IB Economics Paper 3 May 2025

IB Economics HL Paper 3 May 2025 - Full Exam Breakdown

Target Question:

What topics came up in IB Economics Paper 3 May 2025?

Exam: IB Economics Paper 3 Higher Level only May 2025
Duration: 1 hour 45 minutes

Total marks: 60 Calculator permitted
Instruction: Answer ALL questions

This page gives you a teacher-led, mark-scheme-informed breakdown of every question on IB Economics HL Paper 3 May 2025. Question 1 was built around the US fitness industry - covering consumer surplus, market failure as a positive externality, bounded self-control, natural monopoly, marginal revenue, profit calculations, and a 10-mark policy recommendation.

Question 2 used Japan's long history of deflation as the context for the Phillips curve, CPI calculation and inflation measurement, game theory and oligopoly, the real interest rate, and money creation through fractional reserve banking. All calculations are fully worked with mark scheme steps shown. Diagram requirements are explained in full. Both 10-mark extended responses are broken down by mark band.

Paper 3 Format – What Makes It Different

Paper 3 is HL-only. SL students do not sit this paper. It carries 60 marks over 1 hour 45 minutes, and every question is compulsory - there is no choice. The fact there is no choice together with quantitative depth makes Paper 3 the paper students are most likely to struggle with. The assumption that "it's just calculations" as I hear many times from my students, is far from realistic: Paper 3 blends numerical work, diagram analysis, short conceptual answers, and a 10-mark extended policy recommendation in both questions. Students who are unable to cope with the maths section and skip ahead to the essay throw away a lot of easy marks early.

Paper 3 consistently tests:

1. Consumer and producer surplus calculations using triangle area formulae;

2. Marginal and average cost and revenue from data tables;

3. CPI construction, inflation rates, and real versus nominal values;

4. Exchange rate conversions;

5. Keynesian multiplier;

6. Money multiplier;

7. Game theory and payoff matrices;

8. Natural monopoly;

9. And the Phillips curve.

These concepts reflect a core set of HL-only quantitative skills that IB Economics returns to every session.

Each question usually ends with a 10-mark "recommend" question. This is assessed using a five-band rubric that rewards:

1. Identification of a relevant policy

2. Use of economic theory

3. Correct IB Economics terminology

4. Integration of text and data from the question

5. And balanced synthesis and evaluation.

A student who writes about theory without relating it to the numbers of the stimulus material and case study context in the paper cannot reach band 4 or 5.

Question 1 - USA Fitness Industry and Gym Memberships

The context for Question 1 was physical inactivity in the United States. The stimulus presented data on adult exercise rates (only 23% meet recommended levels), the growth of the gym membership market (8.7% industry growth), and the social cost of physical inactivity (USD 130 billion in annual healthcare spending plus productivity losses). Figure 1 showed a supply and demand diagram for gym memberships with an original demand curve D and a shifted demand curve D1. A data table (Table 1) provided monthly price, number of members, and monthly total costs for a small-town gym operating as a natural monopoly.

Question 1(a)(i) - Calculate the Change in Consumer Surplus [2 marks]

Command term: Calculate - show working, give numerical answer with units.

What the question asked: Using Figure 1, calculate the change in consumer surplus resulting from the increase in demand from D to D1.

Reading Figure 1: The supply curve S passes through the origin with a positive slope. The original demand curve D intersects S at Q = 100 million memberships, P = $40. The shifted demand curve D1 intersects S at Q = 150 million memberships, P = $60. The y-axis intercept of D is $80 and the y-axis intercept of D1 is $120.

Worked answer:

Consumer surplus is the triangular area above the equilibrium price and below the demand curve.

Original CS (with D): ½ × base × height = ½ × 100 × (80 − 40) = ½ × 100 × 40 = $2,000 million

New CS (with D1): ½ × base × height = ½ × 150 × (120 − 60) = ½ × 150 × 60 = $4,500 million

Change in consumer surplus = $4,500 million − $2,000 million = +$2,500 million (or $2.5 billion)

Mark scheme notes: [1] for any valid working, including if only one CS figure is correct or if the division by the quantity is omitted. [2] requires valid working AND correct units. An answer of $2,500 million or $2.5 billion with no working earns only [1]. Units are mandatory for full marks.

Common errors: Using the wrong y-intercept (reading 110 or 100 from the graph rather than 80 and 120). Forgetting to subtract the original CS - just calculating the new CS. Omitting units (millions of USD). Using the wrong base - some students use the change in quantity (50) rather than the total equilibrium quantity.

Lawrence's notes: The mark scheme accepts the alternative working of ½ × 20 × (100 + 150), which treats the change in CS as a trapezium. Either method reaches the same answer. The key aspect is to show working clearly - the mark scheme explicitly states that an unsupported answer earns only [1].

Question 1(a)(ii) - Market Failure in the Market for Gym Memberships [4 marks]

Command term: Explain - give a clear account of something, showing how or why it occurs.

What the question asked: Using a diagram, explain how market failure may exist in the market for gym memberships.

Economic argument: Gym membership generates positive externalities of consumption (also acceptable: it is a merit good). When an individual exercises regularly, the benefits extend beyond the individual themselves - reduced strain on the healthcare system, higher labour productivity, lower rates of chronic disease. These third-party benefits are not captured in the individual's private demand curve. The market therefore treats gym membership as if its only benefits are private (MPB), ignoring the social benefit (MSB). Since MSB > MPB, the market equilibrium output Q1 is below the socially optimal output Q*. This is market failure: resources are misallocated, gym memberships are under-consumed, and there is a welfare loss (potential welfare gain not being realised).

Diagram requirements:

Draw a standard positive externality of consumption diagram:

• Y-axis: Price (or Costs/Benefits)

• X-axis: Quantity

• Downward-sloping D curve labelled D (= MPB)

• A second downward-sloping demand curve above and to the right of MPB, labelled MSB

• Upward-sloping supply curve labelled S (= MPC = MSC)

• Market equilibrium at Q1 (intersection of MPB and S)

• Socially optimal output at Q* (intersection of MSB and S)

• Q1 is to the left of Q* - under-consumption shown clearly

• Optional but creditable: welfare loss triangle or potential welfare gain triangle between Q1 and Q*

Mark scheme levels:

Level 1 [1-2 marks]: Diagram alone with MPB < MSB and under-consumption shown, OR written explanation of positive externality / merit good with one of: under-consumption, welfare loss, or misallocation - but not both diagram and explanation together, have been included.

