MICRO

Utility
Utility is the want satisfying capacity of a commodity. It is a record of the level of happiness one receives
from the consumption of a good or service.

The theory was developed by Alfred Marshall who stated that consumer satisfaction can be measured
through imaginary units called “utils”.

The theory represents cardinal approach and is based on premises that the amount of satisfaction
obtained from a particular product can be measured in the same way that the actual units consumed can
be calculated i.e. numbers.

Two important measures are: “Total Utility” and “Marginal Utility”.

Total utility is the sum of all the satisfaction derived from the consumption of all units of a good over a
given time period.

Marginal Utility is the additional or extra satisfaction derived from the consumption of one more unit of
a particular good.

So, if someone gets 10 utils of satisfaction from consuming one bar of chocolate and 15 utils after
consuming two bars, the marginal utility is 5 utils. This concept can be understood with the help of
schedule and relevant graphs as shown below:

Schedule:
Units TU MU
0 0 0
1 50 50
2 80 30
3 100 20
4 110 10
5 110 0
6 90 -20
It is evident from the above graphs that when
marginal utility equals zero, total utility is at
maximum (see graph trend at unit 5). Also,
when MU is positive, TU is increasing but when
MU is negative, TU starts decreasing. It can also
be seen that when consumption increases from
unit 1 to unit 2 and so on, marginal utility falls.
This aspect of consumer behavior is referred to
as “Law of Diminishing Marginal Utility”. As
consumption increases, marginal utility
becomes negative (see MU at unit 6), indicating
dissatisfaction or disutility.
A consumer is in equilibrium at the quantity at which the marginal utility of a good equal its price.

Schedule:
Units MU X PX
1 25 5
2 15 5
3 10 5
4 8 5
5 5 5
6 2 5

The graph above shows an equilibrium point E at unit 5 where the price is equal to the marginal utility of
the product. The consumer will not consume the sixth unit because the satisfaction gained at that point
will not be worth the price paid. Hence the consumer will stop purchasing when the MU and price are
equal.

If MUY/PY is greater than MUX/PX, household will switch from good X to good Y. The following changes
could be seen in the respective demand curves.

The figure on left shows an initial equilibrium point E where market price of good X is “P” and quantity
demand “Q”. When consumers shift to good Y from good X due to fewer additional satisfactions in good
X, the demand curve of good X will shift backwards from D to D1, resulting in a fall in price from P to P 1
and a contraction in quantity demand from Q to Q 1 . Hence a new equilibrium is established at E1.

Since consumers will now prefer good Y due to increase in marginal utility, the demand curve will shift
towards the right from D2 to D3, resulting in an extension in quantity demand from Q 2 to Q3 and an
increase in price from P 2 to P3. Hence a new equilibrium is established at E3 in the market of good Y.

The consumer of good Y will observe the diminishing return after some time as consuming same nature
of good repetitively will open the doors of tiring and endless loop for them. Therefore, they will feel that
one extra unit of good Y will not be worth the price they are paying for. If they could find another
product with a greater marginal utility, it is obvious that they will switch to the new good.

Paradox of value:

It is interesting to note that the prices are determined by marginal utility and not total utility. If this was
not the case, the prices of water should have been higher than diamonds as total utility of water is
higher.

Criticism on Utility theory:

The assumption that the utility can be measured in numbers is extremely doubtful since the satisfaction
derived from various commodities cannot be measured objectively. Moreover, the consumers do not
always act rationally; they may purchase goods without considering price or quality. Meanwhile, other
assumptions that marginal utility diminish when goods are consumed more and more and consumers
should have limited income is also doubtful.
 Paper 3
1.

Answer: B

A: 16 + 14 +12 = 42 C: 16 + 13 + 10 = 39

B: 16 + 13 + 14 = 43 D: 14 + 12 + 9 = 35

2.

The marginal utility of a product to a consumer is zero. What does this indicate?
A. Total utility is also zero.
B. Total utility is maximized.
C. The product is free.
D. The consumer is in equilibrium with the product.

Answer: B

Total utility rises when marginal utility is positive. It reaches its peak when marginal utility is zero and
would start falling if marginal utility becomes negative. A zero marginal utility does not indicate that the
product is free. The consumer is in equilibrium at the quantity at which the marginal utility of a good
equal its price.
3.

Answer: A

When Marginal Utility is positive, Total Utility is increasing.

Total Utility is increasing from Q0 to Q1 indicating positive marginal utility. This means that the consumer
will be willing to spend money as he will be getting additional satisfaction.

The price he will be willing to pay at Q0 will be higher because Total utility has just begun to rise.

B is not the answer because at Q3, the consumer will not be willing to spend extra money as total utility
is decreasing.

C is not the answer because at Q2, the consumer will not be willing to spend extra money as total utility
has started decreasing.

D is not the answer because the consumer would be willing to pay more at Q 1 than at Q3.
4.

Answer: C

When marginal utility is greater, a consumer would be willing to pay a higher price. So, the difference
between the price a consumer is willing to pay and the price he actually paid is consumer surplus.

5.

Basic food products such as rice and bread are cheaper than diamonds. This is despite basic food products
being more essential to people`s lives than diamonds. What could explain this paradox of value?
A. Basic food products are a necessity whereas diamonds are a want.
B. Diamonds are in greater supply than basic food products.
C. There is a difference in market structures.
D. There is a difference between total and marginal utility.

Answer: D

This is the paradox of value. While food has a high total but low marginal utility, the reverse is true for
diamonds.
6.

Answer: C

$1 gives 3 utils. So, $4 will be giving 12 utils. Let’s see till which quantity of goods will create 12 utils of
marginal utility. From good 1 to good 2, MU is 16 utils, from 2 to 3 unit, MU is 14 utils, then from 3 to 4
units, the MU is 12 utils. Beyond this unit, the consumer would not be willing to go.
7.

Answer: A

By observing the total utility curve, we can determine the individual's marginal utility curve, which is the
slope of the total utility curve. The marginal utility curve shows the change in utility the individual
receives from consuming additional units of the good.

8.

Answer: D

This is the formula that has been rearranged: MUx / Px = MUy / Py

9.

Answer: B

Since the utility he gets from spending one dollar is 4 utils, he will get 40 utils if he spends $10. See the
number of kilos he will purchase when the utility is 40. That is 5 kilos. Hence the answer is B.
10.

Answer: D
Paradox of value concept. The observation that the amount of water consumed is lower when a price
per liter is used implies that as the price of water increases, the additional satisfaction (utility) gained
from consuming each additional liter decreases. This is a classic example of the law of diminishing
marginal utility, where the first units of a good consumed provide a high level of satisfaction, but each
subsequent unit provides less and less satisfaction. So, when people must pay more for water, they are
likely to use less of it, as the marginal utility of each additional liter becomes smaller.

Paper 4
20 marks question as per new syllabus:

Question:

Analyze the theoretical relationship between utility, price, and the demand for a product, and discuss
the validity of the economic analysis in estimating demand based on value (utility) for a wide range of
products including standard, poor quality, and luxury goods. [20]

Sample Answer:

Utility is the want satisfying capacity of a commodity. It is a record of the level of happiness one receives
from the consumption of a good or service. The theory was developed by Alfred Marshall who stated
that consumer satisfaction can be measured through imaginary units called “utils”.

The theory represents cardinal approach and is based on premises that the amount of satisfaction
obtained from a particular product can be measured in the same way that the actual units consumed can
be calculated i.e. numbers.

Two important measures are: “Total Utility” and “Marginal Utility”.

Total utility is the sum of all the satisfaction derived from the consumption of all units of a good over a
given time period. Marginal Utility is the additional or extra satisfaction derived from the consumption of
one more unit of a particular good.

So, if someone gets 10 utils of satisfaction from consuming one bar of chocolate and 15 utils after
consuming two bars, the marginal utility is 5 utils. This concept can be understood with the help of
schedule and relevant graphs as shown below:
 Schedule:
Units TU MU
0 0 0
1 50 50
2 80 30
3 100 20
4 110 10
5 110 0
6 90 -20
It is evident from the above graphs that when
marginal utility equals zero, total utility is at
maximum (see graph trend at unit 5). Also,
when MU is positive, TU is increasing but when
MU is negative, TU starts decreasing. It can also
be seen that when consumption increases from
unit 1 to unit 2 and so on, marginal utility falls.
This aspect of consumer behavior is referred to
as “Law of Diminishing Marginal Utility”. As
consumption increases, marginal utility
becomes negative (see MU at unit 6), indicating
A consumer is in equilibrium at the quantity at which the marginal utility of a good equal its price.
dissatisfaction or disutility.

There is a very strong link between utility and price. A consumer is in equilibrium at the quantity at
which the marginal utility of a good equal its price.

Schedule:
Units MU X PX
1 25 5
2 15 5
3 10 5
4 8 5
5 5 5
6 2 5
The graph above shows an equilibrium point E at unit 5 where the price is equal to the marginal utility of
the product. The consumer will not consume the sixth unit because the satisfaction gained at that point
will not be worth the price paid. Hence the consumer will stop purchasing when the MU and price are
equal.

Not only this, but the marginal utility also indicates the prices. It is interesting to note that prices are
determined by marginal utility and not total utility. If this was not the case, the prices of water should
have been higher than diamonds as total utility of water is higher.

Demand is the willingness and ability of a consumer to buy a product at a given price is known as
demand.

According to the Law of Demand, a rise in price from “P” to “P1” will
result in a contraction of quantity demanded by consumers from “Q”
to “Q1”. Similarly, a fall in price from “P” to “P2” will extend the
quantity demand from “Q” to “Q2”.

The Law of Diminishing Marginal Utility is the basis of the Law of Demand. The consumer will buy more
only if the price falls because the more he buys the lower is the marginal utility.

Law of Diminishing Marginal Utility states that larger the quantity, less is the utility whereas Law of
Demand states that larger the quantity, lower will be the price as the utility of the successive units will
be low.

This is the theoretical link between utility, price and demand.

A rational consumer is one who seeks to maximize satisfaction or total utility from consumption by
correctly choosing how to spend their limited income. A rational consumer purchases only those items
whose marginal utility exceeds sales price, giving him/her a positive consumer surplus.

Poor households usually hesitate to buy normal goods (luxury or expensive products) mainly due to
income barrier. Hence, they perceive luxury products to be less important, believing that the goods
available to them are enough for them. This results in a lower marginal utility. Not only this, but such
products for poor household would also result in negative consumer surplus because the price thay will
be willing to pay would be much lower than the price asked.

On the other hand, households with a higher disposable income can not only afford luxury goods and
services but also perceive them to be of higher value / marginal utility. Therefore, they are even ready to
buy them at a higher price; marginal utility exceeds the price, giving them a positive consumer surplus.

However, in reality, quality is a very subjective term and the theory of measuring satisfaction is
extremely doubtful. Moreover, different consumers associate different meanings to the word “quality”; a
low quality good in the eyes of a high-income earner may be treated as a luxury item for a household
earning an income which barely meets his necessities.

In real life, consumers may not be rational as some of their decisions may be influenced by advertising,
attractive packaging, or marketing strategies. Consumers may purchase goods on impulse instead of
doing so rationally, contradicting the economic theory.

The economic theory is based on marginal utility, and it is difficult to ascertain an accurate marginal
utility. Consumers do not have perfect information and tend to make irrational choices. The theory also
assumes that consumers compare the price and marginal utility of every single unit before buying, but in
reality, they buy goods in a higher quantity and do not make choices that vividly and precisely. Due to
such criticism on the theory, it makes it difficult for us to reach a firm conclusion.

Summer 2014 Paper 41 Question 3:

Marking Scheme:

Sample Answer:

Consumer demand is an essential element in any business strategy, as it directly affects a company's
revenue. The question of whether advertising and impulse buying influence demand is a topic of debate
in economics.

Advertising and impulse buying are two significant factors that influence consumer demand. Advertising
aims to persuade consumers to buy a particular product by creating awareness and generating interest in
it. It plays a critical role in creating brand awareness and encouraging consumers to buy products they
may not have otherwise considered. On the other hand, impulse buying refers to the sudden urge to buy
a product without prior planning. This behavior is triggered by various factors such as product packaging,
location, and pricing.

While advertising and impulse buying may seem to be unrelated to the economic theories of consumer
demand based on utility, they are, in fact, closely related.

Utility is the want satisfying capacity of a commodity. It is a record of the level of happiness one receives
from the consumption of a good or service.
 The theory was developed by Alfred Marshall who stated that consumer satisfaction can be measured
through imaginary units called “utils”.

The theory represents a cardinal approach and is based on the premises that the amount of satisfaction
obtained from a particular product can be measured in the same way that the actual units consumed can
be calculated i.e., numbers.

Two important measures are: “Total Utility” and “Marginal Utility”.

Total utility is the sum of all the satisfaction derived from the consumption of all units of a good over a
given time period.

Marginal Utility is the additional or extra satisfaction derived from the consumption of one more unit of
a particular good.

So, if someone gets 10 utils of satisfaction from consuming one bar of chocolate and 15 utils after
consuming two bars, the marginal utility is 5 utils. This concept can be understood with the help of
schedule and relevant graphs as shown below:

Schedule:

Units TU MU
0 0 0
1 50 50
2 80 30
3 100 20
4 110 10
5 110 0
6 90 -20

It is evident from the above graphs that when

marginal utility equals zero, total utility is at
maximum (see graph trend at unit 5). Also,
when MU is positive, TU is increasing but when
MU is negative, TU starts decreasing. It can also
be seen that when consumption increases from
unit 1 to unit 2 and so on, marginal utility falls.
This aspect of consumer behavior is referred to
as “Law of Diminishing Marginal Utility”. As
consumption increases, marginal utility
becomes negative (see MU at unit 6), indicating
dissatisfaction or disutility.
Advertising aims to create a perception of utility or value for a product, and impulse buying is a result of
perceived value. Consumers are rational beings who make decisions based on the perceived benefits and
costs of a product. Persuasive advertising or impulse buying could still be related to a belief in potential
utility and could still be the result of a rational decision. Therefore, firms can still use economic theories
of consumer demand based on utility to determine their likely revenue.

The link between potential demand and firm revenue is a crucial consideration for businesses. Firms
invest in advertising with the expectation of creating an increase in demand for their products or
services. Effective advertising can capture the attention of consumers, increase brand recognition, and
create a positive association with the advertised product. As a result, it can lead to higher demand and,
subsequently, higher revenue for the firm. The success of advertising campaigns can be measured by the
extent to which they generate a favorable response from consumers, translating into increased demand
and revenue.

While advertising aims to stimulate demand and potentially increase revenue, it may also introduce
greater uncertainty and unpredictability. Consumer responses to advertising can vary based on factors
such as market saturation, competition, changing consumer preferences, and the effectiveness of the
advertising campaign itself. The impact of advertising on demand can be influenced by various external
factors beyond the control of the firm. As a result, firms may face challenges in accurately predicting and
forecasting future demand patterns. This uncertainty can have implications for revenue predictability, as
firms may encounter fluctuations in demand that are less predictable compared to situations where
changes in demand follow known annual patterns or established market trends.

Moreover, an increase in demand may not necessarily result in a proportional increase in revenue. The
elasticity of demand plays a significant role in this regard. Elastic demand refers to a situation where a
small change in price results in a significant change in demand. Inelastic demand, on the other hand,
refers to a situation where a change in price does not significantly affect demand.

If demand is elastic, a small increase in price may result in a significant decrease in demand, leading to a
decline in revenue. In contrast, if demand is inelastic, a small increase in price may not affect demand
significantly, resulting in an increase in revenue.

In conclusion, while advertising and impulse buying may seem to be unrelated to economic theories of
consumer demand based on utility, they are closely related. The perceived utility or value of a product
plays a significant role in both advertising and impulse buying. Firms can still use economic theories of
consumer demand to determine their likely revenue.

The link between potential demand and revenue is complex, and firms must consider the elasticity of
demand when advertising or setting prices. Firms must be aware that an increase in demand does not
always result in an increase in revenue, and therefore, they must be cautious when making pricing and
advertising decisions. By doing so, firms can make informed decisions regarding advertising strategies
and effectively manage associated risks.
Summer 2014 Paper 42 Question 2:

Marking Scheme:

Sample Answer:

The analysis of marginal utility has long been regarded as a fundamental concept in economics,
explaining consumer equilibrium and the construction of demand curves. However, there are critics who
argue that marginal utility is limited to the purchase of one good, becomes irrelevant when incomes
increase, and is not applicable when advertising influences consumer preferences.

Utility is the want satisfying capacity of a commodity. It is a record of the level of happiness one receives
from the consumption of a good or service. The theory was developed by Alfred Marshall who stated
that consumer satisfaction can be measured through imaginary units called “utils”.

The theory represents a cardinal approach and is based on premises that the amount of satisfaction
obtained from a particular product can be measured in the same way that the actual units consumed can
be calculated i.e., numbers.

Two important measures are: “Total Utility” and “Marginal Utility”.

Total utility is the sum of all the satisfaction derived from the consumption of all units of a good over a
given time period. Marginal Utility is the additional or extra satisfaction derived from the consumption of
one more unit of a particular good.

So, if someone gets 10 utils of satisfaction from consuming one bar of chocolate and 15 utils after
consuming two bars, the marginal utility is 5 utils. This concept can be understood with the help of
schedule and relevant graphs as shown below:
 Schedule:
Units TU MU
0 0 0
1 50 50
2 80 30
3 100 20
4 110 10
5 110 0
6 90 -20
It is evident from the above graphs that when
marginal utility equals zero, total utility is at
maximum (see graph trend at unit 5). Also,
when MU is positive, TU is increasing but when
MU is negative, TU starts decreasing. It can also
be seen that when consumption increases from
unit 1 to unit 2 and so on, marginal utility falls.
This aspect of consumer behavior is referred to
as “Law of Diminishing Marginal Utility”. As
consumption increases, marginal utility
becomes negative (see MU at unit 6), indicating
A consumer is in equilibrium at the quantity at which the marginal utility of a good equal its price.
dissatisfaction or disutility.

Consumers allocate resources / expenditures among different products to maximize total utility. In
maximizing total utility, the consumer faces a number of constraints.; the most important of which are
the consumer`s income and the prices of the goods and services that the consumer wishes to consume.
The solution to these consumer’s problem, which entails decisions about how much the consumer will
consume of a number of goods and services, is referred to as consumer equilibrium.

A consumer is in equilibrium at the quantity at which the marginal utility of a good equal its price.

Schedule:
Units MU X PX
1 25 5
2 15 5
3 10 5
4 8 5
5 5 5
6 2 5
The graph above shows an equilibrium point E at unit 5 where the price is equal to the marginal utility of
the product. The consumer will not consume the sixth unit because the satisfaction gained at that point
will not be worth the price paid. Hence the consumer will stop purchasing when the MU and price are
equal.

The concept of marginal utility also enables the construction of demand curves. Demand is the
willingness and ability of a consumer to buy a product at a given price is known as demand.

According to the Law of Demand, a rise in price from “P” to “P1” will
result in a contraction of quantity demanded by consumers from “Q”
to “Q1”. Similarly, a fall in price from “P” to “P2” will extend the
quantity demand from “Q” to “Q2”.

The Law of Diminishing Marginal Utility is the basis of the Law of Demand. The consumer's decision to
purchase a good is influenced by the trade-off between its price and the marginal utility derived from
consuming it. The consumer will buy more only if the price falls because the more he buys the lower is
the marginal utility.

Law of Diminishing Marginal Utility states that larger the quantity, less is the utility whereas Law of
Demand states that larger the quantity, lower will be the price as the utility of the successive units will
be low.

While marginal utility analysis is often illustrated using a single good, it can be extended to analyze
consumer equilibrium for multiple goods. Consumers face choices regarding the allocation of their
limited incomes among various goods. The concept of marginal utility allows consumers to compare the
additional satisfaction derived from consuming different goods, enabling them to allocate their limited
income optimally. By comparing the marginal utilities of different goods and considering their respective
prices, consumers can determine the most preferred combination of goods that maximizes their overall
utility. In other words, a consumer will be in equilibrium at a point at which the marginal utility of money
expenditure on both the goods are equal in symbolic terms. This is written in form of an equation below:

Marginal Utility of Good X / Price of Good X = Marginal Utility of Good Y / Price of Good Y

Therefore, marginal utility analysis remains applicable to multiple goods.

Critics argue that marginal utility analysis becomes irrelevant when incomes increase. However, this
viewpoint overlooks the concept of the income-consumption curve. As a consumer's income rises, their
budget constraint expands, enabling them to consume more of all goods. Although the marginal utility of
each good may decrease as a result of increased consumption, the overall satisfaction from the
increased consumption can still be maximized by adjusting the quantities consumed. This adjustment
ensures that the marginal utility derived from the last unit of each good is equalized, allowing the
consumer to allocate their income efficiently. Therefore, marginal utility analysis remains relevant even
with changes in income.

Another criticism suggests that marginal utility analysis is invalid if advertising causes a change in tastes.
While advertising can indeed influence consumer preferences, it does not render marginal utility analysis
useless. Instead, it highlights the dynamic nature of consumer behavior. When tastes change due to
advertising or other factors, the marginal utilities of goods may be altered. However, the underlying
principle of comparing additional satisfaction and making choices based on preferences still holds.
Consumers continuously assess the utility they derive from different goods, including those influenced
by advertising. They adjust their consumption patterns based on their changing preferences and the
marginal utilities associated with each choice. Therefore, marginal utility analysis remains applicable,
albeit with adjustments to reflect changes in tastes.

In conclusion, the opinion that the analysis of marginal utility is limited to one good, irrelevant with
income changes, and not applicable when advertising affects tastes does not withstand scrutiny.
Marginal utility analysis remains a valuable tool for understanding consumer equilibrium and
constructing demand curves, even when considering multiple goods, changes in income, and advertising
influences. It provides insights into consumer decision-making, trade-offs, and optimal resource
allocation. While adjustments may be necessary in certain scenarios, marginal utility analysis remains a
useful and indispensable concept in economics, offering a comprehensive guide to consumer behavior.
One Page Summary::

Utility: It is the want satisfying capacity of a commodity. It is a record of the level of happiness one
receives from the consumption of a good or service.

• Developed by Alfred Marshall who stated that consumer satisfaction can be measured through
imaginary units called “utils”.
• The theory represents cardinal approach, meaning that the satisfaction can be measured in
numbers.

Total utility: It is the sum of all the satisfaction derived from the consumption of all units of a good over
a given time period.

Marginal Utility: It is the additional or extra satisfaction derived from the consumption of one more unit
of a particular good.

1st 2nd 3rd

Satisfaction
Thermometer

The Law of Diminishing Marginal Utility states that the marginal utility of consuming one additional unit
eventually declines.

Equilibrium in case of one good: Price = Marginal Utility

Equilibrium in case of two goods: MUx / Px = Muy / Py

Paradox of Value: (Diamond VS Water)

It is interesting to note that the prices are

determined by marginal utility and not total
utility. If this was not the case, the prices of
water should have been higher than diamonds
as total utility of water is higher.
 Indifference curves
Indifference curves show the combination of two goods that yield the same level of satisfaction.

The slope of the curve is decided by the

marginal utility of good X divided by the
marginal utility of Y (MU X/MUY). This is called
the “Marginal Rate of Substitution”. This
concept has the word “substitution” because
we forgo some units of good Y (from Y to Y1) to
increase consumption of good X (from X to X 1 ).
It is important to note that at point A and B, the
utility gained is the same. Therefore, the curve
is downward sloping indicating a negative
relationship between good X and good Y.
Interestingly, an indifference curve never
intersects with the x axis.

Consumers allocate resources among different products to maximize total utility. Doing so involves
several constraints: the most important of which are the consumer`s income and the prices of the goods
and services a consumer wishes to consume. The solution to this consumer problem is referred to as
consumer equilibrium.

In order to reach an equilibrium, indifference curves must collaborate with the budget line.

Budget Line:

A budget line shows the quantities of two goods that a consumer can buy with the given income or
price. The budget line is a straight line where the area OAB represents affordability of a consumer. The
point “c” shows un-affordability. The slope of the budget line is decided by dividing the price of X with
that of Y (PX/PY).
 An increase in income will shift the budget line towards right as
shown on the graph (from AB to CD). The consumer can now
afford to spend more, forcing him/her to update his/her lifestyle
and living standards by purchasing normal goods.

An increase or decrease in price of any of the two goods will result in a pivotal shift in the budget line.

The diagram on the left shows a pivotal shift in the quantities of good X due to a fall in price of good X
with the quantities of good Y remaining constant. The budget area would change from OXY to OX 1 Y since
the household can now afford more units of X. Similarly, in case of a rise in price of good X, the area for
consumption would reduce from OX 1 Y to OX2Y.

The slope of the budget line being a tangent to the slope

of the indifference curve represents consumer equilibrium.

Consumer attains equilibrium when he/she maximize total

utility at a given income and price of goods.

The impact of reduction in price on consumer equilibrium is shown on next page:

The initial quantity purchased by the consumer is quantity X. The decrease in price of X causes a pivotal
move to the new budget line BL1. Price effect can be divided into substitution and real income effects.
To show the substitution effect separately, a hypothetical budget line BL2 is drawn which is parallel to BL1
and tangent to the initial indifference curve. According to the substitution effect alone, the consumer
raises the demand of good X from X to X 2. Substitution effect is always negative and raises the demand
of relatively cheaper products.
However, real income effect may be positive or negative, depending on the nature of the product. The
increased real income prompts the consumer to move to a higher indifference curve tangent to BL1.

Assuming that X and Y are both normal goods, the demand for X and Y increases as a result of increased
income and the new equilibrium will be at quantity X 1. In this case, income effect is positive and is
reinforced by the substitution effect i.e. they increase the demand for both X and Y.
If X is an inferior good, the new equilibrium will be at X 1. Increased real income lowers the demand of X.
In this case, the income effect is negative and tries to outweigh the substitution effect.
If X is a giften good, the new equilibrium will be at quantity X 2 because increased real income from the
fall in the price of X lowers its own demand. In this case, the income effect is negative and tries to
outweigh the substitution effect. Therefore, even if the price falls, the quantity demanded still decreases.
 Paper 3
1.

Answer: A

When prices of good X increase, consumers will purchase less of good X resulting in a contraction from K
to H. However, consumer`s income must have increased that have made the purchase of more units of
good Y affordable.
2.

Answer: A

A fall in price of G means that the budget line would pivot.

Seeing the position of the indifference curve, it can be judged that good G is an inferior good. (see
explanation above.)

3.

Answer: D

It is important to note that the total utility gained is the same on all points along an indifference curve.
4.

Answer: B

Successful marketing campaign would result in a movement along the budget line. When good Y is
marketed more, consumers will start allocating more funds towards good Y from good X.
5.

Answer: C

Try to understand this on your own.

6.

Answer: C
7.

Answer: C

X1 to X2 shows substitution effect and income effect is shown from X 2 to X4.

8.

Answer: D

Total utility gained is the same on all points along an indifference curve. This means that all points on the
indifference curve are equally desirable.

9.

Answer: A
10.

Answer: D

11.

Answer: D

Paper 4
20 marks questions as per the new syllabus:

Summer 2017 Paper 42 Question2:

Marking Scheme:
Sample Answer:

Choice plays a fundamental role in economics as consumers make decisions based on their preferences,
available options, and external influences.

Indifference curves show the combination of two goods that yield the same level of satisfaction.

