Cambridge IGCSE Economics Past Paper PDF

Chapter 14 Market failure 101 Learning objectives By the end of this chapter you will be able to: define market failure distinguish between social, private and external costs and benefits explain why external cos...

Chapter 14 Market failure 101 Learning objectives By the end of this chapter you will be able to: define market failure distinguish between social, private and external costs and benefits explain why external costs and external benefits cause market failure explain why information failure may cause market failure define merit and demerit goods explain why merit and demerit goods result in market failure define public goods and private goods distinguish between private and public goods explain why public goods result in market failure explain why monopoly power causes market failure explain why factor immobility results in market failure discuss the consequences of market failure Introducing the topic Do you think enough resources are devoted to education and healthcare in your country? Do you think too many resources are devoted in the global economy to cigarette production?  Cambridge IGCSE Economics Are you worried about the level of pollution in your country and the world? Why do market forces sometimes result in a misallocation of resources? Chapter 13 described the benefits that arise when markets work well. In practice, however, there are a number of reasons why markets may fail to be efficient. These reasons were introduced in the previous chapter, and are now explained in more depth here. Some of the measures that governments can take to correct market failure are also outlined briefly. 14.1 The nature of market failure Market failure occurs when market forces fail to produce the products that consumers demand, in the right quantities and at the lowest possible cost. In other words, market failure arises when markets are inefficient. There are a number of indicators of market failure including shortages, surpluses, high prices, poor quality and lack of innovation. If left to market forces, some products may be under-produced, some over-produced and some may not be produced at all. Prices may be high due to lack of competitive pressure and difficulties in lowering the costs. A lack of investment and reduction in expenditure on research and development, can also slow down the improvement in products. KEY TERMS 14.2 Failure to take into account all costs and benefits Third parties: those The consumption and production of some products may affect people who are not involved in not directly involved their consumption or production directly (those indirectly affected are often referred to as third in producing or parties). In such cases, the total benefits and total costs to society, called social benefits and consuming a product. 102 social costs, are greater than the benefits and costs to the consumers and producers, known Social benefits: as private benefits and private costs. For example, the social costs of a firm producing the total benefits to a society of an chemicals will include costs not only to the firm, but also to people living nearby. economic activity. Costs to third parties are called external costs. Among the private costs to the firm Social costs: the total will be the cost of buying raw materials, fuel and wages. The external costs imposed on costs to a society of an those living nearby may include noise pollution, air pollution and water pollution. If the economic activity. decision to produce chemicals is based only on the private costs to the firm, there will be Private benefits: over-production. Figure 14.1 shows that if only the private costs to the firm are taken into benefits received by those directly account, then the supply would be curve SS, whereas the full cost to society is higher at curve consuming or SxSx. The difference between the two is accounted for by the external costs. The allocatively producing a product. efficient output is Qx, but the market output is Q. Private costs: costs Price borne by those directly consuming or D Sx producing a product. S External costs: costs imposed on those who are not involved in the consumption Sx and production D S activities of others directly. 0 Qx Q Quantity Fig. 14.1: Over-production  Chapter 14: Market failure Demand, based just on the private benefits to those consuming the product, will lead to under- consumption and hence under-production if the total benefit to society is greater. For example, among the benefits students may receive by undertaking university degree courses are greater number of career choices, higher future earnings, life-long interests and life-long friends. The KEY TERMS social benefits include not only these private benefits, but also the benefits to other people (external benefits) who will be able to enjoy a higher quantity and quality of output as External benefits: benefits enjoyed graduates are usually highly productive workers. In Figure 14.2 the demand for degree courses, by those who are based on private benefits, is curve DD, whilst the total benefit to the economy is shown by not involved in the curve DxDx. The number of degree courses that would be undertaken, if left to market forces, consumption and is Q, whereas the number which would cause the maximum benefit to the society is Qx. production activities of others directly. Price Socially optimum Dx D output: the level of S output where social cost equals social benefit and society’s welfare is maximised. S Dx D 0 Q Qx Number of degree courses Fig. 14.2: Under-production Whenever there is a gap between the total effects on society, and the effects on those directly consuming and producing the products, markets will fail to allocate resources efficiently. The 103 level of output which will cause maximum benefit to the society (socially optimum output) will occur when the social benefit of the last unit produced is equal to the social cost of that unit. If the social cost exceeds the social benefit, it implies that too many resources are being devoted to the production of the product. Society would benefit from reducing its output. In contrast, if the benefit society would gain from producing more of the product is greater than the cost to society of producing more output, then more resources should be devoted to its production. A case where the social cost (in most countries) exceeds the social benefit, is the use of road space by private cars. When people are thinking of making a trip in their car, they take into account the private costs and benefits, that is the cost and benefits to themselves. If the benefits received by them by undertaking the journey exceed the costs, for example the cost of petrol and wear and tear on the vehicle, they will make the journey. What they do not consider is the external costs caused by them, including air pollution, noise pollution, congestion and accidents. A number of governments, including Singapore and the UK, have introduced road pricing schemes. These seek to charge the full costs of their journeys. Different amounts are charged according to when and where people drive. Someone driving along a deserted country road is likely to cause lower external costs than someone driving into a city centre at peak time.  Cambridge IGCSE Economics Pollution is an external cost TIP It is a common mistake to confuse social and external costs and benefits. Remember: social 104 costs and benefits are the total costs and benefits of an economic activity. They include both the external and private costs and benefits. INDIVIDUAL ACTIVITY 1 In January 2016, people in Buenos Aires and other major cities in Argentina demonstrated against the building of a new, large chemical factory. The demonstrators claimed that the factories would pollute the local river – harming local tourism, farming and fishing. a Identify two private costs of building a factory. b Explain why pollution is an external cost. 14.3 Information failure For consumers to buy the products that will give them the highest possible satisfaction at the lowest possible prices, they have to be fully informed about the nature of the products on offer, the benefits they can receive from them and their prices. Workers need to know what jobs are on offer, the location of the workplace, the qualifications required and the remuneration they would receive. They should also be aware about the nature of jobs for which their skills are best suited. Similarly, producers need to know what products are in demand, where good quality raw materials can be purchased at lowest possible prices and what are the most cost-effective methods of production. If they lack this information, they will make decisions that are not in their best interests. Besides consumers paying more than required and buying products of lower quality than available, workers may end up in the wrong jobs, and producers’ costs may be higher and revenues lower than possible due to information failure.  