Level 2 [3-4 marks]: Diagram AND written explanation. The diagram must show MPB < MSB with market equilibrium below socially optimal output. The explanation must connect this to under-consumption, welfare loss, or misallocation of resources.

Incorrect diagram labelling (e.g., calling the MSB curve MPC, or misplacing Q1 and Q*) caps the mark at [3].

Common errors: Drawing a negative externality diagram instead (MPC > MSC, with over-production). Confusing supply-side and demand-side externalities. Labelling MPB as MPC. Writing about information failure without connecting directly to the under-consumption argument. Identifying gym memberships as a public good (they are not - they are excludable and rival).

Lawrence's notes: The word "may" introduced in the question is relevant - market failure is not a guaranteed outcome. A strong answer acknowledges this: for example, if individuals are well-informed and fully value the external benefits, the externality is internalised and market failure does not necessarily take place. This distinction is rewarded at Level 2 but is not required for full marks. The most common reason students score [2] rather than [4] is drawing a diagram without writing any explanation, or writing an explanation without drawing a diagram.

Question 1(a)(iii) - Define Bounded Self-Control [2 marks]

Command term: Define - give the precise meaning of a term.

The concept:

Bounded self-control is a concept from behavioural economics. It refers to the idea that individuals often fail to act in their own best long-term interests, even when they know what those interests are, because their willpower or self-control is limited. Unlike the standard economic assumption of rational, self-interested agents who maximise utility, behavioural economics recognises that people struggle to resist short-term temptations or immediate gratification at the expense of long-term wellbeing. A person with bounded self-control might know that exercising is good for them, intend to exercise, but repeatedly choose to watch television instead.

Mark scheme levels:

Level 1 [1 mark]: Vague - states that individuals may not act in their self-interest or not act rationally, OR simply says individuals lack self-control.

Level 2 [2 marks]: Accurate - a clear statement that individuals may not exercise self-control even when they are aware (or could be aware) that such behaviour is not in their interests or is irrational.

Common errors: Confusing bounded self-control with bounded rationality (which is about limited information and cognitive capacity) or with bounded willpower (which is the same thing but sometimes named differently in different economics textbooks). Defining it as simply "being irrational" without the self-control element. The key distinguishing feature is the gap between knowing what is good for you and doing it.

Lawrence's notes: The context in the question makes this directly applicable - the professor argues that Americans do not exercise because they have bounded self-control. A strong definition connects the concept directly to this context: individuals who know they should exercise but repeatedly fail to do so are exhibiting bounded self-control. This contextual link is rewarded but not required for [2].

Question 1(a)(iv) - Natural Monopoly AC Curve Sketch [2 marks]

Command term: Sketch - draw a simple, clearly labelled diagram without needing precise scale.

What the question asked: Sketch the average cost curve for a natural monopoly. The context: the town's gym is a natural monopoly because high fixed costs (exercise equipment) combined with a small population (2700) mean only one supplier can survive.

Economic argument: A natural monopoly arises when a firm's long-run average cost curve is still declining throughout the entire relevant range of market demand. In other words, economies of scale are so substantial that one firm can always produce more cheaply than two or more firms sharing the same market. This happens when fixed costs are very large relative to variable costs and relative to total market size. High capital costs (gym equipment, premises) spread across a small number of potential customers mean LRAC keeps falling - the more members, the lower the average cost per member.

Diagram requirements:

• Y-axis labelled: Costs/Revenue (or P, or AC, or LRAC)

• X-axis labelled: Quantity (or Q, or Output)

• A single downward-sloping curve labelled AC or LRAC, falling throughout the relevant output range

• The curve may have a very gentle upward "tail" at extremely high quantities - this is acceptable

• MC and MR curves are NOT required

Mark scheme levels:

Level 1 [1 mark]: A downward-sloping labelled AC/LRAC curve without accurate axis labelling.

Level 2 [2 marks]: A downward-sloping labelled AC/LRAC curve WITH accurate labelling of both axes.

Common errors: Drawing a U-shaped AC curve - this is the short-run average cost curve for a competitive firm, not the natural monopoly LRAC. Drawing multiple curves (MR, MC, AR) unnecessarily - these are not penalised but they waste valuable exam time. Forgetting to label both axes.

Lawrence's notes: This is a gift of a 2-mark question if you have revised and practiced natural monopolies properly. The only content requirement is a continuously falling curve with labelled axes. Do not waste time adding MR = MC or price points - none of that is required here and it will gain 0 marks.

Question 1(a)(v) – Calculate Marginal Revenue (300 to 400 members) [2 marks]

Command term: Calculate - show working, give numerical answer with units.

What the question asked: Using Table 1, calculate the marginal revenue if the number of members increases from 300 to 400 per month.

Table 1 data needed:

At 300 members: price = $100 → TR = 100 × 300 = $30,000

At 400 members: price = $90 → TR = 90 × 400 = $36,000

Formula: MR = ΔTR ÷ ΔQ

Worked answer:

ΔTR = $36,000 − $30,000 = $6,000

ΔQ = 400 − 300 = 100

MR = $6,000 ÷ 100 = $60 per member

Mark scheme notes: [1] for any valid working, including if the division by 100 is omitted (i.e., getting $6,000 rather than $60), or if one TR figure is correct. [2] requires valid working AND correct units. An answer of $60 without working earns only [1].

Common errors: Forgetting to calculate TR and instead using the price directly (using $100 or $90 as total revenue - this is wrong for a monopolist whose demand curve slopes downward). Dividing by the wrong ΔQ. Not dividing by ΔQ at all and leaving the answer as the change in total revenue ($6,000). Omitting dollar signs or per-member units.

Lawrence's notes: This is a typical HL-only calculation question testing whether students understand the relationship between price, total revenue, and marginal revenue for a price-maker. A competitive firm's MR equals price, but for a monopolist (or natural monopoly as here), MR is always below price because lowering the price to sell one more unit means all previous units also sell at the lower price. This question explicitly tests that distinction - MR ($60) is less than the price at 400 members ($90).

Question 1(a)(vi) - Calculate Increase in Profit (400 to 500 members) [2 marks]

Command term: Calculate - show working, give numerical answer with units.

