CAIE A2 Economics

Utility - Notes

In explaining consumer behavior, economics relies on the fundamental premise that people
choose those goods and services they value most highly. When an individual consumes
something, it either gives them satisfaction, or dissatisfaction. To describe the way consumers
choose among different consumption possibilities, economists a century ago developed the
notion of utility.

Utility
Definition: utility is the satisfaction gained from the consumption of a product.

The concept of a utility function is just a way of representing the fact that when people
consume, they take into account their preferences and tastes in a more or less rational way.

For the sake of simplicity, it is useful to suppose that we can measure utility in hypothetical
units, called utils. Products are assigned an absolute value which indicates how much
satisfaction they give the consumer. This is called cardinal utility. Two products can be
compared based on their cardinal utilities.

Example:
A water gives the consumer 1 util.

A drink gives him 5 utils.

The consumer prefers drink 5x as much as water.

Total and Marginal utility

Total utility is the satisfaction gained from the consumption of all units of a product over a
particular time period.

Marginal utility is the satisfaction gained from the last unit of a product consumed over a
particular time period.

Marginal utility is the utility from the next unit you consume, therefore, it is marginal utility
that determines what happens to total utility.

1) When marginal utility is positive, total utility increases.

2) When marginal utility is zero, total utility is constant.

3) When marginal utility is negative, total utility decreases.

Mathematically, marginal utility is the derivative of total utility.

The law of diminishing marginal utility (DMU)
The law of diminishing marginal utility is a situation where as the quantity consumed of a
product by an individual increases, the additional satisfaction gained from each unit (MU) will
eventually decline. This is only true if all other factors such as income, time, etc. remain
unchanged.

Example: suppose if a person is very hungry and has not eaten any food all day. When he
finally starts to eat, the first bite will give him a lot of satisfaction. As he keeps on eating more
and more food, his appetite will go down and come to a point where he does not want to eat
anymore.

Exceptions of diminishing marginal utility

1) Addictions
This law does not hold in case of addictions. The marginal utility of having an additional glass
of alcohol does not decrease for an alcoholic. Similarly, in the case of hobbies, a person who
likes to paint might not experience diminishing marginal utility on making a new painting.

2) Rare items
It also does not hold true in the case of rare items. This is especially true for enthusiasts who
chase such items and are really passionate about them. For example, acquiring a limited
edition watch might give much more satisfaction to an enthusiast who likes collecting watches
and already has a lot of them.

3) Goods with minimum consumption levels

Suppose you need to buy 4 tyres for a car to operate, then the first 3 tyres would give you
zero marginal utility. It is only when you get the 4th tyre that you derive utility from this.
CAIE A2 Economics
Budget line - Notes

Budget line
Definition: a budget line is a line that shows all possible combinations of two products that an
individual is able to purchase at particular prices and with a given level of income.

Derive the budget line

Assume income is m, price of x is Px and price of y is Py.

The amount they spend on x is the quantity of x multiplied by its price: xpx

The amount they spend on y is the quantity of y multiplied by its price: ypy

If a consumer uses all its income, xpx + ypy = m

Rearrange, y = m/py – px/py * x

The maximum amount of good y is the y-intercept of the budget line, which is m/py.

The maximum amount of good x is the x-intercept of the budget line, which is m/px.

The gradient of the budget line is equal to -px/py.

Recall that real income is the purchasing power of income, the area beneath the budget line
represents the consumer's real income.

If the area beneath the budget line increases, it means that the consumer's real income has
increased, and vice versa.

According to the formula, real income = m^2/2pxpy. It follows that a fall in price of goods or
an increase in income would both lead to an increase in real income.
Movement along the budget line
Assume there is a successful advertising campaign about good x, then consumer would
purchase more good x, and less good y. As there is no change in prices or income, this would
lead to a movement along the budget line.

Shift of budget line

Recall the formula of budget line: y = m/py – px/py * x

1) If income increases, with no change in prices, budget line will shift outwards parallelly.

2) If income does not change, but prices of good x and good y both decrease by same
percentage, budget line will also shift outwards parallelly.