Chapter 14: Market failure Information failure can occur in a number of ways. There may be a lack of information or inaccurate information. There may also be asymmetric information which occurs when consumers and suppliers do not have equal access to information. For instance, if a car mechanic tells a motorist that her or his car needs an expensive repair, the motorist may lack the technical knowledge to question the advice. 14.4 Merit goods In the case of some products, there is both the problem of information failure and the KEY TERM problem of social benefits or costs being greater than the private benefits or costs. Merit goods: Merit goods are products that are more beneficial to the consumers than they themselves products which the realise, and they have benefits for those who are not involved in their consumption directly, government considers that is external benefits. This failure of the consumers to acknowledge the true value to consumers do not themselves, and to others, means that these products would be under-consumed and hence fully appreciate how under-produced, if left to market forces. beneficial they are and so which will be Healthcare is an example of a merit good. For instance, some people may not recognise the under-consumed if importance of regular medical check-ups and/or visiting a doctor. Hence, they are unlikely left to market forces. to take into account the benefits of their fitness to others. The associated external benefits Such goods generate may include higher output as a result of workers having less time off work (hence being more positive externalities. productive) and prevention of spread of diseases. There are various measures that a government may adopt to overcome the problem of a lack of consumption, in the case of merit goods. One is by providing information on the benefits of consuming the products. If successful, there should be an increase in demand. In the absence of an increase in demand, the government may need to try another approach. 105 Figure 14.3a shows the demand that will exist if left to market forces, DD, and demand based on the full benefits to society, DxDx. To persuade consumers to purchase the allocatively efficient quantity of Qx, the price of the product needs to fall to P1. Figure 14.3b shows this being achieved, as a result of a subsidy shifting the supply curve to the right. Price Price Dx Dx D S D S S1 P P P1 P1 Dx Dx S D S D S1 0 Q Qx Quantity 0 Q Qx Quantity Fig. 14.3: (a) Under-consumption (b) The effect of subsidy LINK if left to market forces Chapter 15.3 Government measures If a government thinks that consumers undervalue the product significantly or there are to address market considerable external benefits, it may provide the product free to consumers and/or make its failure (Direct consumption compulsory. For example, inoculation against a range of diseases is provided provision) free, and the wearing of seat belts in cars is compulsory in the UK.  Cambridge IGCSE Economics GROUP ACTIVITY 1 Some African countries provide free primary education. In a number of other African countries, state schools charge fees. a Identify two arguments for providing free primary education. b Explain why, if left to market forces, education is likely to be under-consumed. KEY TERM 14.5 Demerit goods Demerit goods: As their name suggests, demerit goods are the opposite of merit goods. Demerit goods products which the are more harmful to consumers than they realise and they generate external costs. For government considers example, cigarettes are a demerit good. Some people do not fully realise the damage consumers do not smoking inflicts on their health. Their smoking also imposes costs on people around them fully appreciate how harmful they are by polluting the air, causing a number of them to develop cancer through passive smoking and so which will be and generating litter. over-consumed if Demerit goods are over-consumed and hence over-produced. To tackle this problem, left to market forces. Such goods generate a government could raise their price by imposing a tax on them. It could also seek to negative externalities. discourage consumption, by providing information about their harmful effects. Also, if it thinks that the consumption of certain products causes serious problems, it may ban them. Recently a number of countries, including the UK and Ireland, have imposed a ban on smoking in public places. This measure is designed not only to discourage smoking, but 106 also to protect the health of non-smokers. Other measures that governments use to reduce smoking include government sponsored health campaigns, placing health warnings on packets of cigarettes, taxation and banning the advertising of cigarettes. Bhutan has gone further than most countries in banning the purchase of cigarettes in the country. GROUP ACTIVITY 2 Between 2007 and 2016, alcohol-related medical emergencies and hospital treatments increased by 50% in the UK. In 2015 the state funded National Health System (NHS) treated 333 010 people for medical problems caused by excessive drinking, including liver disease and severe alcohol poisoning. a Explain why alcohol is a demerit good. b Explain two ways which the UK government could use to reduce the consumption of alcohol. KEY TERM 14.6 Public and private goods Public good: a The degree of market failure is greater in the case of public goods than merit goods and product which is demerit goods. Whilst too few merit goods and too many demerit goods will be produced if non-rival and non- left to market forces, no public goods would be made. excludable and hence needs to be financed As mentioned in Chapter 13, private sector firms will not have any incentive to make products by taxation. they cannot charge for. It is not possible to exclude non-payers from taking advantage of the benefits of products such as defence. If these public goods are provided for some people, others can consume them without paying for them. Those who do take advantage in this way  Chapter 14: Market failure are called free riders. For example, if a flood defence system is built to protect a coastal town, all homes in the area would be protected whether their owners are prepared to pay for it or not. Besides non-excludability, public goods have another key characteristic. This is non-rivalry. This means that consumption of the product by one more person does not reduce someone else’s ability to consume it. For example, one more person walking down a lit street does not reduce the benefit that other people receive from the street lights. Public goods also usually have two other characteristics. They are non-rejectable. It is not possible for people to reject the services of the police, for example. The cost of supplying a public good to one more consumer is often zero. Defending one KEY TERM more person in the country will be unlikely to cost the army anything. Most products, including merit and demerit goods, are private goods. These products are Private good: a both rival and excludable. In these cases, it is possible to stop non-payers from enjoying product which is both the products and if one person consumes a unit of the product, someone else cannot. For rival and excludable. example, an individual cannot take a computer out of a shop without paying for it and if they do buy it, no one else can have that particular computer. Even though primary and secondary education, and healthcare, are not directly charged for in some countries, they are nevertheless private goods. This is because they can be charged for, and also because they are rival goods (in some cases). If one child is occupying a place in a class or one patient is occupying a hospital bed, no one else can occupy these places. Of course, education and healthcare are examples of a special type of private goods – that is, merit goods. Markets will supply private goods, although not necessarily in the right quantities. They LINK will not, however, supply public goods. This means that public goods have to be financed 107 Chapter 15.3 through taxation. The government can then produce them itself or pay a private sector Government measures company to produce them. to address market failure (Direct provision) Flood defences are a public good  Cambridge IGCSE Economics GROUP ACTIVITY 3 Decide whether the following are private goods or public goods: biscuits lighthouse protection for shipping a flood control system public car parking spaces public library services. LINK 14.7 Abuse of monopoly power Chapter 23.2 Monopoly Market failure can arise due to producers having more market power than consumers. If one markets firm dominates a market, it may not be allocatively, productively or dynamically efficient. It will lack competitive pressure to respond to consumer demands, to