1The idea in one paragraph

A free market decides how much of everything gets made, and at the same time, without anybody deciding it, how the output is shared out. It shares it out according to what each household owns and what the market happens to pay for it. Households do not own the same things, so they do not receive the same incomes, and some households own nothing the market will buy and so receive nothing at all. Nothing in the mechanism aims at fairness, checks fairness, or corrects an unfair result once it appears. That is the sense in which the market is unable to achieve equity: not that it is cruel, but that equity is simply not one of the things it does.

2Equality and equity are not the same word

Get this right and the rest of the subtopic falls into place. Get it wrong and even a well-written answer reads as confused.

Equality means sameness. It describes an amount and it can be measured. If two households receive €30,000 each, their incomes are equal, and a statistician can confirm it without knowing anything about them.

Equity means fairness. It is a judgement about whether a distribution is right, and it takes into account things a measurement cannot see: need, effort, circumstance, what people started with, what they had no choice about.

The two ideas point in the same direction often enough that students treat them as one word. They are not. Figure 1 shows the cleanest case of them coming apart.

Three households need different amounts because their circumstances differ: one has a chronically ill member, one does not. In the left panel each receives the same €6,000. That is equality, and household C is still short. In the right panel each receives what it needs, so the amounts are unequal. Most people would call the right panel fairer, and yet by any measure of sameness it is the less equal of the two.

The reverse case exists as well. A policy that forced every household in a country to receive exactly the same income would produce perfect measured equality, and many people would call it inequitable, because it would treat a household that worked eighty hours a week and one that worked none identically.

Equality is a measurement. Equity is a judgement. A policy can raise one while lowering the other.

The guide keeps the two apart in its own framing: inequity is the failure, and the inequalities you can count are what the failure produces. So when you write about this subtopic, use "unequal distribution" for the thing you can measure and "inequitable" for the thing you are judging, and never swap them.

One more thing follows from this, and examiners like to see it acknowledged. Because equity is a judgement, reasonable people disagree about it, and so do economists. Efficiency has a technical test. Equity does not. An answer that states one view of fairness as though it were a fact has stopped doing economics.

3Efficiency without equity: why this counts as a market failure

In 2.8 to 2.11 the market failed by producing the wrong quantity. An externality, a common pool resource, a public good, hidden information, a firm with market power: in each case the market ended up somewhere other than the allocatively efficient output, and you drew a welfare loss to prove it.

Subtopic 2.12 is different, and this is the point most worth understanding. Here the market can hit allocative efficiency exactly, and the outcome can still be one that most people would call unfair. There is no welfare loss triangle to draw, because nothing has been wasted. The quantity is right. What is in question is who got it.

Figure 2 is a market for rice. It clears at P\* and Q\, and every buyer willing and able to pay P\ is served. That is textbook efficiency. Qₙ marks the quantity that would feed every household in the country. The gap between Q\* and Qₙ is not inefficiency, and drawing a welfare loss there would be wrong. It is need with no money attached to it, and the market has no way of registering it.

The reason sits inside the definition of demand you learned in 2.1. Demand is willingness and ability to pay. A household with a real need and no income contributes nothing to demand, so it produces no signal, so no firm responds to it. Figure 3 makes this concrete by ranking six households along the demand curve.

Households A to D can pay more than P\*, so they buy. Households E and F cannot, so they do not. The curve has ranked them by the depth of their pockets, and it cannot tell the difference between a household that does not want rice and a household that is desperate for it and broke.

This has a second consequence worth a mark on its own: because purchasing power is how the market votes, the distribution of income also decides what gets produced. A country with a very unequal distribution will find its builders putting up luxury flats while ordinary housing goes unbuilt, not because anybody chose that, but because the money that votes is concentrated.

Whether all of this deserves the label "market failure" is itself a matter of judgement, and section 9 sets out both sides. The guide places it under market failure, so in an exam you may treat it as one, but you should say why: the market delivers efficiency and delivers nothing at all on equity, and equity is one of the objectives societies actually hold.

4Income and wealth: a flow and a stock

The syllabus line names both, so an answer that only discusses income is half an answer.

Income is a flow. It is money received over a period of time — a week, a year — and the period is part of the definition. In the circular flow it is what households receive for the factors of production they sell: rent for land, wages for labour, interest for capital and profit for enterprise.

Wealth is a stock. It is the value of what a household owns at a single moment in time, net of what it owes: a house, land, shares, savings, a pension pot, a business. Ask "how much per year?" and you are asking about income. Ask "how much, right now?" and you are asking about wealth.