3) If Px becomes relatively cheaper than Py, Px/Py decreases, budget line will become less
steep.

4) If Py becomes relatively cheaper than Px, Px/Py increases, budget line will become steeper.

Interpret shift of budget line

1) If a budget line shifts parallelly, then we could conclude two things:

a. Real income would change

b. There is no change in relative prices of good x and y

2) If a budget line pivots, then we could only conclude one thing: if budget line becomes less
steep, then Px/Py decreases; if budget line becomes steeper, Px/Py increases.

Note that in both cases, we could not conclude whether there is a change in nominal income,
or prices of both goods.
CAIE A2 Economics
Indifference curve - Notes

In section 1.1, we talk about cardinal utility: products are assigned an absolute value which
indicates the level of satisfaction. However, this assumption is very unrealistic as utility cannot
be measured objectively: measurements in different situations are not comparable. Thus,
ordinal utility is more realistic when analysing consumer behaviour.

Definition: ordinal utility is measured subjectively, no numerical measure is involved. Instead,

products are ranked according to the consumer preference.

Say there are two goods, x and y.

If the consumer gains higher utility from x than from y, they prefer x to y.

If the consumer gains higher utility from y than from x, they prefer y to x.

If the consumer gains equal utility from x and y, they are indifferent between x and y.

If consumers’ preferences are given and utility can be measured ordinally, we could construct
an indifference curve for two products for a particular consumer.

Definition: An indifference curve is a line that shows all the consumption bundles that yield
the same amount of total utility for an individual.

Note: in CIE syllabus, all products have non-negative marginal utility when consumed.
Features of a normal indifference curve
1) Higher indifference curves correspond to higher utility

Consumers prefer having more of a good to having less of a good. If a combination gives them
more of both x and y than another combination, it must give them higher utility. Thus, higher
indifference curves correspond to higher utility.

2) Indifference curves cannot cross

A and C are both on I1, so the consumer is indifferent between them.

B and C are both on I2, so the consumer is indifferent between them.
Thus, A and B are indifferent.
However, given same amount of good x, point A has more good y than point B, this means
that point A has higher utility than point B. This is the contradiction.

3) Indifference curves slope downwards

Total utility is constant along an indifference curve. However, when the consumer gains more
of one good X, total utility increases as the marginal utility of the additional unit of good X is
positive. In order to keep total utility constant, they must give up some of the other good y so
that total utility obtained from good Y decreases. Thus, if consumption of good x increases,
consumption of good y must fall, indifference curve is downward sloping.
4) Indifference curve is convex to the origin
To prove this, we need to analyse the slope of indifference curve: marginal rate of
substitution (MRS).

Definition: MRS represents the rate at which the individual is willing to trade x for y to hold
utility constant.

When the consumer gets 1 more unit of x, their utility rises by MUx.

When the consumer gets 1 less unit of y, their utility falls by MUy.

Therefore, when consumer gets 1 more unit of x, they must reduce their consumption of y by
MUx/MUy to keep their utility constant and stay on the same indifference curve.

By intuition, MRS= -MUx/MUy

For instance:
If MUx = 4 and MUy = 4, then MRS = -1.
When the consumer gets 1 more x, they must consume 1 less y to keep utility constant.

If MUx = 8 and MUy 2, then MRS = -4.

When the consumer gets 1 more x, they must consume 4 less y to keep utility constant.

If a consumer moves from A to B, he will consume more good X and less good Y. According to
law of diminishing marginal utility, MU of X will fall while MU of Y will rise. Thus, MUx/MUy
will decrease, indifference curve is less steep at B than A. Similarly, indifference curve is less
steep at C than B. Thus, the shape of indifference curve is convex to the origin.
Special indifference curves
1) Perfect complements
Indifference curves for perfect complements are L-shaped, or right angled.

Perfect complements are goods that are always consumed together in fixed proportions. In
some sense the goods “complement” each other.

