Part 3 Microeconomic decision makers
Part 3 Microeconomic decision makers
Assessment: model answers
1 (a) 
The size of an industry in an economy
could be measured in a number of
ways. First, it could be measured by the
total number of people it employs as a
proportion of the total workforce. Secondly,
the size of an industry could be determined
by the contribution it makes to total
output, i.e. the value of its annual output
as a proportion of the total annual output
of the economy. A third way to measure
the size of an industry in a country is to
compare it with international rivals in
terms of its global market share.
(b) 
Wages in the UK car industry fell because
there was an economic recession. Demand
for cars fell and as a result the demand
for labour decreased. Car makers reduced
wages to help protect UK jobs and factories
from closures.
(c) 
A trade union is an organization of workers
formed to promote and protect the rights
and interests of its members concerning
wages and working conditions, including
reduced hours of work, increased holiday
entitlements and improved health and
safety at work.

Trade unions also aim to agree improved
sick pay, pensions and other benefits for
their members. Trade unions can often
secure these improvements for their
members because they have significant
bargaining power in negotiations with
employers. In the extract, trade unions
have used their collective bargaining
strength to resist job cuts that would have
made UK car workers unemployed during
and following an economic recession when
demand for cars was falling.
(d) The article suggests a decrease in
employment may increase labour
productivity as less skilled and less
productive workers lose their jobs and are
replaced by more efficient and productive
capital equipment.
(e) 
Two functions of commercial banks are:
(i) providing personal and commercial loans
so people can borrow money to fund their
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current consumption and firms can borrow
money to finance new investment. They will
repay their loans with interest from their
future incomes; and (ii) to accept deposits of
money and savings. Banks provide a secure
place for people and firms to save money
and earn interest on their savings.
(f) 
Whether or not a government should
protect the declining car industry depends
on how the costs and benefits of doing so
compare.

The benefits include saving jobs and
preventing unemployment. In turn,
this will prevent a loss of tax revenues
and increased public spending on
unemployment benefits. If the car industry
is a major employer and producer in the
economy, as well as being a major customer
for parts and services supplied by other
domestic firms, it could also help to prevent
a dramatic fall in output, negative economic
growth and declining living standards.

Protecting the industry may slow down the
rate at which it declines but may not stop
or reverse its decline. This, however, will
give workers more time to find other jobs,
to retrain in new skills to improve their
chances of finding alternative employment
and for other industries to grow and to
provide more employment opportunities.
However, using public money to subsidise
the industry may be an expensive and
inefficient use of resources. The resources
may be better used in support of growing
industries or for improving education and
healthcare. These uses will help to increase
the rate of long-run economic growth in
the economy.
Countries with major car industries may
also retaliate by imposing trade restrictions,
making it difficult for the car manufacturers
and many other firms to export their goods
to these countries. As a result, the car
industry and many other firms may require
additional support from the government.
(g) 
Large car manufacturers are likely to enjoy
significant cost advantages in production,
making the average cost of producing each
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car much lower than that of their smaller
rivals. For example, they will be able to
receive bulk purchase discounts on the
parts and materials they buy and have
access to lower cost sources of finance
which may enable them to purchase more
efficient capital equipment. In so doing, the
larger manufacturers will be able to capture
and keep a larger share of the market and
encourage consumer loyalty towards their
car brands.
As such, it will difficult for smaller car
manufacturers to compete with them head
on. They will not be able to produce the
volume or range of models the large firms
do or compete with them on price. If they
try, the larger firms may undercut their
prices to force them out of the market.
Smaller car manufacturers are also unlikely
to be able to be able to compete with the
larger manufacturers on levels of spending
on advertising and on research and
development. However, smaller firms may
be able to specialise in the production and
marketing of more personalised, innovative
and luxury vehicles for small ‘niche’ markets
and be able to price them at a premium.
Further, because the larger car makers
have often invested significant amounts of
money in capital-intensive or automated
production, they may find it more difficult
to adapt their car designs quickly in
response to changes in consumer demand
compared to smaller firms.
The smaller manufacturers may also receive
grants or subsidies from the government.
This will help to reduce their costs of
production and allow them to charge prices
that can compete with larger firms so that
they have a better chance of surviving and
growing.
