AQA A-Level Economics

MICROECONOMICS
STUDENT COMPANION

Authors: Cathy Williams and Geoff Riley

Series Editor: Ruth Tarrant

EDITION DATE: SEPTEMBER 2019

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COMPANION CONTENTS

4.1.1.1 Economic methodology ......................................................................................................... 4

4.1.1.2 The nature and purpose of economic activity ................................................................... 6
4.1.1.3 Economic resources ................................................................................................................ 7
4.1.1.4 Scarcity, choice and the allocation of resources ............................................................. 10
4.1.1.5 Production possibility diagrams ......................................................................................... 12
Numerical Skill 1 – using index numbers ..................................................................................... 17
4.1.2.1 Consumer behaviour ........................................................................................................... 20
4.1.2.2 Imperfect Information ......................................................................................................... 22
4.1.2.3 Aspects of behavioural economic theory ........................................................................ 25
4.1.2.4 Behavioural economics and economic policy ................................................................ 30
4.1.3.1 The determinants of the demand for goods and services ........................................... 34
4.1.3.2 Price, income and cross elasticities of demand .............................................................. 38
4.1.3.3 The determinants of the supply of goods and services ............................................... 44
4.1.3.4 Price elasticity of supply ..................................................................................................... 49
4.1.3.5 The determination of equilibrium market prices ........................................................... 51
4.1.4.1 Production and productivity ............................................................................................... 69
4.1.4.2 Specialisation, division of labour and exchange ............................................................ 71
4.1.4.3 The law of diminishing returns and returns to scale ..................................................... 74
4.1.4.4 Costs of production ........................................................................................................... 77
4.1.4.5 Economies and diseconomies of scale ............................................................................ 83
4.1.4.6 Marginal, average and total revenue ............................................................................... 90
4.1.4.7 Profit ...................................................................................................................................... 94
4.1.4.8 Technological change ......................................................................................................... 97
4.1.5.1 Market structures ................................................................................................................ 100
4.1.5.2 The objectives of firms ...................................................................................................... 103
4.1.5.3 Perfect competition ........................................................................................................... 113
4.1.5.5 Oligopoly ............................................................................................................................ 122
4.1.5.6 Monopoly and monopoly power ................................................................................... 135
4.1.5.7 Price discrimination ........................................................................................................... 143
4.1.5.8 The dynamics of competition and competitive market processes ........................... 148

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4.1.5.9 Contestable and non-contestable markets ................................................................... 150
4.1.5.10 Market structure, static efficiency, dynamic efficiency and resource allocation .... 154
4.1.5.11 Consumer and producer surplus ................................................................................... 158
4.1.6.1 The demand for labour: marginal productivity theory ................................................ 162
4.1.6.2 Influences upon the supply of labour to different markets ........................................ 167
4.1.6.4 The determination of relative wage rates and levels of employment in imperfectly
competitive labour markets ......................................................................................................... 173
4.1.6.5 The influence of trade unions in determining wages and levels of employment .. 175
4.1.6.6 The national minimum wage ........................................................................................... 180
4.1.6.7 Discrimination in the labour market ............................................................................... 183
4.1.7.1 The distribution of income and wealth ........................................................................... 192
4.1.7.2 The problem of poverty ................................................................................................... 197
4.1.7.3 Government policies to alleviate poverty and to influence the distribution of income
and wealth ....................................................................................................................................... 198
4.1.8.1 How markets and prices allocate resources .................................................................. 200
4.1.8.2 The meaning of market failure ........................................................................................ 205
4.1.8.3 Public goods, private goods and quasi-public goods ................................................ 206
4.1.8.4 Positive and negative externalities in consumption and production ....................... 210
4.1.8.5 Merit and demerit goods ................................................................................................. 219
4.1.8.6 Market imperfections ........................................................................................................ 221
4.1.8.7 Competition policy ............................................................................................................ 226
4.1.8.8 Public ownership, privatisation, regulation and deregulation of markets .............. 228
4.1.8.9 Government intervention in markets ............................................................................. 236
4.1.8.10 Government failure .......................................................................................................... 250

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This occurs because not all factor inputs (such as land and labour) are equally suited to producing different
goods and services leading to lower productivity. Initially, firms will move workers (and other factors of
production) towards producing Good X if the firm thinks that the workers will be really good at producing
Good X (i.e. they have the ‘right’ skills for the job). As output of Good X rises, though, firms will have to resort
to moving workers to production of Good X even if they are better suited to producing Good Y.

