Flashcards · 9708 · A Level Topic 7

The price system and the microeconomy (A Level) flashcards

49 cards on A Level Topic 7, subtopics 7.1 to 7.8. Pick a subtopic or study them all.

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7.1 Utility

Total utility, marginal utility and diminishing marginal utility: Total utility: satisfaction from all units consumed in a period. Marginal utility: extra satisfaction from one more unit (change in TU ÷ change in quantity). Diminishing marginal utility: MU falls as more units are consumed in a given time.
TU after each unit is 10, 18, 24, 28, 30, 30. Find MU and say when TU peaks.: MU = 10, 8, 6, 4, 2, 0. TU rises while MU is positive and peaks when MU = 0 (the sixth unit). TU can be rising while MU is falling.
The equi-marginal principle: Utility is maximised when MU of A ÷ price of A = MU of B ÷ price of B, with all income spent. Example: MU of A 18 at price 3 gives 6; MU of B 20 at price 5 gives 4, so buy more A and less B until the ratios are equal.
How does marginal utility theory explain a downward-sloping demand curve?: Assume each unit of money has a constant MU. A unit is bought while its MU is at least that value × price. Because MU diminishes, a lower price is needed to make each extra unit worth buying, so quantity demanded rises as price falls.
Limitations of marginal utility theory: It assumes utility can be measured in numbers and that money has a constant MU, and that consumers are rational. Habit, advertising and limited information mean real consumers may not equalise MU per unit of money; it is a benchmark rather than a description.

7.2 Indifference curves and budget lines

Indifference curve, budget line and marginal rate of substitution: Indifference curve: all combinations of two goods giving equal satisfaction. Budget line: all combinations affordable at given income and prices. MRS: the amount of one good given up for one more unit of the other, keeping satisfaction constant.
Income 200, price of X 10, price of Y 25. Give the budget line intercepts and slope, and what happens if the price of Y falls to 20.: Intercepts: 200 ÷ 10 = 20 X and 200 ÷ 25 = 8 Y. Slope (absolute) = 10 ÷ 25 = 0.4. If Y falls to 20, the line pivots on the X intercept (still 20) and the Y intercept becomes 10.
Consumer's optimum in indifference curve analysis: Where the budget line just touches the highest affordable indifference curve, so MRS = price of X ÷ price of Y.
Substitution effect, income effect and price effect: Substitution effect: the change in quantity from the change in relative price, with real income held constant. Income effect: the change from the change in real income caused by the price change. Price effect = substitution effect + income effect.
Normal, inferior and Giffen goods: income and substitution effects of a price fall: Normal: both raise quantity; demand slopes down. Inferior: substitution raises quantity, a smaller income effect lowers it; demand still slopes down. Giffen: the negative income effect outweighs the substitution effect; demand slopes up. Every Giffen good is inferior.
Budget line: parallel shift versus pivot: A change in income, or both prices changing in the same proportion, gives a parallel shift. A change in one price pivots the line on the intercept of the good whose price did not change.

7.3 Efficiency and market failure

Productive efficiency and allocative efficiency: Productive: producing at the lowest cost per unit; for a firm, output at minimum AC, where MC = AC; for the economy, on the PPC. Allocative: resources go to the goods consumers value most; P = MC (MSB = MSC with externalities).
Pareto optimality and a Pareto improvement: Pareto optimality: no one can be made better off without making someone else worse off. Pareto improvement: at least one person gains and nobody loses. Many Pareto optimal points exist, some very unequal, so it says nothing about fairness.
Dynamic efficiency: Efficiency improving over time through investment and innovation. Market power can cause static inefficiency yet fund research that lowers costs later; it depends on how profit is used and on the threat of entry.
A firm has TC = 100 + Q². Find its productively efficient output.: AC = 100/Q + Q and MC = 2Q. Productive efficiency is at minimum AC, where MC = AC: 2Q = 100/Q + Q, so Q² = 100 and Q = 10, with AC = MC = 20.
Complete versus partial market failure, and the main reasons for market failure: Complete: no market exists (public goods). Partial: a market exists with the wrong price or quantity. Reasons: externalities, public goods, merit and demerit goods, asymmetric information, market power, immobile factors and unequal incomes.