The cost advantages of large-scale
production may also disappear if the large
car manufacturers grow too large and
experience coordination problems and
labour and supply shortages. Deliveries
of cars may be held up and quality may
also suffer as a result. These diseconomies
of scale will increase their average
production costs relative to those of
smaller manufacturers and, if significant,
may give them a cost and also a quality
advantage instead.
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Part 3 Microeconomic decision makers
2 (a) Money is a generally accepted medium of
exchange.
(b) 
Money functions as a unit of account
because it allows the prices of all other
goods and services to be set or expressed in
terms of units of one single, and generally
accepted, means of payment. Money
therefore allows buyers and sellers of
different goods and services to compare
all the prices or values placed on them in
simple monetary terms.

Money provides a standard for deferred
payments because it allows goods and
services to be bought on credit, and for the
amount owed or borrowed to be paid off at
a later date.
(c) 
The money supply in an economy is made
up of notes and coins in circulation and
bank deposits. An increase in bank lending
will therefore increase the money supply in
the economy because it will increase bank
deposits. A person who borrows money
from a bank will have their bank account
credited with the amount of the loan. They
will then be able to make payments from
their bank account using the loan. People
who borrow from their banks will therefore
have more money to spend and this in turn
will increase total demand in the economy.
This will drive up market prices and, in
response, firms are likely to expand their
output.

Firms may also respond by increasing
their own borrowing to fund an increase
in their scale of production, for example,
through investment in new and additional
plant and machinery. This will increase
the productive capacity of the economy
and should also boost the rate of economic
growth. Total output or GDP will increase
and living standards will improve.
However, more lending can result in
rising inflation if total demand increases
at a faster rate than total output in the
economy. Increased borrowing may also
be used to buy more imports, reducing a
balance of trade surplus or worsening a
balance of trade deficit.
(d) The interest rate charged by a bank on a
loan is the cost of borrowing money. It
follows that the higher the rate of interest
charged, the less money people will tend
to borrow. A fall in the rate of interest is
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therefore likely to encourage a rise in total
borrowing. However, many other factors
can affect an individual’s decision to borrow
money from a bank.

A major determinant will be the ability
of the individual to repay the loan plus
interest charges. This will depend on both
their current income and their expectations
of future income. If they expect their
future income to rise, then repaying a loan
will become easier over time. However,
if they expect their income to fall due to
possible illness or unemployment, then the
person may decide against borrowing any
money regardless of how low interest rates
currently are.

The ability to repay a loan rises with
income. People on high incomes are more
able to repay loans than people with low
incomes, but they are likely to have less
need to borrow money to finance their
current consumption than poorer people.
However, while people on low incomes
may have more need to borrow money, for
example to meet unexpected bills, banks
may be less inclined to lend them money
because of the risk they may not be able to
repay their loans.
Whether or not the interest rate on a loan
is fixed or variable will also be an important
consideration. If the interest rate is fixed,
then interest charges will be unchanged if
interest rates rise in the future. If, however,
the interest rate is variable, any increase in
interest rates will increase interest charges
on existing loans making them more
expensive to repay.

Expectations of future interest rates will
therefore also affect the decision to borrow
money now, as will expectations of future
price inflation. For example, if people think
the prices of many goods will rise in future,
they may borrow more money now to buy
the goods they want before their prices rise.
However, no matter how low interest rates
might be, some people simply do not like to
borrow and be in debt.
3 (a) 
Influences on the amount people save
include their ability to save. This will
depend on their disposable income, i.e. the
amount of income they retain after any
income taxes have been deducted. People
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with low disposable incomes may have to
spend it all just to meet their basic needs for
food, clothing and shelter.
People with relatively high disposable
incomes have the ability to save but may
choose not to, especially if interest rates on
savings are low and especially if they are
below the current rate of price inflation.
Interest is the reward for saving but the real
value of savings will fall if the rate of price
inflation exceeds the rate of interest.
(Other influences are propensities to spend or
save from disposable incomes, which in turn
may vary with age, social attitudes, family
circumstances; consumer confidence in the
economy, for example, expectations of recession
and unemployment may persuade more people
to save more money as a precaution; desires to
save for future consumption, including for a
major purchase, such as a house, or to provide
a pension income in retirement; availability
of savings schemes; how wealthy a person is;
whether interest income on savings is taxable
and the rate at which it is taxed.)