keep its costs low and to improve its product. If it is the only firm selling the product, that is a monopoly: consumers KEY TERMS will have no choice but to buy from it, even if the price of the product is high, the product Monopoly: a single does not meet the needs of the consumers and its quality is poor. seller. Abuse of market failure can also occur, when there is more than one firm producing the Price fixing: when product. If there are, for example, five major producers in a market there is a risk that they two or more firms may collude to reduce competition and, in effect, act as one seller. For example, they may all agree to sell a product agree to charge the same high price. This is referred to as price fixing. at the same price. There are various ways through which governments try to promote competition and prevent 108 firms from abusing their market power. These include removing restrictions on the entry of new firms into a market and making uncompetitive practices such as price fixing illegal. They may also stop some firms from merging, that is joining together to form one new firm, if it is thought that the merged firm will act against the interests of consumers by charging high prices and producing poor quality products. TIP In deciding whether a good is a private or a public good, the key thing to consider is not whether a price is charged for it, but whether a price could be charged for it. INDIVIDUAL ACTIVITY 2 In recent years, a number of agreements have been signed between different countries to allow more airlines to fly between particular locations, including between Heathrow Airport in London and the USA. Until 2008, only four airlines – British Airways (BA), Virgin Atlantic, American Airlines and United Airlines – were permitted to fly between London and New York. Now a range of airlines including Air France, Air India, British Airways, Delta, Lufthansa, KLM and Virgin Atlantic fly between Heathrow Airport and the USA. a What incentive would encourage more airlines to fly on a particular route? b Explain two benefits offered by increased competition to consumers.  Chapter 14: Market failure 14.8 Immobility of resources LINK Chapter 2.2 Mobility To achieve allocative efficiency, it is necessary for resources to move from producing of the factors of products that are decreasing in demand towards those which are experiencing an increase production in demand. This requires resources to be both occupationally and geographically mobile. In practice, some resources may be immobile. If, for example, demand for a country’s financial services might be increasing, whilst demand for its steel may be decreasing, there may be a shortage of financial services, unemployment of workers and under-utilisation of capital equipment if resources cannot easily move between the two. The main measures a government can take to promote occupational mobility of labour are to improve education and to provide training in the new skills needed. Also, governments can provide investment grants to make it easier for firms to change the use of land and buildings. Geographical mobility of workers can be encouraged by making it easier for them to buy or rent housing in areas where demand for labour is high. This might be achieved by construction of more houses in such areas or by the government providing financial help for those workers who move to these locations. 14.9 Short-termism There is a risk that market forces may not result in sufficient resources being devoted to capital goods. If a country produces a high quantity of consumer products, people can enjoy a high living standard. For them to enjoy more consumer products in the future, some resources have to be diverted for making capital goods. Private sector firms may be interested in making quick profits and may not plan for times ahead. Such a short-sighted approach can result in a lack of investment. As a result, a government may have to stimulate private sector 109 investment by, for example, cutting taxes on firms and undertake some investment itself. Summary You should know: Market failure occurs when markets do not operate efficiently. If left to market forces, those products whose social benefits exceed their private benefits will be under-consumed and hence under-produced. There will be over-consumption and over-production of products, if their social costs exceed their private costs. Consumers, workers and producers may not make the right choices due to lack of information, inaccurate information or because they have less information than the other party in a transaction (asymmetrical information). Merit goods would be under-consumed, if left to market forces, because people do not realise their true value to themselves and because they generate benefits to third parties. Demerit goods would be over-consumed in a market system. They are more harmful to the consumers than they realise and involve external costs. Public goods are both non-excludable and non-rival. They would not be produced in a market system, as it is not possible to stop free riders from enjoying them. Where there is a lack of competition, a firm may not keep its costs down, may charge a high price and may produce a poor quality product. The most efficient allocation of resources may not be achieved due to a lack of mobility of resources. Private sector firms, keen to earn high profits in the short term, may under-invest.  Cambridge IGCSE Economics TIP In discussing whether a market system works well, or any other economic issue, consider arguments for and against and where appropriate come to a conclusion. Multiple choice questions 1 In which case is market failure occurring? A Consumers determining what is produced B Firms producing above the lowest possible cost C Price falling as a result of a decrease in demand D Price rising as a result of an increase in costs of production 2 A merit good is one which: A has an absence of external benefits B has higher private benefits than consumers realise C imposes costs on those who are not involved in its production directly D is both non-excludable and non-rival 3 Which type of goods would be over-produced if left to market forces? 110 A Basic necessities B Capital goods C Demerit goods D Public goods 4 What is a cause of market failure? A Competition between firms B Consumers lacking information about where the lowest prices can be found C Differences in pay between skilled and unskilled workers D Resources being both geographically and occupationally mobile Four-part question a Define an external cost. (2) b Explain the difference between a merit and a demerit good. (4) c Analyse why the social benefit of education exceeds the private benefits. (6) d Discuss whether or not trees in the rainforests of Brazil should continue to be cut down. (8) Chapter 15 Mixed economic system 111 Learning objectives By the end of this chapter you will be able to: define a mixed economic system explore the effects of imposing maximum and minimum prices in product and labour and markets explain how a range of policy measures including indirect taxation, subsidies, regulation, privatisation, nationalisation and direct provision may be used by the government to correct market failure discuss how effective government intervention is in overcoming the drawbacks of a market economic system compare expenditures by public and private sectors Introducing the topic Why do governments in every country intervene in the economy and why do they do this to a different extent? Can a government actually improve the performance of an economy? Do you think the measures it can take will be successful?  