Examiner tip

Explaining the shape of a PPF might be a multiple-choice question, but many students struggle to gain the
marks because it is such a small part of the syllabus covered so early in the course that they have simply
forgotten it! Always make sure that you review the topics you covered early in the course.

The PPF and economic efficiency

Any point on the PPF represents a productively efficient allocation of scarce resources – all factors of
production are being used in their most efficient way. Points inside the PPF represent an inefficient allocation
of resources since it is possible to produce more of one good without sacrificing any of the other. This is
illustrated on the diagram below, which shows a PPF for a small farm, which can grow just potatoes and
carrots.

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4.1.3.1 The determinants of the demand for goods and services

Key specification content:

• The relationship between price and quantity demanded

• Factors that may cause a shift in the demand curve (the conditions of demand)

What is demand?
Demand is the quantity of a good or service that consumers are willing and able to buy at a given price in a
given time period. Effective demand is when a desire to buy a product is backed up by an ability to pay. When
economists write about ‘demand’, they usually mean ‘effective demand’.

Derived demand is the demand for a factor of production used to produce another good or service. For
example, steel - the demand for steel is linked to market demand for cars and construction of new buildings

Law of Demand
There is usually an inverse relationship between the price of a good and demand.
1. As prices fall, we see an expansion/extension of demand.
2. As prices rise, there will be a contraction of demand.

Quick question

Can you think of any products that people are more likely to buy when they are more expensive?

Ceteris paribus assumption

When drawing a demand curve, economists assume all factors are held constant except one – the price of the
product itself. Ceteris paribus is an important assumption used in nearly all economic analysis that allows us
to isolate the effect of one variable on another variable.

Demand Curve
A demand curve shows the inverse relationship between the price of an item and the quantity demanded over
a period of time. There are two reasons why more is demanded as price falls:
1. The Income Effect: When the price of a good falls, the consumer can maintain the same consumption
for less expenditure; effectively, this increases ‘real income’. Provided that the good is normal (i.e.
one for which demand rises when income rises, and demand falls when income falls), some of the
increase in real income is used to buy more.
2. The Substitution Effect: When the price of a good falls, ceteris paribus, the product is now relatively
cheaper than an alternative and some consumers will switch their spending from the alternative good
or service. The more substitutes there are in the market and the lower the cost/inconvenience of
switching, the bigger the substitution effect is likely to be.

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Total revenue can be determined by calculating price x quantity bought. The relationship between elasticity
of demand and a firm’s total revenue is an important one often tested in exams:
• When demand is price inelastic, a rise in price leads to a rise in total revenue – for example, 20% rise
in price might cause quantity demanded to contract by only 5% (PED = -0.25). So, the rise in price is
more than proportional to the fall in quantity demanded, and so total revenue will rise.
• When demand is price elastic, a fall in price leads to a rise in total revenue - for example, a 10% fall
in price might cause quantity demanded to expand by a much larger 25% (PED = +2.5). The rise in
quantity demanded is proportionately greater than the fall in price, and so total revenue will rise.
• When demand is perfectly inelastic (i.e. PED = zero), a given price change will result in the same
revenue change, for example, a 5% increase in a firm’s prices results in a 5% increase in its total
revenue
• When demand is unit elastic (i.e. PED = -1) a change in the price leads to no change at all in the
revenue

Examiner tip:

Make sure that you can explain the relationships stated above, rather than merely repeat the relationships –
this will help you to pick up analysis (AO3) marks and not just knowledge (AO1) marks.