(b) 
Cash (notes and coins) is money because
it performs the functions of money. First
and foremost, it is generally accepted
as a medium of exchange meaning it is
universally accepted as payment for other
goods and services. This also means that
the prices of every good or service can be
set or expressed in cash because it provides
a single accepted and recognisable unit of
account or measure of value.

Cash is reasonably durable and provides a
good store of value, especially if inflation
is relatively low and stable. The face value
printed on each note or coin will not
change even if what they can buy may be
reduced over time as prices rise. As such,
cash also provides a means of deferred
payment. Because it is a good store of
value and unit of account, an agreed
amount of cash can be borrowed and
repaid at a later date.
(c) 
Commercial banks help trade to take place
in an economy by helping customers make
and receive payments quickly and easily.
They do this by enabling people and firms
to deposit money into current or checking
accounts. These can then be used to make
payments or transfers to the bank accounts
of other customers using cheques and direct
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debit instructions. Bank current accounts
can also therefore be used to receive
payments or transfers from other accounts.
Commercial banks will also exchange
foreign currencies thereby supporting
international trade and tourism.
Banks also provide secure deposit or savings
accounts in which people and firms can
keep their money. In return, banks will
pay savers interest on their total savings
because the banks can use this money to
make loans. These will include personal
loans people can use to buy a new car, for
example, and commercial loans firms can
use to invest in new capital equipment.
Mortgages are long-term loans used to buy
property. In contrast, overdrawing a current
account or making purchases using a bank
credit card are ways of borrowing money
from a bank for short periods. Commercial
banks therefore help to boost current
consumer spending and investment in an
economy by providing loans that people and
firms can repay in instalments, including
interest charges from their future incomes.
(d) People with low incomes may have to
borrow money simply to help pay towards
the cost of buying the basic goods and
services they need, such as food, housing
and electricity costs. They are unlikely to
have any savings or other forms of wealth
they can draw on to fund their day-to-
day expenditures or other more expensive
items such as medical care, furniture,
holidays or even books for their children’s
education. Borrowing may be the only way
they are able to afford these items.
Out of necessity rather than desire,
therefore, poorer people may be more
inclined to borrow money than richer
people and the total amount of money
they borrow is likely to be a much larger
proportion of their low incomes than it is
for richer people.
However, the total amount of money poor
people are willing and able to borrow may
be much less in absolute terms than richer
people who may borrow large amounts of
money to buy luxury homes, new cars and
exotic holidays. This is because people on
lower incomes cannot afford to repay large
loans including interest payments from their
incomes if they remain low. Most people on
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low incomes will not expect their incomes
to rise significantly in the future. On the
contrary, many might expect their incomes
to fall, especially in real terms if they are in
low paid jobs or expect to be unemployed in
the future or receive fixed welfare payments
or pensions from the government.
Banks and other lenders are also unwilling
to lend large sums of money to people with
low incomes and little or no collateral to
offer against their loans because of the risk
they may default on repayments. Lenders
are also likely to charge higher interest
rates on loans to those people who they
think are at greatest risk of not being able
to pay off their loans in full. The higher
the interest charge, the more costly it is to
borrow money.
4 (a) Specialization involves concentrating
productive efforts on completing specific
tasks or products.
Workers will normally specialise in those
jobs or occupations they are most skilled
at or best qualified to perform. Similarly,
rather than producing a wide range of
different products, most firms concentrate
their resources on the production of
a single product or a narrow range of
products. This specialization enables firms
to combine resources in the most efficient
way possible to maximize their productivity
and minimize their unit costs.
(b) 
Fixed costs are production costs that do
not vary with the amount of output.
Because the production of aircraft is capital-
intensive, the fixed costs of buying, hiring
and maintaining the machinery and other
capital equipment will be high in the
aircraft manufacturing industry. Much of
the machinery or equipment used may
have been purchased with borrowed money
and, if so, interest payments on loans will
also be high and will have to paid even
if no aircraft are produced. Similarly, the
manufacture of aircraft will require large
factories and land space. Rental payments
are therefore also likely to be high.