Cambridge IGCSE Economics KEY TERM 15.1 A mixed economy Mixed economic Governments intervene in a mixed economic system. A mixed economic system has a system: an economy combination of the features of a planned and a market economic system. Some firms are in which both the private and public privately owned (in the private sector) and some are government owned (in the public sectors play an sector). Some prices are determined by the market forces of demand and supply, and important role. some are set by the government. In this type of economic system, both consumers and the government influence what is produced. A mixed economy seeks to gain the advantages of both a market and a planned economy, whilst avoiding their disadvantages. Having some products produced by the private sector may generate choice, increase efficiency and create incentives. Benefits may also be gained as a result of state intervention. They may include: The government should take into account all the costs and benefits that will arise from their decisions. This should mean, for example, that even if a railway line and station would not make a profit in the private sector, they would be maintained by the state if the benefit to society is greater than the cost. Government can also encourage the consumption of products that are more beneficial for consumers and others than they realise by granting subsidies, providing information or passing legislation. TIP Be careful not to Government can discourage the consumption confuse a market of products that are more harmful for 112 economic system and consumers and others than they appreciate a mixed economic by imposing taxes on such products, system. In a market providing information or passing legislation. economic system, it is the price Government can finance the production of mechanism which products that cannot be charged for directly, The government in a mixed economy may allocates resources. for example, defence. encourage a healthy diet In a mixed economic Government can seek to prevent private sector system, it is both the price mechanism firms from exploiting consumers by charging high prices. and the government Government is likely to seek to make maximum use of resources, including labour, and which decide the use hence try to ensure that those people willing and able to work can find jobs. of resources. There is a possibility that the government will plan ahead to a greater extent than private sector firms and hence may devote more of its resources to capital goods. Government can help vulnerable groups, ensuring that they have access to basic necessities. It can also create a more even distribution of income, by taxing the rich at a high rate. There are, nevertheless, risks attached even to a mixed economic system and there is no guarantee that it will perform better than the other two types of systems. Market failure can occur and government intervention may make the situation worse.  Chapter 15: Mixed economic system 15.2 Maximum and minimum prices KEY TERMS A government may limit firms’ ability to set their own prices by imposing price controls. Rationing: a limit on A government may set a maximum ceiling on the price in order to enable the poor to afford the amount that can be consumed. basic necessities. To have any impact, a maximum price has to be set below the equilibrium Lottery: the drawing price. Figure 15.1 shows a maximum price being set at Px below the equilibrium price of of tickets to decide P. Some people will now be able to purchase the product at a lower price. The problem who will get the is, however, that a shortage will be created as at this lower price the quantity demanded products. exceeds the quantity supplied. To prevent the development of an illegal market in the product, some method of its allocation will have to be introduced. This might be through queuing, rationing or even a lottery. Price D S P PX Maximum price D S Quantity 20 QS QD Fig. 15.1: The effect of setting a maximum price To encourage production of a product a government may set a minimum price (Px). This is a price floor, as it represents the lowest price producers are allowed to charge. To have an 113 impact on a market, this will have to be set above the equilibrium price as shown in Figure 15.2. This time the problem created is a surplus, with the quantity supplied being greater than the quantity demanded. To prevent the price being driven down, the surplus will have to be bought up by the government or some other official body. Price D S LINK PX Minimum price Chapter 18.2 Wage P determination and the reasons for differences in earnings D (Government policies) S Chapter 33.3 Possible Quantity 0 QD QS government policy measures to reduce Fig. 15.2: The effect of setting a minimum price poverty Chapter 38.1 A foreign A minimum price may also be set on the price of labour in the form of a minimum wage. exchange rate (A fixed The motives for such a move and its impact are discussed in Chapter 18. Minimum and exchange rate) maximum prices can also be used in exchange rate systems.  Cambridge IGCSE Economics INDIVIDUAL ACTIVITY 1 China has recently removed price controls on most consumer goods. Their prices are now determined by the market. The prices of a number of services, however, remain under the control of the National Development Reform Commission – the chief economic planning body in the country. These include, water, oil, power, cable TV fees and parking fees for cars. The price controls are designed to protect people against monopolies and to keep inflation low. There is some evidence, however, that price controls are distorting the market and damaging the economy. Petrol stations in Southern China, for example, run out of oil quite regularly. a How are prices determined by the market? b How do price controls distort the market? c Does the passage suggest that the Chinese National Development Reform Commission sets maximum or minimum prices on the products mentioned? Explain your answer. 15.3 Government measures to address market failure Subsidies and indirect taxes A government may subsidise a number of the country’s firms. In contrast, all firms are likely to be affected by taxes in some way. Government tax firms’ profits, which has an impact on the ability and willingness of firms to invest. Indirect taxes raise firms’ costs of production, whilst income tax lowers consumers’ disposable income, and as a result demand for firms’ products. The effect of a subsidy given to producers is influenced by the size of the subsidy and the LINK 114 price elasticity of demand. As explained in Chapter 8, a subsidy being an extra payment to Chapter 8.4 Conditions producers, shift s the supply curve to the right. The larger the subsidy, the more increase there of supply (Causes of is in supply. changes in supply) On a diagram, the size of the subsidy is represented by the distance between the two supply curves. In Figure 15.3, the subsidy per unit is SY. If all the subsidy is passed on to consumers, prices would fall to P2. As demand is inelastic, producers have to pass on most of the subsidy to encourage an extension in demand. Price actually falls to P1 with consumers receiving most of the benefit (PSXP1) and the producers keeping the rest (P1XYP2). Price D S S1 S P P1 X P2 Y S S1 D Quantity 0 Q Q1 Fig. 15.3: The effect of a subsidy in the case of inelastic demand If demand is elastic, a subsidy will have more impact on the quantity sold and less on the price. In this case, the producers can keep more of the subsidy as shown in Figure 15.4. In deciding whether to grant a subsidy, a government has to consider the opportunity cost as the money which could have been used for another purpose.  Chapter 15: Mixed economic system Price D S S1 S P P1 X P2 Y S D S1 Quantity 0 Q Q1 LINK Fig. 15.4: The effect of a subsidy in the case of elastic demand Chapter 11.4 Elastic The impact of a tax is again influenced by the size of the tax and the price elasticity of and inelastic demand demand. The higher the tax, the greater is its impact. A tax on a product with inelastic Chapter 12.4 Elastic and inelastic supply demand would have a greater effect on price than the quantity sold. In the case of a product with elastic demand, it is the other way round. If a government wants to raise revenue, it should tax products with inelastic demand. This is because the quantity sold will not fall by much. For example, a tax of $2 per product may be placed on a product that initially has sales of 2000 a day. If the tax causes sales to fall to 1800, the government will receive $3600 in revenue. However, if the demand had been elastic and sales had fallen to 900, the government tax revenue would have been only $1800. In contrast, if the government’s aim is to discourage the consumption of a product (in particular a demerit good) it will be more successful if demand is elastic. This is one of the problems in using taxation to discourage smoking, as demand for tobacco products is inelastic. 