What the question asked: Using Table 1, calculate the increase in profit if the number of members increases from 400 to 500 per month.

Table 1 data needed:

At 400 members: price = $90, TC = $21,600 → TR = $36,000 → Profit = $36,000 − $21,600 = $14,400

At 500 members: price = $80, TC = $24,700 → TR = 80 × 500 = $40,000 → Profit = $40,000 − $24,700 = $15,300

Worked answer:

Change in profit = $15,300 − $14,400 = +$900

Mark scheme notes: [1] for any valid working, including if only one profit figure is calculated correctly. [2] requires valid working AND correct units. An unsupported answer of $900 earns only [1].

Common errors: Calculating the change in TR or the change in TC rather than the change in profit. Using cost per member rather than total costs. Getting one profit figure right and the other wrong (still earns [1]). Stating the answer as a negative (confusing a smaller loss with a smaller profit).

Lawrence's notes: Notice that MR ($60 per additional member, as calculated in the previous question) is greater than MC ($31 per additional member, derived from ΔTC/ΔQ = (24,700−21,600)/100 = $31). Since MR > MC between 400 and 500 members, producing the extra 100 members adds to profit - which is exactly what the +$900 confirms. This internal consistency across sub-questions is worth noting for students who want to check their answers.

Question 1(a)(vii) – Average Cost for 600 Members [2 marks]

Command term: Calculate - show working, give numerical answer with units.

What the question asked: If membership increases from 500 to 600, total costs increase by USD 2,800. Using Table 1, calculate the average cost per member for 600 members.

Worked answer:

TC at 500 members = $24,700 (from Table 1)

TC at 600 members = $24,700 + $2,800 = $27,500

AC = TC ÷ Q = $27,500 ÷ 600 = $45.83 per member

Mark scheme notes: [1] for any valid working. [2] requires valid working. An answer of $45.83 without working earns only [1]. The mark scheme notes that incorrect rounding should not be penalised - $45.83 is the required precision.

Common errors: Using only the increase in costs ($2,800) as the total cost, then dividing by 600. Dividing by 100 (the additional members) rather than 600 (total members). Using 500 as the denominator.

Lawrence's notes: The falling average cost as membership increases (from $54 at 300 members, to $49.25 at 500 members, to $45.83 at 600 members) is directly consistent with the natural monopoly AC curve sketched in part (iv). Students who connect these two question parts demonstrate strong analytical coherence - and the 10-mark recommend question in part (b) benefits from students who understand this falling AC structure when discussing pricing or subsidy policy.

Question 1(a)(viii) - Two Alternative Business Objectives [4 marks]

Command term: Explain - give a clear account of each objective, showing how it works in practice.

What the question asked: Explain two alternative business objectives (other than profit maximisation) which the gym owner might adopt.

Mark scheme levels:

Level 1 [1–2 marks]: Limited explanations - may identify objectives without explaining them, or give an accurate explanation of one objective. Award [1] for one limited explanation, [2] for an accurate explanation of one objective OR limited explanations of two objectives.

Level 2 [3–4 marks]: [3] for one accurate explanation plus one limited identification. [4] for accurate explanations of both objectives. If more than two are listed, the best two are assessed.

Creditable objectives from the mark scheme (with accurate explanations):

Revenue maximisation: The firm sets output where MR = 0, maximising total revenue regardless of costs. The owner may pursue this if they want to grow market share, discourage competitor entry, or simply value scale of operations over profit. In the context of the gym, this means accepting lower per-unit profit margins in exchange for the highest possible total membership revenue.

Sales/market share maximisation: The owner seeks to maximise the percentage of total gym users in the town who belong to their gym. In a natural monopoly with 2,700 residents, maximising membership might mean setting a lower price than the profit-maximising price to serve more of the community, even at the cost of some profit.

Corporate social responsibility (CSR): The owner aims to act in an ethical, socially responsible manner - taking into account the interests of all stakeholders, not just shareholders. Given the context of public health and the broader social cost of physical inactivity (USD 130 billion in US healthcare spending annually), a socially responsible gym owner might deliberately subsidise memberships for lower-income residents, introduce community classes, or set a price below profit-maximising level.

Satisficing: Rather than maximising any single objective, the owner targets a satisfactory level of profit while also pursuing other goals such as community service, manageable workload, or employee wellbeing. This is especially feasible for small-business owners who are not accountable to external shareholders.

Growth: The firm prioritises increasing its size or scale - for example, expanding the facility, adding equipment, or opening a second location - even if doing so reduces profit temporarily.

Common errors: Listing objectives without explaining them. Redefining profit maximisation in slightly different words as an "alternative." Confusing revenue maximisation with profit maximisation. Giving three or four objectives without explaining any of them in depth - only the best two count.

Lawrence's notes: The context offered here is extremely relevant. The question tells students that the owner says profit is not the main objective. This invites real discussion in terms of why a gym owner in a small town of 2,700 people might not be primarily profit-driven. CSR and satisficing are particularly well-suited to this context and a well-contextualised explanation will score more convincingly than a generic IB Economics textbook definition.

Question 1(b) - Recommend a Policy to Increase Regular Exercise in the USA [10 marks]

Command term: Recommend - present an advisable course of action with appropriate supporting evidence and reasoning in relation to a given situation, problem, or issue.

The problem: Physical inactivity in the US costs USD 130 billion in healthcare spending annually, reduces labour productivity, and less than 5% of adults complete 30 minutes of physical activity per day. The gym market has grown but most people remain inactive. Causes identified in the text include bounded self-control and poor awareness of the benefits of exercise. Market failure exists because of positive externalities of consumption - private demand understates social benefit.

Possible policies (any one well-argued is sufficient):

Subsidies | Maximum price regulation | Government provision of public facilities | Advertising and public information campaigns | Consumer nudges | Education policy (mandatory school PE) | Policies to increase competition in the gym market | Any other policy you are able to support

If more than one policy is discussed, only the best are assessed - unless policies are shown to be complementary or compared against the chosen policy.

Mark band analysis:

Bands 1–2 (1–2 marks): A policy is identified. No economic theory. Economic terms stated but not relevant. No use of text or data. No evaluation.

Band 2 (3–4 marks): An appropriate policy is identified. Some economic theory used superficially. Some relevant terms. No text/data integration. Superficial evaluation present.