Assume consumer has 1 left shoe and 1 right shoe. An additional left shoe is useless, it will not
bring him any extra utility. In this case, MU of left shoe = 0, the slope of curve is zero,
indifference curve is a horizontal line. Similarly, an additional left shoe is also useless, it will
not bring him any extra utility. In this case, MU of right shoe = 0, the slope of curve is infinite,
indifference curve is a vertical line. If the consumer has 2 left shoes, then a second right shoe
is useful, this will move him to a higher indifference curve.

2) Perfect substitutes
The indifference curves for perfect substitutes are straight lines with a negative slope.

Suppose, for example, that we are considering a choice between red pencils and blue pencils,
and the consumer involved likes pencils, but doesn’t care about color at all. Pick a
consumption bundle, say (10,10). Then for this consumer, any other consumption bundle that
has 20 pencils in it is just as good as (10,10). The indifference curves for this consumer are all
parallel straight lines with a slope of −1. Bundles with more total pencils are preferred to
bundles with fewer total pencils, so the direction of increasing preference is up and to the
right.

The important fact about perfect substitutes is that the indifference curves have a constant
slope.
CAIE A2 Economics
Consumer equilibrium – Notes

The general definition of ‘equilibrium’ is a position from which there is no tendency to change.
A consumer’s equilibrium is state in which they are maximizing their utility. If they were not,
they would want to alter their consumption to attain higher utility so that the current state
would not be an equilibrium.

Equi-marginal principle
Equi-marginal principle is the principle that a rational individual, wishing to maximise total
utility, will allocate their expenditure amongst different products so as to ensure that the
satisfaction or utility gained from the last unit of money spent on each product is the same.

Assuming that utility can be measured cardinally, the equi-marginal principle implies that the
consumer maximises their utility by consuming quantities of and y such that the following
equation is satisfied: MUx/Px = MUy/Py.

Consumer equilibrium over one good

The consumer has to choose how much of a single good x to consume, i.e., consumer has two
options: first, buy good x; second, hold money in hand. We assume marginal utility of money
is constant. Thus, the utility is maximized where

MUx/Px = MUmoney/Pmoney

As price of money is equal to 1, the utility is maximized where MUx/Px = MUmoney.

For example, the schedule shows the total utility derived by a consumer of a good X at
different levels of consumption.

The consumer obtains two units of satisfaction from the last cent she spends on each good
that she purchases, this means that MUmoney = 2.

Thus, when price is 6, consumer will maximise utility by purchasing 2 units since MU/P =
12/6 = 2.

If price is 5, consumer will maximise utility by purchasing 3 units since MU/P = 10/5 = 2.
Consumer equilibrium over two goods
1) Equi-marginal principle
Consumer maximises their utility by consuming quantities of x and y such that the following
equation is satisfied: MUx/Px = MUy/Py. This means that the last dollar the consumer spends
on each good gain them the same amount of extra utility.

If MUx/Px > MUy/Py, then the last dollar the consumer is spending on x gives them more utility
than the last dollar they are spending on y. Therefore, they could increase their total utility by
taking the last dollar they are spending on y and spending it on x instead. In other words, they
can increase their total utility by purchasing less of y and more of x. Assuming DMU for both
goods, this would decrease MUX and increase MUy. This process of substituting x for y would
continue to increase the consumer's utility until the marginal utility per dollar spent on both
goods was equal, i.e. until the equi-marginal principle was satisfied.

2) Indifference theory
The approach of marginal utility theory required cardinal utility. Comparatively, the approach
of indifference theory only requires ordinal utility. The consumer maximises utility by
consuming at the point of tangency, between indifference curve and budget line, which is
point A.

As IC3 is tangent to the budget line, gradient of two curves are same at point A.
Gradient of budget line: - Px/Py.
Gradient of indifference curve: - MUx/MUy.
Thus, at point A, MUx / Px = MUy / Py, which is also referred to equi-marginal principle.

Consumer equilibrium over many goods

If we want to analyse a situation where the consumer is choosing between 3 or more goods
at the same time, the graphical approach is not possible because we can’t draw 3-D graphs.
We should use numerical approach to analyse.