115 TIP In answering questions on subsidies, check whether the question is asking about subsidies to producers (which would shift the supply curve) or subsidies to consumers (which would shift the demand curve). If the question just refers to a subsidy, presume it is a subsidy to a producer as this is the most common form of subsidy. INDIVIDUAL ACTIVITY 2 Emissions of carbon dioxide from the aviation industry more than doubled between 1990 and 2016 and are forecast to double again by 2030. Under international law, aviation fuel for international flights is exempt from taxation. Environmentalists argue that airlines should be taxed for the pollution they cause. a Identify two external costs caused by air travel. b What impact is a tax on air travel likely to have on the number of flights? c Explain one external benefit that could arise from the operation of a new airport. Competition policy Competition policy seeks to promote competitive pressures and prevent firms from abusing their market power. There are a number of ways a government might be able to do this, including prevention of mergers that it thinks will not be in the interest of consumers,  Cambridge IGCSE Economics removal of barriers to entry and exit into markets, regulation of monopolies and prohibition of uncompetitive practices. Uncompetitive practices may include, for example, predatory pricing and limit pricing. Predatory pricing involves a firm charging a price below the cost to drive a rival firm (or firms) out of the market. Limit pricing is setting the price low enough to discourage the entry of new firms into the market. Environmental policies Firms can be affected by a range of policies designed to improve environmental conditions. A government may place restrictions on the amount of pollutants emitted by firms into the air, sea and rivers. It may then fine any firms which exceed these limits. Another policy, which has become more popular in recent years, is tradable permits. This involves a government issuing permits to firms, allowing them to pollute up to a certain limit and to sell part of their allocated limit, if they pollute less. The idea is that the cleanest firms will be able to sell most of their permits, whilst those who pollute the most will have to buy more of other firms’ permits. This will reduce the costs of the cleanest firms, whilst raising the costs of the worst polluting firms. As a result, the cleanest firms should capture a higher market share and consequently, pollution should fall. INDIVIDUAL ACTIVITY 3 The European Union, an economic bloc of European countries, runs an emissions trading scheme. Companies in certain energy-intensive sectors are issued with permits to produce a certain tonnage of carbon dioxide. If they produce less than their allowance, they can sell the 116 excess. a What is meant by an energy-intensive sector? b Explain how an emissions trading scheme may reduce pollution. Regulation Regulation includes rules and laws which place restrictions on the activities of firms. Besides setting price controls, outlawing uncompetitive behaviour and limiting the amount of pollution emitted by a firm, a government may regulate the target audience for the product, the quality of products and mode of staff management by firms. For example a government may pass a law banning the sale of cigarettes to children. It may also require firms to ensure that the products produced by them meet certain standards and that they allow their workers a specified number of regular holidays. In addition, it may place restrictions on timing for opening/closing of shops and control the routes that buses must follow. As a measure to correct market failure, regulations have the advantages of being backed up by law and easily understood. The government does, however, have to check that the rules and laws are being followed and this may be difficult and expensive. Also, a regulation works only if most people agree with it. For example, it would be difficult to enforce a law that everyone wears a safety helmet when riding a motorcycle if such a move is opposed by most of the riders. This is because too much time and money would need to be spent on prosecuting the offenders and the government may become very unpopular. There are a number of other problems with imposing regulations, for example they do not directly compensate those who suffer as a result of market failure and regulations may be too restrictive – reducing market flexibility and creating barriers to entry.  Chapter 15: Mixed economic system Nationalisation and privatisation KEY TERMS To benefit the public and to improve economic performance, a government may set up an Nationalisation: industry or nationalise a private sector industry. Industries owned by the government are moving the ownership known as state-owned enterprises, public corporations, and nationalised industries. The and control of an industry from the chairman and board of managers are appointed by the government. They are responsible private sector to the for the day-to-day management, but are accountable to the government. There are no government. shareholders in state-owned enterprises. The funds come from the government, from Public corporation: a government approved loans and from the private sector. State-owned enterprises do not business organisation always seek to make a profit. Their prime aim is to work in the public interest. owned by the government which is There are a number of advantages that can be claimed for state-owned enterprises. Some designed to act in the of them are as follows: public interest. State-owned enterprises base their decisions on the full costs and benefits involved. They can be used to influence economic activity. To boost the country’s output, public corporations can be directly encouraged to increase their output. LINK In cases where it is practical to have only one firm in the industry, such as rail Chapter 13.1 The infrastructure, a state-owned enterprise would not abuse its market power. market economic system Ownership of a whole industry by the government makes planning and coordination easier. For example, if the state runs the train system, it can ensure that train timetables are coordinated. It is important to ensure that basic industries, such as electricity and transport, survive, charge low prices and produce good quality, as other domestic industries depend on them. 117 There are, however, a number of disadvantages associated with state-owned enterprises. They can be difficult to manage and control. The large size of the organisations may mean that time has to be spent on meetings and communicating with staff, slowing down decision making. They may become inefficient, produce low quality products and charge relatively high prices, due to a lack of competition and the knowledge that they cannot go bankrupt. They will need to be subsidised if they are loss making. The use of tax revenue to support them has an opportunity cost – it could be used to spend on, say, training more teachers and nurses. Concern about the performance of state-owned enterprises and increased confidence in TIP market forces has led a number of countries to sell their state-owned enterprises, or part of Be careful with the word ‘public’. their state-owned enterprises, to the private sector. Those supporting this move argue that Sometimes, it refers private sector firms are likely to produce the products desired by consumers, at a low cost to the government and offer them at low prices. This is because market forces provide an incentive for firms to as in ‘public be efficient in the form of profit and a threat of bankruptcy if they are inefficient. Besides low expenditure’ and prices and high quality, privatisation may result in greater choice. Freedom from government ‘public sector’. It can, regulation may reduce administration costs and enable managers to respond more quickly however, also refer to people as a whole as to changing conditions. There may, also, be less risk of under-investment in the private in the ‘general public’ sector. The funds available to a public sector firm for investment will depend on the profits it or open to all people, earns and its ability to convince shareholders and lenders of its success. Public corporations as in a ‘public limited may be kept short of funds for investment, however successful they are, if the government company’. wants to spend the money elsewhere.  Cambridge IGCSE Economics LINK Privatisation, however, is itself criticised. There is no guarantee that private sector firms will face the full pressure of market forces. Some private sector firms may not face competition – Chapter 13.1 The market economic they may be monopolies (i.e. the only firm selling the product). In this case, they can be system (Private and inefficient, charge high prices and produce low quality products without compromising on public sectors) profits. They may not take into account the total costs and benefits to the society due to their actions. For example, they may cause pollution. Privatisation also reduces a government’s control of the economy. INDIVIDUAL ACTIVITY 4 Copy and complete the table, which compares a state-owned enterprise and a private sector firm. State-owned enterprise Private sector firm Ownership The government Sector Private Aim Acts in the public interest A comparison of a public corporation and a public limited company Direct provision Most governments produce at least some goods and services that they think are essential. In some countries, governments provide affordable housing to rent. Housing, education and healthcare are seen as essential services, and some governments produce them and 118 provide them to people free of cost or at subsidised prices. Besides being essential products, education and healthcare are also merit goods. LINK Chapter 26.2 The reasons for government spending Chapter 14.4 Merit goods Education is a merit good Chapter 14.6 Public and private goods As explained in Chapter 14, a merit good is one whose benefit to consumers and others is undervalued by them. As a result, they would under-consume it and so private sector firms Chapter 13.3 The would under-produce it. This is why some governments produce educational and healthcare disadvantages of a market economic services and other merit goods such as library services. To stimulate the consumption system of merit goods, governments also pay private sector firms to produce them, provide information about their benefits and, in some cases, make their consumption compulsory.  