Cambridge A‑Level Economics (9708) – Price System and the Microeconomy

7.1 Utility and the Marginal Decision‑Rule

• Utility – satisfaction or pleasure derived from consuming a good or service.
• Total Utility (TU) – the sum of utility obtained from all units consumed.
• Marginal Utility (MU) – the additional utility from one more unit: $$MU = \frac{\Delta TU}{\Delta Q}$$
• Law of Diminishing Marginal Utility – as the quantity of a good consumed rises, MU falls.
• Equi‑marginal principle (Utility‑maximising rule) – a consumer maximises total utility when $$\frac{MU_X}{P_X}= \frac{MU_Y}{P_Y}= \dots = \frac{MU_Z}{P_Z}$$ i.e. the marginal utility per pound (or per unit of money) is equalised across all goods.
• Assumptions & limitations
  • Consumers are rational and have stable preferences.
  • Preferences are convex (ICs are bowed‑inwards).
  • Perfect information and no transaction costs.
  • Does not capture non‑monetary motives (e.g., altruism, status).

7.2 Indifference Curves, Budget Constraints & Consumer Choice

• Indifference Curve (IC) – a set of bundles that give the consumer the same level of satisfaction.
• Key properties
  • Downward sloping – more of one good requires less of the other.
  • Never cross – each curve represents a distinct utility level.
  • Higher curves represent higher utility.
  • Convex to the origin – reflects diminishing MU.
• Budget Line (BL) – all combinations of two goods a consumer can afford: $$P_XQ_X+P_YQ_Y = I$$ where I is income.
• Consumer equilibrium – the highest attainable IC is tangent to the BL: $$\frac{MU_X}{P_X}= \frac{MU_Y}{P_Y}$$
• Deriving the individual demand curve
  1. Change the price of good X (hold income constant).
  2. Re‑apply the tangency condition to find the new optimal quantity of X.
  3. Plot the resulting (P_X, Q_X) pairs – this is the consumer’s demand curve.
• Income and Substitution Effects (price change)
  • Substitution effect – movement along the original IC as the relative price changes (real income held constant).
  • Income effect – shift to a new IC because the consumer’s real purchasing power changes.
• Special cases
  • Giffen good – strong positive income effect outweighs the substitution effect, so demand rises when price rises.
  • Veblen good – demand rises because a higher price enhances status; not explained by the utility model.

7.3 Efficiency, Market Failure & Government Failure

Key concepts

• Pareto‑efficiency – a state where no one can be made better off without making someone else worse off.
• Allocative efficiency – achieved when Marginal Benefit = Marginal Cost (MB = MC) for the whole society.
• Productive efficiency – output is produced at the lowest possible average cost (P = minimum of ATC).
• Dynamic efficiency – the economy’s ability to improve products and processes over time (innovation, R&D).
• Market failure – when the free market does not achieve allocative (or productive) efficiency. Main types:
  • Public goods
  • Externalities (positive & negative)
  • Information asymmetry
  • Monopoly power
• Government failure – when intervention creates a net loss of welfare because of:
  • Imperfect information or wrong assessment of costs/benefits.
  • High administrative or compliance costs.
  • Unintended distributional impacts (e.g., regressive taxes).
  • Regulatory capture or policy lag.

7.4 Externalities – Positive and Negative

Definition

An externality occurs when a market transaction imposes costs or confers benefits on third‑parties who are not part of the transaction. This creates a divergence between private and social marginal values and generates a welfare loss.

