Below I have written some model answers for Section B (5, 8, 10, 12, 15 mark questions).
These questions are from an Edexcel Economics A style practice paper (1K), written by me. Here is a link to the full practice paper.
Contents
5 mark question and model answer
a) Explain one possible reason for the trend in average daily water consumption in Figure 1. (5 marks)
Average daily water consumption per person for unmetered users has increased from 156 litres from 2015-16 to 168 litres in 2018-19, a 7.7% rise. This could be because of increasing real incomes due to economic growth. Increasing real incomes means users find water more affordable to consume relative to income, so users may ration their water consumption less. This assumes water is a normal good with income elasticity of demand exceeding zero. So demand for water shifts right, leading to a higher equilibrium quantity of water consumed.
| Commentary on the answer to the 5 mark question. – This answer achieves two marks out of two for application, with reference to the data on water use rising. – The answer identifies a possible reason, real incomes rising. This achieves the knowledge mark. – There are two marks for further explanation: Less rationing, normal good, demand shifting right. – As a result, this answer is likely to score full marks. – Notes for Edexcel on demand. |
10 mark question and model answer
b) With reference to Extract A, assess the market failures in the water and sewage industry. (10 marks).
One market failure is excess sewage being released into rivers. This could reduce the health of swimmers, as the extract mentions “swimmers using rivers (being) sick”. This is a negative externality, resulting in MSC > MPC. The free market would overproduce sewage (disposal), only taking into account private benefits and costs (MPC = MPB). Yet, the socially optimal outcome is where MSC = MSB at a lower quantity, taking into account social benefits and costs.
However, firms may adopt technological improvements over time to reduce excess sewage disposal in rivers. This could include installing smart systems to monitor and manage sewer capacity better. This would reduce the extent of overproduction, moving the market closer to the socially optimal outcome.
Another market failure could come from market power. Water and sewage companies are “regional monopolies, so consumers cannot switch to another provider”. These companies could use their market power to increase the price of water to maximise profits, producing where MC = MR. This is likely to be allocatively inefficient (MC is not equal to AR), resulting in a welfare loss in the free market. Consumer surplus would be lower due to higher water prices.
However, water is a natural (regional) monopoly with “large networks of pipes”, the cost of which could be spread over a larger amount of output, reducing LRAC as output rises. This could be passed onto consumers with lower prices, moving the market closer to allocative efficiency.
| Commentary on the answer to the 10 mark question. – The question asks for market failures (plural). Therefore, two market failures should be explained. – In this response, negative externalities and market power are explained, with reference to technical terms and economic theory. There are also appropriate quotes from the extract throughout the response. – Market failures for this question could include: negative externalities from sewage disposal in rivers, negative externalities from overuse of water leading to drought, underinvestment in water infrastructure or market power. – Note that there can be market failures in the theme 3 part of the course. These include market power and the immobility of labour. – Notes for Edexcel on market failure, externalities and monopoly power. |
8 mark question and model answer
c) Examine the determinants of pay of the “bosses at water and sewage companies” (Extract A, paragraph 3). (8 marks)
One determinant of pay is the CEO’s level of human capital. Higher human capital could increase CEO productivity. This could enable the CEO to be more effective in cutting costs and increasing profits. Water companies made “£2.8 billion in profits in 2021”. Higher profits could suggest the CEO has been effective in cutting costs in order to increase profits. As a result, there could be higher demand for the CEO’s labour, boosting CEO pay.
However, there are also accusations of poor management in water companies. This suggests water CEOs may not be particularly productive, despite being paid highly.
Another determinant of pay could be demand for water. As demand for water rises, there is more derived demand for workers in water companies to supply water. This could include CEOs, as more work from management may be needed to organise other workers to meet the extra demand for water. Higher labour demand could increase equilibrium wages. This could explain the 27% rise in CEO salary in 2021 compared to 2020.