Quick question

Can you think of businesses that have recently a) raised their prices and b) lowered their prices? Using your
knowledge of the relationship between PED and total revenue, can you give an explanation of these business
choices?

Price elasticity of demand and total revenue – numerical example

The table below gives an example of the relationships between price, quantity demanded and total revenue.
As price falls, the total revenue initially increases, in our example the maximum revenue occurs at a price of
£12 per unit when 520 units are sold giving total revenue of £6240.

Price Quantity Total Revenue

£ Per Unit Units £
20 200 4000
18 280 5040
16 360 5760
14 440 6160
Consider the price
12 520 6240
elasticity of demand of
10 600 6000
a price change
from £20 8 680 5440 per unit to
£18 per 6 760 4560 unit.
• The % change in quantity demanded is +40% after a -10% change in price, which gives a PED of -4
(i.e. highly elastic).
• In this situation when PED is highly elastic, a fall in price leads to higher total consumer spending /
producer revenue

Now consider a price change further down the estimated demand curve – from £10 per unit to £8 per unit.

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 Standard
Medium
Store of Unit of of
of
value account deferred
exchange
payment

Quick questions

Take a look at the chart below.

a) What does the chart show in terms of the trends in cash transactions?
b) What factors do you think explain this trend?
c) Why might it be the poorest people in society that lose out as the use of cash declines?

Forecasted number of cash transactions in the United Kingdom from 2006 to 2026, by denomination (in
billions)
< £1 < £5 < £10

20
Number of transactions in

15

10
billions

0
2006 2016 2026*

Key characteristics of money

Durable and Acceptable when Holds value over

Hard to counterfeit
Portable making transactions time

1. Durability i.e. it needs to last

2. Portable i.e. easy to carry around, convenient, easy to use
3. Divisible i.e. money can be broken down into smaller denominations to facilitate purchases
4. Hard to counterfeit - i.e. it cannot easily be faked or copied by currency fraudsters
5. Accepted i.e. money must be accepted as legal tender – there must be sufficient trust in money
6. Valuable – i.e. it generally holds value over time and is not destroyed by the effects of rapid / hyper-
inflation

Examiner tip

Be careful not to confuse the functions of money with the characteristics of money!

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Profit Maximisation
• Profit maximisation occurs at an output where marginal revenue = marginal cost (MR=MC)
• The change in revenue from producing an extra unit of output = the change in cost from producing
an extra unit

Quick question

Take a look at the business pages in a reputable newspaper or news website. There is often information
on the latest profits and accounting figures of well-known companies. Jot down a few notes on which
companies appear to be profitable and which appear to be struggling. Can you think of reasons why this
might be the case?

Common error alert!

Economics students often confuse revenue with profit, assuming that a rise in demand will always, for
example, lead to a rise in profits. Unfortunately, it is impossible to assume this! If you only have information
relating to revenue, then you can only consider the impact on revenue – without additional information
relating to costs, you cannot confidently say anything at all about profit!

A reminder - marginal profit and profit maximisation

Profit maximisation occurs where MC = MR

Price, MC
Cost Profit
maximised
here

Marginal
profit is
negative
Marginal
profit is
positive

MR

Q1 Output

• Firms producing differentiated products choose price and quantity to maximise their profits,
considering the product demand curve and the cost function
• If MR > MC, the firm could increase profit by raising output – look on the diagram above, where you
should be able to see that this occurs at output levels less than Q1
• If MR < MC, the marginal profit is negative. It would be better to decrease output. On the diagram
above, this occurs at all output levels above Q1

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Profit maximisation in the short run – diagrammatic analysis

• When drawing perfect competition diagrams, remember to make a clear distinction between the
market and a representative individual firm i.e. you must draw two diagrams
• The market price is set by the interaction of market supply and demand
• Each individual firm is a price taker in a perfectly competitive market
• The ruling market price becomes the AR and MR curve for the firm
• Average revenue equals marginal revenue at every level of output
• We assume that the aim of each firm is to find a profit-maximising output