The slope of the curve is decided by the

marginal utility of good X divided by the
marginal utility of Y (MUX/MUY). This is called
the “Marginal Rate of Substitution”. This
concept has the word “substitution” because we
forgo some units of good Y (from Y to Y1) to
increase consumption of good X (from X to X 1 ).
It is important to note that at point A and B, the
utility gained is the same. Therefore, the curve
is downward sloping indicating a negative
relationship between good X and good Y.
Interestingly, an indifference curve never
intersects with the x axis.

Consumers allocate resources among different products to maximize total utility. Doing so involves
several constraints: the most important of which are the consumer`s income and the prices of the goods
and services a consumer wishes to consume. The solution to this consumer problem is referred to as
consumer equilibrium.

In order to reach an equilibrium, indifference curves must collaborate with the budget line.

A budget line shows the quantities of two goods that a consumer can buy with the given income or
price. The budget line is a straight line where the area OAB represents affordability of a consumer. The
point “c” shows un-affordability. The slope of the budget line is decided by dividing the price of X with
that of Y (PX/PY).
An increase or decrease in price of any of the two goods will result in a pivotal shift in the budget line.

The diagram on the left shows a pivotal shift in the quantities of good X due to a fall in price of good X
with the quantities of good Y remaining constant. The budget area would change from OXY to OX 1 Y since
the household can now afford more units of X. Similarly, in case of a rise in price of good X, the area for
consumption would reduce from OX 1 Y to OX2Y.

The slope of the budget line being a tangent to the slope

of the indifference curve represents consumer equilibrium.

Consumer attains equilibrium when he/she maximize total

utility at a given income and price of goods.

When shops offer special discounts on previously expensive luxury products, consumer choices can be
influenced. The impact of reduction in price on consumer equilibrium is shown below:

The initial quantity purchased by the consumer is quantity X. The decrease in price of X causes a pivotal
move to the new budget line BL1. The price effect can be divided into substitution and real income
effects. To show the substitution effect separately, a hypothetical budget line BL 2 is drawn which is
parallel to BL1 and tangent to the initial indifference curve. According to the substitution effect alone, the
consumer raises the demand of good X from X to X 2. Substitution effect is always negative and raises the
demand of relatively cheaper products.

However, real income effect may be positive or negative, depending on the nature of the product. The
increased real income prompts the consumer to move to a higher indifference curve tangent to BL 1.

Assuming that X and Y are both normal goods, the demand for X and Y increases as a result of increased
income and the new equilibrium will be at quantity X1. In this case, income effect is positive and is
reinforced by the substitution effect i.e. they increase the demand for both X and Y.
Indifference curves play a crucial role in constructing a consumer's demand curve. By examining different
price-quantity combinations, economists can determine the consumer's preferences and the
corresponding quantities demanded. As the price of a good changes, the consumer's budget line shifts,
altering the feasible combinations of goods available to them. The consumer's demand curve is derived
by connecting the tangency points between the indifference curves and the budget line. The quantity
demanded at each price level is determined by the consumer's preferences, which are reflected in the
shape and positioning of the indifference curves.
In the second diagram, we plotted P against X, which is the first point on the demand curve for good X.
Then, we plotted P1 against X1, which is the second point on the demand curve for good X.

Together, the income and substitution effects can lead to an increase in the quantity demanded of the
luxury product, resulting in a movement along the demand curve.

Advertising plays a significant role in influencing consumer choice and can impact the shape and
positioning of indifference curves. Through persuasive messaging and information dissemination,
advertising aims to alter consumer preferences or tastes for specific products. As consumers are exposed
to advertising stimuli, their perceptions and attitudes can be influenced, leading to changes in their
preferences. Consequently, their indifference curves may shift or change shape, reflecting the updated
preferences resulting from advertising. This can cause a shift in the demand curve as consumers modify
their choices based on newly formed preferences or updated information.
In conclusion, the economic theory of indifference curves serves as a useful framework for constructing
a consumer's demand curve and understanding their choice behavior. It enables economists to analyze
how changes in prices and income affect consumer utility and subsequent purchasing decisions.
However, while the theory provides valuable insights, it may have limitations in fully explaining changes
in choice resulting from special offers on luxury products or persuasive advertising. These changes often
involve psychological and emotional factors that go beyond the realm of utility maximization. Therefore,
while indifference curves offer a solid foundation for analyzing consumer choice, a comprehensive
understanding of consumer behavior requires incorporating additional factors beyond utility
considerations.

Winter 2017 Paper 41 Question 3:

Marking Scheme:

Sample Answer:

Understanding the impact of price changes on consumer behavior is essential for both economists and
manufacturers.

Indifference curves show the combination of two goods that yield the same level of satisfaction.

The slope of the curve is decided by the

marginal utility of good X divided by the
marginal utility of Y (MU X/MUY). This is called
the “Marginal Rate of Substitution”. This
concept has the word “substitution” because we
forgo some units of good Y (from Y to Y1) to
increase consumption of good X (from X to X 1 ).
It is important to note that at point A and B, the
utility gained is the same. Therefore, the curve
is downward sloping indicating a negative
relationship between good X and good Y.
Interestingly, an indifference curve never
intersects with the x axis.

Consumers allocate resources among different products to maximize total utility. Doing so involves
several constraints: the most important of which are the consumer`s income and the prices of the goods
and services a consumer wishes to consume. The solution to this consumer problem is referred to as
consumer equilibrium.

In order to reach an equilibrium, indifference curves must collaborate with the budget line.

A budget line shows the quantities of two goods that a consumer can buy with the given income or
price. The budget line is a straight line where the area OAB represents affordability of a consumer. The
point “c” shows un-affordability. The slope of the budget line is decided by dividing the price of X with
that of Y (PX/PY).

An increase or decrease in price of any of the two goods will result in a pivotal shift in the budget line.

The diagram on the left shows a pivotal shift in the quantities of good X due to a fall in price of good X
with the quantities of good Y remaining constant. The budget area would change from OXY to OX 1 Y since
the household can now afford more units of X. Similarly, in case of a rise in price of good X, the area for
consumption would reduce from OX 1 Y to OX2Y.
The slope of the budget line being a tangent to the slope

of the indifference curve represents consumer equilibrium.

Consumer attains equilibrium when he/she maximize total

utility at a given income and price of goods.

The impact of reduction in price on consumer equilibrium is shown on next page:

The initial quantity purchased by the consumer is quantity X. The decrease in price of X causes a pivotal
move to the new budget line BL1. Price effect can be divided into substitution and real income effects. To
show the substitution effect separately, a hypothetical budget line BL2 is drawn which is parallel to BL1
and tangent to the initial indifference curve. According to the substitution effect alone, the consumer
raises the demand of good X from X to X 2. Substitution effect is always negative and raises the demand
of relatively cheaper products.

However, real income effect may be positive or negative, depending on the nature of the product. The
increased real income prompts the consumer to move to a higher indifference curve tangent to BL1.

Assuming that X and Y are both normal goods, the demand for X and Y increases as a result of increased
income and the new equilibrium will be at quantity X 1. In this case, income effect is positive and is
reinforced by the substitution effect i.e. they increase the demand for both X and Y.
If X is an inferior good, the new equilibrium will be at X 1. Increased real income lowers the demand of X.
In this case, the income effect is negative and tries to outweigh the substitution effect.

If X is a giften good, the new equilibrium will be at quantity X 2 because increased real income from the
fall in the price of X lowers its own demand. In this case, the income effect is negative and tries to
outweigh the substitution effect. Therefore, even if the price falls, the quantity demanded still decreases.

The distinction between the income and substitution effects is crucial for manufacturers as it helps
predict changes in consumer demand and determine the implications for revenue and potential
profitability. By analyzing the income and substitution effects, manufacturers can anticipate the direction
and magnitude of changes in demand resulting from price adjustments.

If a price decrease triggers a significant income effect, leading to a substantial increase in consumers'
purchasing power, the demand for the product may rise significantly. This could result in an outward shift
of the demand curve, leading to increased sales, revenue, and potentially higher profits for the
manufacturer.

Alternatively, if a price increase primarily generates a strong substitution effect, causing consumers to
switch to substitute goods, the demand for the product may decline. In this case, the demand curve
could shift inward, potentially leading to reduced sales, lower revenue, and a decline in profitability for
the manufacturer.

The distinction between the income and substitution effects is particularly important for manufacturers
as it allows them to understand the dynamics of consumer response to price changes. By
comprehending how changes in price affect consumer behavior, manufacturers can make informed
decisions regarding pricing strategies, production levels, and resource allocation, ultimately impacting
their market position and profitability.

In conclusion, the analysis of indifference curves enables us to differentiate between the income and
substitution effects resulting from price changes. The substitution effect captures the consumer's
decision to substitute one good for another in response to a relative price change, while the income
effect reflects changes in purchasing power resulting from a price adjustment. Manufacturers can benefit
from understanding these effects as they provide insights into changes in consumer demand and
implications for revenue and profitability. By leveraging this knowledge, manufacturers can make
strategic decisions regarding pricing, production, and resource allocation to optimize their market
position and financial performance.
 One Page Summary:

Indifference curves: It shows the combination of two

goods that yield the same level of satisfaction.

Budget Line: It shows the quantities of two goods

that a consumer can buy with the given income or
price.

Consumer Equilibrium: When the budget line is a

tangent to the indifference curve.

In case of a fall in price

Normal Goods Inferior Goods

Giffen Goods
 Utility, Indifference Curves and Budget Lines Past Papers Practice Questions

Summer 2014 Paper 41 Question 3:

Summer 2017 Paper 42 Question 2:

Winter 2017 Paper 41 Question 3:

March 2018 Paper 42 Question 2:

 Test Yourself 1
Topic: Utility, Indifference Curves and Budget
Lines
1.

2.

3.
4.
5.

Question:

Explain how the law of diminishing marginal utility and budget lines can be used to construct a
consumer's demand curve and illustrate the impact of price and income changes on normal and inferior
goods. [20]
Marking Scheme:

1. C
2. D
3. B
4. D
5. C

Question Suggested Answer:

Definition of Utility

Definition of Marginal Utility + Graph

Connect this to Diminishing Marginal Utility with an example

Construct a demand curve linking it to Diminishing Marginal Utility

Demand curve drawn with clear explanation

The Law of Diminishing Marginal Utility is the basis of the Law of Demand. The marginal utility
households get will therefore influence their willingness to pay for something. If there are diminishing
marginal returns, then people’s willingness to pay will also decline. Hence the individual demand curve
will be downward-sloping. Price and quantity demanded for most goods and services will be inversely
related.

Law of Diminishing Marginal Utility states that larger the quantity, less is the utility whereas Law of
Demand states that larger the quantity, lower will be the price as the utility of the successive units will
be low. On the other hand, the lower the quantity, the higher will be the price because households will
attach a higher marginal utility with that product.

Definition of Budget Lines + graph

What happens to the budget line when income increases? (it shifts) + graph

When price of one good increases, it will have a pivotal shift in the budget line + graph

The balance of the two changes will vary for a normal and inferior good but precisely quantity of each
will be bought before and after the changes cannot be estimated from the budget line alone. It should
corporate with indifference curves.

Definition of indifference curves + graph

Consumer equilibrium from IC and BL + graph

Explain what will happen to the quantities of good X when it prices increase, also assuming that both
goods are normal goods.

Explain what will happen to the quantities of good X when it prices increase, also assuming that good X is
an inferior good.

(Take help from the notes provided)

 Cost of Production
Production: Any activity which is designed to fulfill the needs or wants of people is called production.

Motive
Producer Profit Maximization

Output

Consumer Goods Capital Goods

Directly satisfy consumer wants They are bought by producers to produce

goods/services

E.g. Machines /
Raw Materials

Consumer Consumer Non-

Durables Durables
Also known as Producer
goods

Last for a long Perishable

time. E.g. cars goods. E.g.
fruits
1.

Answer: C

A: If this was the firm`s aim, they should have decided to produce 2000 units as profit at this stage is the
highest.

B: If this was the firm`s aim, they should have decided to produce 5000 units.

C: Revenue at 4000 is the highest.

D: If this was the firm`s aim, they should have stopped at 2000 units as average cost is the lowest.
Note:

In short run, only one factor of production is fixed i.e. capital.

In long run, all factors of production are variable.

2.

Answer: B

Total Product: Complete / sum of all the products produced with the given factor inputs.

Total Product = Total output

Marginal Product: Additional / extra products produced with the given factor inputs.

Average Product: Output per unit of factor inputs.

AP = Total Product

No. of factor inputs

Note: Factor inputs means factors of production e.g., labor or capital.

Key:

• MP increase, TP increase (Increasing Returns)

• MP = Zero, TP maximum
• MP = Negative, TP starts falling
• AP intersects the MP when AP is at its maximum.
Law of Variable Proportions refers to when the quantity of one factor of production is increased, while
keeping all other factors constant, it will result in the decline of the marginal product of that factor.

3.

Answer: B

Note:

Increasing return to scale is when an increase in quantity of factor inputs leads to a greater
proportionate increase in output.

Decreasing return to scale is when a given increase in the quality of factor inputs leads to a smaller
proportionate increase in output.
 Costs
Fixed Costs: Costs which do not vary with output.

Variable Costs: Cost which increase with output.

Average Fixed Costs: Fixed Cost

Output

Key to remember: Output Per unit FC

Average Variable Costs: Variable Costs
Output

• AVC is a U shaped curve. It declines initially, reach a minimum point and then increase again.
• At a low level of output, production is relatively inefficient. Thus, AVC is at a high.
• It begins to fall with as the optimum level of Factor or Production is approached.
• It begins to rise again as diminishing returns sets in.

Law of Diminishing Returns: As extra units of a resource, or input, are used in the production process,
there will be an increase in output, but there will be successively smaller increases as more inputs are
added.

Note: Do not confuse Law of Diminishing Return with Decreasing Returns to scale.

Law of Diminishing Return = Short Run

Decreasing Return = Long Run

4.

Answer: B

When the first worker is employed, chairs production have increased by 7.

When the second worker is employed, chairs production have increased by 10.

When the third worker is employed, diminishing marginal returns set in as chairs production have
increased by only 9.
Average Total Costs:

5.

Answer: C
6.

Answer: A

FC = Total Cost – Marginal Cost

= 340 – 40

= 300
AFC = 300 / 6 = $50
AFC, AVC and AC on one graph.

Notice that the difference between ATC and AVC is AFC.

Remember:

ATC = AFC + AVC

Economies of Scale:

Economies of scale are achieved when the average total cost fall due to an increase in the production of
output.

1. Internal EOS
• Purchasing EOS
• Financial EOS
• Marketing EOS
• Risk bearing EOS
• Technical EOS
7.

Answer: C

As firm is narrowing its range of products, it would be benefiting from risk-bearing economies of scale as
there is no diversification.

2. External EOS

It arises from growth in the

size of the industry.
• Better infrastructure
• Greater pool of skilled labor
• Greater Access to Knowledge

Dis-economies of Scale:

Diseconomies of scale refer to increase in Long Run Average Costs (LRAC) as a firm increases its scale of
production.

Reasons:

o Shortage of Land
o Shortage of Raw Material / Skilled Labor
o An increase in Tax Rates
o Poor Infrastructure
o Lack of control / coordination
o Inefficient communication
8.

Answer: C

Why Firms Grow?

1. To reduce AC and benefit from economies of scale.

2. Larger market share
3. To maximize desired profits
4. Increase Sales Revenue / Turnover / Volume
5. Specialization

How Firms Grow?

Internal Growth External Growth

Merger
Takeover

Integration

Types of Integrations:

1. Vertical Integration is when firms at different stages of the production process merges.

Backward Forward
Backward Integration is when a firm merges with its supplier.

Forward Integration is when a firm merges with someone ahead of the production stage.

Horizontal Integration is when two firms at the same stage of production or producing the same product
merge.

Conglomerate Integration is when two firms producing unrelated product merge.

Lateral Integration is when a firm merges with another in a similar field. For example a hotel chain taking
over a chain of restaurants.

9.

Answer: B

10.

Answer: C
Relationship between SRAC and LRAC:

Short Run Average Cost1 (SRAC1) initially falls, not only because of increasing returns but also due to a
reduction in average fixed cost as fixed costs are now divided over a larger output.

However, SRAC1 begins to rise when diminishing returns set in. At this point, the reduction in average
fixed cost becomes insignificant (*see AFC graph towards the end*). This prompts the firm to open
another plant / branch / unit which is only possible in the long run.

The cost of operating the second plant i.e. SRAC2 is lower than that of the SRAC1 because of economies
of scale. The firm continues to expand and enjoy benefits until diseconomies of scale sets in. This
happens due to control, coordination and communication issues. SRAC of new plant / branches / units
becomes higher than the previous ones in such cases.

The curve that touches the minimum point of all SRACs is the Long Run Average Cost (LRAC). This is often
called the “envelope curve” as it envelops the minimum point of all SRACs.

The falling portion of the LRAC shows the falling long run average cost and encourages firms to expand
and grow. The rising portion of the LRAC is a disincentive for firms to grow in size. Therefore, the optimal
size of the business will be at Q (the point where the LRAC is at its minimum). This point is called
“Minimum Efficient Scale (MES)”.
11.

Answer: B

A: It shows both; economies and diseconomies of scale

B: Correct Answer
Why some firms are small?

• Choice of the owner

• Targeting a specific market / Market size is small / Focusing on a specific segment
• No access to finance
• Time in the market (It takes time to grow in an industry)

12.

Answer: D
 Paper 4
20 marks question as per new syllabus:

Winter 2010 Paper 43 Question 3:

Marking Scheme:

Sample Answer:

The question at hand raises the proposition that all firms should be encouraged to grow in size without
any government restrictions, as there are numerous benefits associated with large-scale production.

Large-scale production allows firms to achieve economies of scale, leading to lower average costs per
unit.

Average cost is the per unit cost incurred when

producing an output. It is calculated after dividing

total output produced at any chosen point.

When a firm`s output increases, the average total

costs starts to fall. Hence, economies of scale are

achieved.

It enables firms to operate more efficiently, reduce production costs, and potentially offer goods or
services at lower prices to consumers.

Two types of economies of scale include internal and external reasons.

Internal economies of scale are the benefits that a firm receives as a result of its own decisions to
produce on a larger scale. A firm may reduce their average cost by purchasing raw materials in bulk
quantity from suppliers, availing discounts and benefiting from “Purchasing Economies of Scale”.
Moreover, large firms usually have access to more financial facilities than small firms. This is because the
perceived risk of lending money by lenders is lower. As a result, firms can benefit from “Financial
Economies of Scale”.

External economies of scale are benefits received by all firms in the industry as a direct consequence of
the growth of the industry. The advantages may include the availability of a pool of skilled labor or a
convenient supply of components from specialist producers who have grown up to make the items for all
the firms. Silicon Valley in California is a well-known example of this.

Larger firms often have greater market power, enabling them to negotiate favorable contracts with
suppliers and access larger distribution networks. This advantage allows firms to secure better pricing
terms and gain a competitive edge in the marketplace. Additionally, large firms can invest significantly in
research and development, fostering innovation and introducing new products or processes.

In addition to that, large-scale production can enhance profitability through cost advantages, higher
market share, and increased brand recognition. It allows firms to allocate resources effectively,
implement efficient production techniques, and achieve economies of scope. This ultimately contributes
to their competitiveness and long-term sustainability.

However, this does not mean that firms should always be encouraged to grow in size; being a small firm
also has its own pros.

Small firms often specialize in niche markets, catering to specific customer needs that larger firms may
overlook. Furthermore, small niche markets have less competition and therefore are more profitable.
Moving into a mass market may make competition more intense. Niche markets such as handmade
products can have a more price inelastic demand; therefore, firms can charge a bigger markup on the
marginal cost of production. This enables the firm to be more profitable, despite lower volume.

Moreover, they are agile, flexible, and able to respond quickly to changing market demands. Small firms
can drive innovation and introduce disruptive technologies or business models, fostering creativity and
diversifying the economy.

Small firms play a vital role in regional economic development by providing employment opportunities
and contributing to the local tax base. They often have strong community ties and contribute to the
social fabric of their respective areas. Supporting small firms can lead to increased entrepreneurship,
localized growth, and reduced regional disparities.

Besides these, they contribute to healthy competition, promoting consumer choice and preventing
market concentration. Their presence stimulates innovation and ensures that consumers have a variety
of options available to them. Restricting growth solely to large firms may lead to reduced competition,
potentially resulting in higher prices and limited consumer welfare.

Encouraging all firms to grow without any government restrictions may lead to potential negative
outcomes. Unchecked growth can result in monopolistic practices, reducing competition and limiting
consumer choices. Government regulation is necessary to maintain a level playing field, protect
consumer interests, and prevent market abuses. It can address externalities such as environmental
impact, worker safety, and fair labor practices that may arise from unregulated growth.

Government policies should aim to foster innovation and entrepreneurship while ensuring fair
competition. Regulatory frameworks can be designed to promote access to capital, streamline
bureaucratic processes, and provide support to small firms. By facilitating a conducive business
environment, governments can encourage growth while safeguarding against potential negative
consequences.

While some regulations are essential for maintaining market efficiency and protecting societal welfare,
excessive or unnecessary restrictions can stifle innovation and hinder economic growth. Governments
should strike a balance by implementing targeted regulations that address specific market failures and
externalities without unduly impeding entrepreneurial activities.

In evaluating the proposition, it is evident that large-scale production brings numerous benefits,
including economies of scale, market power, and competitiveness. However, it is crucial to recognize the
valuable contributions of small firms. Encouraging growth universally may overlook the benefits derived
from a diverse range of firms.

A balanced approach is required, where firms are encouraged to grow in size when it is appropriate and
in the best interest of both the economy and society. Government regulation should aim to ensure fair
competition, protect consumer interests, and address market failures and externalities associated with
growth. By doing so, policymakers can create an environment that fosters innovation, supports
entrepreneurship, and promotes a diverse and resilient economy.

Practice Question:

Summer 2013 Paper 41 Question 2:

 One Page Summary:

Total Product: Complete / sum of all the Fixed Costs: Costs which do not vary with output.
products produced with the given factor inputs. Variable Costs: Cost which increase with output.
Total Product = Total output Average Fixed Costs: Fixed Costs / Output
Marginal Product: Additional / extra products Average Variable Costs: Variable Costs / Output
produced with the given factor inputs.
Remember: ATC = AFC + AVC
Average Product: Output per unit of factor
Note:
inputs.
In short run, only one factor of production is fixed i.e., capital.
AP = Total Product / No. of factor inputs
In long run, all factors of production are variable.

Economies of Scale: Dis-economies of Scale:

Economies of scale are achieved when the average Diseconomies of scale refer to increase in Long Run
total cost fall due to an increase in the production of Average Costs (LRAC) as a firm increases its scale of
output. production.
1. Internal EOS Reasons:
• Purchasing EOS
• Shortage Skilled Labor
• Financial EOS
• An increase in Tax Rates
• Marketing EOS
• Poor Infrastructure
• Risk bearing EOS
• Lack of control / coordination
• Technical EOS
• Inefficient communication
2. External EOS: It arises from growth in the size
of the industry.

External Growth:
Law of Variable Proportions refers to when
the quantity of one factor of production is Horizontal Integration, Vertical Forward
increased, while keeping all other factors Integration, Vertical Backward Integration,
constant, it will result in the decline of the Conglomerate Integration and Lateral Integration
marginal product of that factor.
Relationship between SRAC and LRAC:
Law of Diminishing Returns: As extra units
of a resource, or input, are used in the LRAC touches the minimum point of all SRACs.
production process, there will be an increase
in output, but there will be successively
smaller increases as more inputs are added.
 Revenues
Marginal Revenue:

Marginal Revenue is the additional revenue received by selling on extra unit.

Formula: in Total Revenue / in Quantity

Average Revenue:

Per unit revenue received by selling an output.

Formula: Total Revenue / Qty

Marginal Cost:

Marginal Cost is the additional cost of producing one extra unit.

 Perfect Competition
Perfect competition is a theoretical extreme of market structures in which thousands of producers
operate selling homogenous or identical products. This means that they are all of the same quality in
the eyes of the consumer. The only industry that comes anywhere near this model is possibly agriculture.

Due to many firms in the market, the market share divides between them, resulting in no space for the
firm in influencing the market price; hence, they are described as price takers. Moreover, the large
number of buyers and sellers has perfect knowledge of market conditions and the price that is offered.

The demand curve for such firm is perfectly elastic at this ruling price. If the firm sells an extra unit of
output (from Q0 to Q1), it will get the price as the one before i.e. “P” as shown in the graph below. The
marginal revenue is therefore equal to the price or the average revenue.

D = AR = MR

Choosing the output is the only decision that the firm has to make. This will be done by considering the
relevant cost of production. Given the assumption that the firms want to maximize profits, the chosen
output will be where Marginal Cost = Marginal Revenue (MC = MR).

For a profit maximizing perfectly competitive firm, equating the price and the marginal cost is a
condition of equilibrium (“e”) as shown on the graph below.
Types of Profits:

• Abnormal Profit
• Subnormal Profit (Loss)
Abnormal Profit:

Abnormal Profit = Average Revenue > Average Cost

Revenue Area OPaQE

Cost Area OCbQE
Profit Area PabC
Normal Profit:

Revenue Area OPEaQE

Cost Area OPEaQE
Profit Area -
Subnormal Profit:

b
a

Subnormal Profit = Average Cost > Average Revenue

Revenue Area OPcQ

Cost Area OabQ
Subnormal Profit Pabc
Area

Note: Subnormal profits are basically losses. But in economics, the word “loss” is not used.
How do firms in perfect competition go from abnormal profits to subnormal profits??

A firm in a perfect competition will make abnormal profits in the short run. Abnormal profits arise when
average variable costs are less than the marginal costs. This will be due to the competitive factor in this
market since each firm will try to boost profits and gain market share by increasing productivity and
lowering the average total cost. The scenario in the short run is graphically represented below:

Price

Price / cost / Revenue

The industry market price is set where the demand and supply curves intersect with each other i.e. at
point “e”. Hence, the market price is set at “P”. The firm`s total revenue is the price multiplied by the
output sold i.e. the area OPaQE. The average cost area is OCbQE. Since the average costs are below the
marginal revenue or price line, firm will be making abnormal profits where area can be identified by
“PabC” (shaded).

Abnormal profits will act as an incentive for the entry of new firms. The absence of barriers to entry
means that the total supply in the market will rise (from S to S1 as shown on the graph on next page).
The effect of this on the existing firms is that the market price will fall (from P to P1) and the abnormal
profit will diminish.
When the abnormal profits reduce, the existing firms will only be covering costs. Hence, in the long run,
MC = ATC = AR = MR. Those firms who are efficient (both productively and allocatively) will be able to
make their place in the long-run equilibrium. Others, who cannot control their costs, may make
subnormal profits (losses) and will be forced to shut down businesses. This is graphically represented
below:

It can be seen in the graph above that the average costs are greater than average revenue leading to
subnormal profits in the area Pabc.
 Paper 3
1.

Answer: A

2.

Answer: C

Profit will be maximized when MR = MC.

Calculate the MR with the formula given in the glossary and see where it equals MC.
3.

Answer: B

At P1, the firm will neither operate in short run not long run.

At P2, the firm will operate in short run but will shut down in long run.

At P3, the firm will operate both in short run and long run.

