative
depending on whether a good is normal or inferior.
• PED is used to predict how changes in price affect revenue, while YED helps classify goods as necessities (YED < 1)
or luxuries (YED > 1), and forecast demand changes due to income growth.

Example:
If the price of Coca-Cola rises by 10% and demand falls by 20%, PED = -2 (elastic).
If income rises by 10% and demand for organic food rises by 25%, YED = +2.5 (luxury good).

Conclusion:
PED focuses on price changes, while YED relates to income changes. Both are crucial for firms and policymakers to predict
demand shifts and plan accordingly.

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Question 3B [15 marks]

Using real-world examples, evaluate the view that an understanding of price elasticity of demand can be useful for firms trying
to increase total revenue.

Model Answer:
Understanding PED helps firms determine how a change in price will affect total revenue (TR = P × Q). The usefulness of this
knowledge depends on whether demand is elastic or inelastic.
1. When demand is elastic (PED > 1)
Lowering price increases total revenue because the percentage increase in quantity demanded outweighs the percentage
decrease in price.
For example, during promotional discounts, fast food chains like McDonald’s see a rise in total revenue due to highly elastic
demand.
2. When demand is inelastic (PED < 1)
Raising price increases total revenue because the decrease in quantity demanded is proportionally smaller.
Pharmaceutical firms exploit inelastic demand for life-saving drugs by setting high prices, as consumers have limited
alternatives.

The diagram illustrates how a firm’s total revenue depends on the price elasticity of demand (PED).
On the elastic portion of the demand curve (PED > 1), a decrease in price leads to a proportionally larger increase in quantity
demanded, so total revenue increases.
Conversely, on the inelastic portion of the curve (PED < 1), a decrease in price leads to a smaller increase in quantity, so total
revenue falls.
Total revenue is represented by the area of the rectangle under each price-quantity point.
By comparing TR₁ = P₁ × Q₁ with TR₂ = P₂ × Q₂, firms can determine whether lowering or raising prices will increase revenue,
depending on the elasticity in that segment of the market.

Limitations:
• Difficulty in measuring PED
Estimating PED accurately requires reliable data and may vary over time and by market segment.
• Non-price factors influence demand
Brand loyalty, quality, and marketing may make PED less relevant. Apple products, for example, have inelastic
demand due to strong brand identity, but price changes still affect luxury perception.
• External market conditions
In a recession, even typically inelastic goods may face more elastic demand due to falling incomes.

Conclusion:
Understanding PED is a valuable tool for pricing decisions and revenue strategies. However, it should be used alongside
market research and strategic considerations, as real-world demand is influenced by multiple dynamic factors.

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• Q1. Using an appropriate diagram, explain how negative externalities are a type of market
failure. [10]
• Model Answer:
Introduction
A negative externality occurs when the production or consumption of a good or service imposes a cost on a third party
not involved in the market transaction. This leads to market failure, as the free market fails to allocate resources
efficiently, resulting in an overproduction or overconsumption of the good.

Body
In a free market, firms and consumers only consider private costs and private benefits. However, when negative
externalities exist, the marginal social cost (MSC) of production exceeds the marginal private cost (MPC).
An example is the production of electricity from coal, which emits pollution. The firm pays for labor and materials
(MPC), but not for the cost of pollution on human health and the environment (external cost). This cost is borne by
society.

Draw a standard negative production externality diagram with:

•MPC (Marginal Private Cost)
•MSC (Marginal Social Cost)
•Demand = MPB (Marginal Private Benefit)
•Overproduction where MSC > MPC
•Deadweight loss shaded between Qe and Q*)

Diagram Explanation:
In the diagram, the market equilibrium is at quantity Qm and price
Pm, where MPB = MPC. However, the true social cost of production
is higher, represented by the MSC curve. The socially optimal output
is Qs, where MSC = MPB. The difference between MSC and MPC
represents the external cost, such as pollution. The shaded triangle
between Q* and Qe represents the welfare loss to society, illustrating
the market failure.
Conclusion:
Therefore, negative externalities cause market failure by leading to overproduction and underpricing, resulting in a
misallocation of resources and loss of societal welfare.

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• Q2. Using real-world examples, evaluate the measures that a government might adopt to correct
market failure arising from negative externalities. [15]
• Model Answer:
Introduction:
Governments can adopt a variety of policy measures to correct market failure caused by negative externalities. These
include indirect taxes, regulation, subsidies for alternatives, and market-based solutions such as tradable permits. Each
measure has advantages and disadvantages in terms of efficiency, effectiveness, and equity.

1. Indirect Taxes
Indirect taxes such as carbon taxes aim to internalize the external cost by increasing the price of goods that generate
negative externalities.
Example: Denmark introduced a carbon tax on livestock to reduce methane emissions from cows and pigs.
Evaluation: Taxes can reduce consumption/production closer to the socially optimal level. They also raise government
revenue that can be reinvested in green initiatives. However, they may be regressive, disproportionately affecting low-
income groups, and it’s difficult to accurately measure the external cost. Firms may pass the tax onto consumers,
limiting its effectiveness.

2. Regulation and Legislation

Governments may set legal limits on pollution or ban certain harmful activities outright.
Example: The EU has strict regulations on vehicle emissions and industrial waste disposal.
Evaluation: Regulations can be simple and immediate, effectively reducing externalities. However, they can be
inefficient if firms have different compliance costs, and monitoring and enforcement are costly. They also remove the
incentive to innovate beyond compliance.

3. Subsidies for Positive Alternatives

Governments may subsidize environmentally friendly substitutes like electric vehicles or renewable energy.
Example: Norway provides substantial subsidies for electric vehicles, leading to high EV adoption rates.
Evaluation: Subsidies encourage a shift in consumption behavior and long-term investment in cleaner technologies.
However, they have opportunity costs, as public funds could be used elsewhere. They may also cause government
failure if poorly targeted or misused by firms.

4. Tradable Pollution Permits

A cap-and-trade system sets a maximum pollution limit and allows firms to trade emission permits.
Example: The EU Emissions Trading System (ETS) is a major example of this approach.

Evaluation: Permits offer a market-based solution, giving firms a financial incentive to reduce emissions cost-
effectively. However, if permits are over-allocated, it reduces effectiveness. Administrative complexity and the need
for accurate monitoring can limit success.

Conclusion:
No single measure is sufficient on its own. Indirect taxes work well when the external cost can be estimated, while
regulations are effective for immediate reduction. Subsidies and market-based mechanisms encourage innovation and
flexibility. An optimal policy mix depends on the specific externality, available data, and institutional capacity.
Governments must weigh the cost-effectiveness, equity implications, and administrative feasibility of each policy.

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