Consider consumer has to choose over many goods 1,2,…,n. A rational consumer chooses
quantities of each good such that
MU1/P1 = MU2/P2 = … = Mun/Pn.
CAIE A2 Economics
Demand curve – Notes

Utility approach
Assume utility can be measured cardinally, equi-marginal principal implies that utility is
maximized where MUx/Px = MUmoney/Pmoney. By definition, Pmoney is 1. Thus, utility is
maximized when MUx = MUmoney * Px. The consumer’s demand curve can be derived from
the ratio of the marginal utility of x to the marginal utility of money at each consumption level.

According to the diagram, if the price is P1, the individual will purchase until MU = P1 *
MUmoney, which is Q1 corresponding to a point X. If price falls from P1 to P2, MU is greater
than P2 * MUmoney at Q1. By law of diminishing marginal utility, as the quantity consumed
of a product by an individual increase, the additional satisfaction gained from each unit will
eventually decline. Thus, to restore the equilibrium, consumer should increase consumption
to Q2 where MU equals to P2 * MUmoney. This is represented by a point Y. Similarly, if price
falls to P3, consumer moves from point Y to Z. If we join points X, Y and Z, demand curve is
derived from the ratio of the marginal utility of good to the marginal utility of money at each
consumption level.

The market demand curve is horizontally summing the individual demand curves. Assume we
have 3 people, market demand at price P1 is equal to person X’s demand (Q1) at P1 + person
Y’s demand (Q2) at P1 + person Z’s demand (Q3) at P1.
Indifference approach
Assume utility can be measured ordinally, we could derive demand curve from indifference
curve and budget line.

When price of good x falls from P1 to P2, consumer could purchase more good x than before.
Thus, budget line will pivot out from B1 to B2. The consumer equilibrium will change from A
to B as consumer could reach to a higher indifference curve.

For normal goods and inferior goods, quantity demand will increase from Q1 to Q2. This is
illustrated by the diagram. We have a downward demand curve for the product.

Differences of two approaches

Derivation of a demand curve by utility theory requires data on the consumer’s marginal utility
at different levels of consumption. Thus, utility should be measured objectively. Once the data
is obtained, price and quantity are explicitly plotted to indicate a consumer’s demand curve.

On the other hand, the derivation by indifference curve theory is solely graphical, no prior
data is needed. As long as utility can be measured subjectively, we could construct an
indifference curve. However, it is insufficient to derive a demand curve by a single graph: we
must use a second graph to indicate the change of consumption if price changes.
Criticism of consumer theory
1) Cardinal utility
We assume utility could be measured cardinally because we employ the equi-marginal
principle to derive consumer equilibrium. However, the measure of cardinal utility is very
subjective, the measurements in different situations are not comparable. For instance, if a
person says today a water gives him 5 utils and says tomorrow that water gives him 50 utils
because he is going to play a basketball game, we could not conclude the actual utils that
person gets from the consumption of water. In addition, decimal quantities are possible when
applying equi-marginal principal. However, most of goods are not divisible, the options that
consumer pick may not maximise total utility.

2) Consumer sovereignty
Consumer sovereignty is the theory that consumer preferences determine the production of
goods and services. If we use consumer theory to predict what an individuals consumes, it
implicitly assumes that they can, in fact, acquire that choice. However, this may not be the
case in reality. For instance, government could just ban certain goods from being produced
even if there’s high demand for it, such as e-cigarettes. In addition, producers do produce
goods that consumers do not want or introduce new products like the iPhone that the
consumers did not know they wanted.