At P4, the firm is having abnormal profits so it will operate in the short run and in the long run.
 Paper 4
20 marks question as per new syllabus:

Question:

To what extent can firms in perfect competition generate profit in a market, and what factors
contribute to their ability or inability to do so? (20)

Sample Answer:

Perfect competition is a theoretical extreme of market structures in which thousands of producers

operate selling homogenous or identical products. This means that they are all of the same quality in the
eyes of the consumer. The only industry that comes anywhere near this model is possibly agriculture.

Due to many firms in the market, the market share divides between them, resulting in no space for the
firm in influencing the market price; hence, they are described as price takers. Moreover, the large
number of buyers and sellers has perfect knowledge of market conditions and the price that is offered.

The demand curve for such firm is perfectly elastic at this ruling price. If the firm sells an extra unit of
output (from Q0 to Q1), it will get the price as the one before i.e. “P” as shown in the graph below. The
marginal revenue is therefore equal to the price or the average revenue.

D = AR = MR

Choosing the output is the only decision that the firm has to make. This will be done by considering the
relevant cost of production. Given the assumption that the firms want to maximize profits, the chosen
output will be where Marginal Cost = Marginal Revenue (MC = MR).
For a profit maximizing perfectly competitive firm, equating the price and the marginal cost is a
condition of equilibrium (“e”) as shown on the graph below.

A firm in a perfect competition will make abnormal profits in the short run. Abnormal profits arise when
average variable costs are less than the marginal costs. This will be due to the competitive factor in this
market since each firm will try to boost profits and gain market share by increasing productivity and
lowering average total cost. The scenario in the short run is graphically represented below:

Price

Price / cost / Revenue

P
The industry market price is set where the demand and supply curves intersect with each other i.e. at
point “e”. Hence, the market price is set at “P”. The firm`s total revenue is the price multiplied by the
output sold i.e. the area OPaQE. The average cost area is OCbQE. Since the average costs are below the
marginal revenue or price line, firms will be making abnormal profits where area can be identified by
“PabC” (shaded).

Firms with lower production costs have a greater chance of generating profits in perfect competition.
Efficient production processes, access to low-cost inputs, economies of scale, and technological
advancements can contribute to cost advantages, allowing firms to produce at lower average costs and
potentially earn positive economic profits.

Moreover, the demand elasticity for the product plays a significant role in profit generation. If demand is
highly elastic, meaning consumers are responsive to price changes, firms may have limited pricing power
and face intense competition, reducing profit margins. Conversely, if demand is inelastic, firms may have
more flexibility to set higher prices and potentially generate profits.

Innovations in production techniques, product development, or marketing strategies can also provide
firms with a competitive edge. By offering improved products or reducing costs through innovation, firms
can enhance their profit potential within the constraints of perfect competition.

While perfect competition assumes homogeneous products, firms can differentiate their products
through branding, packaging, or service quality. By creating perceived value or offering unique features,
firms may be able to charge a price premium, leading to the possibility of generating short-term profits.

However, abnormal profits will act as an incentive for the entry of new firms. The absence of barriers to
entry means that the total supply in the market will rise (from S to S1 as shown on the graph on next
page). The effect of this on the existing firms is that the market price will fall (from P to P1) and the
abnormal profit will diminish.
When the abnormal profits reduce, the existing firms will only be covering costs. Hence, in the long run,
MC = ATC = AR = MR. Those firms who are efficient (both productively and allocativly) will be able to
make place in the long-run equilibrium. Others, who could not control their costs, may make subnormal
profits (losses) and will be forced to shut down businesses. This is graphically represented below:

It can be seen in the graph above that the average costs are greater than average revenue leading to
subnormal profits in the area Pabc. Therefore, the high level of competition in perfect competition limits
the ability of individual firms to generate significant profits in the long run, as prices are driven down .

In addition to that. firms in perfect competition lack the ability to exercise market power and influence
prices. The uniformity of products and the presence of numerous substitutes make it challenging for
firms to differentiate and charge higher prices, thereby constraining profit generation.

Any increase in production costs, such as raw material prices or labor wages, can diminish profit margins
for firms in perfect competition. In the absence of the ability to pass on cost increases to consumers
through price adjustments, firms may face reduced profitability.

While the profit generation prospects for firms in perfect competition are inherently limited, it is
essential to recognize the broader benefits of this market structure. Perfect competition promotes
efficiency, allocative effectiveness, and consumer welfare by driving prices down to their minimum
average costs. It encourages innovation and ensures that resources are allocated efficiently across
industries. Moreover, the absence of monopolistic practices fosters healthy competition and prev ents
market abuses.

The evaluation of profit generation in perfect competition should also consider the role of market
dynamics and external factors. Changes in demand, technological advancements, shifts in consumer
preferences, and regulatory interventions can influence the profit potential for firms in this market
structure. Additionally, the notion of "profit" should be interpreted beyond monetary gains,
encompassing other forms of value creation such as consumer surplus, societal benefits, and innovatio n-
driven progress.

In conclusion, while firms in perfect competition face limitations in generating profits, the broader
economic and societal benefits derived from this market structure outweigh these limitations. Perfect
competition remains a vital cornerstone of market economies, promoting efficiency and ensuring fair
outcomes for consumers. It is through the interplay of diverse market structures, including perfect
competition, imperfect competition, and regulated sectors, that economies achieve a balanced and
sustainable framework for economic growth and prosperity.

One Page Summary:

Perfect Competition: Thousands of producers selling homogenous or identical products.

Firms are price takers.

D = AR = MR
Everyone has perfect knowledge.

Important Diagrams You Should Know:

Normal profit Normal Profit

Subnormal Profit
 Monopoly
A monopoly is where a single firm controls the entire output of the industry; this is called a pure
monopoly and is the other end of the spectrum to perfect competition.

In theory, a monopoly has no close substitutes, high barriers to entry and the monopolist is a price
maker.

However, in practical, this strict definition is relaxed in so far as a monopoly will occur when a firm has a
dominant position in terms of its market share.

A single firm or pure monopolist in theory would face a downward sloping market demand curve. In this
situation, it can either control price or output but cannot control both simultaneously. It faces a trade-off
between higher prices and quantity sold. The downward sloping demand curve for a monopoly (and a
monopolistically competitive firm) means that it has to decrease price on ALL the units to sell more;
resulting in a divergence between the sale price and marginal revenue (MR) i.e. the sale price exceeds
MR.

A profit maximizing monopoly would not charge price when MR = MC at point “e”. Since monopolies
are capable of influencing the market price and output, they will surely try to exploit consumers by using
their monopolistic advantage; they will charge a much higher price, restrict output, produce poor quality
goods (as they will not operate at the minimum point on the Average Cost curve) and ignore the
customer needs and wants.

Since their profits are high, they may spend excessively on marketing and advertising their products
heavily, making the survival of smaller firms near to impossible.
Also, a monopoly may indulge in other unfair practices to restrict entry barriers and deter potential
competitors from entering.

Price Discrimination:

Case:

Price discrimination is a process of charging different prices for reasons unrelated to production costs.

Price discrimination is possible, the seller has some monopoly power and different buyers / market
segments have different elasticities of demand. A higher price is to be charged from customers with
lower elasticity of demand and a lower price from customers who are more sensitive to changes in price.

There are three types of prices discrimination: first degree or perfect price discrimination, second degree
and third degree.

First degree discrimination, or perfect price discrimination, occurs when a business charges the
maximum possible price for each unit consumed. Because prices vary among units, the firm captures all
available consumer surpluses for itself, or the economic surplus. Many industries involving client services
practice first degree price discrimination, where a company charges a different price for every good or
service sold.

Second degree discrimination occurs when a company charges a different price for different quantities
consumed, such as quantity discounts on bulk purchases.

Third degree price discrimination occurs when a company charges a different price to different
consumer groups. For example, a theme park may divide its customers into adults and children, each
paying a different price when visiting the same park. This type of discrimination is the most common.

The above example in the question is third degree price discrimination as the ticket price is different for
different customer groups (Kids and Adults)

Also, price elasticity of demand is low for travelling in peak hours, that is before 19 00 hours. Hence, a
higher price is charged. Travelers making advanced reservations usually have more options, resulting in a
higher price elasticity of demand. Therefore, a lower price is charged from such customers.

Types of Profits:

• Abnormal Profit
• Subnormal Profit (Loss)
Abnormal Profit:

When AR > AC = Abnormal Profit

Normal Profit:

When AR = AC; Normal Profit

A monopoly will shut down its operations when:

AC > AR
 Paper 3
1.

Answer: A

2.

Answer: D
3.

Answer: D
 Paper 4
Question:

Monopolies are inefficient and hence, should be discouraged in an economy. How far do you agree?
(20)

Sample Answer:

The question at hand raises the debate surrounding monopolies and their impact on economic
efficiency.

A monopoly is where a single firm controls the entire output of the industry; this is called a pure
monopoly and is the other end of the spectrum to perfect competition.

In theory, a monopoly has no close substitutes, high barriers to entry and the monopolist is a price
maker.
However, in practical, this strict definition is relaxed in so far as a monopoly will occur when a firm has a
dominant position in terms of its market share.

A single firm or pure monopolist in theory would face a downward sloping market demand curve. In this
situation, it can either control price or output but cannot control both simultaneously. It faces a trade-off
between higher prices and quantity sold. The downward sloping demand curve for a monopoly (and a
monopolistically competitive firm) means that it has to decrease price on ALL the units to sell more;
resulting in a divergence between the sale price and marginal revenue (MR) i.e. the sale price exceeds
MR.
A profit maximizing monopoly would not charge price when MR = MC at point “e”. Since monopolies
possess significant market power, allowing them to control prices and output levels, they will surely try
to exploit consumers by using their monopolistic advantage; they will charge a much higher price,
restrict output, produce poor quality goods (as they will not operate at the minimum point on the
Average Cost curve) and ignore the customer needs and wants. As a result, consumer welfare is
compromised, and resources may not be allocated optimally. This inefficiency is a key concern when
considering the impact of monopolies on an economy.

A firm in a competitive market would produce at Qc and charge Pc. However, a monopoly will produce
less (Qm) and charge a higher price (Pm). The triangular shaded region shows the dead weight loss
caused by monopolies.

Monopolies frequently emerge due to barriers to entry, such as high capital requirements or exclusiv e
access to resources. While these barriers can encourage innovation and provide incentives for firms to
invest in research and development, the absence of competition may lead to a lack of motivation for
continuous improvement and technological progress. Without the pressure to innovate, monopolies may
become complacent, hindering economic growth and stifling innovation.

In a monopoly, consumers often have limited or no alternatives to choose from, resulting in reduced
consumer choice. The absence of competitive pressure may lead to lower product quality, limited
variety, and diminished innovation compared to a competitive market. Higher prices, inferior customer
service, and limited options can negatively impact consumer welfare, highlighting the inefficiency of
monopolies in meeting consumer demands.

Monopolies may engage in rent-seeking behavior, using their market power to influence regulations or
engage in anti-competitive practices. This behavior can distort the economy, diverting resources from
productive uses to maintain and protect monopoly power. Such distortions result in inefficiencies,
misallocation of resources, and reduced overall economic welfare.

However, it is worth noting that not all monopolies are inherently inefficient. Natural monopolies, which
arise due to economies of scale, can deliver goods or services more efficiently than multiple firms.

Proponents of monopolies may also argue that without patents and monopoly power, drug companies,
for example, would be unwilling to invest so much in drug research. The monopoly power of patents
provides an incentive for firms to develop new technology and knowledge, that can benefit society. Also,
monopolies make supernormal profit, and this supernormal profit can be used to fund investment which
leads to improved technology and dynamic efficiency.

However, this can also have downsides with drug companies able to charge excessively high prices for
life-saving drugs. It also gives drug companies an incentive to push pharmaceutical treatments rather
than much cheaper solutions to promoting good health and avoiding poor health in the first place.

Although the argument that monopolies are inefficient and should be discouraged carries weight,
government regulations which try to strike a balance between efficiency and consumer protection are
becoming crucial. Careful oversight is necessary to ensure that regulation promotes efficiency without
stifling innovation or discouraging investment. As a result, the negative effects of monopolies will be
reduced, ensuring a level playing field, and promoting efficient market outcomes.

Additionally, the impact of monopolies on specific industries and their potential long-term effects on
economic growth should be examined. By carefully assessing the costs and benefits of monopolies,
policymakers can devise effective strategies to balance economic efficiency, competition, and consumer
protection in an ever-changing economic landscape. By doing so, consumer`s interests will be protected
while keeping the incentives for firms to grow and expand.
One Page Summary:

Monopoly: A single firm controls the entire output of the industry.

No close substitutes, high barriers to entry and the monopolists are a price maker.

Practically, a monopoly is when a firm has a dominant position in terms of its market share.

Important Diagrams You Should Know:

Normal profit Normal Profit

Subnormal Profit
Monopoly and perfect competition are two extremes, and many industries fall in between. There are
very few pure monopolies, since there are very few commodities for which close substitutes do not exist.
Similarly, there are very few commodities that are entirely homogenous to make the assumption of
perfect competition realistic. There is, thus, a large grey area between these two extremes. Monopolistic
competition is one of the market structures that lie within this grey area.

Monopolistic Competition
Features:

1. Relatively large number of sellers

Monopolistic competition is characterized by a fairly large number of firms, not by the hundreds or
thousands of the firms in pure competition.

2. Small market shares

Each firm has a comparatively small percentage of the total market and, consequently, has limited
control over market price.

3. No collusion

The presence of a relatively large number of firms ensures that collusion by groups of firms to restrict
output and set prices is unlikely.

4. Independent action

With numerous firms in an industry, there is no feeling of interdependence among them; each firm can
determine its own pricing policy without considering the possible reactions of rival firms. A single firm
may benefit from a modest increase in its sales by cutting price, but the effect of that action on
competitors' sales will be nearly imperceptible and probably trigger no response.

5. Products

In contrast to pure competition, in which there is a standardized product, monopolistic competition is

distinguished by product differentiation. Monopolistically competitive firms turn out variations of a
particular product. They produce products with slightly different physical characteristics, offer varying
degrees of customer service, provide varying convenience regarding location, or proclaim special
qualities, either real or imagined, for their products. However, in some cases, monopolistic competition
may also have homogeneous products.

6. Some control over price

Despite the relatively large number of firms, monopolistic competitors do have some control over their
product prices because of product differentiation. If consumers prefer the products of specific sellers,
then, keeping within limits, they will pay more to satisfy their preferences. Sellers and buyers are not
inked randomly, as in a perfectly competitive market. But the monopolistic competitor's control over
prices quite limited, since there are numerous potential substitutes for its product.
7. Easy entry and exit

Entry into monopolistically competitive industries is relatively easy compared to oligopoly or pure
monopoly. Because monopolistic competitors are typically small firms, both absolutely and relatively,
economies of scale and capital requirements are both low. On the other hand, compared with perfect
competition, financial barriers may result from the need to develop and advertise a product that differs
from rival products. Some firms may hold patents on their products or copyrights on their brand names,
making it difficult and costly for other firms to imitate them.

Exit from monopolistic competitive industries is still easier. Nothing prevents an unprofitable
monopolistic competitor from going out of business and shutting down.

8. Advertising

The expense and effort involved in product differentiation would be wasted if consumers were not aware
of product differences. Thus, monopolistic competitors advertise their products, often heavily. The goal
of product differentiation and advertising – so called non price competition – is to emphasize product
differences. If successful, the firm`s demand curve will shift to the right and become less elastic.

9. The firm`s demand curve

The basic feature of this diagram is elasticity of demand, as shown by

the individual firm's demand curve. The demand curve faced by a
monopolistically competitive seller is highly, but not perfectly, elastic. It
is precisely this feature that distinguishes monopolistic competition
from perfect competition. The monopolistic competitor's demand is
more elastic than that for a pure monopolist, because the
monopolistically competitive seller has many competitors producing
closely substitutable goods. The pure monopolist has no rivals at all. Yet,
for two reasons, the monopolistic competitor's demand is not perfectly
elastic like that of the pure competitor.

Firstly, the monopolistic competitor has few rivals; and secondly, its products are differentiated, so they
are not perfect substitutes.

The price elasticity of demand faced by a firm in monopolistic competition depends on the number of
rivals and the degree of product differentiation. The larger the number of rivals and the weaker the
product differentiation, the greater the price elasticity of each seller's demand-that is, the closer
monopolistic competition will be to perfect competition.

10. Imperfect knowledge

Unlike perfect competition, buyers do not have perfect knowledge in monopolistic competition.
11. Non-price competition

Firms in monopolistic competition exercise non-price competition through advertising and other
promotional activities, which were missing in perfect competition.

12. Profits

Firms in monopolistic competition may earn normal, supernormal, or sub-normal profits in the short-
run, but in the long-run normal profits prevail, because of the freedom of entry and exit.

Price and Output Determination in Short Run

As with other market structures, profits are maximized at the output where MC MR. The diagram for a
firm in monopolistic competition will be the same as for the monopolist, except that the AR and MR
curves will be more elastic.

The left diagram illustrates the case of a firm in monopolistic competition earning supernormal profits.
When new firms enter groups, the demand curve of the firm shifts downward to D. and the long run
marginal and average cost curves shift upward as LRMC and LRAC as shown in the figure above. The firm
now only earns normal profits at the point of tangency (d) between the demand curve (DL) and the long
run average cost curve (LRAC). In this situation, each firm sells at a lower price (OPL), with the result that
further entry into the industry is stopped.

If firms cannot earn extra profits in monopolistic competition, they cannot incur losses either. In such a
situation the losing firm will leave the industry. Supply will be reduced, and price will go up. On the other
hand, as firms exit the industry, resources will increase in abundance, and will become cheaper. Costs
will fall. Ultimately, a rise in price and reduction in costs will eliminate losses. The final situation will be
shown in the next figure, where each firm and the industry will be in long-run equilibrium.
One Page Summary:

Comparison Between Perfect Competition and Monopoly:

Perfect Competition Monopolistic Competition

Number of Firms Infinite Many
Market Power None Low
Elasticity of Demand Perfectly Elastic Highly Elastic (long run)
Product Differentiation None High
Excess Profits No Yes / No (Short/Long)
Productive Efficiency Yes No
Allocative Efficiency Yes No
Profit Maximization Condition P = MR = MC MR = MC
Pricing Power Price Taker Price Seller

Remember:

Profit Maximization: MR = MC

Revenue Maximization: MR = 0

Allocative Efficiency: P = MC

Sales Maximization: AR = ATC

 Oligopoly
Features:

The following are the main features of an oligopolistic market.

1. Few sellers: In an oligopolistic market structure, there are only a few sellers dealing in the product.

2. Size of firms: Usually large.

3. Market share: When there are few sellers, each producer has a considerable portion of the market
share and can have a noticeable effect on market conditions.

4. Price maker: One seller can increase or reduce the price for the whole oligopolistic market by changing
the quantity it sells, affecting the profits for all other sellers.

5. Product: Firms in an oligopoly may produce homogenous or differentiated products. Many industrial
products like steel or zinc are standardized, whereas consumer products like clothing and appliances are
differentiated.

6. Interdependence: All firms in an oligopoly are heavily dependent upon one another. In perfect
competition, monopolies, and monopolistic competition, each firm is independent in the market. In
perfect competition, for example, each firm plays such a minute role in the industry that any change in
its price and output policy has no effect on the market at all. In the case of a monopoly producer, there is
no competitor who can be influenced by its policy since it is the only producer. In monopolistic
competition, the numbers of producers are so large that no single producer can have a direct effect on
other producers. However, only in an oligopoly, the actions of one producer directly affect the others.

7. Substitutes: In an oligopoly, firms produce close substitutes, though they are few. The products that
these firms produce have a high cross elasticity of demand with respect to each other.

8. Rivalry: Sometimes this interdependence leads to rivalry and price wars in an oligopolistic market.
Therefore, a single move by one seller leads to counter moves by the others.

9. Aggressive advertising: Due to this increased interdependence firms operating in an oligopoly heavily
invest in advertising. They engage in this form of non-price competition.

10. Barriers to entry: In order to protect the profits being earned by existing firms, oligopolies have high
barriers to entry, preventing new firms from entering the market. These barriers take different forms,
such as high setup costs. New firms entering the market do not have large capital to invest in new plants
and machinery. New firms also do not have an established reputation in the market, so they try to
practice brand loyalty to increase their number of customers. They also have legal protection through
patents and copyrights.

11. Mergers: A key feature of firms in an oligopoly is mergers. Two or more competitive firms may merge
to increase their market share, and this may allow them to achieve greater economies of scale. They will
also have monopoly power, resulting in greater control over the market supply and the price of the
product.

12. Knowledge: Buyers and sellers in an oligopolistic market possess imperfect knowledge.
13. Real-world existence: An oligopoly is the most common market structure in the real world, as far as
the production of goods is concerned. However, for the provision of services, monopolistic competition
is more prevalent.

14. Price collusion: Firms in an oligopolistic market structure behave in a collusive (common price
agreement) or non-collusive (no common price agreement) manner

15. Price rigidity (explained ahead)

Kinked Demand Curve:

Assumptions regarding the kinked demand curve:

The kinked demand curve hypothesis of price rigidity is based on the following assumptions:

1. There is an established or prevailing market price for the product in the oligopolistic industry with
which all sellers are satisfied.

2. If one firm raises its price, the other firms will not follow; rather, they will stick to the prevailing price
and attract customers who divert away from the price-raising seller.

3. Any attempt on the part of the seller to push up his sales by reducing the price of his product will be
countered by other sellers who will imitate him.
Explanation:

The diagram above shows a kinked demand curve BAD, and OPo is the price prevailing in the oligopolistic
market for quantity OQo provided by one seller.

The demand curve is formed of two segments, BA and AD. If this particular firm raises the price
anywhere above the prevailing price of Po, competitors will not follow suit. Therefore, consumers will
switch away from this firm's products to that of its competitors. For the elastic segment of the demand
curve, BA, therefore, any changes in quantity sold will be, proportionally speaking, greater than changes
in price. The part of the MR curve that corresponds to BA is BC, and for this segment it remains positive.

On the other hand, if the seller reduces the price of the product below OPo, his rivals will do the same.
This part of the demand curve (AD) is inelastic, because for these prices the other competitors will
continue to be in direct competition. So, changes in price, proportionally speaking, will be lesser than
those in quantity. As we are aware, decreases in price for an inelastic demand curve led to an overall
decrease in total revenue (as the MR curve also goes into the negative); thereby, we can conclude that
although the seller's sales will increase, his profits will decrease.

The demand curve BAD is kinked exactly at point A, which causes a discontinuity in the MR curve from C
to E. The size of this gap or discontinuity depends on the elasticity of the kinked demand curve. The
more elastic the demand curve is to the left of point A, and the more inelastic it is to the right of point A,
the larger will be the discontinuity CE. To be more precise, the more the angle BAD moves towards
becoming a right angle, the greater the discontinuity CE.

Price will remain stable as long as the MC curve cuts the MR curve in the gap (CE). Thus, the oligopoly
price OP is determined for the product OQo.
According to the above diagram, for output below OQ0, MR exceeds MC; thus, for this entire region, the
more output is reduced, the more marginal profits are lost. For output beyond Qo, MC exceeds MR, so
producing anything beyond Qo increases marginal losses. This holds true no matter which MC curve
applies, as long as the MC curve passes through the gap CE. The best decision, therefore, is to continue
producing output Qo, avoiding losing any marginal profits or incurring any marginal losses. This
establishes the best combination of price and output as Po and Qo. This tendency of an oligopolistic firm
to price its product at Po is known as price rigidity.

However, if the MC curve crosses the broken part of MR and passes through any other point on the MR
curve, it will change both the price and output of the firm.

Limitations of the kinked demand curve model:

The theory of a kinked demand curve in oligopoly pricing is not without its short comings:

1. There is no explanation for how the initial predetermined price and output is achieved. For
instance, as shown in the diagram of the kinked demand curve, the curve is kinked at A because
OP is the prevailing price. But the theory does not explain the force s that established the initial
price OPo.
2. The kinked demand curve analysis in based on two assumptions: Firstly, other firms will follow a
price cut; and, secondly, that those firms will not follow a price rise. Empirical evidence shows
that during an inflationary period the rise in prices is not confined only to one firm but is
industry wide. So, all firms having similar costs will raise their prices together. In other words,
there is little historical basis for a firm to believe that price increases will not be matched by
rivals and that price decreases will be matched.
 3. Even if we accept all assumptions of the kinked demand curve, it is unlikely that the gap in the
marginal revenue curve will be wide enough for the marginal cost curve to pass through. A f all in
demand or costs may even shorten it, thereby causing price to be unstable.

4. One of its major shortcomings is that the theory does not explain why prices that have once
changed should settle down, again acquire stability, and gradually cause a new kink in the
demand curve. Price stability may be illusory because it is not based on actual market behavior.
Sales do not always occur at list prices-they are often deviations from posted prices because of
trade-ins, allowances, and secret price concessions. The oligopolistic seller may outwardly keep
the price stable, but he may reduce the quality or the quantity of the product.

Price rigidity:

Oligopolistic prices that remain stable over a period are called rigid prices. Price rigidity refers to
a situation when, despite changes in cost or demand conditions, the sellers do not feel inclined
to change price. In the case of most durable consumer goods, wholesale prices remain stable for
the entire year.

Reasons of price stability

There are several reasons for price rigidity in certain oligopolistic markets:

1. Individual sellers in an oligopolistic industry might have learnt through experience the futility of price
wars and, thus, prefer price stability.

2. They may be content with current profits and avoid any risky price changes.

3. They may also prefer to stick to the present price level to prevent new firms from entering the
industry.

4. The sellers may intensify their sales-promotion efforts at the current price instead of reducing them.
They may view non-price competition as being better than price rivalry.

5. After spending a lot of money on advertising his or her product, a seller may not want to raise price
and risk losing potential profits. Naturally, he or she would stick to current prices.

6. If a stable price has been set through agreement or collusion, no seller would want to disturb it for
fear of unleashing a price war and, thus, getting caught up in more uncertainty.

7. It is the kinked demand curve analysis which is responsible for price rigidity in oligopolistic markets.

Price Leadership

Oligopolists often try to avoid price competition or price warfare. As a result, price leadership may
emerge. Price leadership is a situation in which a single firm in an industry sets the price of its product,
and other firms follow the price set by the leader. Two types of price leadership have been identified:
dominant price leadership and barometric price leadership.
Dominant price leadership exists when the industry consists of a single large firm that dominates the
industry, and a few smaller firms. Dominant firms are able to secure compliance to their prices by
smaller rivals because of their powerful position in the market. Price changes are initiated by the
dominant firm, and the smaller firms simply follow the leader. A dominant firm is the one whose market
share is high and whose cost of production is low (due to economies of scale). Normally, low-cost firms
act as leaders.

In a situation of barometric price leadership, the industry may not be dominated by any single firm. Any
firm may be the leader, or the leadership role may rotate in a rather orderly manner. Changes in demand
and cost conditions in the industry may cause one firm to initiate a price change that is followed by the
other firms in the industry. Suppliers readily accept any barometric price leader's set price because they
recognize his or her adeptness at establishing prices that are reflective of changing market conditions.

Cartel:

A group of independent producers who enter into a formal agreement to control price and output in a
particular industry is known as a cartel.

Most cartels are illegal domestically as they exploit consumers, but many cartels operate in international
markets. The Organization of Petroleum Exporting Countries (OPEC) and the International Association of
Airlines are obvious examples.

