C7 - Points (Incomplete) Flashcards
Explain the equimarginal principle. (4m)
- For the case of a single commodity, a consumer can decide how much to buy of a good by comparing the price of the given commodity with its utility.
- The consumer will be at equilibrium when marginal utility (in terms of money) equals the price paid for the commodity.
- For the case of two or more commodities, when the ratio of marginal utiolity of a commodity to its price equals the ratio of marginal utility of another commodity to its price, consumer will be in equilibrium.
- MUx/Px = MUy/Py
Explain the limitations of marginal utility theory. (8m)
1) Utility or satisfaction that an individual gains from the consumption of a product may not necessarily be easily measured.
2) Consumers may not always behave in a rational way.
3) Consumers may not have limited incomes because it is possible that incomes may rise over a period of time.
4) Consumers may not always maximise their total utility.
5) Prices are likely to be continually changing and not constant.
6) Consumer tastes and preferences may not remain constant as they may change over time, perhaps as a result of advertising campaigns.
7) Consideration of marginal utility may not always be vitally important, especially where consumption is habit forming or made on impulse.
8) All units of a product available for consumption may not be identical if quality control in the production process is not very efficient.
Explain the concept of budget lines. (3m)
- Anywhere on the budget line, consumer is spending their entire income either on single or both the goods.
- A budget line changes when either the prices of the goods or income of the consumer or both changes.
- A budget line is negatively sloped because to buy more units of a good, consumer must buy less units of the other good as consumers’ income is fixed.
Explain the properties of indifference curves. (5m_
- Indifference curves are always convex to the origin
- Because of diminishing marginal rate of substitution.
- As the consumer consumes more and more of one good, his marginal utility of this good keeps on declining and he is willing to give up less of the other good. - Indifference curves slope downwards (negative)
- When a consumer takes additional units of a commodity then some units of the other goods will have to be given up by the consumer to maintain the same level of satisfaction on an indifference curve. - Indifference curves can never intersect.
- Two indifference curves are not necessarily parallel to each other because the marginal rates of substitution for the curves may or may not be equal
- Different indifference curves represent different levels of satisfaction.
- If two curves cut each other at a point, then it means that at that point, the level of satisfaction is the same on the two indifference curves, but it is impossible. - An indifference curve touches neither x-axis nor Y-axis
- The reason is that if this happens, then the consumer takes only one goods, but this is against the assumption of indifference curves. - A higher indifference curve represents higher level of satisfaction
Explain the substitution effect when price falls for a normal good. (4m)
- Occurs because the relative price of a good changes.
- Consumers buy more of the cheaper good and less of the expensive good. (substitute expensive good for cheaper good)
(DRAW THE GRAPH AND CHECK GOODNOTES FOR ANSWER)
1. Price of good X decreases, budget line rotates outward.
2. Substitution effect is where point A moves to point D, where quantity purchased of X increases and quantity purchased of Y decreases.
Explain the income effect when price falls for a normal good. (4m)
- Occurs because consumers experience a change in real purchasing power when price changes.
- Consumer can buy more of one or both of the goods.
(DRAW THE GRAPH AND CHECK GOODNOTES FOR ANSWER)
1. Parallel shift from imaginary budget line to new budget line.
2. Income effect is where point D moves to point B, where quantity purchased of either or both X and Y increases when price of one of the goods decrease.
Explain the income effect when price falls for an inferior good. (3m)
- For inferior goods, you buy less of it as your income increases.
- Consumers will substitute more expensive, better quality goods for good X.
- The income effect is negative, but not enough to outweigh the substitution effect.
Explain the three main limitations to the indifference curve model. (3m)
- In reality, consumers have to choose from many more goods than just two. Sometimes, they may have to choose between hundreds of goods in the case of everyday food products.
- The term “indifference” implies that consumers are willing to accept any combination of the two goods as represented by an indifference curve. Some economists point out that consumers express their wants and needs in terms of preference or rank order, and not indifference.
- Indifference curves assume that consumers act rationally. This is not always true.
Explain what is meant by economic efficiency. (6m)
- Economic efficiency is a state where scarce resources are optimally used to fulfil as much consumer wants as possible.
- Economic efficiency can be categorised into productive efficiency and allocative efficiency.
- Productive efficiency occurs when production takes place at least cost. (Q = ATC)
- There is productive efficiency if an economy is operating on its production possibility frontier.
- Allocative efficiency occurs when firms produce the combination of goods and services that are most wanted by consumers.
- The point of allocative efficiency can be deemed to exist when the price of a product is equal to its marginal cost of production. (P = MC)
Explain what is Pareto optimality. (4m)
- It is argued that the best possible allocation of scarce resources existed when it was impossible to make one person better off without making another person worse off.
- In an optimal situation, with resources allocated in the most efficient way, this is referred to as Pareto efficiency.
- If production is within the production possibility frontier, it is productively inefficient and therefore is Pareto inefficient, and vice versa.
- Pareto improvement is when a point within the PPC moves outwards, producing more goods/services.
Explain the reasons of market failure. (3m)
- Abuse of monopoly power in the market
- Firms with market power my restrict output in order to raise price.
- This will result in price exceeding marginal cost and lead to allocative inefficiency.
- The lack of competition may cause firms to raise price above lowest possible average cost and so are productively inefficient. - The provision of public and quasi-public goods
- The market may fail to provide certain goods and services.
- There are no markets for public goods. People do not reveal their demand and so private sector firms have no incentive to produce public goods (i.e. defence). - Information failure
- Adverse selection or moral hazard
- Where there are externalities in the market.
- The provision of merit and demerit goods.
Explain the differences between adverse selection and moral hazard. (6m)
- Adverse selection occurs when there is asymettric information between a buyer and a seller before a deal.
- This means one of the two parties (usually the seller) has more accurate or different information than the other party (typically the buyer) before they reach an agreement.
- This puts the less knowledgable at a disadvantage because it is more difficult for them to assess the value or risk of the deal.
- On the other hand, moral hazard occurs when there is asymmetric information between a buyer and a seller and a change in behaviour after a deal.
- This means one of the parties accepts a deal with the intention to change their behaviour after a deal is made.
- This puts the less knowledgable party (usually the seller) at a disadvantage because they are the ones who have to face the negative consequences instead and thus, they might not have agreed to the deal if they had known about the change in behaviour in advance.
Explain the graphs of negative production externalities, negative consumption externalities, positive production externalities and positive consumption externalities.
https://docs.google.com/document/d/1n4dYxcwKAC2Vkc_UltjXuFZD0rKRRzwmPAqkN6SHH-o/edit?usp=sharing
Explain the problems created by externalities.
- Externality could lead to overproduction or underproduction, which is an inefficient allocation of resources.
Overproduction (negative externality)
- When deciding what P and Q to produce, producers only consider private costs and does not take into account external costs.
- Price will be lower than if all social costs were recognised, therefore leading to overproduction and market failure.
Underproduction (positive externality)
- Market may produce output that is below the quantity that maximizes social welfare,
- Because of external benefits, actual demand is actually higher than private demand.
State the framework including four steps of a cost-benefit analysis.
- Identification of all relevant costs and benefits
- Putting a monetary value on all relevant costs and benefits.
- Forecasting future costs and benefits.
- Decision making - the interpretation of the results from cost-benefit analysis.