(c) 
The demand for capital goods by firms
is a derived demand. This means capital
goods are not wanted for themselves, but
are wanted because they are used in the
production of other goods and services.
The demand for capital goods will therefore
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depend not only on their prices but also the
demand and profitability of the other goods
and services they are used to produce.
Like consumer demand for most other
products, the higher the price of capital
goods the lower the quantity firms will be
willing and able to buy. If the capital goods
are purchased with loans, then any increase
in interest rates is also likely to reduce
demand for them.
However, government subsidies may be
available to firms to encourage them to
invest in new capital equipment. The
subsidies will reduce the cost of capital
goods and expand demand for them.
Further, the more profitable the products
produced with the capital goods, the more
firms are likely to demand to increase their
scale of production. Similarly, large firms
are likely to need more capital goods over
time to replace old and worn out plant and
machinery simply because of the large scale
of their production. However, advances
in technology may actually reduce the
quantity of capital they need over time
because new machinery and equipment is
not only likely to be more productive than
the old ones they replace, but may also
last longer. That said, the more productive
capital equipment becomes, the more likely
firms may substitute new capital for labour.
(d) A pure monopoly controls the total market
supply of its product and can therefore
determine the market price that will
maximize its profits. In the absence of close
substitutes, consumers will have no option
but to continue to buy the product of the
monopoly even if the monopoly reduces its
quality to reduce its costs of production and
boost its profits further. Additionally, there
is no competitive pressure on the monopoly
to improve its product.
Therefore, it is argued that market price
will be higher and total supply and quality
lower in a monopoly than under conditions
of perfect competition where many firms
compete to supply the product. However,
there are many reasons why this may not
be the case.
Competing firms may have no incentive
to spend more improving the quality of
their product if rival firms will all be able
to produce identical products of the same
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quality. Any increased profits earned by
the firm from higher sales of its improved
product will soon be competed away. In
contrast, a monopoly can protect its profits
from new competition through natural and
artificial barriers to entry. Not only will it
be able to afford to invest in new product
research and development, but it will also
be able to retain any increase in profits
from sales of better quality products.
Because of its large scale, a monopoly is
also likely to enjoy many cost advantages
over smaller firms, including technical
economies in research and development,
making it cheaper on average for
the monopoly to invest in product
improvements than smaller, competing
firms.
Finally, not all monopolies are able to
protect their markets and profits from new
competition. If there are low barriers to
entry, their markets will be contestable.
This means the only way they will be able
to retain control of their market will be
to ensure they charge competitive prices
and offer good quality products so that
consumers do not switch their demand to
other suppliers.
5 (a) Labour and enterprise.
(b) 
Two influences on what factors of
production a firm uses are their relative
prices and productivity. For example, as
wages rise and labour becomes relatively
more expensive then a firm may replace
labour with capital. Alternatively, a
firm may employ more labour intensive
methods of production as labour becomes
more highly skilled and its productivity
improves. Alternatively, labour may be
replaced by new, more advanced machinery
and other capital equipment because it is
more productive and profitable to use.
(Others influences may include the type of product
the firm produces, for example, passenger aircraft
manufacturing and nuclear power generation
are capital intensive while fruit picking is often
labour intensive; the level of demand for the
product which, if significant, will allow firms to
mass produce the product using capital-intensive
methods; the availability of different factors
of production, for example, a firm may have
to employ more capital-intensive methods of
production is there are labour shortages.)
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(c) 
Many workers are motivated by money and
will tend to choose between occupations
depending on how much they are likely to
earn from each one. In general, the higher
the wage rate for an occupation, the greater
the supply of labour is likely to be to that
occupation. If the supply of labour to an
occupation greatly exceeds the demand for
that labour, then the market wage rate may
be quite low; but even at a relatively low
wage some workers would still supply their
labour to fill available jobs. Those workers
will be relatively low skilled and would
be unable to command higher wages in
alternative occupations.
However, many other factors than potential
earnings also affect labour supply decisions.
For example, people will compare such
factors as when and how long they are
required to work each day or week, holiday
entitlements, promotion prospects, job
security, and any non-wage benefits such as
free medical insurance, subsidized canteens,
or the provision of a company car or free
travel. So, for example, a worker may
choose a job that offers a relatively low
wage over another job with a much higher
wage because it offers more holidays,
greater job security, is closer to home and
involves less travel cost and time, and
provides other benefits which more than
offset the lower wage.