3) Rationality
We assume consumers are able to maximise utility. However, theoretically, it is impossible.
There are two arguments about this: bounded rationality and heuristics. Bounded rationality
is the concept that decision makers have to work under three unavoidable constraints. Firstly,
for consumers, information available is limited so that there is not enough knowledge
available for consumers to compare goods. Secondly, only a limited amount of time is
available for consumers to make a decision. Thirdly, even if the consumers have all the time
and information available, they may not be able to compare all goods because of the limited
mental capacity. Therefore, even individuals who intend to make rational choices, their
rationality is bound to make satisficing choices in complex situations. In this case, consumers
often use heuristics to make decisions. Heuristics simplify the decision-making process to
come to a reasonable decision. Consumers have the tendency to rely on the first piece of
information obtained when considering a decision. Also, their decisions are likely to be based
on the easiest piece of information to recall. Finally, they want to use past experience or
assumptions to make assumptions. For instance, they would pick up the product they have
bought through the entire life, ignoring potentially better choices.
CAIE A2 Economics
Change of consumer equilibrium – Notes

Type of effects
There are three types of effects which we are concerned with
1. Price effect (PE)
The price effect, is the change in consumption due to a change in price, holding non-price
factors (other prices, nominal income, tastes) constant. Graphically, it is the change in
consumption along a demand curve in response to a price change.

For an ordinary good, the price effect, acts in the opposite direction to the price change,
i.e. consumption increases when price decreases, and vice versa. This results in a downward-
sloping demand curve. For a giffen good, the opposite is true, resulting in an upward-sloping
demand curve.

2. Substitution effect (SE)

The substitution effect is the change in consumption due to a change in price, holding utility
constant. Graphically, it is the change in consumption along an indifference curve, as the
consumer substitutes one good for the other.

The substitution effect always acts in the opposite direction to the relative price change, i.e.
consumption increases when a good becomes relatively cheaper, and vice versa. This is true
no matter what type of good is under analysis.

3. Income effect (IE)

The income effect is the change in consumption due to a change in real income, holding
relative prices constant. Graphically, it is the change in consumption when there is a parallel
shift of the budget line.

For a normal, the income effect acts in the same direction as the real income change, i.e.
consumption increases when real income increases, and vice versa.

For an inferior good, consumption increases when real income decreases, and vice versa.
Change in price
When the price of one of the good falls, the substitution effect will always increase demand
for the good. However, consumer’s real income also increases and the income effect varies
depending on the type of good. Thus, we need to decompose the price effect into substitution
effect and income effect. The price effect of a price change is comprised of the substitution
and income effects of that price change: PE = SE+ IE.

If the effect increases consumption, it is called a positive effect.

If the effect decreases consumption, it is called a negative effect.

To analyse the price effect, there are 3 steps involved.

Step 1: Draw the budget line.

Construct an indifference curve tangent to it.
Mark the initial equilibrium as A.

Step 2: Pivot the budget line to reflect the price change.

Shift the indifference curve outwards until tangent.
Mark the new equilibrium as C.

Step 3: Shift the new budget line inwards in parallel until it is tangent to the old indifference
curve. Mark its point of tangency as B.

A to B: Substitution effect
B to C: Income effect
A to C: Price effect

The substitution effect (A to B) is obtaining by holding utility constant, thus moving along the
original indifference curve.

The income effect (B to C) is obtained by holding relative prices constant, thus shifting the
budget line in parallel.
Classification of goods – decrease in price increases
For normal goods, when price decreases,
the movement from A to B represents
substitution effect while movement from B
to C represents income effect.

As both income effect and substitution

negative
effect are positive, the consumption will
increase from Q1 to Q3. The demand curve
is downward sloping and there is an
increase in quantity demand.

Text
Text

For inferior goods, when price decreases,

the movement from A to B represents
positive substitution effect while
movement from B to C represents negative
income effect.

As positive substitution effect outweighs

the negative income effect, the
consumption will increase from Q1 to Q3.
The demand curve is downward sloping and
there is also an increase in quantity demand.

For giffen goods, when price decreases, the

movement from A to B represents positive
substitution effect while movement from B
to C represents negative income effect.

As negative income effect outweighs the

positive substitution effect, the
consumption will decrease from Q1 to Q3.
The demand curve is upward sloping and
there is a decrease in quantity demand.
Change in taste
1) Utility approach
Assume the consumer's tastes change such that x becomes more preferred to y than before
(for instance, due to advertising). We represent this as an increase in MUx and a decrease in
MUy for all levels of consumption. This implies that, at the old equilibrium:

MUx/Px > MUy/Py

To retain equilibrium, the consumer must, increase their consumption of x and/or decrease
their consumption of y. In this case, since we're holding income and prices constant, the
outcome is obvious. They consume more of x and less of y, which is what we'd expect if x
became more preferred, all else held constant.