Negative Externalities

• Definition – production or consumption imposes an uncompensated cost on others.
• Typical examples – air‑pollution from factories, second‑hand smoke, traffic congestion, noise, over‑fishing.
• Cost relationship $$\text{SMC}= \text{PMC}+ \text{External Cost}$$ where SMC = Social Marginal Cost, PMC = Private Marginal Cost.
• Graphical insight – SMC lies above PMC. The market equilibrium (where PMC = Demand) gives a quantity Q_m that exceeds the socially optimal quantity Q_e (where SMC = Demand). The dead‑weight loss (DWL) is the area between SMC and PMC from Q_e to Q_m.
• Optimal policy response
  • Pigouvian tax – a per‑unit tax equal to the marginal external cost:
    $$t = \text{External Cost per unit}$$ Shifts PMC upward to coincide with SMC, reducing output to Q_e.
  • Regulation – quantity limits (quotas), technology standards, or outright bans.
  • Tradable permits (cap‑and‑trade) – the government sets an emissions cap, issues permits, and lets firms trade. The market price of permits reflects the marginal cost of abatement.
  • Coase bargaining – if property rights are well defined and transaction costs are low, parties can negotiate an efficient outcome without government intervention.

Positive Externalities

• Definition – production or consumption confers an uncompensated benefit on others.
• Typical examples – education, vaccinations, R&D, beekeeping (pollination), public parks.
• Benefit relationship $$\text{SMB}= \text{PMB}+ \text{External Benefit}$$ where SMB = Social Marginal Benefit, PMB = Private Marginal Benefit.
• Graphical insight – SMB lies above PMB. The market equilibrium (PMB = Supply) yields a quantity Q_m that is below the socially optimal quantity Q_e (where SMB = Supply). The DWL is the area between SMB and PMB from Q_m to Q_e.
• Optimal policy response
  • Pigouvian subsidy – a per‑unit subsidy equal to the marginal external benefit: $$s = \text{External Benefit per unit}$$ Raises PMB to coincide with SMB, increasing output to Q_e.
  • Public provision – the government directly supplies the good (e.g., free vaccination programmes).
  • Co‑investment – joint funding of R&D projects where benefits spill over to the wider economy.

Evaluation of Policy Instruments

7.5 Cost, Revenue and Profit Analysis

7.6 Market Structures

7.7 Growth, Survival & Development of Firms

• Organic growth – expansion through internal resources (re‑invested profits, R&D, new product development).
• Inorganic growth – expansion via mergers, acquisitions, strategic alliances, or joint ventures.
• Cartels – formal agreements in an oligopoly to fix prices, limit output or share markets; usually illegal under competition law.
• Principal‑agent problem – conflict of interest when owners (principals) delegate decision‑making to managers (agents). Solutions include performance‑related pay, monitoring, stock options, and board oversight.
• Economies of scale
  • Internal – lower average cost as a single firm expands (e.g., bulk buying, specialised labour).
  • External – cost reductions arising from industry‑wide factors (e.g., skilled labour pool, supplier networks).
• Diseconomies of scale – average cost rises after a certain size because of coordination problems, bureaucracy, or morale issues.
• Price discrimination (monopoly)
  • First‑degree (perfect) – charging each consumer their maximum willingness to pay.
  • Second‑degree – price varies with the quantity purchased (e.g., bulk discounts).
  • Third‑degree – different prices to distinct consumer groups (students, seniors).

7.8 Government Failure (Brief Overview)

• Incorrect estimation of external costs/benefits (e.g., under‑taxing pollution).
• High administrative or compliance costs that outweigh welfare gains.
• Unintended distributional impacts – taxes or subsidies that are regressive or favour special interest groups.
• Regulatory capture – firms influencing the regulator to design favourable rules.
• Policy lag – delay between problem identification and effective implementation.

Key Take‑aways

• Utility theory explains consumer choice; the equi‑marginal principle links MU to price.
• Indifference curves and budget constraints illustrate how income and prices affect consumption; tangency yields the demand curve.
• Market failure occurs when private equilibrium diverges from the socially optimal equilibrium; externalities are a classic example.
• Pigouvian taxes/subsidies, regulation, tradable permits and Coase bargaining are the main tools for internalising externalities.
• Cost‑revenue‑profit analysis underpins firm‑level decisions in the short and long run; normal profit equals LR‑ATC.
• Different market structures generate distinct outcomes for price, output, efficiency and welfare.
• Firms grow organically or inorganically; strategic behaviour (cartels, price discrimination, principal‑agent issues) influences long‑run performance.
• Government intervention can correct market failure but may itself cause failure; evaluation must balance effectiveness, efficiency, equity and practicality.