Flashcards · 9640 · A Level Topic 3

The economics of business behaviour and the distribution of income (A Level) flashcards

48 cards on A Level Topic 3, subtopics 3.3.1 to 3.3.5. Pick a subtopic or study them all.

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3.3.1 The objectives of individuals and firms

Marginal utility and the hypothesis of diminishing marginal utility: Marginal utility: the satisfaction from consuming one additional unit (the change in total utility). Diminishing marginal utility: the more consumed in a period, the less satisfaction each extra unit brings. It supports a downward-sloping demand curve.
Bounded rationality versus bounded self-control: Bounded rationality: limited information, time and ability to process it, so choices fall short of fully rational. Bounded self-control: knowing the best action but failing to carry it out, often by overweighting the present.
Behavioural biases: anchoring, inertia, rules of thumb and social norms: Anchoring: over-relying on a first number seen (a high "was" price). Inertia: staying with the current option. Rules of thumb: simple shortcuts. Social norms: unwritten rules followed because others do.
Nudge, with an example: A way of steering choices without banning options or greatly changing prices. Example: making a scheme opt-out (default enrolment) so inertia keeps people in. Limits: effects may fade, vary between people and be too weak for large externalities.
The profit-maximising rule, and the short-run and long-run shutdown rules: Profit maximisation: produce where MR = MC (MC cutting MR from below). Short run: produce if price covers average variable cost. Long run: produce only if price covers average total cost, including normal profit.
Sales revenue maximisation and satisficing: Revenue maximisation: produce where MR = 0 (PED = 1 in size), giving more output, a lower price and lower profit than the profit maximum. Satisficing: aiming for a satisfactory outcome, such as a minimum profit, rather than the maximum.
Divorce of ownership from control and the principal-agent problem: Shareholders (principals) own the firm but managers (agents) run it. Managers may pursue sales, growth or status instead of profit, helped by asymmetric information. Remedies: profit-related pay, share options, audits, independent directors, the takeover threat.
Horizontal, vertical and conglomerate integration: Horizontal: same industry, same stage (scale, market power). Vertical: different stages of one supply chain; backward buys a supplier, forward buys a distributor. Conglomerate: unrelated industries (spreads risk, few synergies).
Organic versus external growth of firms: Organic (internal): growth using the firm's own resources (new products, sites); slower, lower risk, control kept. External: merger or takeover; faster, but higher risk (culture clash, debt, paying too much).

3.3.2 Costs, revenue and profits

Law of diminishing returns versus returns to scale: Diminishing returns (short run): with one input fixed, extra units of a variable input eventually add less and less to output. Returns to scale (long run): how output responds when all inputs are scaled together (increasing, constant or decreasing).
Marginal and average product: workers 3 and 4 raise total output from 27 to 33: MP of the 4th worker = 33 − 27 = 6. AP at 4 workers = 33 ÷ 4 = 8.25, down from 9.0 at 3 workers, because the new worker's MP is below the average.
Why does the short-run MC curve fall and then rise?: MC falls while marginal product rises, then rises when diminishing returns set in: the same wage buys less extra output.
Marginal-average rule for cost curves: MC cuts AVC and ATC at their lowest points. A marginal value below an average pulls it down; above it pulls it up.
What does a rise in fixed cost do to TC, ATC, AVC and MC?: TC rises by the amount of the rise and ATC by that amount divided by output. MC and AVC are unchanged.
L-shaped LRAC curve: LRAC falls steeply at first and then flattens: a firm can often copy a plant it already runs well, so average cost need not rise at large outputs. A U-shape is the alternative if diseconomies of scale appear.
Marginal revenue for a linear demand curve P = a − bQ, and why MR is below AR: MR = a − 2bQ: it starts at the same price intercept and is twice as steep. MR is below AR because selling an extra unit means cutting the price on units already sold. For a price taker, AR = MR = price.
MR, TR and price elasticity of demand: MR positive: demand elastic; a price cut raises TR. MR zero: unit elastic; TR at its maximum. MR negative: demand inelastic; a price cut lowers TR.
Normal versus supernormal profit, with an example: revenue 95,000, explicit costs 71,000, owner's best alternative earnings 18,000: Normal profit: the least reward that keeps the owner in this use; counted as a cost. Supernormal profit is anything above it. Accounting profit = 24,000; supernormal profit = 24,000 − 18,000 = 6,000.
Invention, innovation and creative destruction: Invention: creating a new idea, product or process. Innovation: bringing it to market for the first time. Creative destruction: new products and methods replace old ones, destroying old firms and markets.