2) Indifference approach
If good A is advertised, it becomes more valuable to consumers, MUx will increase. Thus, the
advertising can be represented as changing the marginal rate of substitution. The consumer’s
indifference curves will become steeper (IC2) as MUx/MUy increases. As indifference curve
becomes IC2, consumer equilibrium will change from A to B, consumption of good X will
increase. As there is no change in price of good X, demand curve for good X will shift to the
right.

According to the diagram, demand curve shifts from D1 to D2.

Advertisement could also make a good more price-inelastic. The primary goal is for a company
to build selective demand for its product. For example, car manufacturers often produce
special advertisements promoting the safety features of their vehicles. This type of
advertisement could allow car manufactures to charge more for their products because of the
perceived higher quality the safety features afford. Advertisement could also help firms to
build the brand of the product. Firms create differences in the minds of consumers between
their product and those of other firms. This is achieved by differences in design of packaging
of products as well as in the creation of brand names and trademarks. Once a brand has
created a positive outlook among its consumers, the firm is said to have built brand equity.
This further reduces elasticity which in turn leads to higher total revenue.

Change in income
If there is an increase in real income, budget line will shift out parallelly, consumers could
purchase more goods than before. Ceteris paribus, a higher income will allow them to attain
higher total utility. Thus, consumer could move to a higher indifference curve than before.

For a normal good, if income increases, consumption will increase from Q1 to Q2. As price
does not change, demand curve will shift outward. The extent of the increase will depend on
the income elasticity and will vary between a necessary good and a luxury good.

For necessary goods, the percentage change in quantity demanded is less than the percentage
change in income, 0<YED<1, the good is income inelastic. For instance, when income increases,
the demand for electric power and food will increase, but as they are consumption of
necessities, the effect on quantity demand is minimal. On the other hand, for luxury goods,
the percentage change in quantity demanded is greater than the percentage change in income,
YED>1, the good is income elastic. For instance, with the same percentage change in income,
the demand for luxury goods, such as mobile phone or laptop, will increase more than for a
normal good.
For inferior goods, they are of lower quality than normal goods. Second-hand books and
instant noodles are purchased by people only when incomes fall because they can no longer
afford better quality versions of those goods, such as newest version of books and restaurants,
due to the constraint on their expenditure. Thus, if income increases, consumption will
decrease from Q1 to Q2. As price does not change, demand curve will shift inward.
CAIE A2 Economics
Short-run production function - Notes

Short run and long run

In economics, short run (SR) is defined as the time period during which at least one factor of
production is fixed.

In the long run (LR), firms can adjust the quantity of any factors of production.

Note that the short run does not refer to a specific duration of time but rather is unique to
the firm, industry or economic variable being studied.

For instance, a farm uses only two factors of production, land and labour. In this case, labour
can be varied quickly while buying and selling land takes time. Thus, the short run is the time
period when land is fixed.

Short-run production function

A production function is the relationship between the quantity of inputs a firm uses and the
quantity of output it produces.

A fixed input is an input whose quantity is fixed for a period of time and cannot be varied.

A variable input is an input whose quantity the firm can vary at any time.

To simplify, economists usually assume that there are only 2 inputs: labour (L) and capital (K).

In the short run, labour is a variable input while capital is a fixed input. Assume all workers
have the same intrinsic productivity, different units labour can be combined with fixed
amount of capital to produce various level of output, which is the short-run production
function.

Total, average and marginal product

The total product (TP) is the output produced by a given a certain amount of labour and capital.

The marginal product of labour (MP) measures the change in TP resulting from the
employment of the last worker. (Q)

The marginal product for any value of the variable input is the slope of the total product
function at that point. If the total product function is differentiable, the marginal product is
the derivative of the total product function.
MP = dTP/dq

The average product (AP) measures how much output is produced by each worker.
AP = TP / quantity of labour
Law of diminishing return/law of variable proportions
Law of diminishing return, or law of variable proportions, states that as more workers are
added to a fixed quantity of capital in the short run, the marginal product for labour will
eventually decrease. This is because as employment increases, quantity of capital remains
unchanged. As a result, the capital-labour ratio falls.