Band 3 (5–6 marks): Policy identified and explained. Theory partially supports the recommendation. Some text/data used. Evaluation present but unbalanced.

Band 4 (7–8 marks): Policy fully explained. Theory supports the recommendation. Terms used mostly correctly. Text/data well integrated and applied. Evaluation mostly balanced.

Band 5 (9–10 marks): Policy fully explained. Theory used effectively and throughout. All terms appropriate. Text/data support the analysis effectively. Evaluation is effective and balanced.

Worked example - subsidy on gym memberships:

A subsidy on gym memberships is an appropriate policy to address the under-consumption of exercise in the USA. As shown in Figure 1, the gym membership market has already grown - demand has shifted from D to D1, with equilibrium moving from Q = 100 million to Q = 150 million memberships. However, the text states that physical inactivity still costs USD 130 billion in annual healthcare spending, indicating that market provision remains significantly below the socially optimal level. This is consistent with the positive externality of consumption identified in part (a)(ii): the market equilibrium (Q1) falls short of the socially optimal output (Q*) where MSB = MSC.

A per-unit subsidy paid to gym operators would lower the effective price consumers face, shifting the supply curve downward and to the right. Consumers who previously found gym membership unaffordable would enter the market, moving quantity closer to Q*. This would narrow the welfare gap between market and socially optimal output. The subsidy addresses the market failure directly by bridging the gap between MPB and MSB - in effect, the government pays for the external benefit that private consumers do not value in their own purchasing decisions.

The case for a subsidy is reinforced by the natural monopoly structure in small communities like the town described in the question. With only 2700 residents, a single gym can never recover its high fixed costs without either a high membership price or public support. A subsidy enables the natural monopoly to price closer to average cost, expanding access without requiring the owner to accept losses.

However, subsidies carry limitations. First, the cost to the taxpayer: the text cites USD 130 billion in current healthcare costs, but a national gym subsidy scheme would require significant government expenditure, and the effectiveness depends on whether subsidised gym use actually reduces healthcare costs in the long run. Second, there is a behavioural economics challenge: the text identifies bounded self-control as a key cause of inactivity. Implementing a lower price alone will not solve this - a person who lacks the self-control to exercise will not suddenly begin exercising simply because it is cheaper. This suggests that a subsidy should be complemented by nudge policies or public health campaigns that address the behavioural barrier directly. Third, deadweight loss: if inelastic demand means that a lower price does not significantly increase quantity demanded, the subsidy may primarily transfer income to existing gym members rather than expanding participation.

On balance, a subsidy is a well-justified starting point because it directly addresses the positive externality and is consistent with the scale of the identified market failure. Its effectiveness would be greatest if paired with information campaigns that tackle the awareness and bounded self-control problems identified in the text, ensuring the behavioural barrier to exercise is addressed alongside the price barrier.

Worked example - consumer nudges:

Given that the text identifies bounded self-control as the primary reason for physical inactivity, a consumer nudge may be a more targeted policy than a price-based intervention. Nudges are low-cost interventions designed by governments (or employers, schools, health services) that alter the choice architecture facing individuals - making the desired behaviour the default or the most salient option - without removing any choices or imposing financial penalties.

Examples relevant to the context: placing exercise facilities in prominent, convenient locations in workplaces and schools; defaulting employees into workplace fitness programmes (with opt-out rather than opt-in); sending personalised health reminders via government health apps; designing urban spaces to make walking and cycling the most obvious choice; requiring calorie and activity information to be displayed in public spaces. None of these require large transfers of money, and all exploit the same behavioural tendencies (status quo bias, salience, social norms) that currently cause inactivity.

The key advantage of nudges is that they are cheap relative to subsidies and they directly address the root cause identified in the text - bounded self-control. The key limitation is that nudges are often weak instruments against deeply embedded behaviours: a text notification will not override years of sedentary habit. Their effectiveness is also harder to measure, and there is a legitimate concern about government paternalism - the state deciding what counts as a good choice instead of the individual taking this decision.

A well-balanced response would note that nudges are best understood as a complement to, rather than a replacement for, structural interventions like subsidies or government provision of public sports facilities.

Question 2 - Japan's Deflation, Inflation Measurement, Oligopoly, and Money Creation

The context for Question 2 was Japan's persistent deflation since 1993. Japan has experienced long periods of near-zero or negative inflation, particularly driven by structural factors (ageing population, weak consumer confidence) rather than supply shocks. The Bank of Japan has set a 2% inflation target. Figure 2 plotted actual inflation rate against unemployment rate for Japan 1993–2022, showing a short-run Phillips curve (SRPC). Table 2 provided CPI basket data for Tokyo for 2020, 2022, and 2023. Table 3 provided total basket costs and CPI values. Table 4 presented a payoff matrix for two Japanese commercial banks in an oligopolistic market.

Question 2(a)(i) - Outline the Relationship in Figure 2 [2 marks]

Command term: Outline - give a brief account of something.

What the question asked: Outline the relationship shown by the data in Figure 2.

The relationship: Figure 2 shows the short-run Phillips curve (SRPC) for Japan. The data points and the fitted SRPC line show an inverse (negative) relationship between the inflation rate and the unemployment rate. When unemployment is low, inflation tends to be higher. When unemployment is high, inflation tends to be low - in Japan's case, the data includes periods of deflation (negative inflation) when unemployment was above 4–5%.

Mark scheme levels:

Level 1 [1 mark]: States a trade-off or inverse/negative relationship - but without detail.

Level 2 [2 marks]: States that when unemployment is high/increasing, the inflation rate is low/decreasing, OR explicitly identifies a trade-off or inverse/negative relationship/correlation between unemployment and inflation.

Common errors: Describing the SRPC as a positive relationship. Confusing the axes. Failing to reference both variables. Describing individual data points rather than the overall relationship.

Lawrence's notes: The mark scheme is flexible on wording - "trade-off," "inverse," or "negative relationship/correlation" all work. What distinguishes [1] from [2] is whether the student names both variables and specifies the direction. A Level 2 answer has: unemployment + inflation + inverse relationship.

Question 2(a)(ii) - Draw the Long-Run Phillips Curve for Japan [1 mark]

Command term: Draw - represent by means of a labelled, accurate diagram.

What the question asked: On Figure 2, draw the long-run Phillips curve for Japan.