Chapter 15: Mixed economic system There are some products that private sector firms have no incentive to produce. This is not because people do not want them, but because they know that if they are provided, they can consume them without paying. For example, it is not possible to exclude someone from enjoying the benefits of street lighting even if they are not prepared to pay for them directly. This is why governments produce them, or pay private sector firms to make them, and raise finance through taxation. It is also interesting to note that public goods are non-rival. This means that a person enjoying the product does not reduce someone else’s enjoyment. An additional family moving into a town protected by sea defences, does not reduce the defence experienced by other families. Unfairness Besides intervening in a market economy to correct market failure, governments also intervene on grounds of equity – that is, fairness. As mentioned in Chapter 13, income distribution can become very uneven if it is solely determined by market forces. Some people will be very rich, but some will be very poor. Private sector firms will only produce those products that people are willing to buy and able to pay for. This may mean that they will not produce products needed by the poor. A government is likely to try and ensure that everyone in the country has access to basic necessities including housing, education and healthcare. To achieve this, it can give financial assistance to the poor and provide some essential products free to consumers. In fact, in a number of countries, state education and healthcare is provided free, not only because they are merit goods, but also to make them accessible to the poor. Such free state services are financed by taxation. Taxation and benefits may also be used to reduce income and wealth inequality. A big difference in the income and wealth of the rich and poor, besides being unfair, can be 119 socially divisive and can result in some workers being less productive. Some people in the country, including the elderly and the sick, may be unable to earn incomes. There may be social unrest if there is considerable income inequality. Also, if people are poor they may be less healthy, less well educated and consequently less productive. Effectiveness of government intervention As suggested above, government intervention can reduce market failure. There is a risk, however, that government failure may occur. It may overestimate the extent of the private benefits offered to the people by consuming merit goods and it may find it difficult to calculate the most efficient quantity of public goods to supply. Governments can take time to make decisions and those decisions may be influenced by political factors and, in some cases, corruption. For example, a government may decide not to raise the tax on petrol, despite concerns about the environment, because it may be politically unpopular and may lose it votes. Government intervention may also reduce economic efficiency by reducing incentives. If taxes on earned income and unemployment benefits are high, some people may be discouraged from working. High taxes on firms’ profits can reduce entrepreneurs’ willingness and ability to invest. A development of effectiveness of government intervention There is some debate as to whether public or private sector expenditure leads to a more efficient allocation of resources. Do households and firms make better decisions than the government? In practice, there are advantages and disadvantages of both private and public sector expenditure. A new airport, for example, could be built by the private or public sector. There may be a  Cambridge IGCSE Economics number of advantages in it being built by a private sector firm. The profit incentive and force of competition may imply that it will build a high quality airport at low cost and in less time. There is a risk, however, that a private sector firm may be a monopoly and hence may not be forced to keep its costs down. Thus, it may charge a high price for building the airport. Also, a private sector firm will take only private costs and benefits into account. Using public expenditure to build an airport may also have its own drawbacks. Knowing that the state is paying, a state-owned enterprise, or private sector firm hired by the government, may not keep its costs down. A state-owned enterprise may lack the commercial expertise to complete the project on time. There may also be delays in decision making by the government to go ahead with the project. A major benefit, however, of a major investment project being undertaken by government is that it will base its decision (as to whether to proceed with it) on KEY TERMS the consideration of all factors involved, that is social impact, costs and benefits. It is likely to Cost benefit analysis carry out a cost benefit analysis (CBA) in the first place. This involves measuring all the private (CBA): a method of costs and benefits involved. In the case of an airport, the private costs will involve the cost of the assessing investment land, the cost of the labour employed to build and run the airport, and the cost of the building projects which takes material and maintenance. The major private benefit is the revenue that will be earned. into account, social costs and benefits. After measuring the private costs and benefits, the economists carrying out a CBA, then seek Multinational to place a value on external costs and benefits. This is not an easy process. The external companies (MNCs): costs may include operation of the airport, damage to the environment, noise due to risk companies which of accidents and traffic congestion near the airport. The external benefits may include produce in more than employment in the area due to tourism and making it a more attractive as a site for domestic one country. firms and multinational companies (MNCs). When all the calculations have been made, the social costs and benefits are compared. 120 If social costs exceed social benefits, the government will not proceed with the project. If social benefits exceed social costs, it will go ahead (if the net social benefit is greater than that on rival projects). There will still be a debate, however, on whether it is the best use of government money. Government expenditure on one item always involves a significant opportunity cost. The money could have been spent on, for example, education. GROUP ACTIVITY 1 The private sector in China is responsible for a growing amount of output and employment. Some economists argue that private sector firms are more profitable and efficient than the state sector. In your group, discuss the questions below. a How may the government benefit from private sector firms being more profitable? b Why may private sector firms be more efficient than state-owned enterprises? Summary You should know: In a mixed economy, resources are allocated by means both of the price mechanism and government decision. Subsidies and taxes influence firms’ output and the price they charge for their products. The impact of a subsidy/tax depends on its size and price elasticity of demand. Other types of policies which influence private sector firms are industrial, competition and environmental policies.  Chapter 15: Mixed economic system Maximum prices are set below the equilibrium price. They lower prices, but lead to shortages. Minimum prices are set above the equilibrium price. They can help producers, but lead to surpluses. Regulations are backed up by law, but it can be expensive to implement them and difficult to check their violation by people. Their effectiveness is influenced by their acceptance by the people. Besides correcting market failures, governments intervene in economies to protect vulnerable groups and to ensure an even distribution of income and wealth. Expenditure by the private sector on an investment project may ensure efficiency, but a private sector firm considers only private costs and benefits. Multiple choice questions 1 The production of which of types of goods, given below, has to be financed by the government? A Capital B Consumer C Merit D Public 2 A government decides to subsidise rail travel. What will be an external benefit of this move? A A rise in government expenditure B Increased crowding on trains C Lower fares for train passengers D Reduced congestion on roads 3 A firm, concerned about its reputation, decides to install new equipment in order to reduce the pollution created by it. What impact will this have, on private and external costs? 