3.3.3 Perfect competition, imperfectly competitive markets and monopoly

Perfect competition: the firm's demand curve and the long-run outcome: The firm is a price taker: demand is horizontal at the market price, so AR = MR = P. Output is where MC = P. In the long run entry and exit leave price at minimum AC: normal profit, P = MC (allocative) and minimum AC (productive efficiency).
Monopolistic competition: long-run equilibrium in words: Many firms, differentiated products, low barriers. Supernormal profit attracts entry, which shifts each firm's demand left and makes it more elastic until AR is tangent to AC, to the left of minimum AC. Normal profit, excess capacity, and price above MC.
Oligopoly: key features: A few large sellers supply most output, with barriers to entry and interdependence: each firm's outcome depends on rivals' reactions, which creates uncertainty. Firms may compete, collude, or prefer non-price competition.
The kinked demand curve: why prices may be stable: If a firm raises price, rivals do not follow, so demand above the kink is elastic. If it cuts price, rivals copy, so demand below is inelastic. MR has a vertical gap at the kink, so MC can change within it without changing price. Limit: it does not explain how the kink price was set.
Overt versus tacit collusion; limit versus predatory pricing: Overt: an open or formal agreement (a cartel). Tacit: coordination without an agreement, such as price leadership. Limit pricing: price set low enough to make entry unprofitable, but above cost. Predatory pricing: price below cost to drive out a rival.
Monopoly equilibrium: P = 130 − 5Q and MC = AC = 30: MR = 130 − 10Q = 30, so Q = 10. P = 130 − 50 = 80. Profit = (80 − 30) × 10 = 500. (Competition would give P = 30 and Q = 20.)
Natural monopoly: A market where LRAC is still falling when output reaches market demand, because fixed costs are very large, so one firm can supply at the lowest cost. Pricing at MC leaves a loss; an unregulated firm charges well above cost.
Third-degree price discrimination: the conditions and who pays more: Conditions: market power, separable groups, no resale (arbitrage), different price elasticities. The firm sets MR = MC in each segment, so the less elastic group pays the higher price.
Contestable market: A market where entry and exit are cheap enough, with low sunk costs, that the threat of hit-and-run entry is credible. Even a single incumbent must keep price near AC and earn only normal profit. Contestability depends on potential entry, not the number of firms.
Static, dynamic and X-efficiency: Static efficiency: at a point in time (productive: minimum ATC; allocative: P = MC). Dynamic efficiency: over time, through R&D, investment and new technology. X-inefficiency: actual cost above the lowest possible cost.
Consumer surplus, producer surplus and deadweight loss: Consumer surplus: willingness to pay minus price paid (area between demand and price). Producer surplus: price received minus the minimum supply price (area between price and supply). Deadweight loss: surplus lost to everyone, for example under monopoly.
Price cap regulation (inflation − X): example with price 80, inflation 4.0% and X = 1.5: Allowed price change = 4.0 − 1.5 = 2.5%. New price = 80 × 1.025 = 82.00. The firm can raise profit only by cutting costs. Risk: if X is too tight, quality or investment may fall.
Regulatory capture: A regulator ends up serving the industry it oversees rather than the public, through dependence on the firm's information, lobbying and staff moving between regulator and firm. Result: lenient caps and protected incumbents.
Privatisation: possible benefits and the key condition: Benefits: a profit incentive to cut costs, access to private capital, sale revenue, possible competition. Whether it works depends mainly on whether competition or effective regulation follows; otherwise a state monopoly becomes a private monopoly.

