The price system and the microeconomy (A Level)

7.1 Utility

Utility is the satisfaction gained from consuming a good. Total utility is the satisfaction from all units; marginal utility (MU) is the extra satisfaction from one more unit.

A consumer maximises utility when the marginal utility per dollar is equal across goods: MUₐ ÷ Pₐ = MU_b ÷ P_b. The demand curve is the MU curve in money terms.

The equi-marginal principle: a consumer allocates income so that MU ÷ price is equal for all goods; if one good gives more MU per dollar, buy more of it until diminishing marginal utility restores equality. An individual demand curve is derived by taking a good's price falling, working out the new utility-maximising quantity each time, and plotting price against quantity. Limitations of marginal utility theory: utility cannot be measured in units, it assumes rational behaviour (consumers with perfect information) and ignores habits, advertising, social influence and impulse, which behavioural economics shows matter.

7.2 Indifference curves and budget lines

An indifference curve shows combinations of two goods that give the consumer the same satisfaction. Properties: downward sloping, convex to the origin (diminishing marginal rate of substitution), do not cross, and curves further from the origin show higher satisfaction.

A budget line shows combinations of two goods a consumer can afford with a given income and prices. Slope = −P₁ ÷ P₂ (the ratio of prices). Income rise: the line shifts outwards in parallel. Price fall of one good: the line pivots outwards on the other axis.

Price and income changes: a fall in a good's price moves the consumer to a higher curve; the income effect and substitution effect can be separated. For a normal good both effects raise quantity; for an inferior good the income effect works the other way; a Giffen good (very strongly inferior) has an income effect larger than the substitution effect, so a price rise increases quantity demanded.

7.3 Efficiency and market failure

Market failure exists when the market misallocates resources. Causes: externalities, public goods, merit and demerit goods, information asymmetry, monopoly power and immobility of factors.

7.4 Private costs and benefits, externalities and social costs and benefits

Negative externalities (pollution): external cost; market output is too high and price too low: the MSC curve is above the MPC curve. Positive externalities (education, vaccination): external benefits; market output is too low: MSB is above MPB.

Welfare loss is the area between MSC and MSB over the units where the market over- or under-produces.

Policies to correct externalities:

Limits: it is hard to value externalities, tax rates are difficult to set, political resistance, international pollution.

Asymmetric information exists when one party in a transaction (for example a seller of a used car or a borrower) knows more than the other, leading to poor decisions and market failure. Moral hazard is when a person takes more risk because someone else bears the cost (an insured driver is less careful, or a bank that expects a bailout lends recklessly). Deadweight welfare losses arise from negative externalities (too much is produced, so the units where MSC exceeds MSB are a loss) and positive externalities (too little is produced, so the units where MSB exceeds MSC are lost); the loss is the triangle between MSB and MSC.

Costs and benefits in decisions: private firms compare private costs and benefits; the government also considers external ones. A project is worthwhile if total social benefits exceed total social costs.

7.5 Types of cost, revenue and profit, short-run and long-run production

Production in the short run

The short run has at least one fixed factor. The law of diminishing returns: adding variable factors to a fixed factor eventually gives smaller extra output (marginal product falls). Total, average and marginal product relate: MP cuts AP at the maximum AP.

Costs

Long run: all factors variable. Returns to scale: increasing (output rises by more than inputs), constant, decreasing. The long-run average cost (LRAC) curve shows the lowest cost for each output: economies of scale (falling LRAC), the minimum efficient scale (MES), diseconomies of scale.

Internal economies: technical, purchasing, financial, marketing, managerial, risk-bearing. External economies arise from the industry or area. Diseconomies come from coordination and communication problems.

Revenue and profit

For a price taker, AR = MR = price (horizontal). For a firm with market power, AR slopes down and MR is below it (MR falls twice as fast for a linear demand curve).

7.6 Different market structures

Perfect competition

Firms are price takers; in the short run they may make supernormal profit or loss; in the long run, entry or exit returns the industry to normal profit at minimum AC, so it is allocatively and productively efficient (P = MC = min AC).

