AL Unit 7: The Price System and the Microeconomy

Question 1

Utility

Answer 1

A measure of the level of happiness or satisfaction someone gets from the consumption of a good. Assumes satisfaction can be measured in units. The principle or law of diminishing marginal utility is where marginal utility is the additional utility derived from the consumption of one more unit. Suggests that are consumption increases marginal utility will decrease. Can also be used for prices on sale. Likely to be bought

Question 2

Total utility

Answer 2

Overall satisfaction derived from consumption of all units over time

Question 3

Marginal utility

Answer 3

Additional utility derived from consumption of one more unit

Question 4

Equi-marginal principle

Answer 4

A consumer is in equilibrium when its not possible to switch expenditure to increase total utility. When it applies it is not possible to increase total utility by relocating spending between any available products. Income has maximised utility
MUa/Pa = MUb/Pb = MUc/Pc

Question 5

Assumptions of equi-marginal principle

Answer 5

Consumers have limited income
Consumers will always behave rationally
Consumers seek to maximise utility

Question 6

Derivation of individual demand

Answer 6

If the price of a good is reduced, the price of another good and income is unchanged. MU/P can be recalculated. Gives new consumer equilibrium. Total utility has increased

Question 7

Limitations of marginal utility theory and assumptions of rationality

Answer 7

MUT assumes consumers can put their wants in order and assign value to satisfaction. DMU assumes consumers act and behave rationally when purchasing. Empirical/real world evidence shows purchasing isn’t only influenced by utility

Question 8

Indifference curves

Answer 8

It does not always follow that consumers will buy more of a good when price falls, they will only buy a particular good if it is something they actually prefer. Preferences are represented by indifferences curves. SHows all of the combinations of 2 goods for equal satisfaction. Slopes down to indicate that a fall in consumption of one good is accompanied by an increase in consumption of the other for equal utility. A map shows a number of indifference curves. Higher curves represent higher utility. Rational consumers will opt for the highest curve. Curves can’t cross.

Question 9

Marginal rate of substitution

Answer 9

The slope represents the extent to which the consumer is willing to substitute good. The rate at which this happens is the marginal rate of substitution

Question 10

Budget lines

Answer 10

Consumers are restricted due to limited disposable income and prices. A budget line shows the combinations of 2 gods a consumer can purchase with a given income and prices

Question 11

Causes of a shift in budget lines

Answer 11

A change in the price of one good causes the budget line to pivot. This is the substitution effect of a price change. Rational consumers will always substitute towards the good that is relatively cheaper. Real income has also increased which is the income effect of a price change

Question 12

Effect of income changes on consumption

Answer 12

Consumer choice is optimal where the budget line touches the highest indifference curve. If incomes rise a better combination of goods is chosen. More will be consumed so if the budget constraint rises, both will be consumed more and there is a new optimal position. This position change is when both goods are normal

Question 13

The substitution and income effect of a price change

Answer 13

If the price of a good rises consumers have less spending power, represented by a new budget line. This pivots down towards the origin because less is consumed with the same level of income. Income effect can be eliminated by removing the reduction in real income with an imaginary budget line parallel to the new one but tangent to the original indifference curve. For inferior goods as real incomes rise, consumers substitute more expensive and better quality goods so the income effect is negative but doesn’t outweigh the substitution effect

Question 14

Income and substitution effect of price changes on a graph

Answer 14

The change has 2 stages:
- movement along the curve. This is the substitution effect since the consumer buys less
- shift down. This is the income effect because the consumer has less spending power

Question 15

Giffen goods

Answer 15

Demand falls and price falls. Could be a staple food where consumption rises with price since real incomes fell. Demand curve is upward sloping as the income effect is negative and greater than the substitution effect

Question 16

Limitations of indifference curves

Answer 16

Consumers have more than 2 choices
Indifference implies consumes will accept any combination of the 2 goods. May express wants and needs in rank order instead
Assumes consumer rationality

Question 17

Efficiency

Answer 17

Economic efficiency exists when it can be judged that all scarce resources are being used in the best way. The greatest level of wants is being met and consists of productive and allocative efficiency. When both types exist there is efficient resource allocation. Globally it is achieved when all economies do this but protectionist policies make this impossible

Question 18

Productive efficiency

Answer 18

Occurs when firms produce at the lowest cost and make the best use of resources

Question 19

Allocative efficiency

Answer 19

When firms produce the combination of goods and services wanted by consumers. Gives maximum utility at current income. There is no waste. Price they are willing to pay reflects preferences and benefits derived from consumption. The marginal cost is a measure of the opportunity cost of resources to produce the last unit. Where price is MC, consumers will pay MC signalling allocative efficiency

Question 20

Conditions for productive efficiency

Answer 20

Can be demonstrated through average cost curve. A point on a PPC shows maximum production for any combination of 2 products. Productive efficiency can only exist when producing on the PPC. Competition can lead to productive efficiency. Firms are constrained to produce at the lowest possible cost since they have a profit incentive. A failure to d this in a competitive market could lead to bankruptcy. Lowest point on AC curve is productive efficiency

Question 21

Conditions for allocative efficiency

Answer 21

Exists when P=MC. Price paid by consumer represents the economic cost of the last unit. Any PPC point could be allocatively efficient while the exact location depends on consumer preference. Competition can lead to this since firms are constrained to produce products consumers most desire relative to costs. Desire to make greatest possible profit. In competitive markets firms are forced to produce those most demanded. Point of equilibrium is where P=MC

Question 22

Pareto optimality

Answer 22

Occurs when it is impossible to make 1 person better off without making someone else worse off. Represents the best possible situation with most efficiency allocation. When operating on a PPC it is in a state of pareto optimality. Any point within the PPC is pareto inefficient. If allocation is not pareto efficient there can be improvement. If there are welfare losses on the PPC, reallocation leads to pareto improvement but may require compensation

Question 23

Dynamic efficiency

Answer 23

Benefits a firm over time. Resources are allocated in such a way that output rises relative to resource increase. Achieved when a firm meets the changing market needs by introducing new production processes in response to competition. By using excess profits firms can engage in R&D to protect market share. Lower prices for consumers. Requires investment which can initially cause higher costs. If a firm doesn’t invest, it may be less efficiency so forced to leave market. LRAC shift down when dynamically inefficient

Question 24

Consequences of market failure

Answer 24

Where there are externalities in the market
The provision of merit and demerit goods
The provision of public and quasi-public goods
Information fialure
Adverse selection or moral hazard
Abuse of monopoly power