7.4 Private costs and benefits, externalities and social costs and benefits

Marginal social cost and marginal social benefit: MSC = MPC + MEC. MSB = MPB + MEB. The free market produces where MPB = MPC; the social optimum is where MSB = MSC.
The four types of externality and the market outcome: Negative production: MSC above MPC, over-production. Positive production: MSC below MPC, under-production. Negative consumption: MSB below MPB, over-consumption. Positive consumption: MSB above MPB, under-consumption.
Car trips: MPB = 96 − 4Q, MPC = 12 + 2Q, marginal external cost of consumption = Q. Find the over-consumption and welfare loss.: Market: 96 − 4Q = 12 + 2Q, Q = 14. Optimum: MSB = 96 − 5Q = 12 + 2Q, Q = 12. Over-consumption 2. At Q = 14, MSB = 26 and MC = 40, a gap of 14, so welfare loss = ½ × 14 × 2 = 14.
Deadweight welfare loss from an externality: where is it on the diagram?: The triangle between MSB and MSC, between the market quantity and the social optimum. For a negative externality it lies to the right of the optimum; for a positive externality, to the left.
Asymmetric information and moral hazard: Asymmetric information: one party to a transaction knows more than the other (used goods, financial products). Moral hazard: behaviour changes because someone else bears the cost of risk. Example: insurance raises the claim chance from 4% to 6% on a 5,000 loss, so the expected claim rises from 200 to 300.
How is cost-benefit analysis used for a decision?: List private and external costs and benefits, put money values on each, add up social benefit and social cost, and go ahead if net social benefit (SB − SC) is positive. Then test which values are least certain.

7.5 Types of cost, revenue and profit, short-run and long-run production

Law of diminishing returns: Beyond some point, each extra unit of a variable factor combined with fixed factors adds less output than the one before. It is a short-run law because it needs a fixed factor.
Why does marginal cost fall then rise in the short run, and where does MC cut AVC and ATC?: MC mirrors marginal product: as MP rises (specialisation) MC falls; once diminishing returns set in, MC rises. MC cuts AVC and ATC from below at their minimum points. Fixed costs do not affect MC.
Returns to scale versus diminishing returns: Returns to scale: long run, all inputs change in the same proportion; explains the LRAC shape. Inputs +60% and output +90% means increasing returns. Diminishing returns: short run, at least one factor fixed; explains rising short-run MC.
Minimum efficient scale (MES): The lowest output at which LRAC reaches its minimum. Its size relative to the market limits how many firms can reach it: with MES of 300 and a market of 1,000 units, at most 3 firms can.
Internal versus external economies of scale: Internal: the firm itself grows (technical, purchasing, managerial, financial, marketing, risk-bearing): a movement along the LRAC. External: the industry grows (skilled labour pool, specialist suppliers, shared infrastructure): a downward shift of the LRAC.
Demand is P = 30 − 3Q. Write MR, and say where total revenue is maximised.: TR = 30Q − 3Q², so MR = 30 − 6Q: same intercept, twice the slope. TR is greatest where MR = 0, at Q = 5 (TR = 75), where PED = −1. For a price taker, MR = AR = price.
Normal, supernormal and subnormal profit: Normal profit: the minimum reward needed to keep the entrepreneur in the industry, treated as a cost (TR = TC, AR = ATC). Supernormal: TR > TC (AR > ATC). Subnormal: TR < TC (AR < ATC). Example: (7.40 − 6.85) × 1,200 = 660 supernormal.