The answer: The long-run Phillips curve (LRPC) is a vertical line at the natural rate of unemployment. The text states that Japan's natural rate of unemployment is 3% (due mainly to structural unemployment from the shift from manufacturing to services). The LRPC is therefore a vertical line drawn at the 3.0% point on the x-axis (unemployment rate), extending above the SRPC. It should be labelled LRPC.

Mark scheme notes: A labelled vertical line at 3.0 earns [1]. The line may extend below the x-axis. Crucially, the line must extend above the SRPC to earn the mark - a short tick mark at 3.0 that does not rise above the curve is not sufficient.

Common errors: Drawing the LRPC as a horizontal line. Placing the LRPC at 2.5% or 4.0% rather than 3.0%. Forgetting to label it LRPC. Drawing it to the right of the SRPC's plotted data range without connecting to the 3.0 point on the x-axis.

Lawrence's notes: The LRPC represents the monetarist/new classical view that there is no long-run trade-off between unemployment and inflation. In the long run, the economy returns to its natural rate of unemployment regardless of the inflation rate - hence the vertical line. Japan's case is interesting because structural unemployment (skills mismatch between manufacturing jobs lost and service jobs created) dominates the natural rate, making it relatively resistant to short-term demand management.

Question 2(a)(iii) - Calculate Total Cost of Basket in JPY for 2023 [2 marks]

Command term: Calculate - show working, give numerical answer.

What the question asked: Using Table 2, calculate the total cost of the basket of goods per week in JPY in 2023. Enter the result in Table 3.

Table 2 data:

Rice: 2 kg per week × JPY 2,304 per kg (2023 price) = JPY 4,608

Childcare: 3 hours per week × JPY 5,500 per hour (2023 price - unchanged since 2020) = JPY 16,500

Self-service coffee: 1 cup per week × JPY 110 per cup (2023 price) = JPY 110

Total: JPY 4,608 + JPY 16,500 + JPY 110 = JPY 21,218

Mark scheme notes: [1] for any valid working including at least two correct elements. [2] requires valid working and the correct total. An unsupported answer of 21,218 earns only [1]. The answer may be entered in the table or in the working space - both are credited.

Common errors: Using 2020 or 2022 prices instead of 2023 prices. Forgetting one of the three items. Multiplying the wrong quantities (e.g., using price per unit rather than quantity × price). Arithmetic error in the rice calculation (2 × 2304 = 4608, not 4618 or 4508).

Lawrence's notes: The childcare price does not change across 2020, 2022, and 2023 - this is deliberate. In Japan's deflationary environment, some service prices are notably sticky downwards. Childcare prices in Japan are heavily regulated and subsidised, making them unusually stable. Students who notice this and comment in their answers to the limitations question (a)(vi) are demonstrating strong contextual awareness and should be rewarded.

Question 2(a)(iv) - Calculate CPI for Tokyo in 2023 [1 mark]

Command term: Calculate - apply the CPI formula.

Formula: CPI = (Cost of basket in current year ÷ Cost of basket in base year) × 100

Worked answer:

CPI (2023) = (21,218 ÷ 21,168) × 100 = 100.24

Mark scheme notes: [1] for the correct answer. Own-figure rule (OFR) applies from part (iii) - if a student used an incorrect basket cost from (iii) but applies the formula correctly, they earn the mark. Working is not required for this question. Incorrect rounding is not penalised.

Common errors: Dividing by the 2022 cost (21,002) rather than the base year 2020 cost (21,168). Forgetting to multiply by 100. Reversing the numerator and denominator.

Lawrence's notes: The base year for the Tokyo CPI is 2020, not 2022 - this is stated clearly in the question. The 2022 CPI (99.22) confirms that Tokyo was in deflation in 2022 relative to 2020 (a CPI below 100 indicates a lower price level than the base year). The 2023 CPI of 100.24 means prices just edged above the 2020 level - a very mild return to positive territory consistent with the broader narrative of Japan slowly approaching its 2% inflation target.

Question 2(a)(v) - Calculate the Rate of Inflation for 2023 [2 marks]

Command term: Calculate - show working, give answer as a percentage.

Formula: Rate of inflation = ((CPI current year − CPI previous year) ÷ CPI previous year) × 100

Worked answer:

Rate of inflation (2023) = ((100.24 − 99.22) ÷ 99.22) × 100

= (1.02 ÷ 99.22) × 100

= 1.03%

Mark scheme notes: [1] for any valid working. [2] for valid working and the correct answer. OFR applies from (iv). An unsupported answer of 1.03 earns [1]. Note: if a student retained 100.236 in their calculator (rather than rounding to 100.24), the answer becomes 1.02% - this is accepted for full marks.

Alternative method - using expenditure figures directly: ((21,218 − 21,002) ÷ 21,002) × 100 = (216 ÷ 21,002) × 100 = 1.03%. Full marks.

Common errors: Using the change in CPI (100.24 − 99.22 = 1.02) as the inflation rate - this gives 1.02 instead of 1.03, and the working is technically incorrect because the denominator should be the previous year's CPI, not 1. Calculating inflation relative to the base year 2020 rather than the previous year 2022.

Lawrence's notes: The 1.03% inflation rate is below the Bank of Japan's 2% target, which sets up the 10-mark recommend question (b) perfectly. Students should carry this number forward into their policy analysis - specifically, they need to explain why current policy has delivered only 1.03% and what additional intervention could close the gap to 2%.

Question 2(a)(vi) - Two Limitations of Using CPI to Estimate Inflation in Tokyo [4 marks]

Command term: Explain - give a clear account of each limitation, showing why it causes the CPI to inaccurately measure the inflation rate.

Mark scheme levels:

Level 1 [1–2 marks]: Stating one limitation [1]. An accurate explanation of one limitation OR stating two limitations [2].

Level 2 [3–4 marks]: Accurate explanation of one + statement of one [3]. Accurate explanations of two [4]. Best two assessed if more than two given.

Creditable limitations (from mark scheme) with full explanations:

Quality bias: The price of a good may have risen since the base year (2020), but the quality of that good has also improved. The CPI records the higher price as inflation, but consumers are actually getting more for their money. For example, if the quality of childcare services in Tokyo improved between 2020 and 2023 (better-trained staff, extended hours, improved facilities), the constant price of JPY 5,500 actually represents deflation in quality-adjusted terms. The CPI cannot capture this because it treats all price changes as purely inflationary.