Some people also work for relatively
low pay in charities that help people
and animals in need, because of the job
satisfaction it gives them.
(d) A firm that increases its scale of production
may experience economies of scale that
reduce the average cost of producing each
item as output rises.
Economies of scale are cost advantages
associated with large-scale production, for
example, because the firm is able to buy the
parts or materials it needs for production in
bulk quantities and in return for doing so
may receive bulk price discounts from their
suppliers. Smaller firms will not be able to
buy or store items in bulk and so will not
be offered similar price discounts.
The firm may also experience technical
economies of scale, because its large scale
of production enables it to use more
and larger cost efficient technologically
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advanced machinery and equipment.
As a large firm, it may additionally be
offered lower cost loans to purchase new
equipment because it will have more
assets it can offer as security against loans
from banks and other lenders. As a larger
company with a bigger market share and
more sales, it may also be more attractive to
investors who are willing to buy its shares.
This will allow it to raise permanent capital
that does not have to be repaid. If the firm
was a small, sole trader it would be unable
to sell shares and would have to rely on
loans to finance expansion, often at much
higher rates of interest.
Specialist staff may also be employed
because the high cost of their salaries can be
spread over a much higher output. Similarly,
spending on advertising and research and
development is more cost effective for items
mass-produced in large quantities.
The industry in which the firm operates
may also be growing in size, enabling
the firm to take advantage of external
economies of scale.
However, if the firm expands too far too
fast, it may experience diseconomies of
scale. Total costs may rise faster than
output, such that the average cost of
producing each item rises as scale is
increased. This is because controlling and
coordinating production in a large firm
can be difficult, especially if it produces
and sells a wide variety of products in
many different locations. A large firm
can have thousands of employees and
many different layers of management.
This can cause communication problems
and disagreements between managers at
different levels in different parts of a firm.
It is also harder for senior managers to stay
in day-to-day contact with employees in
large firms that employ many hundreds or
thousands of workers. As a result, workers
may feel their ideas and skills are not
valued. This can reduce their motivation
with potentially damaging consequences
for output and product quality. Production
may be disrupted by industrial actions, such
as strikes, if workers feel they are not being
consulted or treated fairly, or if they feel
their jobs are at risk of being substituted for
capital equipment.
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Some very large firms may also need vast
quantities of materials, components or
power for production. They may have
to pay much more to obtain the supplies
they need and they may also experience
shortages that can hold up production.
They may also be unable to attract enough
workers with the right skills and may have
to raise the wages they pay to attract them
away from rival firms or increase spending
on training. All of these factors can push up
the total and average costs of production in
large firms relative to smaller ones. point at either end of its PPC) or two goods (a
6 (a) An economic good is one that is limited in
supply because scarce resources must be
used to produce it. This means there is an
opportunity cost involved in the production
of an economic good.
(b) 
A production possibility curve shows the
maximum possible output that an economy
can produce with its factor resources. It
therefore illustrates the economic concepts
of scarcity of resources and opportunity cost.
A PPC shows there is a limit to what can be
produced with existing resources because
they are limited in supply and scarce
relative to unlimited human wants. All
societies must therefore choose how best to
use their resources. This involves deciding
what goods and services to produce with
them. That is, all societies must choose
which human wants will be satisfied and
which ones will not.
If more resources are devoted to the
production of one type of product, fewer
resources will remain to produce another
product. This is shown by a movement
along the curve from one allocation of
resources to another. Each movement
along the curve therefore shows what has
to be given up to produce more of the other
good. So, for example, using more labour
and capital to produce cars means less
labour and capital is available to produce
computers. The benefit given up from those
computers is therefore the opportunity cost
of the decision to allocate more resources to
the production of cars.
Other concepts a PPC can be used to demonstrate
are:
• The efficient allocation of resources and full
employment: any point of production on the
curve represents a full and efficient allocation
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of resources while at any point of production
inside the curve there will be inefficiency and
less than full factor employment.
• Economic growth: actual growth is shown by
a movement closer to the PPC from a point of
production inside the PPC and an increase
in productive potential will shift the PPC to
the right.