Cartels may be perfect or imperfect. In a perfect cartel, all decisions regarding price and output are taken
by a central authority, and the profits are distributed to each firm according to some rule and offers in
practice, however, each firm has some decision-making power, and may be allowed to keep whatever
profits it may earn. This type of cartel is called an imperfect cartel. However, in most cartels there is a
strong temptation for each cartel member to cheat and produce more than its quota for earring more
profits.

Moreover, if a new firm enters the cartel, and there is no increase in the total demand for the industry's
product, the optimum output for the cartel remains unchanged, but the given profits of the group must
now be shared among a greater number of members. If the new firm enters the industry but is not
admitted into the cartel, then the cartel may breakdown.

Pricing and Output Policies in Cartel

If the cartel decides to maximize joint profits, it chooses a price-output combination that equates
marginal revenue with marginal cost. In other words, the cartel behaves exactly like a monopolist
producing its output in different plants. Cartels are usually established with the purpose of either
exploiting the joint market power of suppliers to extract monopoly profits, or as a means of preventing
cut-throat competition, eventually forcing firms to operate at a loss, often resorted to in times of
depressed demand (a so-called 'crisis cartel').

In the former case, a central administration agency could determine the price and output of the industry,
and the output quotas of each of the separate member firms may be distributed in such a way as to
restrict total industry output and maximize the joint profits of the group. Price and output will thus tend
to approximate those of a profit-maximizing monopolist.
Once the cartel decides on its price-output combination, it faces the further problem of allocating output
and profits among cartel members. The allocation may be done in any of several ways, including the
assignment of exclusive territories and the establishment of output quotas for members. The output
quota approach is followed by OPEC-perhaps the best-known cartel.

We may illustrate the mechanics of an oligopolistic cartel with the help of the diagrams above. D is the
industry's demand curve, showing the aggregate quantity which the combined group may sell over a
range of possible prices and MR is the industry's marginal revenue curve. The industry's marginal cost
curve ∑MC is constructed by joining the marginal cost curves of the individual firms making up the cartel
(i.e., MCa+ MCb). For any given level of industry output the cartel is required to calculate the allocation
of the output among the member firms on the basis of their individual marginal costs to obtain the
lowest possible aggregate cost of producing "their" output.

To maximize industry profit the cartel will set price at Po and produce output Qo. Quotas of Qoª and Qob
are given to firms A and B respectively, where a horizontal line drawn from the intersection of MR and
EMC (the line of aggregate marginal costs) intersects MCa and MCb. The profit contributed by each firm
is computed by multiplying the number of units produced by the difference between the industry price
and the firm's average cost at that level of output. Firm A will earn abnormal profits of area Poabc and
firm B will make abnormal profits of area Podef, as shown in the diagrams above.

The aggregate profit is then shared by the member firms in some agreed manner, not necessarily in the
same proportion as actually contributed by each of the individual firms. Disputes over the sharing of
aggregate profit frequently lead to the breakup of cartels.

Cheating Behavior:

The cartel form of collusion is, however, inherently unstable, because the presence of a strong "cheating
incentive for cartel members”. An individual firm can reap high profits (provided that other cartel
members will stick to cartel policy) either by selling more than the quota allocated to it at the cartel price
or reducing the price of its product secretly, e.g., by giving discount prices. The former case can be
explained by the following diagram:
Let us assume that a cartel sets a fixed price Po in the market and allocates profits by selling quotas of
the output each firm can sell. Suppose that, initially, firm A is allocated a sale quota of Q0ª at price P0 by
the cartel. Firm A is earning supernormal profits, denoted by the area P0abc. The firm will have a strong
incentive to cheat and sell an output beyond its quota up to the point where P=MR=MC, i.e.,Q1 a. At this
output, the firm can earn extra profits, quantified by the area aghj, while incurring a loss of profits
quantified by the area ijbc. As can be observed, the loss is far exceeded by the gain.

However, cheating by one firm will reduce the sales and profits of other cartel members, and so they will
also start violating the cartel agreement, eventually resulting in a breakdown of the cartel, or causing a
price war among the firms.

Factors determining the strength of the collusion (cartel and leadership)

It will be easier for firms to collude if the following conditions apply:

1. There are only a few firms, all well-known to each other.

2. They are open with each other about costs and production methods.

3. They have similar production methods and average costs, and are thus likely to want to change prices
at the same time and by the same percentage.

4. They produce similar (homogeneous) products, and thus can more easily reach agreements on price.

5. There is one dominant firm.

6. There are significant barriers to entry and, thus, there is little fear for disruption by new firms.

7. The market is stable. If industry demand or production costs fluctuate wildly, it will be difficult to make
agreements, partly due to difficulties in making predictions and partly because agreements may
frequently have to be amended. A particular problem in a declining market is that firms may be tempted
to undercut each other's prices to maintain their sales.
8. There are no government measures to curb collusion.

Factors that weaken collusion:

1. Number of firms:

If there are only a few firms, all well-known to each other, price collusion will be stronger-and vice- versa.

2. Open to each other for cost and revenue information:

If firms are open with each other about costs, sales, revenue, and production methods, it is less likely for
member firms to cheat. This would strengthen collusion.

3. Homogeneity of the product:

Firms producing homogeneous products are more likely to face the same costs and demand conditions
and, therefore, find it easier to collude. Firms with differentiated products are less likely to do so.

4. Demand and cost differences:

When oligopolists face different costs and demand curves, it is difficult for them to agree on a price. This
is particularly the case in industries where products are differentiated and change frequently. Even with
highly standardized products, firms usually have different market shares and operate with different
degrees of productive efficiency. Thus, it is unlikely that even oligopolists producing homogenous
commodities would have the same demand and cost curves.

In either case, differences in costs and demand mean that the profit-maximizing price will differ among
firms; no single price will be readily acceptable to all. So, price collusion depends on compromises and
concessions that are not always easy to make.

5. Barriers to entry:

The greater prices and profits that result from a collusion may attract new entrants, including foreign
firms. Since that would increase market supply and reduce prices and profits, successful collusion
requires that colluding oligopolists block the entry of new producers by establishing high barriers to
entry.

6. Cheating incentive:

As the game-theory model makes clear, there is a temptation for collusive oligopolists to engage in
secret price cutting to increase sales and profit. The difficulty with such cheating is that buyers who are
paying a high price for a product may become aware of the lower-priced sales and demand similar
treatment. Or buyers receiving a price concession from one producer may use the concession as a wedge
to get even larger price concessions from rival producers. Buyers' attempts to play producers against one
another may precipitate price wars among the producers. Collusion is more likely to succeed when
cheating is easy to detect and punish. Then the conspirators are less likely to cheat on their price
agreements.

7. Government legislations: Antimonopoly laws prohibit cartels and price-fixing collusions from forming.
So less obvious means of price control have evolved in many countries.
8. Number of firms

Other things equal, the larger the number of firms, the more difficult it is to create a cartel or some
other form of price collusion. An agreement on price by three or four producers that control the entire
market may be relatively easier to accomplish. But such an agreement is more difficult to achieve when
there are, say, 10 firms, each with roughly 10% of the market, or where the big three have 70% of the
market while a competitive group of 8 to 10 smaller firms battle for the remainder.

9. Number of dominant firms:

The greater the number of big players in the market, the less likely it is that cheating firms will be
punished, thereby weakening the effectiveness of the collusion.

10. Recession

A long-lasting recession usually serves as an enemy of collusion because slumping markets increase
average total costs. In technical terms, as the oligopolists demand and marginal revenue curves shift to
the left in response to a recession, each firm moves leftward and upward to a higher operating point on
its average total cost curve. Firms find they have substantial excess production capacity, sales are down,
unit costs are up, and profits are reduced. Under such conditions, businesses may feel they can avoid
serious profit reductions (or even subnormal profits) by cutting price and, thus, gaining more sales at the
expense of rivals.

Game Theory

Game theory analyzes competitive situations to determine the possible, probable, and optimal
outcomes. Games consist of a set of players and a set of strategies for each player which are given or
defined by rules. For each combination of players and possible strategies, there is a payoff.

Game theory was first developed by John von Neumann, and John Nash greatly expanded on existing
game theory, helping to develop it much further.

Basic Example: The Prisoners' Dilemma

The prisoners' dilemma is a popular, basic, yet illustrative example of game theory. There are two
prisoners, Tom, and Gerry, who have just been captured for robbing a bank. The police don't have
enough evidence to convict them but know that they committed the crime. They put Tom and Gerry in
separate interrogation rooms and lay out the consequences:

If both Tom and Gerry confess, they will each get 10 years in prison.

If one confesses and the other doesn't, the one who confessed will go free and the other will spend 20
years in prison. If neither person confesses, they will both get 5 years for a different crime they were
wanted for.

It is easier to see and compare these outcomes if they are put into a matrix:
Since Tom's strategies are listed in rows, or the x-axis, his payoffs are listed first. Gerry's payoffs are listed
second because his strategies are in columns, or on the y-axis. "C" means "confess" and "NC" means "not
confess." This matrix is called "Normal Form" in game theory. Moves are simultaneous, which means
that neither player knows the other's decision and decisions are made at the same time (in this example,
both prisoners are in separate rooms and won't be let out until they have both made their decision).

At first glance, it may seem that both players not confessing is the best choice since each prisoner will
only get 5 years, but a more in-depth look will show that this is not the case.

Dominant Strategy

By looking at each prisoner individually, we can find the dominant pure strategy. First look at Tom. Let's
assume that Gerry is going to confess, what's the best strategy for Tom?

If Gerry confesses and Tom doesn't, Tom will go to prison for 20 years, but if he does confess, he'll only
go for 10. In this case, it's best for Tom to confess. Let's highlight this payoff in the matrix to keep track:

Now let's assume that Gerry is not going to confess. If Tom confesses, he will go free, if he doesn't
confess, he'll get 5 years. Again, his best option is to confess, no matter what Gerry does. Since in both
cases his best option was to confess, confessing is his dominant pure strategy (it's also correct to say not
confessing is dominated by confessing). A dominant strategy is a strategy that has the best payoff no
matter what the other player chooses.
Since Tom and Gerry both have the same options and payoffs, Gerry's dominant pure strategy is also
confession. After going through the same steps, you can highlight your matrix as follows:

Nash Equilibrium

You'll notice that the payoffs for (confess, confess) are both highlighted. Since both prisoners have the
same dominant pure strategy, confess, they will both confess, and each will get 10 years in prison. This is
the Nash Equilibrium, named after John Nash. A Nash Equilibrium is any outcome where there is no
unilateral profitable deviation-that is, holding all other players constant; one player cannot choose a
strategy that will make him better off. In this case, if either player doesn't confess, he will get 20 years
instead of 10. The payoff box (5,5) that results from (NC, NC) is NOT a Nash Equilibrium because either
player could confess (holding the other player constant) and go free instead of spending 5 years in
prison.
 Paper 3
1.

Answer: C

This is the graph of an oligopolistic firm. Refer to the notes above if you have any issue.
2.

Answer: D

The starting part of the demand curve is elastic, this means that as prices fall and output increases, total
revenue will rise. The second part of the demand curve is inelastic, which means that when prices fall,
there is a reduction in the total revenue curve.
3.

Answer: C

While drawing the kinked demand curve, it is assumed that the action of one firm will affect the other
firms in the market (interdependence). If one firm raises its price, the other firms will not follow (elastic
segment of the demand curve) However, if the firm reduces its prices, this will result in price wars
(inelastic segment of the demand curve).
One Page Summary:
Features:

• Few sellers but close substitutes are being produced.

• Considerable portion of market share
• Firms are price takers.
• Differentiated products with aggressive advertising.
• High barriers to entry,
• Extreme rivalry and interdependence among firms.

Kinked Demand Curve:

Upper Portion Elastic.

Below Portion Inelastic.

If the firm increases its price, it will lose

customers.

Reducing price will cause price wars and no one

will be able to really benefit.

Hence, price will stick at P 0 .

Game Theory: It studies strategic decision-making in situations where the outcome of one person's
choices depends on the choices made by others. It provides a framework for analyzing and predicting
the behavior of rational individuals or groups in competitive or cooperative settings. (Prisoner’s
Dilemma)

Price Leadership: This is a strategy where one dominant firm sets the price and other firms follow suit,
allowing for coordinated pricing without explicit collusion.

Cartel: A cartel is a group of independent firms that collude to restrict competition by coordinating their
production levels and prices, often through agreements and secret arrangements, to maximize their joint
profits and minimize competition between them.
 Contestable Markets
Contestable markets refer to a theoretical economic concept that characterizes the degree of
competitiveness in a market based on the ease with which firms can enter or exit the market. In a
contestable market, the threat of potential competition plays a significant role in determining market
outcomes, even if there are only a few existing firms.

In a contestable market, entry and exit barriers are low, allowing new firms to enter the market and
compete with existing firms. This potential for entry acts as a disciplining force on incumbent firms, as
they know that if they engage in anti-competitive behavior or charge excessive prices, new firms can
quickly enter and attract customers away from them.

Contestable markets are characterized by “hit and run” competition.

If a firm in a contestable market raises its prices much beyond the average price level market, and thus
begins to earn excess profits, potential rivals will enter the market, to exploit the price level for easy
profit. When the original incumbent firm(s) respond returning prices to levels consistent with normal
profits, the new firms will exit. Because of this, even a single-firm market can show highly competitive
behavior.

Key characteristics of a contestable market include:

1. Low barriers to entry: There are minimal obstacles, such as legal or financial barriers, preventing
new firms from entering the market.
2. Low sunk costs: Sunk costs are costs that cannot be recovered if a firm decides to exit the
market. In contestable markets, sunk costs are relatively low, making it easier for firms to exit
without suffering significant losses.
3. Ease of access to resources: New firms can readily access necessary resources, such as raw
materials, capital, and technology, without facing significant restrictions.
4. Freedom of entry and exit: Firms can freely enter or exit the market without facing legal or
regulatory barriers that protect incumbent firms.

Difference between Contestable Markets and Perfect Competition:

Contestable markets are different from perfect competitive markets. For example, it is feasible in a
contestable market for one firm to dominate the industry, have price-setting power and for firms in a
market to produce a differentiated product both of which run counter to the assumptions behind the
traditional model of perfect competition.

There are three main conditions for pure market contestability:

1. Perfect information and the ability and/or the right of all suppliers to make use of the best
available production technology in the market.
2. The freedom to market / advertise and enter a market with a competing product.
3. The absence of sunk costs - this reduces the risks of coming into a market.
 Paper 4
20 marks question as per the new syllabus:

Winter 2016 Paper 42 Question 4:

Sample Answer:

The concept of equilibrium is central to understanding the behavior of firms in different market
structures.

Perfect competition is a theoretical extreme of market structures in which thousands of producers

operate selling homogenous or identical products. This means that they are all the same quality in the
eyes of the consumer. The only industry that comes anywhere near this model is possibly agriculture.

Due to many firms in the market, the market share divides between them, resulting in no space for the
firm in influencing the market price; hence, they are described as price takers. Moreover, the large
number of buyers and sellers has perfect knowledge of market conditions and the price that is offered.

The demand curve for such firm is perfectly elastic at this ruling price. If the firm sells an extra unit of
output (from Q0 to Q1), it will get the price as the one before i.e. “P” as shown in the graph below. The
marginal revenue is therefore equal to the price or the average revenue.

D = AR = MR

Choosing the output is the only decision that the firm has to make. This will be done by considering the
relevant cost of production. Given the assumption that the firms want to maximize profits, the chosen
output will be where Marginal Cost = Marginal Revenue (MC = MR).

For a profit maximizing perfectly competitive firm, equating the price and the marginal cost is a
condition of equilibrium (“e”) as shown on the graph below.
A firm in a perfect competition will make abnormal profits in the short run. Abnormal profits arise when
average variable costs are less than the marginal costs. This will be due to the competitive factor in this
market since each firm will try to boost profits and gain market share by increasing productivity and
lowering average total cost. The scenario in the short run is graphically represented below:

Price

Price / cost / Revenue

P
The industry market price is set where the demand and supply curves intersect with each other i.e. at
point “e”. Hence, the market price is set at “P”. The firm`s total revenue is the price multiplied by the
output sold i.e. the area OPaQE. The average cost area is OCbQE. Since the average costs are below the
marginal revenue or price line, firms will be making abnormal profits where area can be identified by
“PabC” (shaded).

Abnormal profits will act as an incentive for the entry of new firms. The absence of barriers to entry
means that the total supply in the market will rise (from S to S1 as shown on the graph on next page).
The effect of this on the existing firms is that the market price will fall (from P to P1) and the abnormal
profit will diminish.

When the abnormal profits reduce, the existing firms will only be covering costs. Hence, in the long run,
MC = ATC = AR = MR. Those firms who are efficient (both productively and allocativly) will be able to
make place in the long-run equilibrium. Others, who could not control their costs, may make subnormal
profits (losses) and will be forced to shut down businesses. This is graphically represented below:
It can be seen in the graph above that the average costs are greater than average revenue leading to
subnormal profits in the area Pabc.

In contrast, a monopoly is where a single firm controls the entire output of the industry; this is called a
pure monopoly and is the other end of the spectrum to perfect competition.

In theory, a monopoly has no close substitutes, high barriers to entry and the monopolist is a price
maker.

However, in practical, this strict definition is relaxed in so far as a monopoly will occur when a firm has a
dominant position in terms of its market share.

A single firm or pure monopolist in theory would face a downward sloping market demand curve. In this
situation, it can either control price or output but cannot control both simultaneously. It faces a trade-off
between higher prices and quantity sold. The downward sloping demand curve for a monopoly (and a
monopolistically competitive firm) means that it has to decrease price on ALL the units to sell more;
resulting in a divergence between the sale price and marginal revenue (MR) i.e. the sale price exceeds
MR.

A profit maximizing monopoly would not charge price when MR = MC at point “e”. Since monopolies are
capable of influencing the market price and output, they will surely try to exploit consumers by using
their monopolistic advantage; they will charge a much higher price, restrict output, produce poor quality
goods (as they will not operate at the minimum point on the Average Cost curve) and ignore the
customer needs and wants.

In a monopoly market, the firm's ability to earn positive economic profit in the long run is due to barriers
to entry that prevent new firms from entering the market and competing away profits. This can be due
to factors such as patents, exclusive control over raw materials, or economies of scale that make it
difficult for new firms to enter the market. The graph below shows a monopolistic firm making abnormal
profits:

Therefore, while both perfectly competitive and monopoly markets can be in equilibrium in the short run
and the long run, the difference lies in the ability of a monopoly firm to earn positive economic profits in
the long run due to the absence of competition. In contrast, perfect competition can only earn normal
profits in the long run due to the ease of entry and exit in the market.
Summer 2018 Paper 42 Question 3:

Sample Answer:

Oligopoly is a market structure characterized by a small number of large firms dominating the market,
leading to interdependence among them. This interdependence arises because each firm's decision
affects the profits of the other firms. Additionally, the presence of uncertainty, such as changes in
consumer preferences or technological advances, further complicates decision-making for oligopoly
firms.

One method that oligopoly firms use to reduce uncertainty and interdependence is collusion, which
involves firms agreeing to cooperate rather than compete with each other. This can take the form of
price-fixing agreements, where firms agree to set prices at a certain level, or output quotas, where firms
agree to limit the quantity of goods produced. Collusion can lead to increased profits for the firms
involved, but it is illegal in many countries and can lead to fines and legal penalties.

This may take two forms: Price Leadership or Cartel.

Price leadership is a situation in which a single firm in an industry sets the price of its product, and other
firms follow the price set by the leader. Two types of price leadership have been identified: dominant
price leadership and barometric price leadership.

Dominant price leadership exists when the industry consists of a single large firm that dominates the
industry, and a few smaller firms. Dominant firms are able to secure compliance to their prices by
smaller rivals because of their powerful position in the market. Price changes are initiated by the
dominant firm, and the smaller firms simply follow the leader. A dominant firm is the one whose market
share is high and whose cost of production is low (due to economies of scale). Normally, low-cost firms
act as leaders.

In a situation of barometric price leadership, the industry may not be dominated by any single firm. Any
firm may be the leader, or the leadership role may rotate in a rather orderly manner. Changes in demand
and cost conditions in the industry may cause one firm to initiate a price change that is followed by the
other firms in the industry. Suppliers readily accept any barometric price leader's set price because they
recognize his or her adeptness at establishing prices that are reflective of changing market conditions.

A group of independent producers who enter into a formal agreement to control price and output in a
particular industry is known as a cartel.

If the cartel decides to maximize joint profits, it chooses a price-output combination that equates
marginal revenue with marginal cost. In other words, the cartel behaves exactly like a monopolist
producing its output in different plants. Cartels are usually established with the purpose of either
exploiting the joint market power of suppliers to extract monopoly profits, or as a means of preventing
cut-throat competition, eventually forcing firms to operate at a loss, often resorted to in times of
depressed demand (a so-called 'crisis cartel').

In the former case, a central administration agency could determine the price and output of the industry,
and the output quotas of each of the separate member firms may be distributed in such a way as to
restrict total industry output and maximize the joint profits of the group. Price and output will thus tend
to approximate those of a profit-maximizing monopolist.

Once the cartel decides on its price-output combination, it faces the further problem of allocating output
and profits among cartel members. The allocation may be done in any of several ways, including the
assignment of exclusive territories and the establishment of output quotas for members. The output
quota approach is followed by OPEC-perhaps the best-known cartel.

We may illustrate the mechanics of an oligopolistic cartel with the help of the diagrams above. D is the
industry's demand curve, showing the aggregate quantity which the combined group may sell over a
range of possible prices and MR is the industry's marginal revenue curve. The industry's marginal cost
curve ∑MC is constructed by joining the marginal cost curves of the individual firms making up the cartel
(i.e., MCa+ MCb). For any given level of industry output the cartel is required to calculate the allocation
of the output among the member firms on the basis of their individual marginal costs to obtain the
lowest possible aggregate cost of producing "their" output.

To maximize industry profit the cartel will set price at Po and produce output Qo. Quotas of Qoª and Qob
are given to firms A and B respectively, where a horizontal line drawn from the intersection of MR and
EMC (the line of aggregate marginal costs) intersects MCa and MCb. The profit contributed by each firm
is computed by multiplying the number of units produced by the difference between the industry price
and the firm's average cost at that level of output. Firm A will earn abnormal profits of area Poabc and
firm B will make abnormal profits of area Podef, as shown in the diagrams above.

The aggregate profit is then shared by the member firms in some agreed manner, not necessarily in the
same proportion as actually contributed by each of the individual firms. Disputes over the sharing of
aggregate profit frequently lead to the breakup of cartels.

Another method used by oligopoly firms to reduce uncertainty is non-price competition, which involves
firms competing on factors other than price, such as advertising, product differentiation, and customer
service. This allows firms to differentiate their products and create brand loyalty, reducing the impact of
price changes on demand. Non-price competition can benefit consumers by providing them with a
greater variety of products and services, but it can also lead to higher prices as firms seek to recoup their
advertising and marketing costs.

Other methods used by oligopoly firms to reduce uncertainty and interdependence include strategic
alliances and mergers and acquisitions. Strategic alliances involve firms working together on joint
projects or sharing resources to achieve a common goal, while mergers and acquisitions involve one firm
acquiring another. These methods can reduce uncertainty by providing firms with access to new
markets, technologies, or resources. However, they can also lead to reduced competition and higher
prices for consumers.

The methods used by oligopoly firms to reduce uncertainty and interdependence can have both positive
and negative impacts on consumers.

Collusion can have a negative impact on consumers. When firms collude to set prices, it can lead to
higher prices and reduced choice for consumers. This is because colluding firms have less incentive to
compete on price, and they may agree to set prices higher than they would in a competitive market. This
can result in reduced consumer welfare as consumers pay higher prices for goods and services.

Non-price competition can benefit consumers by providing them with a greater variety of products and
services, as well as by encouraging firms to innovate in order to differentiate their products. However, it
can also have a negative impact if firms engage in deceptive advertising or if they use their market power
to prevent new entrants from competing. In addition, firms may pass on the cost of their advertising and
marketing campaigns to consumers in the form of higher prices.

Strategic alliances and mergers can reduce uncertainty by providing firms with access to new markets,
technologies, or resources. They can also increase efficiency and lower costs by enabling firms to achieve
economies of scale. However, this can have a negative impact on consumers by reducing competition
and leading to higher prices. When firms form strategic alliances or merge, they may be able to increase
their market power, which can enable them to raise prices and reduce output. In addition, strategic
alliances and mergers can reduce consumer choice if they result in the consolidation of multiple firms
into a single entity.

In conclusion, while oligopoly firms face challenges in decision-making due to uncertainty and
interdependence, they have various methods at their disposal to reduce these problems.

The impact of these methods on consumers can vary depending on the specific strategy employed, and
policymakers must carefully consider the trade-offs between promoting competition and allowing firms
to reduce uncertainty and interdependence.
Utility and Market Structure Combined 20 marks question as per new syllabus:

Winter 2014 Paper 42 Question 2:

Marking Scheme:

Sample Answer:

The idea that the purchases a consumer makes are solely based on marginal utility, and supply has no
relevance in determining market equilibrium in perfect competition, raises important questions about
the interplay between consumer behavior and market dynamics.

Utility is the want satisfying capacity of a commodity. It is a record of the level of happiness one receives
from the consumption of a good or service. The theory was developed by Alfred Marshall who stated
that consumer satisfaction can be measured through imaginary units called “utils”.

The theory represents a cardinal approach and is based on premises that the amount of satisfaction
obtained from a particular product can be measured in the same way that the actual units consumed can
be calculated i.e., numbers.

Two important measures are: “Total Utility” and “Marginal Utility”.

Total utility is the sum of all the satisfaction derived from the consumption of all units of a good over a
given time period. Marginal Utility is the additional or extra satisfaction derived from the consumption of
one more unit of a particular good.

So, if someone gets 10 utils of satisfaction from consuming one bar of chocolate and 15 utils after
consuming two bars, the marginal utility is 5 utils. This concept can be understood with the help of
schedule and relevant graphs as shown below:
 Schedule:
Units TU MU
0 0 0
1 50 50
2 80 30
3 100 20
4 110 10
5 110 0
6 90 -20
It is evident from the above graphs that when
marginal utility equals zero, total utility is at
maximum (see graph trend at unit 5). Also,
when MU is positive, TU is increasing but when
MU is negative, TU starts decreasing. It can also
be seen that when consumption increases from
unit 1 to unit 2 and so on, marginal utility falls.
This aspect of consumer behavior is referred to
as “Law of Diminishing Marginal Utility”. As
consumption increases, marginal utility
becomes negative (see MU at unit 6), indicating
A consumer is in equilibrium at the quantity at which the marginal utility of a good equal its price.
dissatisfaction or disutility.

Consumers allocate resources / expenditures among different products to maximize total utility. In
maximizing total utility, the consumer faces a number of constraints.; the most important of which are
the consumer`s income and the prices of the goods and services that the consumer wishes to consume.
The solution to these consumer’s problem, which entails decisions about how much the consumer will
consume of a number of goods and services, is referred to as consumer equilibrium.

A consumer is in equilibrium at the quantity at which the marginal utility of a good equal its price.

The concept of marginal utility also enables the construction of demand curves. Demand is the
willingness and ability of a consumer to buy a product at a given price is known as demand.
 According to the Law of Demand, a rise in price from “P” to “P1” will
result in a contraction of quantity demanded by consumers from “Q”
to “Q1”. Similarly, a fall in price from “P” to “P2” will extend the
quantity demand from “Q” to “Q2”.

