Explain how knowledge of price elasticity of demand could be used by a firm that is considering changing the price of its product.

Discuss how the introduction of a subsidy in a market will affect consumers, producers and the government.

Marks should be allocated according to the paper 1 markbands for May 2013 forward, part A.

Answers may include:

• definition of price elasticity of demand
• diagram to show the revenue consequences of elasticity when the price is changed
• explanation of how total revenue changes following a change in price depending on whether the demand for the product is price elastic, price inelastic or unit elastic
• examples of “real-world” products with different elasticities to support the explanation (students do not need to provide actual total revenue figures, but should provide a consideration of why demand for the product might be more or less likely to be elastic or inelastic).

Marks should be allocated according to the paper 1 markbands for May 2013 forward, part B.

Answers may include:

• definition of subsidy
• diagram to show the imposition of a subsidy and the consequences for the three stakeholders
• explanation of how a subsidy lowers the price of the product and may lead to increased consumption/consumer surplus by consumers, increased production/revenue/producer surplus for producers and increased government expenditure
• examples of markets where subsidies have been introduced in practice
• synthesis or evaluation (discuss).

Examiners should be aware that candidates may take a different approach which, if appropriate, should be rewarded.

Discussion may include: judgments about which stakeholders are better off and which stakeholders are worse off due to the imposition of a subsidy, which are well supported by the explanation of the theory, the diagram and the example(s).

For many candidates, the difficulty in this question was to focus the answer on a single firm that sells a specific product. Many candidates drew diagrams with supply curves as if there are many firms that constitute the supply in a competitive market but then gave an example with a single firm that should be a price taker in a competitive market (and therefore should not be able to change the price of its product/should not have a downward sloping demand curve). Another common mistake, stemming from the failure to distinguish between the supply of a single firm and the supply of the market, was to use examples from broad categories of goods whose demand can be considered price inelastic (such as agricultural products or cigarettes), ignoring the fact that the demand for a single producer (of agricultural products) should be rather price elastic due to the competitive nature of such markets and the substitutability of such goods.

The subsidy is a difficult topic to examine because there are many types of subsidies that governments use in practice to support the firms in a given industry. The two main types are a subsidy that has the form of a specific cash payment per unit of production (the opposite of a specific per unit tax) and a subsidy that decreases the cost of production (such as provision of infrastructure, subsidized wages, subsidized energy, low-interest loans, etc). A correctly drawn diagram appropriate for the first type of subsidy was often used, but in their explanations, candidates were confusingly explaining that the subsidy decreases the producers' cost of production. Some weaker answers also had the effects of the subsidy on consumer and producer surplus shown incorrectly on the diagram. Another common mistake was to give an example where the subsidy is provided to stimulate the production and consumption of a merit good while simultaneously pointing out that the provision of subsidy would create deadweight loss/lead to allocative inefficiency.