Monopoly

A single seller with barriers (patents, control of resources, economies of scale). It maximises profit where MR = MC and charges the price on the demand curve at that output: higher price and lower output than competition, supernormal profit persists, there is deadweight loss and possible X-inefficiency. Possible benefits: economies of scale (a natural monopoly), funds for R&D, price discrimination that raises output. Price discrimination (different prices to different groups) needs market power, separable markets and different elasticities.

Monopolistic competition

Many firms with differentiated products: short-run supernormal profit attracts entry, shifting demand left until normal profit in the long run; excess capacity and product variety; non-price competition (advertising).

Oligopoly

Few firms; interdependence: each reacts to the others. Collusion (cartel, tacit) can raise prices but is illegal in many places and unstable (cheating). The kinked demand curve explains price rigidity: rivals match price cuts but ignore price rises. Game theory (prisoners' dilemma) shows why firms may compete even though co-operation would pay more. In a pay-off matrix for two firms choosing a high or low price, the numbers show each firm's profit (Firm A, Firm B):

Whatever B does, A earns more by choosing the low price (12 > 10 and 6 > 4), and the same is true for B, so both choose low and end at (6, 6), although (10, 10) would be better for both. This is a Nash equilibrium: neither firm can gain by changing alone. Co-operation (a cartel or tacit agreement) can reach (10, 10) but each firm is tempted to cheat. Non-price competition and barriers are common.

Contestable markets

A contestable market has low entry and exit barriers (sunk costs): even with few firms, the threat of entry forces competitive behaviour (lower prices, normal profit). Limit pricing and predatory pricing may deter entrants.

A concentration ratio shows the share of a market's output or sales taken by the largest firms: a four-firm concentration ratio of 80% means the biggest four firms supply 80% of the market. A high ratio indicates an oligopoly or monopoly. Barriers to entry and exit include physical barriers (control of essential resources or a vital location), legal barriers (patents, licences), economies of scale, brand loyalty, high start-up and sunk costs and predatory behaviour. Contestable market features: low sunk costs, free entry and exit and the ability of entrants to compete on equal terms; the implication is that even a monopolist must keep price near cost and avoid abnormal profit to deter entrants, producing outcomes close to competition. Market structure is explained by the number of buyers and sellers, product differentiation, freedom of entry and exit, availability of information and control over price.

7.7 Growth and survival of firms

Growth: internal (organic) or external (mergers and takeovers: horizontal, vertical, conglomerate). Reasons: economies of scale, market power, spreading risk, managers' objectives. Why small firms survive: niche markets, flexibility, personal service, low costs.

The divorce of ownership and control (shareholders own, managers run) creates a principal–agent problem: managers may pursue their own aims (sales, growth, status) not profit.

External growth (integration): horizontal (same stage, same industry), vertical forward (towards the customer) and backward (towards the supplier), and conglomerate (unrelated). Reasons: economies of scale, more market power, a larger market share, spreading risk, access to new technology and removing a competitor. Consequences: for firms, higher profit and power but also diseconomies and integration problems; for consumers, possibly lower costs or higher prices and less choice; for workers, redundancies. Reasons for different sizes of firms: market size, economies of scale, barriers to entry, owners' aims, finance and the nature of the product.

Cartels are agreements between firms to restrict output and raise price. Conditions for an effective cartel: few firms, similar costs and products, barriers to entry, a way to monitor cheating and weak competition law. Consequences: higher prices and profits for members, lower output and choice for consumers and a tendency to collapse as members cheat.

7.8 Differing objectives and policies of firms

Pricing and output policies: limit pricing, predatory pricing, cost-plus, price discrimination. Competition policy: regulating monopolies, preventing cartels, price caps, public ownership.

The traditional objective is profit maximisation (MR = MC). Survival matters for new and struggling firms: they may accept lower profit or even losses to remain in business. Price leadership is where one dominant firm sets the price and the others follow, avoiding price wars. For a normal downward-sloping demand curve, revenue is maximised where PED = 1 (MR = 0): above that output demand is elastic (a lower price raises revenue); below, inelastic. In the kinked demand curve model, demand is elastic above the kink (rivals do not follow a rise) and inelastic below (rivals match a cut), so firms avoid changing price.