7.6 Different market structures

Perfect competition: features, and the long-run adjustment from supernormal profit: Many buyers and sellers, an identical product, free entry and exit, perfect information; firms are price takers. Supernormal profit → entry → industry supply shifts right → price falls → only normal profit remains, with P = MC = minimum ATC.
Natural monopoly: One firm can supply the whole market at a lower average cost than two or more, because LRAC falls over the whole range of market demand. Example: fixed cost 90,000, variable cost 1, demand 30,000: one firm AC = 4, two firms AC = 7.
Concentration ratio: The combined market share of the n largest firms, written CRn. Shares of 30, 20, 15 and 10% give CR4 = 75%. It hides how shares are split, depends on how the market is defined, ignores imports and says nothing about barriers.
Monopoly: demand P = 64 − 2Q and TC = 144 + 4Q + Q². Find the profit-maximising output, price and profit.: MR = 64 − 4Q and MC = 4 + 2Q. MR = MC gives Q = 10, so P = 44. TR = 440, TC = 284, supernormal profit = 156. Price is above MC, so it is allocatively inefficient.
Monopolistic competition in the long run: Entry or exit shifts each firm's demand until AR is tangent to ATC, so profit is normal. But price is above MC and output is below the minimum-ATC level (excess capacity), so it is neither allocatively nor productively efficient; consumers gain variety.
Contestable market: A market where entry and exit are easy enough that the threat of entry disciplines incumbents: low barriers, little sunk cost, hit-and-run entry possible. Even one or two firms may price near average cost and earn normal profit.
Prisoner's Dilemma: two firms each earn 30 if neither advertises, 26 each if both do, and 34 vs 22 if only one does. What happens?: Advertising is a dominant strategy for each (34 > 30 and 26 > 22), so both advertise and earn 26, worse than the 30 each from cooperating. This explains the temptation to collude, and to cheat on any agreement.

7.7 Growth and survival of firms

Why do small firms survive alongside large ones?: Small or local markets, niche or personalised products, owners who want control, scarce finance, and diseconomies of scale that start early. Size follows minimum efficient scale: a small MES relative to the market allows many small firms.
Organic growth versus diversification: Organic (internal) growth: growth from within by selling more, opening outlets or adding capacity. Diversification: moving into new products or markets to spread risk.
Horizontal, backward vertical, forward vertical and conglomerate integration: Horizontal: a firm at the same stage in the same industry. Backward vertical: with a supplier. Forward vertical: with a distributor or retailer. Conglomerate: with a firm in an unrelated industry.
Conditions that make a cartel effective, and why cartels are unstable: Few firms, similar products, high barriers, similar costs, stable demand, easy detection of cheating and weak competition law. Unstable because each member gains by producing above its quota while others stick to theirs: a Prisoner's Dilemma.
Principal-agent problem: Shareholders (principals) want profit and long-term value; managers (agents) may want salary, status, growth or security, and know more about the firm. Solutions: profit-related pay and share options, monitoring, shareholder votes, takeover threat; each has costs.
Why do many mergers fail to deliver the expected gains?: Culture clash and poor communication, expected cost savings that do not appear, paying too high a price, and a combined firm too large to manage (diseconomies of scale).

7.8 Differing objectives and policies of firms

Output rule for profit maximisation, revenue maximisation and sales maximisation: Profit maximisation: MR = MC (MC cutting MR from below). Revenue maximisation: MR = 0, where PED = 1. Sales maximisation: the highest output with AR = AC (no loss), so profit is normal.
P = 100 − 4Q, TC = 200 + 24Q. Compare profit at the profit maximum and the revenue maximum.: Profit maximum: MR = 100 − 8Q = 24, so Q = 9.5, P = 62, profit = 589 − 428 = 161. Revenue maximum: MR = 0, so Q = 12.5, P = 50, profit = 625 − 500 = 125. Revenue maximisation gives up 36 of profit.
First, second and third degree price discrimination: First: each customer pays their own maximum willingness to pay; all consumer surplus is taken. Second: price depends on quantity bought (block tariffs, bulk discounts). Third: different groups with different PED pay different prices (peak and off-peak, student and adult).
The three conditions for price discrimination: The firm has price-setting power; it can separate customers or markets and stop resale; and the groups have different price elasticities of demand. The less elastic group pays the higher price.
Market 1: P = 50 − Q; market 2: P = 30 − Q; MC = 10. Find the third-degree discriminating prices and profit.: Market 1: MR = 50 − 2Q = 10, so Q = 20, P = 30. Market 2: MR = 30 − 2Q = 10, so Q = 10, P = 20. Profit = 20 × 20 + 10 × 10 = 500, against 450 at a single price of 25.
Limit pricing versus predatory pricing: Limit pricing: setting price just below a potential entrant's lowest average cost, so entry is unprofitable; it stays above the incumbent's cost. Predatory pricing: pricing below cost to force a rival out, then raising price; it risks losses and legal challenge.
Kinked demand curve in oligopoly: Above the current price demand is elastic (rivals do not follow a rise); below it, inelastic (rivals follow a cut). Either change lowers revenue, so prices are sticky. MR has a vertical gap at the kink, so MC can shift within it with no change in price or output. Weakness: it does not explain how the price was set.