Substitution bias: When the price of a good in the basket rises, rational consumers switch to cheaper substitutes that are not in the basket. The CPI assumes fixed consumption patterns (the same quantities as in the base year 2020), so it exaggerates the true cost of living because it ignores the cost savings consumers achieve through substitution. For example, if self-service coffee becomes more expensive, some consumers will shift to making coffee at home - but the CPI records the higher coffee shop price as if they still buy the same quantity.

New product bias: New goods that have become significant parts of consumer spending since the base year (2020) are not included in the basket. If a new product, such as a streaming service or a new type of food delivery, has become important to Tokyo households since 2020, the CPI misses price changes in that product. This is particularly relevant given how quickly Japanese consumer habits changed after 2020.

Outlet bias: Consumers may shift their purchasing to cheaper retail outlets (e.g., discount supermarkets, online retailers) when prices rise, but the CPI measures prices at a fixed set of outlets. If Tokyo consumers switch from a premium supermarket to a budget chain for their rice, their actual cost of living rises less than the CPI suggests.

Different household compositions: The basket is based on the spending pattern of a "typical" household, but households in Tokyo, similar to everywhere else, vary significantly by income, age, and family structure. A retired couple has a very different consumption pattern from a young family - particularly with regard to childcare (weight of 3 hours per week in the basket). Families with higher childcare usage will experience a higher weight on a price-stable item, while single adults will experience a basket dominated by rice and coffee, making the CPI a poor measure of their actual inflation rate.

Common errors: Stating that the CPI "doesn't include all goods" without explaining why is certainly a limitation. Confusing the limitations with each other (e.g., describing new product bias as if it is substitution bias). Saying the CPI is "inaccurate" without specifying whether it overstates or understates inflation and why. Giving more than two limitations without fully explaining any of them.

Lawrence's notes: The mark scheme is generous - names of biases are not required. A student who explains that "consumers will switch to cheaper goods when prices rise, but the CPI doesn't account for this" earns credit for substitution bias even without using the term. The Tokyo context is highly useful here: childcare prices (sticky and unchanged 2020–2023) and coffee prices (rising from JPY 100 to JPY 110) provide direct examples that students can reference.

Question 2(a)(vii) - Strategy to Maximise Combined Profits (Game Theory) [1 mark]

Command term: Identify - locate and name relevant information.

What the question asked: Using Table 4 (payoff matrix), identify a strategy for each bank that would maximise their combined total profits. Assume the banks collude.

The payoff matrix:

Both raise interest rate: Bank A = JPY 3m, Bank B = JPY 3m → Total = JPY 6m

A raises, B lowers: Bank A = JPY 2m, Bank B = JPY 3.2m → Total = JPY 5.2m

A lowers, B raises: Bank A = JPY 3.2m, Bank B = JPY 2m → Total = JPY 5.2m

Both lower interest rate: Bank A = JPY 2.5m, Bank B = JPY 2.5m → Total = JPY 5m

Answer: Both Bank A and Bank B should raise the interest rate. This produces a combined profit of JPY 6 million, which is higher than any other combination.

Mark scheme: "Each bank should raise the interest rate" earns [1]. No working required.

Lawrence's notes: This is the typical prisoner's dilemma setup. The joint-profit-maximising outcome requires collusion - both banks agree to raise rates and maintain the agreement. However, as shown in the next question, each bank has an individual incentive to defect from this agreement, which is why cartels in oligopolistic markets are inherently unstable. In Japan, this context is realistic: Japanese banking was historically characterised by close relationships between banks and corporate clients (keiretsu structure), which created implicit coordination and implicit price leadership arrangements.

Question 2(a)(viii) - Show Bank A Has an Incentive to Cheat [2 marks]

Command term: Show - demonstrate using profit figures from the payoff matrix.

What the question asked: Using profit figures from Table 4, show that Bank A has an incentive to cheat by not following the collusive agreement.

Worked answer:

Under the collusive agreement, both banks raise interest rates. Bank A earns JPY 3 million.

If Bank A cheats (lowers its interest rate while Bank B sticks to the agreement and raises), Bank A earns JPY 3.2 million.

JPY 3.2 million > JPY 3 million - Bank A gains JPY 0.2 million by cheating.

Therefore Bank A has a financial incentive to cheat on the agreement.

Mark scheme notes: [1] for identifying that Bank A would lower its interest rate. [2] for identifying the strategy AND citing both profit figures: JPY 3.2 million (if cheating) is greater than JPY 3 million (if cooperating).

Common errors: Identifying the cheating strategy without citing both figures. Identifying the wrong strategy (saying Bank A should raise rates). Comparing the wrong cells (e.g., comparing Bank A's JPY 3m with the joint profit of JPY 6m rather than with Bank A's own gain from cheating).

Lawrence's notes: The word "show" means the answer must include numbers - stating that "Bank A has an incentive to cheat because it can earn more" without citing JPY 3.2m and JPY 3m earns only [1]. This is the classic prisoners' dilemma result: the dominant strategy for each player individually (lower rates) is different from the jointly optimal strategy (raise rates), which is why collusion is inherently unstable unless enforced by contract or repeated interaction.

Question 2(a)(ix) - Calculate the Real Interest Rate [1 mark]

Command term: Calculate - apply the Fisher equation.

Formula: Real interest rate = Nominal interest rate − Inflation rate

Worked answer:

Real interest rate = 0.8% − 1.0% = −0.2%

Mark scheme: An answer of −0.2% or −0.2 without working earns [1].

Lawrence's notes: A negative real interest rate means that savers in Bank A are losing purchasing power - the inflation rate is eroding the value of their savings faster than the nominal interest rate is growing them. This is economically significant in the Japan context: for decades, Japan's near-zero nominal rates combined with deflation meant positive real rates, discouraging borrowing and investment. As Japan slowly achieves its 2% target, real rates will become more negative, incentivising borrowing and spending. This directly supports the Bank of Japan's argument for why moderate inflation is desirable.

Question 2(a)(x) - Explain the Money Creation Process [4 marks]

Command term: Explain - give a clear account of how the money creation process works, showing cause and effect.