The Law of Diminishing Marginal Utility is the basis of the Law of Demand. The consumer's decision to
purchase a good is influenced by the trade-off between its price and the marginal utility derived from
consuming it. The consumer will buy more only if the price falls because the more he buys the lower is
the marginal utility.

Law of Diminishing Marginal Utility states that larger the quantity, less is the utility whereas Law of
Demand states that larger the quantity, lower will be the price as the utility of the successive units will
be low.

While marginal utility analysis focuses on individual consumers, market demand is derived from
aggregating individual demand curves. Each individual's demand curve is constructed based on their
unique preferences, income, and the marginal utility they derive from consuming each unit of a good. By
horizontally summing the quantities demanded at each price level across all consumers, the market
demand curve is formed. However, it is important to note that the market demand curve alone does not
determine market equilibrium in perfect competition. It represents the cumulative preferences and
quantities desired by consumers but does not account for the supply side of the market.

Supply is a crucial determinant of market equilibrium, especially in the context of perfect competition.
Perfect competition assumes many buyers and sellers in the market, with no individual entity having the
power to influence prices. In such a scenario, price is determined by the forces of supply and demand.
Producers respond to consumer preferences and demand by supplying goods at various prices. As prices
increase, producers are incentivized to increase their supply, while lower prices may reduce their
willingness to produce.

In perfect competition, market equilibrium is not solely determined

by the market demand curve, but rather by the interaction of both
demand and supply. The equilibrium price and quantity are
determined at the point where the market demand curve intersects
with the market supply curve. This intersection represents the price
and quantity at which the intentions of buyers and sellers align,
ensuring that there is neither excess demand nor excess supply in the
market. Consequently, market equilibrium is dependent on both the
demand side (captured by marginal utility and the demand curve) and
the supply side, highlighting the relevance of supply in determining
the equilibrium outcome.
While marginal utility guides consumer choices, it is intricately linked with the concept of supply in
determining market equilibrium. The interaction between these factors is crucial in understanding the
dynamics of consumer behavior and market outcomes. As consumers consume more units of a good, the
marginal utility derived from each additional unit tends to diminish due to the law of diminishing
marginal utility. However, if the supply of the good is limited or scarce, it can create a situation where
consumers are willing to pay a higher price to obtain the good, despite the diminishing marginal utility.
In this case, supply conditions affect market equilibrium, as prices adjust to balance supply and demand.

In the context of perfect competition, market equilibrium is established through the interplay of supply
and demand. Marginal utility influences consumer demand, but it is not the sole determinant of market
equilibrium. Perfect competition assumes that producers are price takers, adjusting their supply based
on market conditions. Marginal utility guides consumers in evaluating the satisfaction gained from
consuming goods, while supply represents the willingness and ability of producers to provide goods at
various prices. Market equilibrium occurs when the quantity demanded by consumers matches the
quantity supplied by producers at a specific price. Both supply and demand, along with their respective
factors, are integral to determining market equilibrium in perfect competition.

In conclusion, the claim that consumer purchases are solely determined by marginal utility, rendering
supply irrelevant in establishing market equilibrium in perfect competition, oversimplifies the
complexities of consumer behavior and market dynamics. While marginal utility plays a significant role in
consumer decision-making and influences demand, it cannot be viewed in isolation from the concept of
supply. In perfect competition, market equilibrium is a result of the interplay between supply and
demand. Supply is a crucial factor in determining the quantity of goods available at different prices,
which directly impacts on market equilibrium. Ignoring the role of supply undermines the
comprehensive understanding of market interactions and equilibrium. Therefore, recognizing the
significance of both marginal utility and supply is essential for a thorough analysis of market dynamics
and equilibrium in perfect competition.

Winter 2014 Paper 43 Question 2:

Marking Scheme:

Sample Answer:

The relationship between marginal utility and price for consumers, and the connection between
marginal cost and price for producers, are fundamental concepts in economic analysis.
 Utility is the want satisfying capacity of a commodity. It is a record of the level of happiness one receives
from the consumption of a good or service. The theory was developed by Alfred Marshall who stated
that consumer satisfaction can be measured through imaginary units called “utils”.

The theory represents a cardinal approach and is based on premises that the amount of satisfaction
obtained from a particular product can be measured in the same way that the actual units consumed can
be calculated i.e., numbers.

Two important measures are: “Total Utility” and “Marginal Utility”.

Total utility is the sum of all the satisfaction derived from the consumption of all units of a good over a
given time period. Marginal Utility is the additional or extra satisfaction derived from the consumption of
one more unit of a particular good.

So, if someone gets 10 utils of satisfaction from consuming one bar of chocolate and 15 utils after
consuming two bars, the marginal utility is 5 utils. This concept can be understood with the help of
schedule and relevant graphs as shown below:

Schedule:
Units TU MU
0 0 0
1 50 50
2 80 30
3 100 20
4 110 10
5 110 0
6 90 -20
It is evident from the above graphs that when
marginal utility equals zero, total utility is at
maximum (see graph trend at unit 5). Also,
when MU is positive, TU is increasing but when
MU is negative, TU starts decreasing. It can also
be seen that when consumption increases from
unit 1 to unit 2 and so on, marginal utility falls.
This aspect of consumer behavior is referred to
as “Law of Diminishing Marginal Utility”. As
consumption increases, marginal utility
becomes negative (see MU at unit 6), indicating
A consumer is in equilibrium at the quantity at which the marginal utility of a good equal its price.
dissatisfaction or disutility.

Consumers allocate resources / expenditures among different products to maximize total utility. In
maximizing total utility, the consumer faces a number of constraints.; the most important of which are
the consumer`s income and the prices of the goods and services that the consumer wishes to consume.
The solution to these consumer’s problem, which entails decisions about how much the consumer will
consume of a number of goods and services, is referred to as consumer equilibrium.

A consumer is in equilibrium at the quantity at which the marginal utility of a good equal its price.

Schedule:
Units MU X PX
1 25 5
2 15 5
3 10 5
4 8 5
5 5 5
6 2 5

The graph above shows an equilibrium point E at unit 5 where the price is equal to the marginal utility of
the product. The consumer will not consume the sixth unit because the satisfaction gained at that point
will not be worth the price paid. Hence the consumer will stop purchasing when the MU and price are
equal.

While marginal utility analysis is often illustrated using a single good, it can be extended to analyze
consumer equilibrium for multiple goods. Consumers face choices regarding the allocation of their
limited incomes among various goods. The concept of marginal utility allows consumers to compare the
additional satisfaction derived from consuming different goods, enabling them to allocate their limited
income optimally. By comparing the marginal utilities of different goods and considering their respective
prices, consumers can determine the most preferred combination of goods that maximizes their overall
utility. In other words, a consumer will be in equilibrium at a point at which the marginal utility of money
expenditure on both the goods are equal in symbolic terms. This is written in form of an equation below:

Marginal Utility of Good X / Price of Good X = Marginal Utility of Good Y / Price of Good Y

This ratio represents the trade-off consumers make between the satisfaction derived from consuming
different goods relative to their respective prices. Consumers allocate their limited budget in a way that
maximizes their overall utility. The link between marginal utility and price is crucial in understanding
consumer behavior and decision-making in reaching equilibrium. It guides consumers in making optimal
choices by evaluating the additional satisfaction gained from consuming an extra unit of a good relative
to its price. Thus, the statement accurately reflects the significance of the relationship between marginal
utility and price in consumer equilibrium.

For firms, equilibrium is determined by the equality of marginal cost (MC) and marginal revenue (MR). In
perfect competition, where firms are price takers, MR is equal to the market price.

This is due to the many firms in the market; the market share divides between thousands of firms,
resulting in no space for the firm to influence the market price; hence, they are described as price takers.
The demand curve for such firm is perfectly elastic at this ruling price. If the firm sells an extra unit of
output (from Q0 to Q1), it will get the price as the one before i.e. “P” as shown in the graph below. The
marginal revenue is therefore equal to the price or the average revenue.

P = D = AR = MR

This condition ensures that firms are producing at an output level where the additional cost of producing
one more unit (marginal cost) is equal to the additional revenue generated from selling that unit
(marginal revenue). This equilibrium guides firms in optimizing their production decisions to maximize
profit. The link between marginal cost and price is significant for firms as it directly influences their
profit-maximizing output level.

In perfect competition, there is a parallel between consumer and producer equilibrium. Both equilibria
are determined by the equality of a ratio involving a marginal measure (marginal utility for consumers
and marginal cost for producers) and price. This similarity arises due to the price-taking behavior of both
consumers and firms in perfect competition. Consumers aim to equalize the marginal utility per unit of
expenditure across goods, while firms aim to equalize marginal cost and marginal revenue to maximize
profit. This link reflects the importance of the relationship between marginal measures and price in
achieving equilibrium in perfect competition.

However, it is important to acknowledge that the significance mentioned in the statement is specific to
the context of perfect competition. In non-perfectly competitive markets, such as monopolistic
competition, oligopoly, or monopoly, the equilibrium conditions for firms differ substantially.
Monopolistic firms, for instance, face a downward-sloping demand curve and set prices above marginal
cost to maximize profit. In oligopoly, firms may engage in strategic pricing and interdependent decision-
making, resulting in deviations from the simple MC = MR condition. Consequently, the link between
marginal cost and price loses the similar significance observed in perfect competition. Similarly, the link
between marginal utility and price for consumers may vary as market structures deviate from perfect
competition, leading to different patterns of consumer behavior and equilibrium outcomes.

In conclusion, the statement accurately reflects the significance of the link between marginal utility and
price for consumers and between marginal cost and price for producers in the context of perfect
competition. Both relationships play a vital role in achieving equilibrium. However, it is crucial to
recognize that this significance is specific to perfect competition, where the conditions for consumer and
producer equilibrium are aligned. In other market structures, such as monopolistic competition,
oligopoly, or monopoly, the equilibrium conditions, and the relevance of the link between marginal cost
and price may vary significantly. Similarly, consumer equilibrium is influenced by market structures,
impacting the relationship between marginal utility and price. Understanding these variations is essential
for a comprehensive analysis of equilibrium in different market contexts.

Cost of Production / Size of Firms / Market Structures Past Papers

Winter 2016 Paper 42 Question 4:

Summer 2018 Paper 42 Question 3:

Summer 2018 Paper 43 Question 3:

Winter 2018 Paper 43 Question 2:

Winter 2019 Paper 41 Question 2:

Summer 2020 Paper 41 Question 4:
 Efficiency
Productive Efficiency:

It is a situation where goods and services are produced at the minimum possible cost using the least
possible resources.

For Productive Efficiency to be met, the following conditions should be fulfilled:

1. Lowest possible AC curve (X – efficiency)

2. Lowest possible point on a given AC Curve

A productively efficient
firm will operate at
point “x” of AC3 instead
of AC2 and AC1. This is
because point “x” is the
minimum point of the
lowest possible average
cost curve.

Productive Efficiency through Production Possibility Curve:

Allocative Efficiency:

Allocative efficiency is achieved when society allocates its resources to produce those goods and services
which are most desirable by consumers in society.

Allocative efficiency can be judged through various criteria:

1. When P = MC, i.e., the value which a consumer puts to an extra unit of a good is equal to the
cost involved in the production of that extra unit.
2. When there is maximum total surplus (i.e., consumer surplus + producer surplus) and there is
no dead weight loss.
3. When MSC = MSB i.e., there is no divergence between private and social costs.

Why are you seeing Marginal Utility (MU) in the graph?

Allocative efficiency is at an output level where the Price equals the Marginal Cost (MC) of production.
This is because the price that consumers are willing to pay is equivalent to the marginal utility that they
get. Therefore, the optimal distribution is achieved when the marginal utility of the good equals the
marginal cost.
Pareto Efficiency and Improvement:

Any point on the boundary of the PPC shows

full employment and pareto efficiency because
if there is any movement at the boundary, for
example from A to B, more services will be
produced and less consumer goods, it means
that someone will be better off, and someone
will be worse off. However, any point inside the
PPC boundary shows unemployment and
pareto improvement because from moving
from point D to A or B, someone will be better
off without making someone else worse off.

Dynamic Efficiency:

A firm which is dynamically efficient will be reducing its cost curves by implementing new production
processes. Dynamic efficiency will enable a reduction in both SRAC and LRAC.

For example, investment in new machines and technology may enable an increase in labour productivity.

Dynamic efficiency may also involve implementing better working practices and better management of
human capital. For example, better relationships with unions that help to introduce new working
practices.

The graph above shows the change in LRAC from 2010 to 2017. The firm has now become more
dynamically efficient.
 Market Failure
Market failure refers to a situation in which the allocation of goods, services, or resources in a market
economy leads to inefficient outcomes or fails to achieve desirable social or economic objectives. In
other words, markets fail to efficiently allocate resources and produce socially optimal outcomes.

Externalities:

These occur when the production or consumption of a good or service imposes costs or benefits on third
parties who are not involved in the transaction.

1. Negative Externalities
2. Positive Externalities

Negative externalities:

It refers to the costs or harmful effects imposed on third parties or society as a whole because of the
production or consumption of goods and services.

Example:

The exhaust from automobiles is a negative externality because it creates smog that other people must
breathe. As a result of this externality, drivers tend to pollute too much. The federal government
attempts to solve this problem by setting emission standards for cars. It also taxes gasoline to reduce the
amount that people drive.

Positive externalities:

It exists when others benefit from your actions without paying.

Example: if most people get flu shots, even those who don`t get shots benefit from the reduced
likelihood of catching the flu.

If you hate country music, then having it waft into your house every night would be a negative
externality. If you love country music, then what amounts to a series of free concerts would be a
positive externality.

Markets fail when externalities exist, producing too many of the things we don`t want (demerit goods)
and too few of the things we do want (merit goods).
The socially optimum level of output is at Q. In a market economy, merit goods won`t be produced.
Hence, the quantities traded are at Qmerit. On the contrary, demeit goods are over produced and over
consumed. Hence, the quantities traded are at Qdemerit. In both the cases, if the economy deviates
from the socially optimum level of output, it will result in a dead-weight loss and eventually market
failure.

How much does it really cost for a Honda Civic?

Your private additional costs include monthly payments, insurance, gas, repairs, and maybe parking. If
you can afford it, and if the additional benefits of driving are greater than taking public transport, then
buying the car is a smart choice for you. [MB > MC]

There are also social costs you don`t usually consider when choosing your Honda Civic. The exhaust from
your driving will contribute to air pollution, to global warming, and — depending on your choice of
muffler or sound system — to noise pollution that might drive your neighbors crazy. By adding one more
car to the roads, you will (marginally) worsen traffic jams and increase other driver`s commute times.
Your choice creates these real costs for others and to society, but you don`t have to directly pay for them.

Negative Externalities or External costs affect people external to the original activity — others not
involved in the exchange between you and the Honda dealer.

Social Costs = Private Costs + External Costs

Positive Externalities or External benefits: Benefits to society from your private choice that affect
others, but that others do not pay you.

When there are positive externalities, benefits include both private benefits and external benefits. So,
when positive externalities are factored in, social benefits are greater than private benefits.

Social Benefits = Private Benefits + External Benefits

Example: Public transit is another example of a positive externality. If you decide against the Honda Civic
and continue to take public transit, your private benefits include the ability to get around inexpensively,
without car expenses. But by keeping one more car off the roads, you unintentionally reduce pollution
for everyone, reduce traffic jams, and decrease other driver`s commute times.

Production Externalities:

Firms generate production externalities when producing goods to be sold in the market.

Negative Production Externalities can occur in the form of pollution released into the atmosphere due
to the businesses’ course of production. [Example: manufacturing plants cause noise and atmospheric
pollution during the manufacturing process]

Social Cost > Private Cost

How to achieve the optimal outcome?

One way would be to tax aluminum producers for each ton of aluminum sold. The tax would shift the
supply curve for aluminum upward by the size of the tax. If the tax accurately reflected the social cost of
smoke released into the atmosphere, the new supply curve would coincide with the social-cost curve. In
the new market equilibrium, aluminum producers would produce the socially optimal quantity of
aluminum.
Positive Production Externalities can occur if a business develops a new technology that other
companies can implement, improve their efficiency, and make the production process more
environmentally friendly. [Example: Production of robots or seat belts]

Social Cost < Private Cost

How to achieve the optimal outcome?

In this case, the government can provide a subsidy to the producer. If the government paid firms a
subsidy for each robot produced, the supply curve would shift down by the amount of the subsidy, and
this shift would increase the equilibrium quantity of robots. To ensure that the market equilibrium
equals the social optimum, the subsidy should equal the value of the technology spillover.
Consumption Externalities:

Consumption externalities are impacts on third parties generated by the consumption of a good or
service.

Negative Consumption Externalities:

When an individual’s consumption of goods or services negatively affects others, negative consumption
externalities can arise. [Example: people talking loudly to each other]

Social Value < Private Value

How to achieve the optimal outcome?

Tax alcoholic beverages and tobacco products! [Excise tax rate on tobacco in Pakistan: 45%.
Recommended tax by WHO.]
Positive Consumption Externalities can arise when consuming a good or service generates benefits to
other individuals. [Example: wearing a mask during the Covid-19 pandemic to prevent the spread of an
infectious disease.]

Social Value > Private Value

How to achieve the optimal outcome?

Subsidizing education through public schools, universities, and government scholarships.

Asymmetric Information

Asymmetric information occurs when one party in an economic transaction has more information than
the other party. It means that either the buyer or the seller possesses information that the other party
does not have, creating an information imbalance. This imbalance can lead to adverse selection and
moral hazard.

Adverse Selection: Adverse selection refers to a situation where one party in a transaction (typically the
buyer) possesses less information than the other party (typically the seller) about the quality, value, or
characteristics of the product or service being exchanged. As a result, the party with superior
information may take advantage of the information gap by offering lower-quality goods or overcharging
for low-value products. This can lead to market breakdown or the emergence of low-quality products
dominating the market.

Moral Hazard: Moral hazard arises when one party (usually the agent) in a transaction has an incentive
to take risks or engage in actions that are hidden from or not fully observable by the other party (usually
the principal) after the transaction has taken place. This is because the party with more information may
have limited liability or face fewer consequences for their actions. Moral hazard is commonly observed in
situations where insurance or contract arrangements create incentives for individuals or firms to behave
recklessly or negligently, knowing that they will not bear the full cost of their actions.
Examples:

Insurance: In the insurance industry, moral hazard can occur when insured individuals or companies may
be inclined to take more risks or engage in reckless behavior, knowing that the insurer will cover the
losses. This can lead to higher claims and increased premiums for all policyholders.

Financial markets: Asymmetric information is prevalent in financial markets. For example, in the case of
stocks, insiders or institutional investors may possess non-public information about a company, allowing
them to make informed trading decisions ahead of other market participants.

Employment contracts: Moral hazard can be observed in employment relationships. When an

employee's performance is difficult to observe or measure, the employee may engage in shirking or
opportunistic behavior, knowing that their actions are not easily detected by the employer.

How to Reduce Asymmetric Information and Moral Hazard?

Addressing asymmetric information and moral hazard often requires the implementation of mechanisms
to reduce information asymmetry or create incentives for parties to act in the best interests of both
parties. These mechanisms can include transparency and disclosure requirements, monitoring and
enforcement mechanisms, the use of contracts, insurance deductibles or co-payments, and aligning
incentives through performance-based compensation or risk-sharing arrangements.

Cost Benefit Analysis:

When the government compares social costs and social benefits before a decision.

If SB > SC, government proceeds with the decision.

Paper 3
1.

Answer: B

Dynamic efficiency refers to a firm's ability to innovate, adapt, and improve its production processes,
technologies, and products over time. When the average total cost curve of a firm decreases over time,
it indicates that the firm has achieved dynamic efficiency by finding ways to produce output at a lower
cost.
2.

Answer: C

The optimum level of output is where MSB = MSC. That is at Q 1 . Since the equilibrium quantity is at Q,
this shows underproduction and underpricing.

3.

Answer: D
There are two types of externalities: Positive and Negative.

Negative Externalities (Negative External Costs) can be calculated through the formula:

Social Costs = Private Costs + External Costs

450 – 400 = External Costs

External Costs = 50

Positive Externalities (Positive External Benefits) can be calculated through the formula:

Social Benefit = Private Benefit + External Benefits

480 – 440 = External Benefits

External Benefits = 40

Therefore, total externalities equal 90 (50 + 40).

4.

Answer: A

That`s the definition of Pareto efficiency.

5.

Answer: D

Negative externalities is when the harmful effects of the production of the costs will be borne by the
third party.
6.

Answer: B

Increased merger and takeover activity in the deregulated industries can lead to a consolidation of
market power, resulting in reduced competition. When firms merge or take over their competitors, it can
result in fewer players in the market, leading to decreased competition and potentially higher prices for
consumers. This reduces allocative efficiency as resources may not be allocated optimally to meet
consumer preferences.

Moreover, increased consolidation can also hinder productive efficiency. With fewer firms competing,
there may be less incentive for innovation, cost reduction, and efficiency improvements. This can result
in reduced dynamic efficiency, as there is less pressure for firms to continuously improve and innovate to
remain competitive.

On the other hand, options A, C, and D, are changes that are more likely to contribute to the
government's aim of increasing allocative and productive efficiency:

A: increase in the availability of cheap loans to start new businesses can encourage entrepreneurship
and competition, fostering allocative and productive efficiency.

C: an increase in information about prices for consumers available on the internet can empower
consumers to make informed choices and put pressure on firms to offer competitive prices, improving
allocative efficiency.

D: a reduction in fixed costs in the deregulated industries can lead to lower production costs, potentially
improving both productive and allocative efficiency.

7.
Answer: C

Productive efficiency refers to the ability of a firm or economy to produce goods or services at the lowest
possible cost. It means achieving the maximum output with the minimum number of resources or
inputs. When a firm or industry is productively efficient, it is producing its output at the lowest possible
average cost per unit.

Option A does not accurately define productive efficiency. Productive efficiency focuses on minimizing
costs, whereas profits can be influenced by various factors, including pricing, revenue, and other
business strategies.

Option B refers to Pareto efficiency, which is not the same as productive efficiency. Pareto efficiency is a
concept related to the allocation of resources where it is impossible to improve the well-being of one
person without adversely affecting another.

Option D refers to the limits of production possibilities based on available resources and technology, but
it does not specifically address the concept of productive efficiency.

Therefore, the statement that best defines productive efficiency is C. It is not possible to produce the
level of output at a lower unit cost.

8.

Answer: C

“Too many sugary drinks” – over consumption - “yes”

“Bad for health” – negative externalities of consumption as people who consume sugary drinks may be
admitted to hospital taking up space and affecting others (third party) - “yes”

“Negative externalities of production” – no – because there is no such evidence of this in the case
provided.
9.

Answer: D

A Cost Benefit Analysis should be done.

Social Costs = 1.7

Social Benefits = Private Benefit + External Benefit = 0.5 + 1.8 = 2.3

Since SB > SC, the government should proceed.

10.

Answer: C

Public goods are not provided by the free market due to its non-excludability and non-rivalry.
11.

Answer: A

The optimum level of output is where MSB = MSC.

12.

Answer: C

Cost of building the railway = Private Cost

Increased Noise Levels = Negative Externalities = External Cost

13.

Answer: C

When people discard chewing gum on pavements instead of disposing of it properly, it leads to aesthetic
and cleanliness issues. Gum sticks to surfaces and can be difficult and costly to remove, causing visual
pollution and making public spaces less appealing. Additionally, discarded gum can be stepped on and
become a nuisance for pedestrians.

14.

Answer: B

If the firm can produce the same output at a lower average cost by adopting different methods of
production, it suggests that the firm has achieved dynamic efficiency.

The given information does not provide any details about the firm's allocation of resources or whether it
is producing the optimal combination of goods and services that maximizes society's welfare. Therefore,
we will say the firm is not allocatively efficient.
15.

Answer: D

Excess of marginal social benefit over marginal social cost refers to a situation where the benefits to
society from a particular activity or project outweigh the costs. Let's analyze each group to determine
where this excess is likely to be the greatest:

A. Construction workers who built the site: While they may have received employment and income
during the construction phase, once the project is completed, their direct benefits from the project
diminish. The excess of marginal social benefit over marginal social cost for this group is not likely to be
as significant in the long term.

B. Factory workers who returned to their jobs after the games: The closure of factories during the games
to reduce air pollution may have had short-term benefits in terms of improved air quality. However, once
the games were over and factories resumed operation, the marginal social benefit may not significantly
exceed the marginal social cost for this group.

C. Residents who were rehoused far away from Beijing: These residents experienced the loss of their
homes and were relocated far away from their communities. This relocation could have resulted in social
and emotional costs for these individuals and may not outweigh the benefits they received from the
Olympic Games in terms of infrastructure development.

D. Those who live in the former athletes' accommodation: These individuals now have access to housing
in the former athletes' accommodation, which is being utilized as apartments. This group is likely to
experience a higher excess of marginal social benefit over marginal social cost compared to the other
groups. They directly benefit from improved housing options and the attractiveness of living in a major
tourist attraction.
 Paper 4
Feb March 2023 Paper 42 Question 2:

Marking Scheme:
Sample Answer:

The market for air travel is subject to negative externalities, which result in market failure. Negative
externalities occur when the consumption or production of a good or service affects the well-being of
third parties who are not involved in the transaction. In the case of air travel, negative externalities
include noise pollution, greenhouse gas emissions, and congestion in the airspace. The government can
intervene in the market to correct this market failure by implementing policies such as taxes, subsidies,
and regulations.

To assess the extent to which a government can intervene to correct market failure in the air travel
market, a diagram can be used to illustrate the concept of negative externalities. The diagram below
shows the market for air travel before and after the introduction of government intervention.

Price

Qty

The diagram shows the demand and supply curves for air travel. The demand curve (D) shows the
quantity of air travel demanded at different prices. The supply curve (S) shows the quantity of air travel
supplied at different prices. The equilibrium price and quantity in the absence of government
intervention is QMARKET.

However, the production and consumption of air travel generate negative externalities. This represents
the additional costs imposed on society by air travel, including noise pollution, greenhouse gas
emissions, and congestion. The negative externalities cause the social cost of air travel to be higher than
the private cost, resulting in market failure. The optimal level of output is at Q OPTIMUM where the social
cost curve intersects the demand curve.

To correct this market failure, the government can

intervene by implementing policies that internalize
negative externalities. One way to do this is by
imposing a tax on air travel, which increases the price
of air travel to reflect the social cost of the negative
externalities. This is represented by the shift of the
supply curve from S to S+T. The tax (T) represents the
cost of the negative externalities, and it raises the
price of air travel from P to P1. As a result, the
quantity demanded decreases from QMARKET to
QOPTIMUM, reducing the negative externalities and
correcting the market failure.

Regulations are also a common approach to internalizing negative externalities. For example, the
government can impose restrictions on the types of planes that can operate at certain airports, or it can
require airlines to use specific technologies to reduce noise pollution or greenhouse gas emissions.

However, the effectiveness of these policies may vary depending on the nature of the good/service
under consideration. The precise level of taxation required to achieve allocative efficiency may be
difficult to determine and its effectiveness as a policy tool may be limited by the elasticity of demand for
air travel. If demand is relatively inelastic, then the tax may only have a small effect on reducing the
quantity of air travel and achieving allocative efficiency. Furthermore, if the tax is too high, it may
discourage some individuals from traveling altogether, reducing consumer welfare, and potentially
harming the economy.