Figure 4 shows why the two cannot be separated. Income arrives, some is spent, and whatever survives becomes saving, which becomes wealth. Then the arrow that matters: wealth pays an income of its own — rent from a flat, interest from savings, dividends from shares — which flows straight back into the household's income. A household with a stock has a second source of income. A household without one has only the first.

Two things follow, and both are worth saying explicitly in an answer.

Wealth is almost always distributed more unequally than income, because wealth is the accumulated result of many years of unequal income, plus whatever was inherited.

And wealth inequality feeds income inequality, through that return arrow, which is the mechanism section 7 builds on.

5The circular flow model, and where the syllabus wants you to look

This is the diagram the guide names for 2.12, so learn to draw it quickly and accurately.

There are two groups of agents and two markets.

In the product market, at the top, firms supply goods and services to households, and households pay for them. In the factor market, at the bottom, households supply the factors of production they own to firms, and firms pay them for it. Money runs one way round the loop and real things run the other.

Now look only at the bottom-left arrow, the one running from the factor market back into households. That single arrow is the distribution of income. A household's income is not decided by a government, a committee or a plan. It is decided by two things and nothing else: which factors of production it owns, and what price the market puts on them.

That is the whole answer to the syllabus question, and everything in section 6 is a way of taking it apart.

6Why the flow comes out uneven

Four reasons, all of them visible on the same diagram. A strong Paper 1 answer picks two or three, explains each properly, and refers to the diagram while doing it.

Households do not own the same factors. This is the first and biggest reason. One household owns nothing but a pair of hands and no particular training. Another owns hands, a qualification that took seven years, a shop and a holding of shares. Both are selling into the same market on the same terms.

In Figure 6, household A sells unskilled labour and receives €18,000 a year. Household B sells skilled labour and receives €45,000. Household C sells skilled labour and also owns a shop and shares in firms, so three income streams arrive instead of one, and it receives €140,000. Nothing improper has happened. Every household was paid the market price for what it brought.

The market does not pay the same price for every factor. Factor prices are set by demand and supply like any other price. A skill that is scarce and much wanted commands a high wage; a skill that many people have commands a low one. Because the demand for labour is derived demand — firms want workers for what the workers produce, not for their own sake — a worker producing something valuable is paid more than one producing something cheap, whatever the effort involved. The market is pricing the output, not the person.

Profit flows to owners. When a firm's revenue exceeds its costs, the surplus goes to whoever owns the firm. Ownership of firms is itself concentrated, so profit tends to arrive at households that already have income from other sources.

Some households own nothing the market will buy at all. This is the sharpest point in the subtopic and the one students most often miss, because it is not visible if you only look at the households already drawn on the diagram.

A child, a pensioner with no savings, someone too ill to work, someone whose skills have become obsolete and who cannot find a buyer for them: household D in Figure 7 has no factor to sell, so no factor income arrives, so it can buy nothing in the product market. Notice what the model does when this happens. It does not break, register an error or produce a shortage. It simply has no arrow to that household, and there is nothing inside the model that would ever create one.

7Why it does not correct itself, and why it widens

The market is very good at correcting some things. If there is a shortage, the price rises, which draws in supply and rations demand, and the shortage disappears. That feedback is the reason economists trust markets to clear.

There is no equivalent feedback aimed at the distribution. Nothing about a household earning €18,000 this year makes it earn more next year. The self-correcting machinery exists for prices and quantities, and simply does not exist for shares of the total.

Worse, the loop that does exist runs the other way.

In Figure 8 the household with a large income saves €30,000, buys a flat and some shares, and those assets pay €9,000 a year in rent and dividends. Next year it starts from €149,000 rather than €140,000. The household with a small income saves nothing once rent and food are paid, so it acquires no assets, so no second income stream arrives, and next year it starts exactly where it started this year. The gap widens without anything new happening at all.

The same mechanism works through people rather than assets. A household with spare income can pay for tutoring, keep a child in education longer, support an unpaid internship, move to a district with better schools. It is buying its children a more valuable factor of production to sell. So the endowments in Figure 6 are partly inherited, which means the distribution the market produced in one generation becomes the starting point it works from in the next.

Put all of this together and you have the meaning of the subtopic's title. The market is not failing to try to achieve equity. It has no instrument that points at equity, no signal that reports on it and no feedback that corrects it, and its ordinary operation tends to widen the gaps it created.