What the question asked: Explain the money creation process by which a customer's cash deposit of JPY 10,000 in Bank A eventually results in a much greater increase in Japan's money supply. The minimum reserve requirement is 0.8%.

Mark scheme levels:

Level 1 [1–2 marks]:

[1] A cash deposit of JPY 10,000 increases the reserves of Bank A by JPY 10,000, a portion of which (0.8%) must be retained as required reserves.

[1] The remainder (JPY 9,920) can be lent to other customers.

Level 2 [3–4 marks] - all four of the following:

[1] A cash deposit of JPY 10,000 increases Bank A's reserves by JPY 10,000; 0.8% (JPY 80) must be retained.

[1] The remainder (JPY 9,920) is lent to other customers.

[1] These loans, through consumer spending or investment, are deposited in another bank.

[1] The process repeats - each new deposit generates new loans - leading to a much greater increase in total money supply.

Alternative full credit approach - use the money multiplier formula:

The money multiplier = 1 ÷ reserve requirement ratio = 1 ÷ 0.008 = 125

Maximum increase in money supply = 125 × JPY 10,000 = JPY 1,250,000

Or: excess reserves loaned out = JPY 9,920, so maximum = (1/0.008) × 9,920 = JPY 1,240,000

A brief process explanation plus this calculation earns [4].

Key numbers for context:

Required reserve = 0.8% × JPY 10,000 = JPY 80

Excess reserves (available to lend) = JPY 10,000 − JPY 80 = JPY 9,920

Money multiplier = 1/0.008 = 125

Maximum theoretical increase = JPY 10,000 × 125 = JPY 1,250,000

Common errors: Using the wrong reserve ratio (confusing 0.8% with 8%, which gives a multiplier of 12.5 rather than 125). Describing the process as if the entire deposit is lent out (ignoring the required reserve). Stopping after one round of lending rather than explaining the reiterative nature of the process. Stating the multiplier formula without explaining the process.

Lawrence's notes: The 0.8% reserve requirement is deliberately very low - this is Japan, where the Bank of Japan has maintained extraordinarily loose monetary conditions, including near-zero interest rates and quantitative easing, for decades. A 0.8% reserve requirement produces a very high money multiplier (125), meaning a small deposit theoretically generates a large increase in the money supply. In practice, the actual increase will be much smaller because: (a) banks hold excess reserves voluntarily; (b) not all loans return to the banking system as deposits; (c) some cash is held outside the banking system. A strong answer acknowledges this distinction between the theoretical maximum (JPY 1,250,000) and the likely real-world outcome.

Question 2(b) - Recommend a Policy to Increase Japan's Inflation to 2% [10 marks]

Command term: Recommend - present an advisable course of action with appropriate supporting evidence and reasoning in relation to a given situation, problem, or issue.

The problem: Japan has experienced deflation or near-zero inflation for most of the period since 1993. The Bank of Japan has set a 2% inflation target. Expansionary fiscal policy has been tried but has not delivered significant price rises due to weak business and consumer confidence. Most recent price rises have come from yen depreciation rather than domestic demand growth. The calculated inflation rate for 2023 (from the Tokyo CPI data) is approximately 1.03% - below the 2% target. The natural rate of unemployment is 3%, largely structural.

Possible policies (any one well-argued is sufficient):

Expansionary monetary policy (lower interest rates, quantitative easing, forward guidance) | Expansionary fiscal policy (government spending, tax cuts, transfer payments) | Exchange rate policy (deliberately weakening the yen to generate imported inflation) | Policies to improve business and consumer confidence | Any other available IB Economics policy you are able to support.

Mark band analysis: (Same five-band rubric as Question 1(b) above)

Worked example - expansionary monetary policy (quantitative easing):

The most appropriate policy to increase Japan's inflation to 2% is an expansion of quantitative easing (QE) by the Bank of Japan, potentially combined with forward guidance that commits to maintaining low rates until the 2% target is sustainably achieved.

Japan's inflation problem is fundamentally one of weak aggregate demand. As the text states, expansionary fiscal policy has already been attempted but has not delivered significant price increases due to weak confidence - both businesses and consumers are reluctant to spend and invest because they expect prices to remain flat or fall. This is a typical deflationary trap: when people expect deflation, they delay spending (why buy today what will be cheaper tomorrow?), which further depresses demand, which reinforces deflation. Monetary policy that credibly commits to reflation - and backs that commitment with large-scale asset purchases - can break this cycle by shifting inflation expectations.

QE works as follows: the Bank of Japan purchases government bonds and other financial assets from commercial banks. This increases the reserves held by commercial banks (consistent with the money creation process described in part (a)(x)), reduces long-term interest rates, and injects liquidity into the financial system. With lower borrowing costs, firms are more likely to invest and households more likely to consume - increasing aggregate demand and pulling the price level upwards. The money multiplier effect means that a given injection of central bank reserves generates a much larger expansion of broad money supply (as shown: a JPY 10,000 deposit with a 0.8% reserve requirement generates up to JPY 1,250,000 in new money).

The data supports the case for continued monetary stimulus. The real interest rate is currently −0.2% (nominal 0.8% - inflation 1.0%), which is already slightly stimulative. However, the 2023 CPI of 100.24 represents only a 1.03% rise over 2022, still short of the 2% target. More aggressive QE - increasing the size of asset purchases and broadening the types of assets purchased - would push real rates negatively further and increase inflationary pressure.

The most significant limitation is weak transmission. The text explicitly notes that expansionary fiscal policy has not produced significant price rises due to lack of confidence - and the same transmission problem affects monetary policy. If banks do not lend out their excess reserves, or if households and firms save rather than spend the additional liquidity, QE adds to bank reserves without stimulating aggregate demand. Japan has experienced this "pushing on a string" dynamic before. Additionally, there is a risk that inflation overshoots 2% if confidence recovers sharply, requiring the Bank of Japan to tighten quickly - and Japanese bond markets are highly sensitive to changes in the Bank's direction after decades of near-zero rates.

A complementary approach would be to combine QE with fiscal stimulus targeted at low-income households, who have a higher marginal propensity to consume. This addresses the confidence problem directly by increasing disposable income for the households most likely to spend it immediately. The text confirms that fiscal policy alone has been insufficient, but a coordinated monetary-fiscal combination may overcome the confidence barrier that has prevented Japan from reaching its inflation target.