Price, Market Supply and Price, Revenues, Costs and Profits for a
Cost Demand Cost Competitive Firm

S
MC
Supernormal
profits
AR=MR
P1

AC
C1

Output Q1 Output

Examiner tip:
Firms can also make losses in the short run in perfect competition – this will happen if the ruling market price
is less than the average cost for a particular firm. Practice drawing diagrams in which the individual firm is
initially making a loss rather than earning supernormal profit. This causes firms to leave the industry, raising
the market price. Sub normal profits are shown below.

Sub-normal profit (economic losses) in the short run in perfect competition

Price, Market Supply and Price, Revenues, Costs and Profits for a
Cost Demand Cost Competitive Firm

MC

S AC

C1

P1
AR1 = MR1

Output Q1 Output

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 Web Search Messaging E-Commerce Taxi apps Streaming Sharing
services economy
Exam Technique: Building a chain of reasoning:
Question: How is a natural monopoly different from other industries?

A natural monopoly is a This is because of the For example, the supply

special case where one
large business can
supply the entire market
at a lower unit cost than
with multiple providers.
nature of costs in a of water or electricity to
natural monopoly houses and businesses
industry. Typically there involves building a big
are very high fixed costs network infrastructure.
and low marginal costs.

This means that long
run average cost (LRAC)
may fall across all ranges
of output. Only one firm
might reach the
minimum efficient scale.
Therefore, the average As a result, fixed costs
total cost will continue are enormous but the
to fall as extra users are marginal cost of adding
added to the network. an extra user is very low
This is an internal
economy of scale.

Examiner tip:

Use the natural monopoly argument as a theoretical and practical piece of evaluation for essays relating to
the pros and cons of monopoly i.e. if a natural monopoly did not exist in a particular market then it may be
the case that there would be a missing market. Furthermore, many natural monopolies operate in the national
interest. The quality of service provided makes a big difference to the everyday lives of millions of households
and businesses.

Quick question

Why might it be beneficial for firms that have the characteristics of natural monopoly to be nationalised, or
run in the public interest?

Economic efficiency in monopoly

The standard case against monopoly is that it is leads to a loss of economic efficiency which can then cause
reductions in the welfare of consumers affected. But this view can be challenged as part of your evaluation. It
is important to judge the exercising of market / monopoly power on a case-by-case basis based on how
businesses with such power actually conduct themselves.

Economic Case against Monopoly

i) Prices are higher than under competitive conditions
o This leads to a loss of allocative efficiency (because the monopoly price > MC)
o Higher prices can have a regressive effect on lower-income households
ii) Absence of genuine market competition may lead to production inefficiencies
o X-Inefficiencies such as wasteful production and advertising spending
iii) Higher prices can limit output in a market and lead to fewer economies of scale being exploited

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Producer Surplus
Producer surplus is the difference between the price producers are willing and able to supply a product for
and the price they get in the market. Producer surplus is shown by the area above the supply curve and below
the price. Higher prices provide an incentive to for businesses to expand supply. This is due to the profit
motive.

Changes in demand and supply, market price and producer surplus

Lower2supply2costs2cause2price2
Price to2fall2and2equilibrium2quantity2
to2rise.2Producer2surplus2
increases2from2area2ADB2to2
area2FEC2
An2increase2in2market2demand2
Price leads2to2a2higher2price2&2
quantity2leading2a2rise2in2
producer2surplus2from2area2
ABC2to2DEC

S1 S1
D E
A D
E B
S2 A D2
F

B C
D1
D1
C

Q1 Q2 Quantity Q1 Q2 Quantity

Another term for producer surplus is “supernormal profit”.

Quick question:

You can now illustrate total revenue and producer surplus (“profit”) on a demand and supply diagram. One
‘triangle’ of the total revenue area is producer surplus – can you explain why the remaining ‘triangle’ in that
total revenue rectangle must represent total costs?

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