121 Private costs External costs A fall fall B fall rise C rise fall D rise rise 4 What is an argument for state intervention in an economy? A To encourage the consumption of harmful products B To increase the role of the price mechanism in allocating resources C To make the distribution of income more uneven D To prevent private sector firms from overcharging consumers Four-part question a Define a minimum price. (2) b Explain how a maximum price will affect a market. (4) c Analyse three ways a government could encourage consumption of a merit good. (6) d Discuss whether or not consumers benefit more from a market economic system or a mixed economic system. (8)  Cambridge IGCSE Economics Exam-style questions Multiple choice questions 1 Who decides what is produced in a market economy? A consumers B managers C shareholders D the government 2 The table shows demand and supply schedules for bread. Price of a loaf of Number of loaves demanded Number of loaves supplied bread ($) per week per week 0.80 500 180 1.00 400 240 1.20 320 320 1.40 240 500 What will be the equilibrium price for a loaf of bread? A $0.80 B $1.00 122 C $1.20 D $1.40 3 Price is initially set above equilibrium. Market forces then move it towards equilibrium. As price falls, what will happen to demand and supply? Demand Supply A contracts contracts B contracts extends C extends extends D extends contracts 4 Which of the following is likely to cause the price of the lamb to decrease? A an decrease in the number of sheep farmers B an increase in the price of beef C a subsidy given to sheep farmers D a successful advertising campaign for lamb 5 What effect is an increase in advertising expenditure likely to have, on the demand and supply curves of a product in the short term? Demand Supply A decreases decreases B decreases increases C increases increases D increases decreases  Chapter 15: Mixed economic system 6 The table shows the demand and supply of a book published by a Japanese firm. Price per book ($) Quantity demanded per week Quantity supplied per week 10 5000 2000 15 4000 3000 20 3000 4000 25 2000 5000 When the price rises from $10 to $15 per book, what is the price elasticity of demand for the book? A –0.4 B –0.8 C –1.0 D –2.5 7 What could make demand for a product become more elastic? A a fall in its price B a fall in the proportion of income spent on the product C a decrease in the time period under consideration D an increase in the number of close substitutes 8 What is meant by inelastic supply? 123 A when a fall in price causes a greater percentage fall in supply B when a fall in price causes a smaller percentage fall in supply C when a rise in price causes a fall in supply D when a rise in price causes no change in supply 9 Which profit-making enterprise will not harm the environment? A intensive farming using chemical fertilisers B recycling waste paper into newspapers C steel manufacturing, which generates the emission of carbon dioxide D deforestation in tropical rainforests to obtain timber for furniture production 10 Which government measure is designed to increase external benefits? A A decision to reduce spending on education B A subsidy given to bus companies C A reduction in the tax on alcohol D The removal of fines on companies that pollute  Cambridge IGCSE Economics Data response questions Study the source material for each question carefully and then answer Questions 1 and 2. Source material: Transport and cotton production There is not much traffic on the motorway between Islamabad and Lahore. This first motorway built in Pakistan was opened in 1997. It cost $1.2 billion to construct. One reason for the lack of traffic on the motorway is the existence of a rival road, the Grand Trunk Road, which is shorter and toll-free. Improvements in road infrastructure can bring a number of benefits to an economy. These include reducing costs of production faced by a number of industries including construction materials, cotton and paper products. Some economists, however, argue that less tax revenue should be spent by the government on roads and more on education. Higher spending on education can increase labour productivity which, in turn, can reduce unemployment and increase productive potential. Labour productivity, for example, is higher in the USA in the cotton industry than in the other major cotton producers. The pie chart shows the share of the global output of cotton (96.5 million bales) in the five largest producers in 2016. Rest of the world India 124 Brazil Pakistan China USA Percentage share of global cotton production One of the reasons for the greater productivity in the USA is that workers work with more advanced farm machinery. India is seeking to raise its labour productivity by a range of ways. These include reducing congestion on its roads. Between 2000 and 2015, the number of cars on India’s roads tripled. The higher volume of traffic is causing considerable pollution. In 2016 India’s capital city, Delhi, was named by the World Health Organisation (WHO) as the world’s most polluted city. The government has introduced new regulation including stricter emissions standards for new vehicles and has stopped subsidising diesel fuel in an attempt to reduce pollution. It is also increasing its investment to modernise and expand the country’s train service. 1 Referring to the source material in your responses, complete all parts of Question 1. a Identify one example of a capital good. (1) b Explain one external cost. (2)  Chapter 15: Mixed economic system c Explain a possible opportunity cost of the Pakistan government building more roads. (2) d Analyse the effect of improvements in road infrastructure on the market for cotton. (5) e Analyse, using a production possibility curve diagram, the effect of the change in labour productivity on the economy. (5) f Explain the pattern of cotton production. (4) g Discuss whether or not train travel is a close substitute to road travel in a city. (6) h Discuss whether or not regulation, in the form of stricter emission standards for new cars, is likely to reduce pollution. (6) Source material: Jordan’s search for new sources of energy Jordan is currently trying to find new sources of energy for the country’s firms, farms and households to use. It is exploring the possibility of nuclear power generation and has started to produce solar energy. The country benefits from long hours of sunshine and the solar energy industry converts sunshine into power. Jordan is not the only country to be developing a solar energy industry. Other countries include China, Dubai, India, Italy, the UAE and the UK. Indeed, 2016 was the first year in which the world invested more in the industry than in coal and gas-fired power generation. Solar power is seen as a cleaner and more environmentally friendly source of energy. With advances in technology, the price of solar panels is falling. This is reducing the cost of producing solar energy and its price to customers, increasing its price competitiveness. In 125 a number of countries the price of coal is rising which is reducing the sales of coal. Jordan’s agricultural industry needs a boost. The country lacks water and some of its land is not very fertile. It does produce a range of agricultural products including citrus fruits, tomatoes, cucumbers and olives. The country has benefited from an increased preference for fruit. In 2016, shortages of lemons pushed up their price and increased imports. The country could not take full advantage of this change as the price elasticity of supply was only 0.25. The table shows how the price of lemons rose throughout one month in 2016 and how this affected demand. Price of 1 kilogram of lemons (Jordanian dinars) Daily demand for lemons (tonnes) 1.00 200 1.20 180 1.50 144 2.00 32 The price and demand for lemons in one month in Jordan in 2016 Agriculture is a small industry in the country. It only accounted for 4% of the country’s output and employed only 2% of its workers in 2016. Most of the country’s workers are employed in the public sector where wages are higher. For example, in 2016 25 000 people were employed in the police force. This position is, however, changing. A number of the country’s industries have been privatised and market forces are playing an increasing role in the economy.  