3.3.4 The labour market

Marginal revenue product (MRP) and the hiring rule: MRP = MPP × MR (MPP × price for a price taker): the revenue added by one more worker. A profit-maximising firm employs workers while MRP is at least the extra cost of the worker. The MRP curve is the firm's demand curve for labour.
Why is the demand for labour a derived demand, and what shifts it?: Labour is wanted for what it produces. Higher demand for the product raises MR and MRP, so labour demand shifts right. Higher productivity and cheaper complements shift it right; cheaper substitutes such as machines shift it left. A wage change is a movement along it.
Determinants of the elasticity of demand for labour (more elastic if…): Labour is a large share of total costs; substitutes (capital or other workers) are easy to find; demand for the product is price elastic; more time has passed since the wage change.
What influences the supply of labour to an occupation?: Monetary rewards (wage, overtime, bonuses, pension) and non-monetary ones (hours, conditions, security, status, satisfaction, training, promotion). Higher pay in a rival occupation shifts supply left; better conditions shift it right.
Monopsony: wage and employment compared with a competitive labour market: A single (dominant) buyer of labour faces the upward-sloping supply curve, so MCL lies above ACL. It hires where MCL = MRP and pays the wage on the supply curve below that point. Employment and the wage are both lower than in a competitive market, and the wage is below MRP.
Effect of a trade union raising the wage: competitive market versus monopsony: Competitive market: a higher wage, fewer jobs and excess supply of labour (unemployment). Monopsony: a higher wage and, within a range, more jobs, because the union removes the employer's reason to restrict hiring.
National minimum wage in a competitive labour market: D = 900 − 30w, S = 40w + 200, floor of 12: Equilibrium: 700 = 70w, so w = 10 and employment 600. At 12: demand 540, supply 680, so unemployment is 140. In a monopsony a floor can instead raise employment.
Conditions for wage discrimination to persist: The employer has some power over wages; groups can be identified and separated; groups differ in the elasticity of labour supply to the firm (the less elastic group is paid less); workers have poor information or cannot move. Only the unexplained part of a pay gap points to discrimination.

3.3.5 Poverty and inequality

Income versus wealth: Income: a flow of earnings and receipts over a period. Wealth: a stock of assets owned minus debts at a point in time. Wealth is usually more unequal than income, and the two feed each other.
Lorenz curve and Gini coefficient: Lorenz curve: cumulative share of income (vertical) against cumulative share of households from the poorest (horizontal); the further it bows from the 45° line of equality, the more unequal. Gini = area between the line of equality and the Lorenz curve ÷ the whole area under the line of equality: 0 equality, 1 maximum inequality.
Absolute versus relative poverty: Absolute: income below the cost of a fixed basket of basic necessities. Relative: income below a share of typical income, often 60% of the median.
Causes of inequality in the distribution of income: Differences in skills, qualifications and productivity; market power and unions; discrimination; unemployment and part-time work; ownership of capital (rent, interest, dividends); household structure; taxes and benefits; technology and globalisation.
Poverty trap, with an example: benefit withdrawn at 50p per 1 earned and income tax at 20%: Extra earnings are mostly lost through withdrawn benefits and tax, so the incentive to work more is weak. Combined marginal rate = 70%: extra earnings of 200 leave 200 − 40 − 100 = 60.
Means-tested versus universal benefits: Means-tested: paid only below an income or asset test; targets the poorest at lower cost but risks a poverty trap, stigma and low take-up. Universal: paid to all in a category; simple and no stigma, but costly and some help goes to the non-poor.
Evaluation: costs and benefits of a more equal distribution of income: Benefits: less poverty, social cohesion, wider access to education and health, and extra total satisfaction if an extra unit of income matters more to the poor. Costs: higher taxes can blunt incentives and encourage avoidance and emigration. How much equality is fair is a value judgement.