AQA A Level Economics: Individuals, Firms, Markets and Market Failure — Practice Questions

These are original questions written for Marlbridge, in the style and at the standard of the examination. They are not reproduced past-paper questions — examination boards hold copyright in their own papers. Use these alongside the official past papers available free from your board.

Related: Individuals, Firms, Markets and Market Failure revision notes

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Section A

1. Explain the law of diminishing returns and state the condition necessary for it to apply. [3]

2. Distinguish between economies and diseconomies of scale, giving one example of each. [4]

Section B

3. Explain the relationship between marginal cost and average cost, and why MC cuts AC at its minimum. [4]

4. Compare perfect competition and monopoly in terms of price, output, efficiency and long-run profit. [10]

5. Explain three characteristics of an oligopoly and explain why firms in an oligopoly may avoid price competition. [8]

6. Evaluate the view that monopolies are always against the consumer interest. [12]

Section C

7. Explain what is meant by “bounded rationality” in behavioural economics, and explain how this challenges the traditional assumption of a rational consumer. [4]

8. Explain what is meant by a “nudge”, giving an example, and explain one advantage of nudges over taxation as a policy tool. [4]

9. Explain what is meant by monopsony power in a labour market, and explain why a minimum wage can raise both wages and employment in a monopsonistic labour market. [6]

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Answers

1. As successive units of a variable factor are added to a fixed factor, the marginal product of the variable factor eventually falls [1] [1]. It applies only in the short run, when at least one factor of production is fixed [1].

2. Economies of scale are falling long-run average costs as output rises, e.g. bulk buying giving discounts on raw materials [1] [1]. Diseconomies of scale are rising long-run average costs as output rises, e.g. communication and coordination problems in a very large organisation slowing decisions and causing errors [1] [1].

3. When MC is below AC, AC is falling, because each additional unit costs less than the current average and pulls it down [1] [1]. When MC is above AC, AC is rising [1]. It follows that MC must cut AC at its minimum point, where AC is momentarily neither rising nor falling [1].

4. Price and output: in perfect competition the firm is a price taker and price equals marginal cost; in monopoly the firm is a price maker and sets a higher price and lower output [1] [1]. Allocative efficiency: perfect competition achieves P = MC, so it is allocatively efficient; monopoly sets P > MC, so it is allocatively inefficient and creates a deadweight welfare loss [1] [1]. Productive efficiency: perfect competition produces at the minimum of AC in the long run; monopoly need not, so may be productively inefficient — X-inefficiency may also arise from the absence of competitive pressure [1] [1]. Long-run profit: in perfect competition freedom of entry competes supernormal profit away, so only normal profit is earned in the long run [1] [1]; in monopoly barriers to entry allow supernormal profit to persist indefinitely [1] [1].

5. Any three characteristics, 2 marks each: the market is dominated by a few large firms with a high concentration ratio [1] [1]; there are significant barriers to entry [1] [1]; firms are interdependent — each must consider rivals’ likely reactions before acting [1] [1]; products are often differentiated through branding [1] [1]. Firms avoid price competition because a price cut is likely to be matched by rivals, so the firm gains little market share but all firms earn less revenue — the kinked demand curve suggests demand is elastic above the current price and inelastic below it [1]. A price war can be mutually destructive [1], so firms compete instead through advertising, branding, loyalty schemes and product innovation, where the gains are harder for rivals to copy immediately [1].

6. Arguments that monopoly harms consumers: it restricts output and charges a price above marginal cost, reducing consumer surplus and creating a deadweight welfare loss [1] [1]; the absence of competitive pressure permits X-inefficiency, with costs higher than necessary [1]; monopolies may offer less choice and lower quality, and may use their power to exclude potential entrants [1]. Arguments that monopoly may benefit consumers: economies of scale may make average costs so much lower that the monopoly price is below the competitive industry price [1]; supernormal profit funds research and development, which competitive firms earning only normal profit cannot afford — dynamic efficiency may outweigh static inefficiency [1] [1]; a natural monopoly avoids the wasteful duplication of infrastructure such as rail track or water pipes [1]; the prospect of monopoly profit is what incentivises innovation in the first place, which patents deliberately protect [1]. Judgement: it depends on whether the monopoly is contestable, whether it is regulated, and whether it reinvests its profit [1] [1]. A regulated natural monopoly delivering economies of scale and investment can serve consumers well; an unregulated monopoly protected by artificial barriers and content to take profit is likely to harm them [1] [1].

7. Bounded rationality is the idea that consumers have limited information, limited time and limited cognitive ability to process choices, so they cannot make a fully optimal decision as traditional theory assumes [1] [1]. This challenges the traditional assumption because it implies consumers instead rely on rules of thumb (heuristics) and are influenced by how choices are framed, rather than rationally weighing every option to maximise utility [1] [1].

8. A nudge is a change to the way choices are presented — such as an altered default option — that encourages a particular decision without restricting choice or changing the financial incentive [1] [1], e.g. automatically enrolling employees into a pension scheme, which they can opt out of but usually do not [1]. Advantage: a nudge can change behaviour more cheaply than a tax or ban, since it requires no enforcement and does not reduce consumer welfare through a price rise — it only requires redesigning the choice architecture [1].

9. Monopsony is where there is a single, or dominant, buyer of labour in a market, giving that employer the power to restrict employment and pay a wage below the competitive-market wage [1] [1]. Introducing a minimum wage, set above the monopsony wage but at or below the competitive wage, removes the monopsonist’s incentive to restrict employment in order to keep wages low [1] [1]; because the firm must now pay the same wage to every worker regardless of how many it employs, hiring an additional worker no longer forces up the wage paid to all existing staff, so the firm actually expands employment towards the competitive level as the wage rises [1] [1] — the opposite of the standard competitive-market prediction that a minimum wage set above equilibrium always causes unemployment.

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Where marks are usually lost

• Saying diminishing returns applies in the long run.
• Confusing economies of scale with falling average costs from higher output in the short run.
• Describing monopoly without the deadweight loss.
• Not considering dynamic efficiency in the evaluation.