Policymakers also need to consider the potential for rent-seeking behavior by firms and special interest
groups. For example, airlines may lobby against regulation or taxes that would reduce their profits, while
environmental groups may push for more stringent regulation regardless of its economic impact. Airlines
may form a cartel, restricting air travel routes and raising prices for households in response to greater
regulations. Policymakers need to balance these competing interests and ensure that the policy
intervention is designed to achieve the greatest net benefit for society.

Furthermore, government interventions may have unintended consequences and create new
inefficiencies. For example, taxes on air travel could disproportionately affect low-income individuals
who rely on affordable flights for leisure or business purposes. Additionally, regulations and standards
may impose compliance costs on airlines, potentially leading to reduced profitability and negative
impacts on employment within the industry.
It is also important to consider the potential for international spillover effects. If one country implements
policies to reduce negative externalities associated with air travel, airlines may simply shift their
operations to other countries with less stringent regulations, leading to unemployment in the home
country. This could undermine the effectiveness of domestic policy interventions and lead to a race-to-
the-bottom scenario where countries compete to attract airlines by offering lower taxes and fewer
regulations. To address this, policymakers may need to coordinate their efforts at the international level
to ensure a level playing field and prevent free riding by some countries.

Lastly, the ability of governments to intervene in air travel markets may be constrained by political and
economic considerations. Powerful lobbying groups representing airlines or tourism sectors could resist
or water down proposed interventions, leading to compromised policy outcomes. Moreover,
governments may prioritize economic growth and competitiveness over environmental concerns, leading
to inadequate or delayed action to address market failures in air travel.

Therefore, while government intervention can reduce the level of inefficiency caused by negative
externalities, it is not clear whether the net effect of government intervention will always be positive.
Some types of intervention will be more effective than others, and policymakers need to carefully
consider the costs and benefits of each policy option. However, by internalizing the negative
externalities, the government can ensure that the market for air travel operates efficiently and
sustainably.

Moreover, the effectiveness of government intervention depends on the accuracy of estimating the true
social cost of air travel. Quantifying negative externalities like carbon emissions and noise pollution is a
complex task, and policymakers may face challenges in determining the optimal level of taxation or
regulation. If the external costs are underestimated, the intervention may not fully correct the market
failure, leading to continued negative impacts on the environment and public health.

To conclude, the extent to which the government can intervene depends on the effectiveness of the
policy and the willingness of stakeholders to comply with it.
One Page Summary:

Productive Efficiency: To produce at the lowest point of

the AC.

Allocative Efficiency: Allocating resources desirably.

Pareto Efficiency: Operating at PPC Boundary.

Pareto Improvement: Operating Below the PPC and

improving.

Dynamic Efficiency: Reducing cost by implementing new

production processes.

Market Failure: When the market fails to achieve desirable outcomes.

Negative Externalities: Harmful effects on third party. Remember:

Positive Externalities: Positive effects on third party. Social Costs = Private Costs + External Costs
Social Benefits = Private Benefits + External Benefits

Remember 4 Diagrams:
Negative Production Externalities Positive Production Externalities

Social Cost > Private Cost

Social Cost < Private Cost
 Negative Consumption Externalities Positive Consumption Externalities

Social Value < Private Value Social Value > Private Value

Efficiency and Market Failure Past Papers

Summer 2017 Paper 43 Question 2:

Winter 2017 Paper 41 Question 2:

Winter 2018 Paper 41 Question 2:

Winter 2018 Paper 42 Question 2:

March 2019 Paper 42 Question 2:

Summer 2019 Paper 42 Question 2:

Winter 2019 Paper 42 Question 2:

March 2020 Paper 42 Question 2:

Summer 2020 Paper 41 Question 2:

Summer 2020 Paper 42 Question 4:

Winter 2020 Paper 41 Question 2:

 Labour Market
Demand for Labour:

Labour demand is derived demand. This means the more the firm produces goods and services, the
more labour will be demanded.
If there is an increase in demand for floral cakes, it will lead to an increase in demand for cake designers.

Market for Floral Cakes Demand for Cake Designers

How many labour will the firm employ?

This is an economic theory which suggests demand for labour depends on the marginal revenue product
(MRP) of a worker.

MRP = MPP x MR where, MPP means Marginal Physical Product and MR means Marginal Revenue

MRP: Additional revenue earned by employing one extra worker.

MPP: Additional output that an extra worker produces.
MR: Additional revenue earned by the firm from selling the last unit of output.
To maximize profits, the firm will employ at an equilibrium where marginal revenue of an extra worker
equals the marginal cost of employing an extra worker.
 The graph shows the MRP of labour
and marginal cost of labour.

A firm will employ till the point where

MRP = MC.

In this case, it is 6.5 labour. Now of

course, you cannot employ six and a
half worker, the firm will have to stop
employing at six.

Wage Determination in Competitive Labour Markets:

W W

Key Points:

The industry wage is determined by supply and demand for labour.

An individual firm in a perfectly competitive labour market is a wage taker. Therefore, its supply curve is
elastic.

The firm maximizes profits where MRP of workers equals the marginal cost of employing them (at Q1).
Wage Differentials Exists. BUT WHY?
1. Skill and Education
2. Supply and Demand
3. Job Complexity and Responsibility
4. Risks and Physical Demands
5. Experience and Seniority
6. Social Value and Perception
7. Discrimination and Bias

These are a few reasons that you might have studied in your O levels. But since it`s A2, let me add one
more reason.
One of the reasons why wage differentials exist is the MRP.
A doctor`s MRP is far greater than that of a janitor.

D2 = Higher MRP = Higher Wage = W2

D1 = Lower MRP = Lower Wage = W1

Common Reasons for a Shift in Labor Demand:

• Changes in the marginal productivity of labor, such as technological advances brought on by

computers.
• Changes in product demand
• Changes in the number of firms

Labour Supply:

It refers to the total number of hours that labour is willing and able to work at a particular job or
industry for a given wage rate.
As wages rise, the supply will increase. Hence, the supply of labour is upward sloping.
The extent to which a rise in wages leads to an expansion in the supply depends on the elasticity of
labour supply.
Shifts in the labour supply:

The supply curve of labour is just like any other supply curve you have studied till now. But since, this is
A2, we have a little twist to the supply curve of labour:
Backward Supply of Labour:
The backward supply curve of labor refers to a phenomenon where individuals may choose to work less
as their wages increase beyond a certain point. This behavior contradicts the typical assumption of an
upward-sloping supply curve, where individuals are willing to supply more labor as wages rise.

There are several reasons why the backward supply curve of labor occurs:

1. Income-Leisure Trade-off: As wages increase, individuals face a trade-off between earning more
income and having more leisure time. With higher wages, individuals may choose to work fewer
hours and enjoy more leisure activities, resulting in a decline in the quantity of labor supplied.
2. Substitution Effect: In the context of the backward supply curve of labor, the substitution effect
refers to the initial response of individuals to higher wages by supplying more labor.

When wages increase, individuals are motivated to substitute leisure time with work because
the potential earnings from work become more attractive. In other words, the higher wages
create an incentive for individuals to work more hours to maximize their income.

However, as wages continue to rise, the substitution effect weakens, and individuals start
substituting leisure for work less. This occurs because the additional income earned from extra
work becomes less appealing compared to the utility derived from leisure. Individu als may reach
a point where they prefer to maintain a certain level of leisure time and work fewer hours, even
if wages continue to increase.

3. Diminishing Marginal Utility of Income: The concept of diminishing marginal utility of income is
based on the observation that as individuals acquire more income, the additional satisfaction or
well-being they derive from each extra unit of income diminishes.

Initially, as wages rise, individuals experience an increase in their standard of living. They may
use the additional income to fulfill basic needs, improve their quality of life, or engage in desired
consumption. This leads to a positive relationship between wages and the quantity of labo r
supplied.
 However, beyond a certain threshold, individuals reach a point of satiation where their basic
needs and desired lifestyle have been adequately met. At this stage, the incremental utility
gained from additional income begins to decline. The marginal utility of income diminishes
because the individual's preferences shift towards non-monetary aspects of well-being, such as
leisure time, family time, or pursuing personal interests.

As a result, individuals may choose to work fewer hours and prioritize these non-monetary
aspects over additional income. Even if wages continue to increase, the diminishing marginal
utility of income reduces the incentive to supply more labor, contributing to the backward -
bending shape of the labor supply curve.

Monopsony in the Labour Market:

A monopsony producer has buying power in the labour market when seeking to employ extra workers
and may use that buying power to drive down wage rates.
The monopsonist knows that they face an upward sloping labour supply curve, in other words, to attract
more workers in their industry, they must pay a higher wage rate – so the average cost of employing
labour rises with the number of people taken on.
Because the average cost of labour is increasing, the marginal cost of extra workers will be even higher,
since we assume that an increase in the wage rate paid to attract one extra worker must also be paid to
existing workers.

In a competitive labour market, the

equilibrium will be where D=S at Q1,
W1.
The profit maximizing level of
employment is when MRP = MC. That is
at Q2. However, a monopsony can pay
lower wages (W2) and employ fewer
workers (Q2).
Problems of Monopsony in Labour Markets

• Monopsony can lead to lower wages for workers. This increases inequality in society.
• Workers are paid less than their marginal revenue product.
• Firms with monopsony power often have a degree of monopoly selling power. This
enables them to make high profits at the expense of consumers and workers.
• Firms with monopsony power may also care less about working conditions because
workers don’t have many alternatives to the main firm.

Government Intervention in Labour Markets to Combat the Effects of Worker Exploitation:

• Legal Protections
• National Minimum Wage
National Minium Wage:

A minimum wage of W1 will increase

employment to Q1.
A minimum wage of W3 would keep
employment at Q2.
Trade Unions in a Competitive Labour Market:

In a competitive labour market,

wages were W1. If a trade union
successfully bargains for a higher
wage of W2, then employment falls
to Q2

This situation can lead to real wage

unemployment of Q3-Q2.

This is why economists who believe

labour markets are generally
competitive argue that trade unions
can cause inefficiency and
unemployment.

Trade Unions in a Monopsony:

Initially, a monopsony can pay a wage
of W2 and employ just Q2. Note this
profit maximizing level is a lower
wage and lower employment level
than a competitive equilibrium of Q1,
W1.

In this situation, if a trade union

bargains for W3, it does not create
unemployment, but employment
stays at Q2.

We can say that a trade union is

counter-balancing the monopsony
power of employers.
Transfer Earnings and Economic Rent:
Transfer earnings are the minimum income a worker needs to supply their labour.

Economic rent is the extra income a worker receives – above the minimum level they need to work.

Suppose a football player would be willing to work for £200 a week. If the football player got paid
$1,000 a week. His economic rent is $800 a week.

Economic rent is the area between the supply curve and the wage rate. The supply curve indicates the
minimum wage people are prepared to work at.

The elasticity of demand and supply will determine the relative size of economic rent. If we take a
footballer, demand is quite wage inelastic (not many alternatives to best players. Therefore, economic
rent is relatively large.

Example of Economic Rent – Property

Suppose a landlord has a property and he would be willing to rent it out for a minimum of £400 a
month. If the landlord was able to rent the property for £950 a month, then his economic rent is £550.
Example of Transfer Earnings for Labour

A worker may have a transfer earning of £150 a week. If he was paid less, he wouldn’t want to work in
that occupation. For example, a worker may feel he is better off claiming unemployment benefits that
working for less than £150 a week.

Low skilled jobs = low economic rent

 Paper 3
1.

Answer: C
Marginal revenue product refers to the additional revenue generated by employing one additional unit
of a factor of production (such as labor or capital), while keeping the quantities of all other factors of
production constant. It measures the change in total revenue resulting from the addition of one more
unit of a factor.
2.

Answer: A
Since employee starts earning more, they prefer leisure and work fewe r hours.
3.

Answer: C
Real wages refer to the purchasing power of wages or the amount of goods and services that can be
obtained with a given nominal wage. It takes into account the effects of inflation or changes in the
general price level. Real wages reflect the actual standard of living and the ability of workers to afford
goods and services.
4.

Answer: D
Average earnings = Total Earnings / Population. If the population increase, the average earnings will
decrease.
5.

Answers: B
Since the equilibrium quantity of labor employed was where we can see Y, an introduction of minimum
wage reduced the demand to X. So, the distance XY is from redundant existing workers whereas the
distance YZ is of unemployed new entrants. Overall, the distance XZ shows excess labor.
6.

Answer: A
If labor costs are a small percentage of total cost (option A), it would make the demand for labor
inelastic. When labor costs represent a small portion of the total cost structure of a firm or industry,
changes in wages would have a relatively smaller impact on the overall costs. As a result, firms would be
less responsive to changes in wage rates, and the demand for labor would be relatively inelastic.

In industries where labor costs are a small fraction of total costs, such as industries with high capital
intensity or heavily automated processes, firms may be less sensitive to changes in wages. The costs of
replacing labor with capital or implementing technological alternatives may outweigh the potential
savings from wage reductions. Therefore, the demand for labor becomes less elastic, as firms have
limited incentive to adjust labor inputs in response to wage changes.
7.

Answer: C
This is the basic formula: MRP = MPP x MR
8.

Answer: B
9.

Answer: C
Draw and check.
10.

Answer: B
If the elasticity of demand for workers is high, more quantities of labor will be made redundant due to
an increase in wage.
 Distribution of Income and Wealth
Income is a flow concept; flow of factor incomes such as wages and earnings from work, rent from
ownership of land and interest and dividends from savings and ownership of shares.

Wealth is a stock concept; stock of financial and real assets such as property, savings in the bank, and
ownership of land.

The Lorenz Curve:

The Lorenz curve is a way of showing the distribution of income (or wealth) within an economy. It was
developed by Max O. Lorenz in 1905 to represent wealth distribution.
The Lorenz curve shows the cumulative share of income from different sections of the population.

A completely equal distribution of income is represented by a 45-degree line on the diagram. The more
the inequality, the higher is the difference between the line of equality and the curve (higher Gini
coefficient).

The Gini coefficient is a numerical measure of the extent of inequality.

If the income distribution is equal, this coefficient will have a value of 0. At the other extreme, if all
income accrues to just one person, then the Gini coefficient is 1. Both extremes do not occur in reality –
the norm is for coefficients to be somewhere between these two values. A Gini coefficient of 0.3
therefore indicates a more equal distribution of income than say a coefficient of 0.5.

Economic Reasons for Inequality of Income and Wealth:

• Human Capital and Education: Individuals with higher levels of education and skills tend to have
better job prospects and earn higher wages, while those with limited education may face lower-
paying jobs and higher unemployment rates.

• Technological Advancements: This can lead to a decline in wages for low-skilled workers and an
increase in the demand and wages for high-skilled workers, exacerbating income disparities.
 • Globalization and Trade: Globalization and trade can lead to job displacement in certain
industries and regions, resulting in income inequality. Furthermore, the mobility of capital
across borders can disproportionately benefit the wealthy, allowing them to take advantage of
investment opportunities abroad.

• Market Forces and Labor Market Institutions: Factors such as supply and demand dynamics,
wage-setting mechanisms, and bargaining power can influence wages. Weak labor market
institutions, such as declining unionization rates and weakened collective bargaining, can result
in lower wages for workers and contribute to income inequality.

How Governments Try to Reduce Inequality?

1. Providing Benefits:
i) Means Tested Benefits: Given only to those who have low income /
who really need it. For example, unemployment benefits.
ii) Universal Benefits: Paid to everyone. For example, child support.
2. Through the tax system: Tax money can be paid to low-income persons and families to increase
their disposable income.
3. Progressive Taxation: Progressive income taxes lead to those earning higher income being taxed
a higher percentage of their income than those on lower incomes. Hence, the income
differentials are reduced.
4. Setting a minimum wage: By establishing a floor on wages, workers will be able to earn a
certain level of income deemed sufficient to meet their basic needs.
5. Transfer payments: Transfer payments refer to government programs that provide financial
assistance to individuals or families with low incomes. These programs include social welfare
benefits, unemployment insurance, food stamps, and housing assistance.
6. State Provision of Goods and Services: The government can provide essential goods and
services, such as healthcare, education, and infrastructure, to ensure equitable access and
reduce disparities. By offering these services directly or subsidizing their costs, the state can
enhance social mobility and provide opportunities for individuals regardless of their income or
wealth.
Poverty Trap:

The concept of a "poverty trap" refers to a situation in which individuals or households are caught in a
cycle of persistent poverty from which it is difficult to escape.

Paper 3
1.

Answer: D

Option C suggests that an equitable distribution of income is achieved when incomes are equally
distributed among members of society. This perspective aligns with a more egalitarian approach to
income distribution, where there is a focus on reducing income disparities and ensuring a more equal
sharing of resources.
2.

Answer: A

Indirect taxes are regressive which hurts the poor most. Means tested benefits should be increased.
Benefits for everyone should be decreased because “everyone” also includes the rich people. They many
generate disproportionate wealth from the benefits provided and create income inequality.

3.

Answer: B

By providing a subsidy on healthier alternatives, the government can lower the price of these foods,
making them more affordable for individuals across income levels. This intervention encourages
individuals to choose healthier options without directly increasing the cost of harmful foods or
disproportionately impacting lower-income individuals. Lower-income individuals, who may be more
price-sensitive and have limited resources, would benefit from the reduced cost of healthier food
options, ensuring equitable access to healthier choices.
4.

Answer: A

A poverty trap refers to a situation where individuals or households are trapped in persistent poverty
due to factors that make it difficult for them to escape poverty, such as low wages, limited job
opportunities, or barriers to accessing education and skills development.

In option A, if a female worker is paid less than a male worker for performing the same job, it suggests a
gender pay gap and a form of wage discrimination. In this case, it is more likely that the female worker
has the potential to earn a higher income if paid equally to the male worker, reducing the likelihood of a
poverty trap.

Let`s explore other options:

B. A worker is paid the minimum wage and refuses a higher paid job because net income is lower after
tax: In this scenario, if the net income from a higher-paid job is lower after taxes, the worker may be
discouraged from taking the job due to the perception that they would be worse off financially. This can
contribute to a poverty trap if the worker remains stuck in a low-wage job with limited income growth
prospects.

C. A worker refuses higher-paid work as it means more expensive travel and childcare costs: If the costs
associated with accepting higher-paid work, such as increased travel expenses and childcare costs,
outweigh the potential income gain, the worker may opt to remain in a lower-paid job. This can create a
situation where the worker is unable to escape poverty due to the financial constraints imposed by the
additional costs.

D. An unemployed worker refuses a job because earnings are less than unemployment benefits: If the
earnings from accepting a job are lower than the unemployment benefits received, the worker may
choose to remain unemployed. This can create a situation where the individual is trapped in a cycle of
unemployment and dependency on benefits, limiting their ability to escape poverty.
5.

Answer: B

Regressive taxes increase inequality.

6.

Answer: C

When a government decides to increase the highest rates of tax on personal income, it is often driven by
equity considerations rather than efficiency ones. Equity refers to the fairness and justice in the
distribution of resources and burdens within society.
Option C suggests that the government prioritizes equity considerations, meaning that it values a more
equal distribution of income and wealth. By increasing the highest rates of tax on personal income, the
government aims to reduce income inequality and ensure a more progressive tax system, where higher-
income individuals contribute a larger share of their income in taxes.

While the increase in tax rates may have implications for efficiency (economic incentives, labor market
behavior, etc.), in this scenario, the government places greater emphasis on addressing income
inequality and promoting a fairer distribution of wealth and resources.

Option A, expecting total tax revenue to be unaffected by the policy change, is less likely because
increasing the highest rates of tax on personal income generally leads to changes in the behavior of high-
earning individuals, potentially affecting overall tax revenue.

Option B, being concerned about the possibility of emigration by high-earning individuals, may be a
factor for governments to consider, but it is not the main reason stated in the question.
Option D, switching the emphasis of the tax system from direct to indirect taxation, is not directly related
to increasing the highest rates of tax on personal income. It refers to a broader shift in the tax structure,
and the question focuses specifically on increasing the highest rates of tax on personal income.

7.

Answer: B

When individuals on low incomes experience a reduction in benefits and an increase in income tax as
their earnings rise, they may find it difficult to escape poverty. The reduction in benefits and the
additional tax burden can offset or even outweigh the financial gains from higher earnings. As a result,
individuals may perceive little incentive to increase their income through employment or income-
generating activities since the net increase in income is insufficient to improve their overall financial
situation.
 Paper 4
Summer 2019 Paper 41 Question 4:

Marking Scheme:

Sample Answer:
The economic theory of wage determination provides insights into the relationship between wage rates,
production costs, profits, inflation, and the overall impact on firms and workers. To evaluate the
statement that a rise in wages and salaries is detrimental, each component needs to be examined in
detail.
Undoubtedly, an increase in wage rates can indeed raise production costs for firms. Higher wages
directly affect the labor cost component of production, leading to higher expenses for employers.
However, the impact on profits depends on several factors. If firms can pass on the increased costs to
consumers through higher prices without negatively affecting demand, profit margins may not be
significantly impacted. This can be done if the firm`s product has an inelastic demand.

Having an inelastic demand will give firm`s the opportunity

to pass most of their burden onto the customers in form of
raising prices (from P to P1) and still not loose most
customers (from Q to Q1). This way the firm will continue to
get more sales revenue.
Additionally, firms may also consider productivity improvements to offset higher wage costs and
maintain profitability. Increased productivity can result from technological advancements, skill
development, or process improvements, allowing firms to produce more output with the same amount
of labor.
Regarding inflation, the relationship with wage increases is complex.

While higher wages can contribute to increased

consumer spending, which can potentially shift the
aggregate demand from AD1 to AD2, lead to
demand-pull inflation (as seen by an increase from
P1 to P2). However, other factors such as
productivity growth and the overall state of the
economy also play a role.

It is also important to note that moderate wage increases driven by productivity gains can have positive
effects on both workers and the economy by boosting consumer purchasing power and overall
economic activity.
The impact of wage increases on firms and workers can also be influenced by factors such as trade union
bargaining power and the existence of minimum wage policies.
Trade unions can negotiate higher wages for workers, which may put additional pressure on firms'
profitability. Trade unions can exert influence and negotiate higher wages when they have sufficient
bargaining power, which typically arises in markets with imperfect competition. In a perfectly
competitive labor market, since firms have no market power, trade unions may struggle to secure higher
wages through collective bargaining.
 To maximize profits, a firm should employ
workers where MRP = MC i.e., at Q2.

But a monopsony will be paying a wage of

W2 instead of W3 to employ Q2 quantities
of labour. Note this profit maximizing level
is a lower wage and lower employment
level than a competitive equilibrium of Q1,
W1.

In this situation, if a trade union bargains

for W3, the same number of labour (Q2)
can now get a higher wage.

However, the bargaining power of trade unions varies across industries and countries, and their
influence on wage determination can differ accordingly.
Minimum wage policies set by governments can establish a floor for wage rates, ensuring a b asic level of
income for workers, but their impact on firms depends on the size and composition of the workforce,
the elasticity of demand for the product or service, and the ability of firms to absorb higher labor costs.
In addition, the existence of large monopolistic employers, which have substantial market power in the
labor market, can lead to lower wage rates compared to competitive levels. In such cases, an increase in
wages may not necessarily harm firms but rather improve workers' well-being by reducing labor market
exploitation.
In conclusion, the relationship between wage increases and their implications for firms and workers is
nuanced and contingent on several factors. A simplistic view that portrays wage increases as universally
detrimental overlooks the complex dynamics at play. Therefore, it is crucial to consider the broader
context and potential trade-offs involved.
Evaluating the impact of wage increases requires a careful examination of the specific circumstances,
including industry characteristics, market conditions, and policy frameworks. A balanced approach that
considers the interests of both firms and workers is essential. Governments, in collaboration with social
partners, can play a crucial role in establishing policies that foster fair wage growth, promote
productivity improvements, and create an enabling environment for sustainable economic
development.
In analyzing the implications of wage increases, it is also important to recognize that the outcomes can
vary across different contexts and over time. Economic circumstances, technological advancements,
labor market dynamics, and social norms can evolve, leading to changes in the relationship between
wages, profits, and inflation. Therefore, a comprehensive evaluation should account for these dynamic
factors and acknowledge the complexities involved in wage determination.
By embracing a nuanced understanding of wage dynamics and adopting evidence -based policy
approaches, governments, employers, and workers can strive to create a balanced and inclusive labor
market that supports both economic prosperity and social well-being.
150 Topical
Micro MCQS
(WITH EXPLANATIONS)
 Consumer Theory

1.

2.
3.
4.

5.
6.
7.

8.
9.

10.
11.

12.
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14.

15.
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17.
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19.
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21.
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23.
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25.
26.

27.
28.

29.
30.
31.
32.
33.
34.

35.

Where does a consumer reach equilibrium on a graph showing the budget line and indifference curve?

A) At the point where the budget line is tangent to the indifference curve

B) At the point where the budget line intersects the indifference curve

C) At the point where the budget line is parallel to the indifference curve

D) At the point where the budget line is perpendicular to the indifference curve
 Cost of Production / Size of Firms / Market Structures

36.

37.

38.
39.
40.
41.

42.

43.
44.

45.

46.
47.

48.
49.

50.
51.

52.

53.
54.

55.
56.

57.

58.
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60.
61.

62.

63.

64.
65.
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67.
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69.
70.

71.

72.
73.

74.

75.
76.

77.
78.

79.

80.
81.

82.
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84.
85.
86.

87.

88.
89.

90.
91.

92.
93.

94.

95.
96.

97.
98.
99.

100.
101.

102.

103.
104.

105.

106.
107.

108.

109.
110.

111.
112.

113.

114.
115.

Efficiency / Market Failure

116.
117.

118.
119.

120.

121.
122.

123.

124.
125.

126.

127.
128.

129.
130.

131.

132.

133.
134.

135.

136.
137.

138.

139.
140.

Labour Market

141.
142.
143.
144.

145.

146.

147.
148.

149.
150.
Answers:

1. D (Budget line becomes steeper means: Price of good X has increased resulting in a lower

quantity of good X. Hence the correct option is D.)

2. C (Since prices have fallen for good X, consumer will substitute more of their income to

purchase good X. Hence option C. Additional information: Point G to Point H shows income

effect.)

3. D (Every point on the indifference curve yields the same level of satisfaction. Hence, all points

are equally desirable.)

4. B (First chocolate bar because MU of chocolate bar is greater than MU of toffee bars. Second

chocolate bar because MU of second chocolate bar is greater than MU of first toffee bar. Now, a
 toffee bar will be selected as MU Of toffee bar is greater than MU of third chocolate bar. Hence,

2 chocolate bars and 1 toffee bar will be selected.)

5. A (Fall in price of G has resulted in a pivotal shift in the budget line. Substitutional effect = X to Y

Income effect = Y to Z Consumer is now also consuming more of good F, indicating that G is an

inferior good.)

6. A (Price of good Y must have been fallen. Price of good C must have risen.)

7. C ($1 is giving 3 utils. So, $4 will be giving 12 utils. Let’s see till which quantity of good will create

12 utils of marginal utility. From good 1 to good 2, MU is 16 utils, from 2 to 3 unit, MU is 14 utils,

then from 3 to 4 units, the MU is 12 utils. Beyond this unit, the consumer would not be willing to

go.)

8. A (By observing the total utility curve, we can determine the individual's marginal utility curve,

which is the slope of the total utility curve. The marginal utility curve shows the change in utility

the individual receives from consuming additional units of the good.)