• Specialization in production: a PPC curve can
be used to show how a firm uses its resources
to specialize in the production of one good (a
point of production along its PPC).
(c) 
Price elasticity of demand is the
responsiveness of the demand for a product
to a change in its price. If demand is price
elastic, a small percentage change in price
will result in a larger percentage change in
quantity demanded each period.
There are a number of factors that will
cause consumer demand for a product to
become more price elastic over time. For
example, in the short run the product may
have very few close substitutes. Consumers
will therefore either have to continue
buying the product following an increase in
its price or go without. However, over time
more substitutes may become available
if the product is profitable and new firms
enter the market offering alternatives.
Demand will also tend to be more price
elastic the more time consumers have
to search or shop around for alternative
suppliers or products, for example, if the
product is not a necessity and it is possible
to delay its purchase.
Demand also tends to become more
price sensitive the higher the price of the
product. Over time as price continues to
rise, for example, due to inflation, the
product will become less and less affordable
until eventually consumers are forced to
find cheaper alternatives or stop buying it
altogether.
Some products, such as telephone and
broadband services, electricity supplies, car
insurance and satellite television services,
are usually only supplied to consumers
who have agreed to long supply contracts.
These contracts will ‘lock’ a consumer into
an individual supplier for periods of 12,
18 or more months during which prices
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may rise. Early exit fees can be expensive
so consumers may have no choice but to
pay the higher prices. However, after the
contract expires, consumers will able to
shop around for alternative suppliers.
(d) Through growth, a firm is able to enjoy a
number of cost advantages over smaller
firms. When a firm expands its scale of
production, it has a chance to become
more efficient. Average or unit costs of
production can be reduced as a firm grows
in scale because it gives the management
or owners a chance to reorganize the way
the firm is run and financed. Cost savings
that result from increasing the scale of
production are called economies of scale
and will allow firms to increase their profits.
For example, large firms are often able to
buy the materials, components and other
supplies they need in bulk because of the
large scale of their production. Suppliers
will usually offer price discounts for bulk
purchases because it is cheaper for them
to make one large delivery than several
smaller deliveries. Larger firms are also
able to borrow more money and at lower
interest rates than smaller businesses.
Bank managers and other lenders often
consider lending to big organizations as
less risky than lending to smaller ones.
This is because large firms are often more
financially secure and can offer more assets,
including property and other investments,
that they can use as collateral against loans.
Larger firms may also be able to form a
limited company and sell shares to raise
non-repayable share capital.
With more financial resources than smaller
firms, a large enterprise can invest in
specialized machinery and equipment, to
train and recruit highly skilled workers,
and to research and develop new products
and processes to increase the efficiency of
their production. They can also diversify
into other products and markets. In this
way, a large firm is able to reduce the risk
to its business of losing a major customer,
or a fall in demand for a product in one of
its markets.
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Large firms can pass on some of these
cost savings to their customers as lower
prices, and because they can invest in
developing new and improved products
and in improved customer service levels,
consumers can also gain from wider
product choice and quality.
However, growth in the size of firms may
not always benefit consumers or their
owners. This is because some firms can
experience problems if they try to expand
their size and scale of production too much
and too quickly. As a result, productivity
may fall and average costs will rise. These
problems are caused by diseconomies of
scale. These occur because managing a
large firm can be difficult, especially if the
firm has factories or offices spread over
many different locations producing many
different types of products, and with many
different layers of management. This can
cause communication breakdowns and
disagreements between different managers
in different parts of the organization and
at different levels in the management
hierarchy. Some large firms may also be
unable to attract enough workers with the
right skills. Their costs may rise as they
have to spend more money on training
their workers and increasing their wages
to ensure they do not leave to take jobs in
other firms.
If a large firm experiences significant
diseconomies of scale, it may attempt to
pass on these costs to consumers as higher
prices. The mass production of standardized
products by many large firms also reduces
product choice for consumers. Many
consumers may prefer the personalized
service and products that smaller firms
may offer.
Some large firms may also grow to
dominate the market supply of a product
and may use this market power to restrict
new competition so they are able to charge
higher prices and earn abnormal profits.
Consumers will suffer reduced choice
and higher prices as a result of such anti-
competitive behaviour.
8