Cambridge IGCSE Economics 2 Referring to the source material in your responses, complete all parts of Question 2. a Explain why sunshine is a free good. (2) b Explain why demand for coal is likely to become more elastic in the future. (2) c Calculate the effect that an 8% rise in the price of lemons would have on the demand for lemons. (2) d Analyse, using a demand and supply diagram, the effect of an increased preference for fruit on the market for fruit. (5) e Analyse how changes in the price of lemons affected the price elasticity of demand for lemons. (4) f Explain whether Jordan operates a market economic system or a mixed economic system. (3) g Discuss whether or not a rise in the price of a product, such as coal, will always be accompanied by a fall in sales. (6) h Discuss whether or not governments have to produce public goods such as the police service. (6) Four-part questions 1 Air-India is a state-owned airline. Most airlines are, however, in the private sector and the prices they charge move between equilibrium and disequilibrium as a result of changes in market forces. The price elasticity of demand for air travel differs from other forms of transport. a What is meant by market forces? (2) 126 b Explain the difference between an equilibrium price and a disequilibrium price. (4) c Analyse why different products have different price elasticities. (6) d Discuss how useful knowledge of price elasticity is to an airline company. (8) 2 Gym membership is a normal good. More people throughout the world are joining gyms in a bid to get fitter. This change in demand is also affecting the demand for substitutes and complements to gym membership. In some countries gym membership is taxed. Some economists argue that rather than taxing gym membership, governments should subsidise it. a Define a normal good. (2) b Explain the difference between a complement and a substitute. (4) c Analyse, using a demand and supply diagram, the effect of introducing a tax on gym membership. (6) d Discuss whether or not governments should subsidise gym membership. (8)  SECTION 3 Microeconomic decision makers 127  Chapter 16 128 Money and banking Learning objectives By the end of this chapter you will be able to: state the forms of money explain the functions of money describe the characteristics of money analyse the role of commercial banks discuss the importance of commercial banks analyse the role of central banks discuss the importance of central banks Introducing the topic Would you like more money? Most people would. What would you do with it? You might, perhaps, spend it. On the other hand, you might save it. You might even lend it to someone else. Banks lend money and look after our savings. All our lives are affected by banks more than we realise. The policy measures of some countries’ central banks can change the prices of products not only in their own countries, but also in other countries.  Chapter 16: Money and banking 16.1 Money Forms of money The main forms of money used in most countries are coins, notes and bank accounts. Coins KEY TERM are often used to make small purchases and are given in change. Notes are used to buy Money: an item more expensive items. In most countries, the main form of money is bank accounts. These which is generally are responsible for the largest proportion (in terms of value) of payments made. There are acceptable as a means a number of ways of transferring money from one bank account to another. These include of payment. direct debits, credit cards and mobile phones. Although bank accounts are the most important form of money they are not legal tender, whereas coins (up to a certain value) and bank notes are. Legal tender is any form of payment which, by law, has to be accepted in settlement of a debt. So a person has to accept bank notes in payment, but they have the right to refuse, for example, a credit card. In practice, however, most people and firms find payment from bank accounts convenient and hence are willing to accept it. The functions of money Money carries out four functions. It acts as a: medium of exchange store of value unit of account standard of deferred payments. 129 Money allows people to buy and sell products. In carrying out this function, money is said to act as a medium of exchange. Products are exchanged for money and that money is used to buy other products. Products → Money → Products Enabling people to exchange products is money’s most important function. Acting as a store of value means that money can be saved. It would be pointless to save eggs, for example, as eggs go bad over time and no one will be prepared to accept them a few weeks after they have been laid. Money, however, does not deteriorate with time and hence will be acceptable in the future. Money can also be used to place a value on an item. Prices are expressed in monetary terms. A newspaper may be priced at $2 and a book at $30. This function of acting as a unit of account, or measure of value (as it is sometimes called), enables buyers and sellers to agree on what items are worth, relative to each other. In the example above, one book is worth fifteen newspapers. With $60 to spend, a person can either buy two books or thirty newspapers. The fourth function of money is to act as a standard of deferred payments. This means that money allows people to borrow and lend. Someone who wants to buy something now can get it by borrowing money from someone who does not want to use it now. They can make an agreement about the amount to be repaid in the future. The characteristics of money To act as money, an item does not need to have intrinsic value. This means that it does not have to be worth something in its own right. For example, both silver and bank notes can act  Cambridge IGCSE Economics as money, but whereas silver is wanted for a variety of purposes, bank notes have no intrinsic value. An item does have to possess a number of characteristics for it to serve as money. The most important one is that it should be generally acceptable. If people are not prepared to accept the item as payment, it will not be able to carry out the functions of money. To achieve general acceptability, the item has to be in limited supply. Why, for instance, should people accept twigs as payment in a country with many trees? The other characteristics an item needs are that it is durable (will last some time), portable (can be carried around easily), divisible (can be divided into units of different values), homogeneous (every note or coin of the same value should be exactly the same) and recognisable (people can easily see that the item is money). TIP Do not confuse the functions and characteristics of money. Remember: the functions concern the transactions/operations that money helps to make possible, whereas the characteristics are the features which an item needs to possess to act as money. GROUP ACTIVITY 1 Discuss how many characteristics of money each of the following items possesses: a leaves b sea shells c gold. 16.2 Banking 130 Commercial banks Banking is a major industry in a number of countries. It helps people to borrow and lend and KEY TERM carry out a range of other financial activities. By doing this, it enables more efficient use of Commercial banks: resources and encourages the growth of output of economies. banks which aim Commercial banks are also called retail or high street banks. All three names tell us to make a profit by providing a range of something about them. Commercial indicates that they are business organisations which banking services to usually seek to make a profit. Retail suggests that they are selling the public something – in households and firms. this case banking services. High street tells us that these banks are found in most towns and cities. They are the banks we are most familiar with. Commercial banks are a familiar sight in towns and cities  Chapter 16: Money and banking The role and importance of commercial banks The three main and traditional functions of commercial banks are to accept deposits, to lend and to enable customers to make payments. The first function enables customers to keep their money in a safe place. Deposits can be made into two types of bank account. One is a current account, sometimes called a demand account or sight account. There is easy and immediate access to money in this type of account, but usually interest is not paid on money held in such an account. Customers use current accounts mainly to receive and make payments. The other type of account is a deposit or time account. A period of notice often has to be given before money can be withdrawn from this account. Interest is paid on any money held in a deposit account and customers use deposit accounts as a way of saving. There are two main ways of borrowing from a bank. One is in the form of an overdraft. This enables a customer to spend more than what is in her or his account, up to an agreed limit. Interest is charged on the amount borrowed. This can be a relatively expensive way of borrowing and is mainly used to cover short-term gaps between expenses and income. The other way of borrowing is by taking a loan. This is usually for a particular purpose and for a particular period of time. Interest is charged on