However, water companies may need extra engineers to fix or build pipes to meet extra water demand, but CEOs may not be needed much more. So labour demand for CEOs may not rise.
| Commentary on the answer to the 8 mark question. – This question is about CEO pay. Therefore, referring to labour market theory, such as labour supply or labour demand, is a good way to answer the question. – The extract gives some references to the fact that CEO pay is rising. There are references to CEO pay being tied to performance metrics. – However, to answer this question, you need to think of possible causes of the rise in CEO pay. This is where labour market theory comes in. – For example, what determines demand for labour? In the model answer above, I have discussed productivity and demand for the output (derived demand). You could also discuss factors that influence labour supply in your response. – Other ways of answering the question are possible. For example, referring to business objectives or even the principal-agent problem. – Notes for Edexcel on labour supply and labour demand. |
12 mark question and model answer
d) Referring to the information provided, assess the effect of nationalising water and sewage companies. (12 marks)
Nationalised firms may maximise social welfare rather than maximising profits. This may lead to nationalised water companies taking into account the external costs of their actions. This could include water and sewage companies reducing the extent of sewage release into rivers, reducing the harm to the health of swimmers swimming in rivers. Specifically, instead of maximising profits and producing at q where MPB = MPC, taking into account private cost only, the nationalised firm could take into account external costs too, producing the amount of wastewater where MSB = MSC at q1. This would reverse the welfare loss area ABE from the negative externality, increasing social welfare by area ABE.
However, the government may underestimate the size of the externality, owing to a lack of information about the harms to swimmers from sewage. This could mean the overproduction still remains to some degree, so the welfare loss may not be entirely eliminated.
Nationalisation could lead to greater investment. Instead of a private company needing to pay shareholders dividends, the nationalised water company could reinvest those dividends back into the company. Over 28 years water companies paid out dividends of £57bn. This redirection of dividends could increase investment in “water pipes and treatment”. This could lead to fewer leakages in water pipes, increasing productivity of water supply, lowering average cost of supplying water. This could be passed onto consumers with lower prices.
However, if nationalised, water companies may have less incentive to cut costs as the government may subsidise the company if it makes a loss. So profits may fall, so there are reduced profits to reinvest, reducing investment.
15 mark question and model answer
e) Apart from nationalisation, evaluate other policy options to improve outcomes in the water and sewage industry. Refer to Extract B in your answer. (15 marks)
There could be larger fines for water companies who pollute by releasing sewage, such as increasing fines above the current level of “10% of a firm’s turnover”. This could force water companies to take into account the external cost of sewage disposal, namely the harm to the health of swimmers. This increases the firm’s marginal private cost from MPC to MPC+fine, such that the firm’s new marginal private cost is equal to the marginal social cost, fully internalising the external cost. This reduces the quantity of sewage disposed from q to q1. This creates a welfare gain of area ABE, by reversing the welfare loss associated with the negative externality. This comes from improved health for swimmers using the rivers.
However, fines could be subject to regulatory capture. Firms may offer regulators highly paid jobs in the private sector in the future, in exchange for watering down fines today. If the fine is small as a result, the MPC may not shift as far left, so there would still be overproduction. So the welfare loss would remain and the water and sewage company would not have internalised the externality.
Price controls could prevent water companies from exploiting market power. Ofwat puts limits on water prices, which are set every five years. An unregulated water company, as a regional monopoly, would set output where MR=MC, leading to a price above the allocatively efficient level. Putting a price cap at the allocatively efficient price, where AR = MC, would reduce the price, leading to a welfare gain by reversing the welfare loss from allocative inefficiency. By lowering the price, there is an extension along the AR curve, increasing the quantity. This could increase consumer surplus in the water industry, making water more affordable while also increasing the quantity demanded.
However, price caps may reduce supernormal profits for water companies. This could make water companies dynamically inefficient. With less profit, there are less funds to invest in improving water infrastructure. So water infrastructure, such as pipes, may degrade over time, which will only add costs in future to repair, which may increase water bills in the future, reducing consumer surplus.
Final thoughts on the model answers
The answers above are likely to score full marks or close to this.
Other points are certainly possible, instead of the points mentioned above.
If you found these model answers or practice questions helpful, there are more resources linked below.
Related resources for Edexcel Economics A
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