8What an unequal distribution looks like

The measuring of inequality — the Lorenz curve, the Gini coefficient, poverty lines — belongs to subtopic 3.4, Economics of inequality and poverty, and that is where it is examined. No calculation is required of you here. But you cannot describe "an unequal distribution of income" confidently without having seen one drawn, so this section shows you the picture and then hands it over.

Start with the raw data. Rank every household in a country from poorest to richest and split them into five equal groups, called quintiles, then record what share of the country's total income each fifth receives.

Plot the running totals against the running share of households and join them, and you have a Lorenz curve.

The straight diagonal is the line of equality: the path the curve would take if every fifth received exactly a fifth of the income. Real distributions sag below it, and the further they sag, the more unequal they are.

Figure 10 puts a number on the sag. The Gini coefficient is the area between the line of equality and the Lorenz curve, marked A, divided by the whole area under the line of equality, which is A plus B. It runs from 0, where the curve sits on the line and every household receives the same, to 1, where a single household receives everything. For this distribution A is about 0.22 and A plus B is exactly 0.5, so the Gini is about 0.44.

Figure 11 adds a second country. Lorenz₂ sags further from the line, so its area A is larger and its Gini is higher, at about 0.55. Reading two curves against each other like this is how you compare distributions, or compare one country with itself before and after a policy.

Now the warning, because it is the whole reason section 2 came first. A Gini coefficient measures equality, not equity. It cannot tell you whether a distribution is fair, because fairness depends on things the number does not contain: whether people can move between the quintiles over a lifetime, whether the differences reflect choices or circumstances nobody chose, whether the poorest fifth is comfortable or starving. Two countries with the same Gini can be judged completely differently, and an answer that treats a higher Gini as automatic proof of injustice has skipped the argument rather than made it.

9Does the inequality matter? Where economists disagree

This subtopic invites opinion, and the exam rewards an answer that argues rather than one that preaches. Here are both sides properly stated. You are expected to reach a judgement; you are not expected to reach any particular one.

The case that market-generated inequality is a problem.

An extra euro is worth more to a poor household than to a rich one. This is the law of diminishing marginal utility from 2.1 applied to money itself: the household on €18,000 spends its next euro on food, and the household on €140,000 spends it on something it barely notices. If that is true, the same total income spread more evenly would produce more total satisfaction, and a very unequal distribution is leaving well-being on the table.

Inequality of income becomes inequality of opportunity, as Figure 8 showed. Talented children in poor households do not develop the skills they could have, which is a loss to them and a loss of output to the whole economy. On this argument, inequality is not only unfair but wasteful.

Large gaps can strain social stability and the trust between groups that a functioning economy relies on.

And because purchasing power is how the market votes, a very unequal distribution changes what is produced, tilting output towards what rich households want and away from what poor households need.

The case that it is not a problem, or not a simple one.

Unequal rewards are a signal. Higher pay for difficult, scarce or risky work is what persuades people to train for years, move for a job, or start a business that might fail. Flatten the rewards and the signal goes with them, and with it some of the effort and enterprise that raise output for everyone. Correcting the distribution therefore has a cost, and how large that cost is remains genuinely disputed.

Some of the measured gap reflects choices rather than circumstances: hours worked, whether to save, whether to take a risk. Removing differences that came from choices is itself a kind of unfairness, and one that the household that worked the extra hours will feel keenly.

A snapshot overstates the case. Measured inequality at a single moment counts a twenty-year-old student in the bottom fifth and the same person at forty-five in the top fifth as two different households. Where mobility between quintiles is high, a wide gap in one year says less than it appears to.

And what people actually mind about may be poverty rather than inequality. An economy where the poorest fifth is comfortably housed and fed but the richest fifth is very rich may be preferable to one where the gap is narrow and everybody is poor. On this view the target should be the floor, not the spread.

Where that leaves you. Economists disagree about how much inequality matters, how much correcting it costs, and which parts of it are unfair. What they broadly agree on is the positive claim this subtopic actually teaches: the free market produces an unequal distribution as a by-product of how it works, and contains nothing that would correct it. That claim you can argue for with a diagram and be right.

What to do about it is a separate question and a separate part of the course. The tools of intervention are in 2.7, and the redistribution policies — progressive taxation, transfer payments, the direct provision of education and healthcare — are set out and evaluated in 3.4. If a question asks you why the market produces the inequality, policy earns you nothing. If it asks what should be done, you need those subtopics too.