9. B (At S, consumer is consuming 20 units of X, exhausting his complete budget. This means that

the price of good X will be $120 / 20 units = $6. Similarly, at P, only 12 units of Y are being

consumed. So, $120 / 12 units = $10.)

10. A (As an individual consumes more units of a good, the marginal utility from each additional unit

tends to decrease. When the marginal utility of a good decreases, the individual is willing to pay

a lower price for an additional unit of the good, and therefore their demand for the good

decreases at higher prices. This relationship between price and quantity demanded is reflected

in the downward slope of the demand curve.)

11. B (Since there is a change in good Y from M to N, the price for good Y have fallen. And since, the

quantities of good X have reduced from M to N, this means prices of good X have increased.
 Since price of good Y have increased, the consumer would want to increase the quantities of

good Y. B is the only option on the new budget line NN)

12. A (Since price of X has fallen, consumer income will rise. The consumer might consume more of

X. However, good X is a giffen good, an increase in income won`t motivate consumers to

allocate more of their money towards them and they will be more likely to consume the other

good. Hence, the correct answer is Option A)

13. D (This is the formula that has been rearranged: MUx / Px = MUy / Py)

14. B (In case of perfect substitutes, the indifference curves are parallel straight lines because the

consumer equally prefers the two goods and is willing to exchange one good for the other at a

constant rate)

15. B (When the price of a good falls, ceteris paribus (assuming all other factors remain the same),

the consumer will have an increased incentive to buy more of that good. This results in a

movement along the consumer's demand curve rather than a shift in the demand curve itself.

The consumer's demand curve shows the relationship between the price of a good and the

quantity of that good that the consumer is willing and able to purchase at each price. A fall in

the price of the good will result in a movement along the same demand curve, as the consumer

responds to the lower price by buying more of the good. Therefore, the correct answer is B a

movement along the consumer's demand curve)

16. C (F to G represents substitution effect)

17. B (A: The indifference curves for inferior goods slope downward from left to right, meaning as

the quantity of an inferior good increases, the total utility derived from the good decreases. The

curves do not show higher satisfaction on lower curves.

B: The marginal rate of substitution (MRS) is the amount of one good a consumer is willing to

give up obtaining an additional unit of another good, while remaining indifferent or achieving
 the same level of satisfaction. Indifference curves for normal goods are convex to the origin,

showing a diminishing marginal rate of substitution, meaning the consumer is willing to give up

fewer units of one good as the quantity of that good increases.

C: Indifference curves for perfect complements are shaped like L-shaped or right-angled, and

they do not go through the origin. These curves show that the goods are always consumed in

fixed proportions, with no substitution between them.

D: Indifference curves for perfect substitutes are straight lines, and they do not form right

angles)

18. B (Since the utility he gets from spending one dollar is 4 utils, he will get 40 utils if he spends

$10. See the number of kilos he will purchase when the utility is 40. That is 5 kilos. Hence the

answer is B)

19. A (A consumer wants to operate on a higher IC. So if he moves from point Q to R, he is acting

rationally meaning he is acting logically/sensibly)

20. C (A is wrong because for inferior goods income and substitution effect works in opposite

directions.

B is wrong because income effect does not outweigh substitution effect in case of giffen good.
D is wrong because for normal goods income and substitution effect works in the same

direction. Hence C is the correct answer. This is graphically shown below:

21. D (In case of an inferior goods, even if the price of good X falls, the income effect outweighs the

substitution effect. You can refer to the graph above for inferior goods for better idea)

22. D (Paradox of value concept. The observation that the amount of water consumed is lower

when a price per liter is used implies that as the price of water increases, the additional

satisfaction (utility) gained from consuming each additional liter decreases. This is a classic

example of the law of diminishing marginal utility, where the first units of a good consumed

provide a high level of satisfaction, but each subsequent unit provides less and less satisfaction.
 So, when people must pay more for water, they are likely to use less of it, as the marginal utility

of each additional liter becomes smaller.)

23. D (the slope of the budget line represents the trade-off between the two goods, and changes in

the price of one of the goods affects this trade-off.)

24. D (The total amount of income that could be spent by the households is same at all the points

on the budget line)

25. A (Preferences are assumed to be constant while drawing the budget line)

26. A (In the case of the 'eat all you can' banquet, as a person eats more and more food, the

additional satisfaction or utility gained from each additional course will eventually decline. By

the time they reach the final course, they are likely to be feeling full, and the additional

satisfaction gained from the final course is likely to be relatively low compared to the earlier

courses. This illustrates the law of diminishing marginal utility, as the additional satisfaction

gained from each additional course of food declines as more and more courses are consumed.

Option B, the last coin to complete an enthusiast's coin collection, may not be the best example

of the law of diminishing marginal utility because it is possible that the satisfaction or utility

gained from each additional coin added to the collection remains constant or even increases.

For example, the last coin may be particularly rare or valuable, which could result in a high level

of satisfaction or utility for the collector.

Option C, the second of the two rolls of wallpaper needed to decorate a room, may not be the

best example of the law of diminishing marginal utility because it assumes that the additional

utility or satisfaction gained from each additional roll of wallpaper is declining, which may not
 necessarily be the case. It is possible that the second roll of wallpaper is just as important as the

first roll in achieving the desired outcome of a well-decorated room.

Option D, the tenth driving lesson needed to enable a learner to pass the driving test, may not

be the best example of the law of diminishing marginal utility because it assumes that the

additional utility or satisfaction gained from each additional driving lesson is declining, which

may not necessarily be the case. It is possible that the tenth driving lesson is just as important as

the first lesson in preparing the learner for the driving test. Additionally, passing the driving test

may result in a significant increase in utility, which would not be consistent with the law of

diminishing marginal utility.)

27. B (Only if the price of X increase, the consumer will be consuming less of good X. Whereas, if the

price of good Y falls, the consumer will be willing to buy more of good Y)

28. D (A consumer will be willing to operate on a higher indifference curve as it shows more

satisfaction)
29. A (In case of giffen goods, substitution effect is positive but income effect is negative)

30. A (When total Utility increases by a decreasing rate, it shows the MU is diminishing i.e., at 3)

31. C (When price of X rise, the quantities for good X will decrease from Q to R. There is no change

in price of good Y that results in a pivotal shift. Pivotal shifts are due to a change in price and not

due to changes in income)

32. C (Substitution effect is shown from X1 to X2. Income effect is from X2 to X4. Hence C is the

answer)

33. A (As the MU of the consumer is lower at Q1 than Q0, the consumer will naturally be willing to

pay more at Q0 than Q1)

34. B (Complete shifts are caused due to change in income whereas pivotal shifts are caused due to

changes in price. A successful advertising campaign for good Y will persuade the consumer to

buy more of good Y. Hence, the individual will allocate more of his resources towards the

consumption of good Y, reducing his consumption of good X)

35. A (At the point where the budget line is tangent to the indifference curve)

36. B (As employment increases, the capital-labor ratio falls, which leads to diminishing marginal

returns to labor. The capital-labor ratio measures the amount of capital available per worker,

and as employment increases, the amount of capital per worker decreases. This leads to

diminishing marginal returns because the workers are becoming less and less productive, as

they must share a smaller and smaller amount of capital. So, as employment increases, the

capital-labor ratio falls, and the law of diminishing returns is observed.)

37. C (Average cost equals total costs divided by the number of units produced. At unit 1, total cost

is $60, avg cost is also $60. At unit 2, total cost is $50, avg cost is $25. At unit 3, total cost is $30,

avg cost is $10. At unit 4, total cost is $30, avg cost is $7.5. At unit 4, total cost is $70, avg cost is

$14. Hence, the level of output that minimizes average total cost is 4)

38. B (In many industries, firms specialize in certain components or inputs that are used in th e final

product. Larger firms may choose to outsource the production of these components to smaller

firms that specialize in them, rather than producing everything in-house. This can lead to the

coexistence of both large and small firms in the same industry)

39. C (It is possible that the firm may not change its price or output if it changes its objective from

sales volume maximization to revenue maximization while retaining the same minimum profit

constraint. If the firm is already producing at a point where its marginal revenue equals its

marginal cost, then changing its objective to revenue maximization may not require any changes

in price or output.)
40. D (This is the graph of MP and AP which we did in class!)

41. B (The firm will produce quantities OJ.)

42. B (Profit maximization is the standard assumption for the primary objective of a firm in

economics. However, in some cases, a firm's objective may deviate from profit maximization,

particularly if there are many shareholders and few paid managers. In this case, the managers

may have personal goals that are not directly tied to profit, such as power, prestige, or personal

enjoyment from running the firm. They may also be motivated by non-financial incentives, such

as social responsibility, or a desire to provide a certain type of product or service. These

personal goals may take priority over profit maximization, leading to different decisions and

outcomes than if profit were the only objective.)

43. C (A firm is maximizing profit and producing at the minimum point on its AC, this means the firm

is not making normal profit.)

44. B (Price discrimination requires different price sensitivity (elasticity of demand) among different

consumer groups, so that a seller can charge different prices for the same good or service to

maximize revenue. The seller charges a higher price to consumers with less price -sensitive

demand, and a lower price to those with more price-sensitive demand.)

45. C (To maximize total revenue, the firm should produce at the output level where marginal

revenue equals zero. This is because total revenue is maximized at the output level where

marginal revenue is zero and any further increase or decrease in output would result in a decline

in total revenue. Therefore, the correct answer is C - increase the firm's output to where

marginal revenue is zero.

Decreasing the firm's output to where marginal revenue equals average revenue (option A) or

decreasing the product's price to where average revenue is zero (option B) will not maximize
 total revenue, as these strategies do not take into account the relationship between marginal

revenue and total revenue.

Increasing the product's price to where marginal revenue equals average revenue (option D) will

not necessarily maximize total revenue either, as it depends on the price elasticity of demand

for the product. If the demand is relatively elastic, a price increase may result in a decrease in

total revenue. Therefore, option C is the most effective strategy to maximize the total revenue

of the firm)

46. B (JLN is the long run average cost curve as it envelops the other curve)

47. C (The kinked demand curve model of oligopoly attempts to explain why firms in an oligopolistic

market tend to maintain price stability despite fluctuations in costs and demand. The model

suggests that each firm faces a demand curve that is relatively elastic above the current price

and relatively inelastic below the current price, creating a kink in the demand curve. This kink

arises from the assumption that firms expect their rivals to match any price reductions but not

price increases. However, the model does not explicitly explain how the equilibrium market

price is determined. Instead, it focuses on how firms behave and interact with each other in the

market.)

48. C (At MR = M, profit maximization. At AR = AC; sales maximization. Hence the old profit was

P1HGF while the new profit will be P2KLF)

49. B (When demand is inelastic, a change in quantity demanded is proportionally smaller than the

change in price. This would cause the total revenue to decrease when the output increases, as

the increase in quantity demanded will not be sufficient to compensate for the fall in price.)

50. A (The profit maximizing level of output is where MR = MC. Since P = ATC, the monopoly is

making normal profit.)

 P

51. B (Risk bearing economies of scale refers to greater diversification as risks has expanded)

52. C (One strategy a firm could use to eliminate competition and become a monopoly is to engage

in predatory pricing. This involves setting prices so low that competitors are unable to compete,

forcing them to exit the market. Once the competitors are gone, the firm can raise prices to

monopoly levels and maintain its dominant market position. By reducing prices, the firm is able

to attract customers away from competitors, which can lead to increased market share and

eventually, a monopoly position.)

53. C (The principal-agent problem is a conflict of interest between a principal (shareholders) and

their agent (directors of the company), where the agent may act in their own interests rather

than the principal's interests. This can cause a separation of ownership and control in a firm)

54. D (The kinked demand curve theory implies that there is a tendency towards price stability. This

is because firms are reluctant to raise their prices, due to the fear of losing market share to their

competitors. Therefore, the theory suggests that firms operating in an oligopolistic market are

likely to maintain their prices at a stable level, rather than engage in price wars.)

55. D (Profit is maximized at MR = MC. The ATC are at K so JK multiplied by OQ)

56. A (While improving management control and co-ordination can be a potential benefit of growth,

it is not typically the primary motivation for a firm to seek growth.)

57. C (Profit maximization occurs when marginal revenue (MR) equals marginal cost (MC).

Sales maximization occurs when marginal cost equals marginal revenue, which results in

producing at a higher output level than the one that maximizes profits. This can be a goal of a

firm in some cases where it seeks to increase market share and deter potential competitors.

Satisficing refers to a situation where a firm aims to achieve satisfactory performance, rather

than to maximize profit or output. It occurs when a firm sets a target level of profit or outpu t

and seeks to achieve that level, rather than trying to maximize beyond that level.

Sales revenue maximization occurs when marginal revenue is equal to zero, meaning the firm

produces the quantity of output where it earns the maximum amount of total reve nue. This can

be a goal of a monopoly that seeks to maximize revenue, rather than profit or output.)

58. A (The FC of this firm is 120. The average fixed cost of producing 6 units is 20.)

59. B (In a contestable market, the threat of potential competition can limit the market power of

existing firms. Therefore, a firm operating in a contestable market is likely to set its price based

on the threat of entry from new competitors.

Option B, "It will set a price to deter the entry of new firms," is the most accurate answer. By

setting a price that is too low, the existing firm risks attracting new entrants who can compete

on price, eroding the existing firm's profits. On the other hand, by setting a high price, the

existing firm can deter potential entrants from entering the market, as it makes it less attractive

to compete in the market.

Options A, C, and D are not necessarily true in a contestable market. In a contestable market,

the firm's goal is not necessarily to maximize revenue or sales in the short run, but rather to
 maintain a sustainable profit margin while deterring new entrants from entering the market.

Therefore, the answer is B, "It will set a price to deter the entry of new firms.")

60. D (The demand curve of oligopoly is like this because of the response of rival firms that might

come as the said firm changes its price. If one firm raises its price, the other firms will not follow.

They will stick to the prevailing price P1. However, if the firm reduces its prices, this will result in

price wars.)

61. C (The main difference is that products in monopolistic competition are differentiated, while in

perfect competition, they are identical.)

62. A (Regulation refers to the use of government policies to limit or control the behavior of firms in

a market. In the context of reducing the abuse of monopoly power, regulation typically involves

imposing restrictions on the behavior of monopolies to prevent them from charging excessive

prices or engaging in anticompetitive behavior.

Option A, legislation to forbid price fixing by cartels, is an example of regulation. Price fixing

occurs when a group of firms agrees to set prices at a certain level, which can be

anticompetitive and result in higher prices for consumers. Legislation to forbid price fixing by

cartels is an example of regulatory intervention to prevent anticompetitive behavior by firms.

Option B, removal of import tariffs, is an example of a trade policy measure that can increase

competition in a market, but it is not a form of regulation.

Option C, subsidizing small firms, is a form of government intervention in the market, but it is

not a form of regulation to reduce the abuse of monopoly power.

Option D, taxation of monopoly profits, is a form of government intervention in the market, but

it is not a form of regulation to reduce the abuse of monopoly power.)

63. A (A contestable market is a market where there are low barriers to entry and exit, which means

that new firms can enter the market and compete with existing firms easily. In this case, the
 market for souvenir products sold to people walking to the sporting event is a contestable

market because street traders are able to produce and sell cheaper, unofficial souvenirs without

having to pay for licenses or official approval to sell their products. This competition from street

traders keeps prices lower and makes the market more competitive, despite the presence of

official souvenir products from the organizers of the sporting event.)

64. C (The short-run production function is a relationship between the quantity of inputs used and

the quantity of output produced by a firm in the short run. It assumes that at least one factor of

production is fixed (usually capital), while the other factors of production (usually labor) are

variable. In addition to this assumption, the state of technology is also assumed to be fixed in

the short run.

In the short run, a firm can increase output only by varying the quantity of the variable input(s),

given that the fixed input(s) cannot be changed. Therefore, the level of technology used to

transform inputs into outputs is assumed to be fixed in the short run.

Option A, "All factors of production are fixed," is incorrect because if all factors of production

were fixed, the firm would not be able to produce any output in the short run.

Option B, "All factors of production are variable," is incorrect because this assumption applies to

the long run, not the short run.

Option D, "The state of technology is variable," is also incorrect because changes in technology

are assumed to occur in the long run, not the short run.)
65. D

66. A (The fixed costs of this firm is $40. The variable cost for 1 unit of output is 15. For the second

and third unit its 5. For the fourth unit its 15 again. The total variable cost is $40. The average

variable cost for 4 units is $10.)

67. D (Perfectly contestable markets are characterized by zero barriers to entry and exit, allowing

firms to enter and exit the market easily and quickly. This means that potential competitors can

enter the market without incurring any additional costs, and existing firms can leave the market

without facing any significant costs. This condition ensures that there is no market power held
 by any individual firm, and that firms are forced to operate as if they are in a perfectly

competitive market, where price is equal to marginal cost.

The other options, such as A (all firms in the industry are price-takers), B (all firms in the industry

produce an identical product), and C (there are a large number of firms in the industry) are

characteristics of perfectly competitive markets, but they are not sufficient conditions fo r a

market to be perfectly contestable. For example, a market may have a large number of firms

producing identical products and still have significant barriers to entry or exit.)

68. C (This is the graph of an oligopolistic firm. Refer to the class lecture if you have any issues on

how the graph look like.)

69. A (In the long run, both perfect competition and monopolistic competition result in zero

economic profit, where the price equals the average total cost of production. However, the two

market structures differ in terms of their efficiency and the level of competition.

In perfect competition, firms are price takers, producing at the minimum point of their average

total cost curves, leading to productive efficiency. Furthermore, due to the existence of

numerous firms in the market, consumers are not willing to pay a premium for differentiated

products, leading to allocative efficiency.

In contrast, in monopolistic competition, firms produce differentiated products, which can be

perceived as substitutes but are not perfect substitutes, leading to some market power. As a

result, firms in monopolistic competition may produce at a point of excess capacity, where their

average total cost curve is not minimized, leading to lower productive efficiency compared to

perfect competition.

Therefore, the most likely outcome when comparing the long-run equilibrium outcome in

monopolistic competition with that in perfect competition is a greater degree of excess capacity

in monopolistic competition. Option A is the correct answer. Option B is incorrect because in the
 long run, economic profit is zero in both market structures. Option C is also incorrect because

monopolistic competition generally has fewer firms than perfect competition. Option D is not

necessarily true, as the elasticity of demand depends on the specific characteristics of the

products and the market.)

70. B (This is an example of lateral integration)

71. C (In perfect competition, firms produce at the minimum point of their average total cost curves,

resulting in productive efficiency, where marginal cost (MC) equals average total cost (ATC). In

contrast, in imperfect competition, firms have some degree of market power, which allows

them to charge a price above marginal cost.

In the long run, firms in imperfect competition adjust their output and price to achieve zero

economic profit, where price equals average total cost. However, since the price is above the

marginal cost, the marginal cost curve will be below the average total cost curve at the profit-

maximizing level of output. Thus, option C is the correct answer.

Option A, supply is elastic, is a characteristic of perfect competition where firms have no market

power and can adjust their output easily in response to changes in price. In imperfect

competition, firms may have some market power and therefore may not be able to adjust their

output as easily.

Option B, demand is inelastic, is not a necessary condition for imperfect competition, as the

elasticity of demand depends on the specific characteristics of the products and the market.

Option D, average revenue will be below marginal revenue, is true for all firms, regardless of

whether they are in perfect or imperfect competition. This is because, in order to sell more

units, a firm must lower the price for all units sold, which decreases the average revenue for all

units sold. Therefore, marginal revenue is always below average revenue.)

72. C (A firm is allocatively efficient at MC = AR).

73. D (Standardization of the industry's product means that all companies in the industry produce

the same product with little or no variation. This makes it difficult for small firms to differentiate

themselves and stand out from the competition.)

74. A (When a firm operates at the maximum point on its average product curve, it is producing at

the most efficient level of output for the given level of variable inputs. This means that the firm

is able to produce more output with the same level of variable inputs, resulting in a lower

average variable cost. Therefore, the average variable cost is at a minimum at the point where

the firm is producing at the maximum point on its average product curve.)

75. B (In this scenario, the dominant firm is setting up a research institute to carry out new product

development. This can be seen as an example of non-price competition, as the firm is investing

in research and development to create new products and gain an advantage over its rivals.

At the same time, this project can also be seen as an example of creating barriers to entry, as

the research institute may require significant investment and expertise, making it more difficult

for new firms to enter the market and compete with the dominant firm.

Option A, collusion, refers to an illegal agreement between firms to fix prices or reduce output

to increase profits, which is not present in this scenario.

Option C, non-price competition and price leadership, does not fully capture the feature of

creating barriers to entry that is present in this scenario.

Option D, price leadership and collusion, is also incorrect, as there is no mention of collusion in

the scenario.)

76. D (Nudge theory uses the principles of behavioral psychology to persuade individuals to make

choices that are in their best interests or the interests of society.)

77. D (The starting part of the demand curve is elastic, this means that as prices fall and output

increases, total revenue will rise. The second part of the demand curve is inelastic, which means

that when prices fall, there is a reduction in the total revenue curve.)

78. D (Shortages of the good are often an undesirable side effect of imposing a maximum price on

certain goods that is below the free market price. When the government sets a maximum price,

it creates a situation where the quantity demanded of the good exceeds the quantity supplie d.

This creates a shortage of the good as consumers are willing to buy more of the good at the

lower price, while producers are unwilling to supply as much of the good at the lower price since

it is less profitable. The shortage of the good can lead to long lines, black markets, and other

inefficiencies. Additionally, producers may shift their focus to producing goods that are not

subject to price controls, leading to a reduction in the supply of the controlled good.)

79. A (In the long run, all inputs are variable, and firms can enter or exit the market as needed. In a

perfectly competitive market, this entry and exit of firms will continue until each firm is

operating at the minimum point on its average total cost curve, where average costs are at a

minimum. This means that each firm is producing at the most efficient level possible, given the

market conditions, and cannot lower its costs any further. At this long-run equilibrium point,

firms earn only normal profits, which is the minimum amount of profit necessary to keep a firm

in business. Therefore, in the long-run equilibrium of a perfectly competitive market, each firm

produces at the output level where its average costs are at a minimum.)

80. A (If a firm estimates that an increase in its output will result in an equal proportionate increase

in its revenue, this implies that the firm faces a perfectly elastic demand curve. Therefore,

option A is correct, i.e., the demand curve for the firm's product is horizontal. A perfectly elastic

demand curve means that the firm can sell as much output as it wants at the market price, and

any increase in production will not affect the market price.)

81. A (The increase in sales revenue maximization may lead to the firm lowering the price of its

products to increase demand, which may benefit consumers in the short run. The shift from

profit maximization to sales revenue maximization may negatively affect shareholders in the

short run. The focus on increasing sales revenue may lead to lower profits, which could result in

a decrease in shareholder dividends or a lower stock price. Additionally, if the firm incurs

additional costs to increase sales revenue, such as advertising or offering discounts, this could

further reduce profits and negatively impact shareholder value.)

82. A (The minimum efficient scale (MES) of production is the lowest level of output at which a firm

can produce goods at the lowest possible average cost in the long run. If the MES is relatively

low in an industry, then it is easier for small firms to compete with larger firms. Small firms can

take advantage of lower start-up costs, lower overheads, and a greater ability to respond quickly

to changes in market conditions. This can allow them to be competitive with larger firms despite

their smaller size.

Option B, "greater scope for specialization and division of labor," is not as strong a reason for

the existence of small firms in various industries compared to a low minimum efficient scale of

production (option A). While it is true that small firms can benefit from specialization and

division of labor, this advantage is not unique to small firms. Large firms can also take advantage

of specialization and division of labor, often to a greater extent than small firms due to their

larger size and greater resources. In fact, larger firms often have the advantage of economies of

scale more.

However, option C (the need to diversify in order to reduce risk) and option D (the principal-

agent problem) are less likely to be reasons for the existence of small firms in various indu stries.

Diversification is often more feasible for larger firms due to their greater resources and ability to

spread risk over a wider range of activities. The principal-agent problem, which refers to the
 potential conflict of interest between managers and shareholders, can occur in both small and

large firms. Therefore, the correct answer is option A, a low minimum efficient scale of

production.)

83. D (In monopolistic competition, firms face a downward-sloping demand curve, meaning they

can increase their sales by lowering their price. This means that the marginal revenue (MR) for

the firm is always less than the price (P), so option C and D are the possible answers. However,

option C can be eliminated as the firm is making a loss and its average total cost (ATC) exceeds

the price, so it cannot be the case that AR is greater than MR.

Option D is correct because it states that the average revenue (AR) is greater than the marginal

revenue (MR), but the average variable cost (AVC) is less than the AR. This condition ensures

that the firm is covering its variable costs and contributing to its fixed costs, even though it is

making a loss in the short run. By continuing to produce in the short run, the firm can hope to

earn enough revenue to cover both variable and fixed costs and eventually earn a profit in the

long run.)

84. C (When the demand is perfectly elastic, the total revenue curve is upward sloping.)

85. A (This objective refers to the attempt by a firm to minimize its losses in the short run. In the

short run, a firm may be unable to avoid making a loss due to fixed costs and other factors.

Therefore, it may choose to produce at a level where the marginal revenue is equal to the

marginal cost to minimize its loss.)

86. C (While drawing the kinked demand curve, it is assumed that the action of one firm will affect

the other firms in the market (interdependence). If one firm raises its price, the other firms will

not follow (elastic segment of the demand curve) However, if the firm reduces its prices, this will

result in price wars (inelastic segment of the demand curve).)

87. D (According to the law of variable proportions , as more units of the variable factor are added

to the fixed factor, the total product initially rises at an increasing rate, then rises at a

diminishing rate, and finally may start to decline.

Option A is incorrect because the marginal cost of production is not necessarily related to the

proportion of factors used but is instead related to the change in total cost resulting from

producing one more unit of output.

Option B is also incorrect because it describes the relationship between total product and the

proportion of all factors used, which is not what the law of variable proportions refers to.

Option C is incorrect because it implies that the marginal cost of production diminishes as more

of a variable factor is added, which is not generally true in the short run.)

88. C (External growth occurs from mergers and takeovers.)

89. B (The successful advertising campaign is likely to increase the demand for the firm's product,

which could shift the AR curve to the right. As a result, the MR curve will also shift to the right,

reflecting the increase in marginal revenue from selling an additional unit of the product. The

increase in MR will result in a higher profit-maximizing output level.

The successful advertising campaign may also affect the firm's cost structure. If the advertising

campaign increases the firm's sales, it could increase the firm's total AC curve. Hence, the

answer is B.)

90. C (When monopolies are prevented from dominating the market, it opens up opportunities for

smaller firms to compete and grow. By promoting greater competition and preventing the

dominance of a few large players, smaller firms may have a better chance of survival and

growth, ultimately leading to an increase in their numbers.)

91. D (In the short run, if the firm reduces its emphasis on increasing sales revenue and instead

focuses on maximizing profits, it may lead to an increase in prices. Hence, consumers will loose.

Also, in order to maximize profits, firms may reduce wages. Hence, workers may also loose.)

92. C (When there are low barriers to entry, new firms can easily enter the industry and compete

with existing firms. This makes it difficult for the colluding firms to maintain high prices and

market power. The threat of new entry can act as a deterrent to collusion, as the colluding firms

will not want to lose market share to new competitors. Therefore, low barriers to entry increase

the competition in the market, which makes collusion less likely to succeed.)

93. A (The theory of contestable markets can be applied to all the market structures mentioned in

option A, which are monopolistic competition, monopoly, and oligopoly.)