Worked example - exchange rate depreciation policy:

An alternative policy is deliberate yen depreciation. The text notes that most recent price rises in Japan have resulted from a depreciated yen - this is the policy mechanism that has actually delivered inflation in recent years. The Bank of Japan can engineer yen depreciation by expanding the money supply (through QE) or through foreign exchange market intervention (selling yen to purchase foreign currencies). A weaker yen raises the cost of imports, creating cost-push inflationary pressure, and makes Japanese exports more price competitive, boosting export demand and aggregate demand simultaneously.

The limitation of this approach is its dependence on external conditions - trading partner exchange rates, import price sensitivity, and the risk of currency war retaliation from other countries. It is also primarily a cost-push mechanism, which may be less sustainable than demand-pull inflation in reaching a stable 2% target.

Quick Reference: What Came Up in IB Economics Paper 3 May 2025

Question 1 (USA fitness industry): Consumer surplus calculation from supply and demand diagram | Market failure as positive externality - diagram (MPB < MSB) and explanation | Bounded self-control definition (behavioural economics) | Natural monopoly AC curve sketch | Marginal revenue calculation from data table | Profit increase calculation from data table | Average cost calculation with new data | Two alternative business objectives | 10-mark recommend: policy to increase exercise in the USA

Question 2 (Japan and deflation): Phillips curve relationship from scatter diagram | LRPC drawn at natural rate of unemployment (3%) | CPI basket cost calculation for 2023 | CPI index number calculation | Rate of inflation from CPI | Two limitations of CPI | Game theory - joint profit-maximising strategy from payoff matrix | Bank A's incentive to cheat (prisoner's dilemma) | Real interest rate calculation | Money creation process with 0.8% reserve requirement | 10-mark recommend: policy to increase Japan's inflation to 2%

Key syllabus areas: Consumer and producer surplus | Positive externalities of consumption / merit goods | Behavioural economics (bounded self-control) | Natural monopoly | Monopoly revenue and cost data | Business objectives beyond profit maximisation | Phillips curve (short run and long run) | CPI construction and limitations | Oligopoly and game theory | Real versus nominal interest rates | Money creation and the money multiplier

Calculations tested: Consumer surplus triangle (½ × Q × ΔP) | Marginal revenue (ΔTR ÷ ΔQ) | Total revenue and profit | Average cost (TC ÷ Q) | CPI basket total | CPI index (basket year ÷ base year × 100) | Rate of inflation from CPI ((CPI₁ − CPI₀) ÷ CPI₀ × 100) | Real interest rate (nominal − inflation) | Money multiplier (1 ÷ reserve requirement ratio)

Frequently Asked Questions: IB Economics Paper 3 May 2025

What topics came up in IB Economics HL Paper 3 May 2025?

IB Economics HL Paper 3 May 2025 covered two compulsory questions. Question 1 used the US fitness industry as context and tested consumer surplus calculation, positive externality/merit good market failure with a diagram, bounded self-control from behavioural economics, natural monopoly average cost curves, marginal revenue and profit calculations from a data table, average cost calculation, two alternative business objectives, and a 10-mark policy recommendation to increase physical activity. Question 2 used Japan's deflation as context and tested the short-run Phillips curve relationship, drawing the long-run Phillips curve, constructing and using a CPI to calculate inflation, limitations of the CPI as a price index, game theory and the prisoner's dilemma in an oligopoly payoff matrix, the real interest rate, money creation and the money multiplier, and a 10-mark policy recommendation to increase Japan's inflation to its 2% target.

How do you calculate consumer surplus in IB Economics Paper 3?

Consumer surplus is calculated as the area of the triangle above the equilibrium price and below the demand curve. The formula is ½ × equilibrium quantity × (y-axis intercept of demand curve − equilibrium price). In the May 2025 Paper 3, the original consumer surplus was ½ × 100 × 40 = $2,000 million, and the new consumer surplus after the demand shift was ½ × 150 × 60 = $4,500 million, giving a change of +$2,500 million. Always show working and include units - an unsupported correct answer earns only one of the two available marks.

How do you calculate marginal revenue in IB Economics Paper 3?

Marginal revenue is calculated as the change in total revenue divided by the change in quantity: MR = ΔTR ÷ ΔQ. Total revenue equals price multiplied by quantity. In the May 2025 Paper 3, TR at 300 members was $100 × 300 = $30,000, and TR at 400 members was $90 × 400 = $36,000. ΔTR = $6,000, ΔQ = 100, so MR = $60 per member. Note that MR ($60) is below the price at 400 members ($90) - this is a key feature of a price-maker facing a downward-sloping demand curve.

How is the CPI calculated in IB Economics?

The consumer price index is calculated by: (1) fixing the base year basket of goods and their quantities; (2) calculating the total cost of that basket in the current year using current prices; (3) expressing that cost as a ratio to the base year cost, multiplied by 100. The formula is: CPI = (cost of basket in current year ÷ cost of basket in base year) × 100. The inflation rate is then calculated as: ((CPI current year − CPI previous year) ÷ CPI previous year) × 100. In the May 2025 Paper 3, the 2023 Tokyo CPI was 100.24, giving an inflation rate of 1.03% relative to 2022.

What is the money multiplier and how is it used in IB Economics Paper 3?

The money multiplier is equal to 1 divided by the minimum reserve requirement ratio. It represents the maximum amount by which an initial bank deposit can expand the total money supply through the fractional reserve banking process. In the May 2025 Paper 3, the reserve requirement was 0.8% (0.008), giving a multiplier of 1 ÷ 0.008 = 125. A JPY 10,000 deposit could therefore theoretically expand the money supply by up to JPY 1,250,000. In practice, the actual increase is lower because banks hold excess reserves and not all loans return to the banking system as new deposits.

What is the difference between the short-run and long-run Phillips curve?

The short-run Phillips curve (SRPC) shows a negative (inverse) relationship between the unemployment rate and the inflation rate - as unemployment falls, inflation tends to rise. This is because a tighter labour market pushes up wages and costs. The long-run Phillips curve (LRPC) is a vertical line at the natural rate of unemployment, reflecting the monetarist/new classical view that there is no permanent trade-off between unemployment and inflation in the long run. In Japan's case, the LRPC is drawn at 3%, where the natural rate of unemployment is dominated by structural unemployment arising from the economy's shift from manufacturing to services.

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