OCR A Level Economics: Microeconomics — Revision Notes

Condensed for the final weeks. For the full explanation, use the Microeconomics study guide.

Demand, supply and the price mechanism

Demand slopes downward because of the income and substitution effects; supply slopes upward because higher prices make production more profitable and cover rising marginal costs.

Movement along a curve is caused only by a change in the good’s own price. A shift of the curve is caused by anything else — income, tastes, substitutes and complements, or population for demand; costs, technology, taxes, subsidies, or the number of firms for supply. Confusing the two is the single most common error at this level.

The price mechanism performs three functions: it signals where resources are wanted, it incentivises producers to respond, and it rations scarce goods to those willing to pay.

Elasticity

PED = %dQd/%dP    PES = %dQs/%dP    YED = %dQd/%dY    XED = %dQd(A)/%dP(B)

Inelastic demand → a price rise raises revenue. Negative YED identifies an inferior good. Positive XED means substitutes; negative means complements.

Tax incidence follows elasticity: the more inelastic side bears more of the tax. This is the single most useful application, and it explains both why duties on inelastic demerit goods raise large revenue and why they change behaviour so little — the same fact from two ends.

Worked example. A good has PED of −0.4. A firm raises price by 10%. What happens to revenue?

%change in Qd = PED x %change in P = -0.4 x 10 = -4%
price +10%, quantity -4%  ->  revenue changes by roughly +10 - 4 = +6%

Demand is inelastic, so the price rise more than offsets the fall in quantity, and revenue increases.

Costs, revenue and profit

AC = TC/Q     MC = dTC/dQ     AR = price     MR = dTR/dQ
profit maximised where MC = MR

Short run: at least one factor fixed, so the law of diminishing returns eventually raises marginal cost. Long run: all factors variable, so economies and diseconomies of scale shape the average cost curve.

Marginal cost cuts average cost at its minimum — and the reason should be given, not just the fact: while MC is below AC it drags the average down; once above, it pulls it up, so they must cross at the minimum.

Normal profit is the minimum return needed to keep the entrepreneur in the industry and counts as a cost. Supernormal profit is anything above it.

Market structures

Structure	Barriers	Long-run profit	Efficiency
Perfect competition	None	Normal only	Allocative and productive
Monopolistic competition	Low	Normal	Neither, but close
Oligopoly	High	Supernormal	Neither
Monopoly	Very high	Supernormal	Possibly dynamic

Barriers to entry are the explanation for persistent supernormal profit, not an incidental feature. Without them, entry competes profit away.

• Allocative efficiency: P = MC.
• Productive efficiency: at minimum AC.
• Dynamic efficiency: innovation over time, which supernormal profit can fund — the strongest defence of monopoly.

Oligopoly is defined by interdependence: each firm’s optimum action depends on rivals’ responses, giving price rigidity, non-price competition and an incentive to collude.

Price discrimination requires market power, separable markets, and different PEDs. It raises producer surplus and can permit output that would otherwise be unprofitable, but transfers surplus from consumers.

Labour markets

Demand for labour is derived from demand for the product. Elasticity depends on skill, training time and substitutability.

Monopsony — a single buyer of labour — restricts employment and pays below the competitive wage. A minimum wage can therefore raise both wages and employment in a monopsonistic market, which the simple competitive model does not predict. That counter-intuitive result is high-value.

Wage differentials arise from skill, training, compensating differentials for unpleasant work, discrimination, and immobility of labour.

Market failure and intervention

Externalities in production and consumption, public goods, information gaps (adverse selection before the transaction, moral hazard after), factor immobility, monopoly power.

Externality diagrams must be labelled — MPC, MSC, MPB, MSB, market outcome, social optimum, and the shaded welfare loss triangle. An unlabelled diagram is much weaker evidence of diagram technique, even when the explanation is correct.

Intervention: taxes, subsidies, regulation, tradable permits, state provision, price controls — each with its limitation.

Government failure — information gaps, administrative cost, unintended consequences, regulatory capture. A strong evaluation usually includes it.

Exam traps

• Stating MC cuts AC at the minimum without explaining why.
• Explaining monopoly profit without barriers to entry.
• Unlabelled externality diagrams.
• Assuming a minimum wage always causes unemployment.
• Confusing adverse selection with moral hazard.
• Concluding without a criterion.

Self-test

1. Who bears more of an indirect tax, and why?
2. Why must MC cut AC at its minimum?
3. Why does supernormal profit persist under monopoly?
4. Distinguish adverse selection from moral hazard.
5. Why might a minimum wage raise employment in a monopsony?

Answers: 1. The more inelastic side of the market, because it can least easily change quantity in response to the price change. 2. While MC is below AC it pulls the average down and once above it pulls the average up, so the curves must intersect where AC is at its lowest. 3. Barriers to entry prevent new firms entering to compete it away. 4. Adverse selection occurs before the transaction, when the worse risks are the ones who choose to participate; moral hazard occurs afterwards, when behaviour becomes riskier once covered. 5. A monopsonist restricts employment to keep wages down; a minimum wage removes that ability, so both wages and employment can rise.