94. D (The law of diminishing returns, also known as the law of variable proportions, states that as

more of a variable input is added to a fixed input (in the short run), the marginal product of the

variable input will eventually decrease. This means that the increase in output resulting from

adding each additional unit of the variable input will become progressively smaller, eventually

reaching zero and then becoming negative.

This occurs because, in the short run, at least one input is fixed, so as more of the variable input

is added, there will be a point at which the fixed input becomes a constraint on further increases

in output. This leads to a situation in which additional units of the variable input will not be as

productive as the previous units, leading to the diminishing marginal returns.

Option D correctly states that the proportions in which the factors are combined will eventually

result in progressively smaller increases in output. Therefore, D is the correct answer.)

95. C (The situation that the firm is facing is a prisoner's dilemma. In a prisoner's dilemma, two

individuals or entities have to make a decision without knowing what the other will choose, and
 the outcome depends on the choices made by both parties. In this case, Firm X has to decide

whether to co-operate with its rival or not, without knowing what the rival will choose.

If both firms co-operate, they will both earn $2000 a month, for a total joint profit of $4000.

However, if only one firm co-operates, it will earn $0, while the other earns $4000. If neither

firm co-operates, they will both earn $1200 a month.

Firm X's dominant strategy would be to not co-operate, as that would guarantee it a profit of

$2800 a month if it kept all its customers. However, if the rival decides to undercut its price and

take some of its customers, Firm X's profit would drop to $1200 a month.

Thus, even though co-operating would be mutually beneficial for both firms, the uncertainty and

lack of trust between them makes it difficult to achieve a co-operative outcome, leading to a

prisoner's dilemma.)

96. A (Rent controls artificially limit the price that landlords can charge for rental properties. This

price ceiling may discourage landlords from investing in the rental market, as the potential for

profit is limited by the price ceiling. As a result, there may be a decrease in the supply of rental

properties over time, as landlords exit the market or reduce the number of properties they own.

Option B, "The number of unoccupied privately rented houses will increase over time," is not

necessarily a direct consequence of rent controls. It is possible that landlords may keep re ntal

properties unoccupied rather than renting them out at the lower price ceiling, but it is also

possible that landlords may choose to rent out their properties despite the rent control,

particularly if they do not have other viable investment options.

Option C, "The price of owner-occupied houses will increase," is not directly related to rent

controls on rental properties. However, if there is a decrease in the supply of rental properties,

there may be an increase in demand for owner-occupied housing, leading to an increase in the

price of owner-occupied houses.

 Option D, "There will be no effect on the supply of the rental housing," is unlikely to be the case

in the long run, as rent controls are likely to discourage investment in the rental market and lead

to a decrease in the supply of rental properties over time.)

97. D (For a horizontal integration, the industry and stage of production should be same.)

98. C (OP represents fixed costs. For average fixed costs, fixed costs should be divided by the

output. Hence, the correct answer is OP / OQ.)

99. C (A firm in a perfect competition have a perfectly elastic demand curve. For such demand

curves, total revenue curve is always upward sloping.)

100. A (A natural monopoly occurs when a single firm can provide a good or service at a

lower cost than any potential competitor. This situation arises when there are high fixed costs of

production and economies of scale that result in falling average costs over all outputs

demanded. As a result, it becomes more efficient for one firm to supply the entire market rather

than having multiple firms each producing a smaller quantity at a higher cost.

In contrast, legal restrictions on new entrants, a single firm controlling the supply of raw

materials, and a firm having a patent on an essential process are not necessarily the factors that

lead to a natural monopoly. These situations may contribute to a monopoly or oligopoly, but

they do not necessarily result in a natural monopoly.)

101. B (In an imperfectly competitive industry, firms have some degree of market power and

can influence the market price by their actions. If one firm increases its advertising spending, it

can attract more customers and increase the overall demand for the industry's product.

However, if other firms respond by increasing their advertising spending, the competition for

customers intensifies, and the market price may not increase enough to offset the increased

advertising costs for each firm.

 As a result, the firm that initially increased its advertising spending may experience a fall in

profits despite the overall increase in demand for the industry's product. This situation is known

as the advertising war or the prisoner's dilemma in advertising, where each firm tries to gain an

advantage over the others by increasing advertising spending, but all firms end up worse off.

Production being subject to diseconomies of scale, the demand for the industry's product being

price-inelastic, or the increase in demand for the firm's output being entirely at the expense of

other firms may also contribute to the firm's fall in profits. However, these factors alone do not

fully explain the situation described in the question.)

102. C (Marginal cost is equal to price is the statement about the profit-maximizing output of

the small firms that is correct in an industry consisting of a dominant firm, which acts as a price

leader, and a large number of small firms.

In such an industry, the dominant firm sets the market price, and the small firms must choose

their output levels based on this price. Since the small firms are price takers, they cannot

influence the market price and must produce at the market price set by the dominant firm.

To maximize their profits, the small firms will produce where their marginal cost (MC) equals the

market price (P), which is also equal to the marginal revenue (MR) since the small firms are in a

perfectly competitive market. Therefore, option C is correct.

Option A, average cost being equal to average revenue, is not correct because in a perfectly

competitive market, the price is equal to both average revenue and marginal revenue, but the

average cost is not necessarily equal to either of these.

 Option B, average cost being minimized, is not correct because the small firms will not

necessarily produce at the point where their average cost is minimized. Instead, they will

produce where their marginal cost equals the market price.

Option D, marginal revenue being zero, is not correct because in a perfectly competitive market,

the marginal revenue is equal to the market price, which is positive.)

103. D (The situation that the firm is facing is a prisoner's dilemma. In a prisoner's dilemma,

two individuals or entities have to make a decision without knowing what the other will choose,

and the outcome depends on the choices made by both parties.

If Firm X acts independently, it can earn either $900 or $400 per week, depending on its rival's

choice. On the other hand, if Firm X works with its rival, the joint profit of both firms is $1400

per week, which is higher than what Firm X can earn by acting independently. However, since

Firm X does not know what its rival will do, it must consider the possibility that the rival may

choose to act independently, in which case Firm X would be better off also acting

independently.

This situation illustrates the prisoner's dilemma because both firms have a dominant strategy of

acting independently, regardless of what the other firm does, even though they would both be

better off if they cooperated. The incentive to act independently arises because each firm is

concerned about the possibility of being worse off if it trusts the other firm to cooperate, and

the other firm takes advantage of this to act independently as well.

Option A, contestable market, refers to a market where entry and exit are easy and potential

competitors can enter and exit the market freely. Option B, kinked demand curve, is a model of

oligopoly behavior where firms face a demand curve that is kinked at the current price and

quantity level. Option C, principal-agent problem, refers to a situation where one party (the
 principal) delegates decision-making authority to another party (the agent) who may have

different interests and incentives from the principal.)

104. C (The kinked demand curve model assumes that firms in oligopoly expect their

competitors to match any price decreases but not price increases. Therefore, a firm that raises

its price will lose customers to its competitors, while a firm that lowers its price will not gain

many new customers.

The result of this expectation is price rigidity, where firms tend to maintain the current price

rather than raise it. This is because they fear that a price increase will cause a significant loss of

customers to their competitors, while a price decrease will not re sult in a significant gain in

customers.

Option A, collusion between all firms in the industry in the setting of prices, assumes that all

firms in the industry cooperate to set prices, which is not realistic in practice.

Option B, the assumption that a single firm acts as a price leader for all firms in the industry,

assumes that a single firm sets the price, and the other firms follow suit. This is not necessarily

true in oligopoly, where each firm may have some market power and may act independently.

Option D, the presence of barriers to the entry of new firms into the industry, may affect the

behavior of firms in oligopoly but does not explain the kinked demand curve model of price

rigidity.)

105. C (Price discrimination is the practice of charging different prices to different customers

for the same product or service. For a firm to successfully practice price discrimination, it must

be able to identify and separate different groups of buyers in the market and charge different

prices to each group.

Option A, there are many buyers in the market, may be beneficial for a firm that wants to

practice price discrimination, but it is not necessary. A firm can practice price discrimination
 even if there are only a few buyers in the market, as long as it can identify and separate them

into different groups and charge different prices to each group.

Option B, there are many firms in the market, is not necessary for a firm to practice price

discrimination. In fact, price discrimination is more likely to occur in markets with only a few

dominant firms, as they have more market power and can charge different prices to different

buyers.

Option D, the price elasticity of demand for the product is inelastic, may make it easier for a firm

to practice price discrimination, as it means that buyers are less sensitive to changes in price.

However, it is not necessary for price discrimination to occur. In fact, firms may practice price

discrimination even when the price elasticity of demand is elastic, as long as they can separate

the buyers into different groups and charge different prices to each group.)

106. C (A backward vertical integration occurs when a company decides to acquire or control

the inputs or raw materials it needs to produce its products or services.)

107. D (If an imperfectly competitive firm was making supernormal profits but the following

year made normal profit with no change in output, this suggests that new firms have entered

the market or existing firms have expanded their production, leading to a reduction in the price

and the elimination of the supernormal profits.

This situation can be shown on a diagram by an upward shift in the average cost curve. The

firm's average revenue and marginal revenue curves will remain unchanged, but the price will

have decreased, leading to a reduction in the firm's profits. As a result, the firm's average cost

curve will shift upward to intersect with the new, lower price level, and the firm will earn only

normal profit at the new equilibrium.)

108. D (A contestable market is one where there are low barriers to entry and exit, which

makes it easy for new firms to enter and for existing firms to leave the market. In such markets,
 existing firms cannot maintain their monopoly power or earn abnormal profits in the long run

because they are under constant threat of entry by new firms. This competitive pressure can

also prevent firms from exploiting their market power and charging high prices, as they risk

losing customers to new entrants who may offer lower prices.

Therefore, the main implication of a contestable market is that monopoly power is not

necessarily exploited, as the presence of potential competition keeps prices competitive and

prevents firms from earning excessive profits.)

109. B (When a company pays a low proportion of its profits as divide nds, it retains more

earnings to reinvest in the company. This can allow the company to finance new projects and

expansions, which can lead to growth in the long run. In contrast, if a company pays a high

proportion of its profits as dividends, it leaves less money for reinvestment, which can limit the

company's growth potential.)

110. D (The least change in economic welfare would occur if the firm operates in a market

structure where it already produces at the allocatively efficient output.

In a perfectly competitive market, firms are already producing at the allocatively efficient

output, which means that marginal cost equals price. Therefore, if the firm changes its objective

from profit maximization to producing at the allocatively efficient output, there would be no

change in economic welfare in this market structure. Therefore, the correct answer is D) Perfect

competition.)

111. D (The two features that a firm in an oligopoly market show are price rigidity and

interdependence.)

112. C (Fuel is a variable cost whereas the cost of purchasing an aircraft is a fixed cost (one

time investment).. A fall in price of fuel means variable cost have decreased while a rise in price

of aircraft means fixed costs have increased.)

113. C (The feature of production that would make it more likely that an industry is a

contestable market is (C) low fixed costs. Low fixed costs would make it easier for new firms to

enter the market because they would not have to invest a large amount of capital to start

production. This means that new firms can enter the market and start producing at a lower cost

than existing firms.

In contrast, (A) advertising has established consumer loyalty would make it harder for new

entrants to compete because existing firms have already established a loyal customer base. (B)

all firms in the industry share research and development would lead to less competition because

all firms would have access to the same technology and knowledge. (D) market rivals aim to

reduce product differentiation would also make it harder for new entrants to compete because

existing firms would have already differentiated their products, making it harder for new firms

to differentiate themselves.)

114. A (A backward vertical integration occurs when a company decides to acquire or control

the inputs or raw materials it needs to produce its products or services.

While option C, a vineyard buying an apple orchard, could also be considered an example of

backward vertical integration, it may not be as clear-cut as option A. The vineyard may be able

to purchase apples from other sources or work with an existing supplier, whereas the bakery

relies heavily on wheat as a fundamental ingredient.)

115. D (Profit maximizing level of output of a monopoly is when MR = MC. At this point, the

firm is making supernormal profits meaning P > AC. When the firm changed its aim to sales

revenue maximization (MR = 0), the Price is still above the AC, indicating supernormal profits

again.)

116. A (Economic efficiency refers to the ability of an economy to produce goods and services

in the most optimal way, given the available resources. An economy is considered economically
 efficient if it is not possible to make any individual or group better off without making someone

else worse off.

Option A reflects this definition because if it is possible to make some people better off without

making other people worse off, then the current allocation of resources is not economically

efficient. In this scenario, the economy could be better off if resources were reallocated to

produce more goods and services or if policies were implemented to ensure a more equitable

distribution of resources.

Options B, C, and D do not accurately reflect the concept of economic efficiency. Option B refers

to income distribution, which is a separate issue from economic efficiency. Option C suggests

that government growth is inherently inefficient, which is not necessarily the case. Option D

refers to a situation where wage rates rise faster than production, which could indicate a

problem with inflation, but does not necessarily mean that the economy is inefficient.)

117. B (The quantity Q is before the equilibrium quantity. This means that the good is being

underproduced and under consumed. The dead weight loss in this case will be v + w.)

118. D (A negative externality from consumption occurs when the consumption of a good or

service imposes costs on third parties who are not involved in the transaction. In this case,

smoking is a consumption activity that has negative effects on the health of smokers and on the

health service that has to treat smoking-related illnesses. The cost of treating these illnesses is

borne not only by smokers themselves but also by taxpayers and the broader society. This is an

example of a negative externality from consumption.)

119. A (In order for the firm to achieve maximum efficiency, it must produce at a level where

the cost of producing the last extra unit is equal to the value the consumers place on it. This is

because if the cost of producing the last unit is higher than the value that consumers place on it,
 the firm is not generating a profit and is therefore not operating efficiently. If the cost is lower

than the value that consumers place on it, the firm could have increased its profits by producing

more.)

120. D (Cost-benefit analysis (CBA) is a tool used to evaluate the potential benefits and costs

of a project or policy. The key difference between the use of CBA in public-sector investment

projects compared with its use in private-sector investment projects is that the benefits in

public-sector projects are often non-market benefits that are difficult to quantify or value. This is

because many public-sector projects involve providing goods and services that do not have a

market price.

In contrast, private-sector investment projects typically involve market goods and services, and

therefore the benefits can be more easily measured and valued. Additionally, private -sector

investment projects may have less uncertainty and risk compared to public-sector investment

projects. However, private-sector investment projects may still face challenges in accurately

estimating costs, as costs can be difficult to compute in certain contexts.

Therefore, the key difference between the use of cost-benefit analysis in public-sector

investment projects compared with its use in private-sector investment projects is that the

frequent absence of prices in public projects makes benefit estimates more uncertain.)

121. D (Dynamic efficiency refers to a firm's ability to innovate and improve its production

processes, products, and services over time. It involves investing in research and development,

adopting new technologies, and continually improving product quality and design. Therefore,

the action by a firm that is most likely to raise its dynamic efficiency is retaining its curre nt profit

for product research and development.

By investing in research and development, a firm can develop new products, improve existing

products, and find new and more efficient ways of producing goods and services. This can help
 the firm to stay competitive, expand its market share, and increase its long-term profitability. In

contrast, distributing all its current profit to existing shareholders, maximizing labor

productivity, or minimizing average cost may improve short-term profitability, but may not

necessarily improve the firm's ability to innovate and adapt to changing market conditions over

time.)

122. B (The Pareto criterion is also known as Pareto efficiency or Pareto optimality. A

situation is Pareto efficient if no individual or group can be made better off without making

someone else worse off. In other words, a situation is Pareto efficient if it is impossible to

reallocate resources or goods in a way that would make at least one person better off without

making someone else worse off. Only in Option B, Samir is better off without Tariq being wore

off.)

123. B (The concept of allocative efficiency assumes that resources are allocated in a way

that maximizes the satisfaction or utility of consumers, based on their own preferences and

judgments about their own economic welfare. This implies that individuals are the best judges

of their own welfare, and that markets are efficient in allocating resources to meet their needs

and preferences.

However, some goods and services may have social benefits that are not fully reflected in their

market prices or demand. For example, merit goods such as education, healthcare, and

environmental conservation may provide benefits to society as a whole, but individuals may not

fully recognize these benefits when making their consumption decisions. In such cases,

government intervention in form of providing subsidies may be necessary to ensure that these

goods are provided and consumed at socially optimal levels.)

124. A (Net External Benefit = External Benefit – External Cost)

125. A (The Pareto criterion is also known as Pareto efficiency or Pareto optimality. A

situation is Pareto efficient if no individual or group can be made better off without making

someone else worse off. In other words, a situation is Pareto efficient if it is impossible to

reallocate resources or goods in a way that would make at least one person better off without

making someone else worse off. Only in Option A, both are being worse off. Hence, A is not the

point where allocative efficiency will increase.)

126. D (Productive inefficiency occurs when an economy is not able to produce goods and

services at the minimum possible cost. This can happen due to various reasons, such as poor

allocation of resources, technological inefficiency, or lack of competition. If an economy is

productively inefficient, it means that it is not able to produce the maximum possible output

with the given resources and technology.

Unemployment due to deficient aggregate demand is an indicator of productive inefficiency

because it implies that there is a shortfall in the level of output that the economy could

potentially produce. This can happen when there is insufficient demand for goods and services

in the economy, which results in firms producing less than what they are capable of. As a result,

some resources, such as labor, remain idle, which is an indicator of inefficiency.)

127. C (Economic efficiency refers to the ability of an economy to produce goods and services

using the minimum possible amount of resources. It is achieved when an economy produces the

maximum possible output with the given resources and technology. Economic efficiency is

important because it ensures that resources are used in the most optimal manner and are not

wasted.

Achieving economic efficiency leads to several benefits, such as lower production costs,

increased output, and higher standards of living. It also allows an economy to produce more
 goods and services while using fewer resources, which can help to conserve resources and

reduce the environmental impact of economic activities.

Therefore, the purpose of achieving economic efficiency is not to achieve full employment or to

use as many resources as possible, but rather to ensure that resources are used in the most

effective and sustainable manner possible, which can ultimately bene fit society as a whole.)

128. B (Economic efficiency refers to the ability of an economy to produce goods and services

using the minimum possible amount of resources. When a firm increases its production, it can

improve economic efficiency if it can produce additional units at a cost that is lower than the

price consumers are willing to pay for those units.

Option A is incorrect because increasing production may not necessarily lead to higher total

revenue, especially if there is insufficient demand for the additional units.

Option C is incorrect because average and marginal revenue are not necessarily related to

economic efficiency. The efficiency of a firm's production is determined by the relationship

between the cost of producing the last unit and the value that consumers place on that unit.

Option D is also incorrect because if the firm can produce additional units at a cost that is lower

than the price consumers are willing to pay for those units, then the marginal cost will not rise,

and the total cost may even decrease as the firm benefits from economies of scale.)

129. B (We are given that the private costs of the power station were $800m, the private

benefits were $900m, and the external benefits were $300m.

To determine the external costs, we need to use the concept of net external benefit, which is

calculated as follows:

Net External Benefit = External Benefit - External Cost

We are given that the proposal for the power station was not socially beneficial, which means

that the net external benefit is negative. Therefore:

 Net External Benefit = External Benefit - External Cost < 0

Substituting the values we have, we get:

$300m - External Cost < 0

Simplifying the inequality, we get:

External Cost > $300m

Therefore, we can conclude that option B is correct: External costs were greater than $400m.)

130. B (Option B, income inequality, is not a source of market failure. Market failure refers to

situations where the allocation of goods and services by a free market is not efficient, resulting

in either under-allocation or over-allocation of resources. Income inequality is a distributional

issue, and while it can have social and economic consequences, it is not directly related to

market failure. On the other hand, options A, C, and D are all sources of market failure.)

131. D (When the government regulates the consumption of a demerit good, it aims to

reduce the negative externalities associated with its consumption. This can be achieved by

imposing taxes or setting limits on consumption.

The net welfare of society will increase when the fall in the total social cost is greater than the

fall in the total social benefit. This is because the total social cost represents the total cost to

society of producing and consuming the good, while the total social benefit represents the total

benefit to society of consuming the good. By reducing consumption, the negative externalities

associated with the production and consumption of the demerit good can be reduced, which

leads to a reduction in the total social cost. As a result, society's net welfare increases.)

132. B (Noise Pollution = Negative Externality = Market Failure)

133. D (The correct answer is D, the production of a good at minimum average cost for a

given output, is a necessary condition for the achievement of productive efficiency. When firms

produce at the minimum average cost, they are producing in the most efficient way possible
 given the resources available to them. This ensures that the economy is producing goods at the

lowest possible cost, leading to an efficient allocation of resources.)

134. A (The government will choose a project in which Social Benefits > Social Costs. Only in

Option A, this is possible.)

135. C (If the social benefits of the development outweigh the social costs, then the

government should allow the project to proceed. If the social costs outweigh the benefits, then

the government should reject the proposal. It is important to note that the private costs and

benefits may not always align with the social costs and benefits, and thus, it is important to

consider both when making a decision.)

136. A (Pollution = Negative Externality = Market Failure)

137. C (Social Cost = Private Cost + External Cost)

138. C (The policy of requiring firms to pay a minimum wage is primarily aimed at improving

income distribution and reducing poverty, rather than correcting inefficiency in resource

allocation.)

139. A (In order to see the government`s decision, we must compare the social costs with

social benefits. The social costs of the project are $525 (450 + 75) whereas the social benefits

are $525. This means that the government will be willing to build the road as SB > SC.

In order to see the private firm`s decision, we must compare the private costs with the private

benefit. Here, the private benefit is $500 (Social Benefit - External Benefit). Hence, both the

parties would be willing to build it.)

140. B (SC > PC indicating negative externality.)

141. B (The transfer earnings of the fashion model are the amount he could earn in his next

best alternative job, which is $100000 a year.

 The economic rent of the fashion model is the difference between his current income and his

transfer earnings, which is:

$500000 - $100000 = $400000

Therefore, the transfer earnings of the fashion model are $100000 a year and his economic rent

is $400000 a year.)

142. D (A reduction in the price of the firm's product would decrease the marginal revenue of

the firm, which in turn would decrease the marginal product of labor, and thus shift the MRP

curve to the left.

An increase in labour productivity (A) would shift the MRP curve to the right, as the worker is

now able to produce more output per unit of time, and therefore, their marginal revenue

product would increase.

An increase in the wage rate (B) would also shift the MRP curve to the right, as the worker

would have a higher opportunity cost of their time, and therefore, the firm would only hire

them if they can generate a higher revenue.

A reduction in labour hours (C) would also shift the MRP curve to the right, as the worker would

have less time to produce output, and therefore, their marginal revenue product would

increase.)

143. A (Without the minimum wage, the firm would hire workers up to the point where the

marginal revenue product of labor (MRP) equals the marginal factor cost (MFC) which is given

by the MFCL curve. This happens at point J where the MRP curve intersects the MFCL curve.

Currently the firm, the firm hires OK workers and pays them a wage rate of OW.

Therefore, if the minimum wage is abolished, the firm will revert to hiring OJ workers. Hence,

the number of firms employed will decrease by JK.)

144. D (The situation described in the question is an example of the law of diminishing

returns. According to this law, as additional units of a variable input (such as labor) are added to

a fixed input (such as capital), the marginal product of the variable input will eventually

decrease. In this case, the fact that the new worker adds less to output than the previous

worker indicates that the firm has reached a point where additional workers are becoming less

productive, reflecting the diminishing returns to labor.

Therefore, the correct answer is D, the law of diminishing returns. The other options are not

directly related to this concept. Decreasing marginal costs (option A) refer to the reduction in

the cost of producing each additional unit of output as production increases, which is a result of

economies of scale. Diseconomies of scale (option B) occur when the cost of producing each

additional unit of output increases as production increases, often due to coordination and

communication difficulties within a larger organization. Increasing returns to scale (option C)

occur when the output of a firm increases more than proportionally to the increase in all inputs,

meaning that as a firm gets larger, it becomes more efficient and productive.)

145. B (To calculate the total cost of labor, we can use the formula:

Total cost of labor = (number of workers) x (hourly rate of pay)

Initially, the school has 10 cleaners who are paid an hourly rate of $8.00. Therefore, the total

cost of labor is:

Total cost of labor = 10 x $8.00 = $80.00

When the school hires one more cleaner and raises the hourly rate of pay to $8.50, the total

cost of labor becomes:

Total cost of labor = 11 x $8.50 = $93.50

The increase in total cost of labor is $93.50 - $80.00 = $13.50, which is the marginal cost of labor

per hour to the employer.

 Therefore, the correct answer is $13.50.)

146. C (For a firm in imperfect competition, the marginal revenue product of labor (MRP) at

any given level of employment is equal to the marginal physical product of labor (MPP)

multiplied by the marginal revenue (MR) that the firm earns from selling an additional unit of

output. Mathematically, this relationship can be expressed as:

MRP = MPP x MR

Therefore, the correct answer is C, the marginal physical product of labor multiplied by marginal

revenue.)

147. C (Minimum wage policy can directly increase the wages of low-income workers, which

can help to reduce income inequality. By setting a minimum wage, the government can ensure

that workers receive a wage that is sufficient to cover their basic needs, such as food, housing,

and healthcare. This can also provide an incentive for employers to invest in their workers' skills

and productivity, which can lead to higher wages in the long run.

Progressive income taxes (option D) are also an effective way to reduce income inequality, as

they tax higher-income households at a higher rate than lower-income households. This can

help to redistribute income from higher-income to lower-income households, thereby reducing

the gap between them. However, progressive income taxes may not be sufficient on their own

to address the root causes of income inequality, such as differences in education, skills, and job

opportunities.

Government support for trade unions (option A) can help to increase the bargaining power of

workers and negotiate better wages and benefits. This can help to reduce income inequality to

some extent, but may not be sufficient to address the broader structural factors that contribute

to income inequality.
 Import duties on manufactured goods (option B) are not directly related to reducing income

inequality. While they may protect domestic industries and promote job growth, they can also

lead to higher prices for consumers and reduce overall economic efficiency.

Therefore, of the options given, the most effective policy for achieving a more equal distribution

of disposable incomes between households is C, minimum wage policy.)

148. B (Means-tested benefits take into account the size of the household or family when

determining the amount of benefit paid. A larger family or household may receive a higher level

of benefit to reflect the increased cost of living associated with a larger family.

Option A, age, is not a determining factor for means-tested benefits, although some benefits

may have age-related eligibility criteria.

Option C, income, is a crucial factor in determining the amount of benefit paid, as means-tested

benefits are designed to assist those with low income.

Option D, qualifications, is not typically a determining factor for means-tested benefits, although

some benefits may have education or training-related eligibility criteria.)

149. A (If the Lorenz curve shifts to the right, it means that income inequality has increased.

Therefore, the least likely cause for this shift would be option A, where capital gains tax has

been reduced, as this measure could potentially exacerbate income inequality by benefiting the

wealthy who hold more capital assets.

150. B (In a perfectly competitive market, a firm faces a horizontal demand curve for its

product. Therefore, the firm can sell all of its output at the market price, but it cannot charge a

higher price for its output by increasing the quantity produced. As the firm hires more of a

factor of production, the marginal physical product of that factor will eventually diminish, as the

firm adds units of the factor to a fixed amount of other factors. As a result, the additional output
generated by each additional unit of the factor will decline, which leads to a fall in the marginal

physical product of the factor.)

 My Top Picks for Case Studies (Micro)
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Winter 2021 Paper 42 Section A:
Winter 2021 Paper 43 Section A: