Chapter 7 - Prices, resource allocation and concept of the margin Flashcards
What is marginal principle?
The idea that economic agents may take decisions by considering the effect of small changes from the existing situation.
What is rational decision making?
A decision that allows an economic agent to maximise their objective, by setting the marginal benefit of an action equal to its marginal cost.
What assumption is made about the marginal principle?
It assumes that rational decision making takes place.
What is utility?
The satisfaction received from consuming a good or service.
What is marginal utility?
The additional utility gained from consuming an extra unit of a good or service.
What is the law of diminishing marginal utility?
It states that the more units of a good that are consumed, the lower the utility from consuming those additional units.
How does marginal utility and demand link?
One way of interpreting the marginal utility that you receive from consuming a good is that it informs your willingness to pay for it. The higher your marginal utility, the higher the price you would be prepared to pay.
So, if marginal utility were measured in terms of money, then the MU curve would become a person’s demand curve. The quantity of the good Q* provides this individual with marginal utility of MU. If the price of the good were higher than MU, then the individual would not buy Q* of the good, as the price exceeds his valuation. On the other hand, if price were to be set lower than MU, then the individual would be prepared to buy more than Q, as the marginal utility would be higher than the asking price.
Another way of putting this is to say that the consumer will purchase the good up to the point where the price is equal to the marginal utility gained from consuming the good.
Why may consumers not always act rationally?
This branch of economic analysis recognises that the psychology of human decision making is more complex than the simple desire to maximise utility. People do not always focus on purely economic influences, but may act on impulse, or in response to their feelings. This can lead them to take decisions about their spending that cannot be explained only by utility maximisation.
For example, they may make charitable donations or may purchase more of some goods than would be dictated by rational economic behaviour, perhaps because there were seen to be special offers available.
What is the ‘laissez-faire’ approach to resource allocation?
In a free market economy (minimal government intervention), prices play the key role in resource allocation.
What is a price signal?
Where the price of a good carries information to producers or consumers that guides the market towards equilibrium and assists in resource allocation.
How does the allocation of resources work?
If market forces are to allocate resources effectively, consumers need to be able to express their preferences for goods and services in such a way that producers can respond.
Consumers express their preferences through prices, as prices will adjust to equilibrium levels following a change in consumer demand.
Producers have an incentive to respond to changes in prices. In the short run this occurs through output adjustments of existing firms (movements along the supply curve), but in the long run firms will enter the market (or exit from it) until there are no further incentives for entry or exit.
What is allocative efficiency?
It is achieved when society is producing the appropriate bundle of goods and services relative to consumer preferences - this occurs when PRICE (marginal benefit) equals MARGINAL COST.
What is economic efficiency?
A situation in which both productive efficiency and allocative efficiency have been reached.
What is productive efficiency?
A situation where society is operating on the PPC, and therefore using its resources effectively.
It is attained when it is operating at minimum cost, choosing an appropriate combination of factors of production and producing the maximum output possible from those inputs. Points on the PPC represent points of productive efficiency.