Graphical analysis

1) Given a fixed amount of capital, if a firm decides to employ workers, the MP of second
worker will be higher than the first worker because of division of labour. However, as capital
is fixed, diminishing return sets in after a certain amount of workers. Thus, MP will increase
when quantity of labour is low, but starts to fall after Q1. When quantity of labour is greater
than Q2, MP could even become negative.

If MP is positive and increasing (up to Q1), we have increasing marginal returns for labour.
If MP is positive but decreasing (up to Q2), we have decreasing marginal returns for labour.
If MP is negative (after Q2), we have decreasing marginal returns for labour.

2) If the marginal product of this labour is greater than the average product of previous labour
(MP > AP), AP will rise.
If MP = AP, AP will remain unchanged.
If MP < AP, AP will fall.
MP passes through the highest point of AP.

3) MP is the slope of TP curve. When MP is increasing and positive, TP is increasing and

bending upwards. After Q1, MP is decreasing, but still positive. Thus, TP is still increasing, but
at a decreasing rate, TP is bending downwards. After Q2, MP is negative, TP is decreasing.

4) To figure out the average product at each point on a graph of total product, draw a straight
line from the origin to that point. AP is equal to the gradient of that line.

5) To figure out the marginal product at each point on a graph of total product, observe the
slope of the graph at that point.
CAIE A2 Economics
Short-run cost function - Notes

Type of costs
The fixed cost (FC) is a cost that does not depend on the quantity of output produced. It is the
cost of the fixed input. Note that fixed cost only exists in the short run.
The average fixed cost (AFC) is the fixed cost per unit of output. AFC = FC / TP.

The variable cost (VC) is a cost that depends on the quantity of output produced. It is the cost
of the variable input.
The average variable cost (AVC) is the variable cost per unit of output. AVC = VC / TP

The total cost (TC) of producing a given quantity of output is the sum of the fixed cost and the
variable cost of producing that quantity of output. TC = VC + FC
The average total cost (AC) is the total cost per unit of output. AC = AVC + AFC.

The marginal cost (MC) refers to the change in TC or VC generated by the production of the
last unit of output (Q). Mathematically, MC = dTC/dQ = dVC/dQ because dFC/dQ = 0.

Cost curves
1) MP and MC curves have opposite variations.
In short run, capital is fixed but labor is variable. In such a situation, there are diminishing
returns to the labor because each additional unit of labor has less capital to work with. As a
result, the marginal cost of output will rise because the extra output produced by each extra
labor unit is going down. In other words, diminishing returns to the variable factor will imply
an increasing short-run marginal cost.
Assume a constant wage rate w, mathematically, MC = w/MP.

2) AP and AVC have opposite variations.

If the AP is low, then the firm needs to hire many workers to produce each unit of output so
the AVC is high. Note that in the short run, capital is fixed, AP measures how much output is
produced by each worker. Thus, when analysing costs, we only consider variable cost, capital
cost is not included. Hence, AP and AVC have oppositive variations, but not AC. AVC is U-
shaped.
3) AC = AFC + AVC, AC is U-shaped.
As FC is fixed throughout the entire range of output, AFC decreases throughout the entire
range of output, this is the spreading effect. However, after certain output, diminishing
returns set in, AVC starts to rise.

At low levels of output, spreading effect is more powerful than diminishing returns effect,
because small increase in output cause large reductions in AFC, AC decreases.

At higher levels of output, diminishing returns effect is more powerful, because AFC is already
very small, an increase in output has very small spreading effect, AC increases.

Thus, AC is also U-shaped.

ATC = AFC + AVC, when AVC’ = 0, ATC’ is negative because AFC’ is negative. Thus, when AVC
reaches the minimum, AC is still falling. We could conclude that the ATC curve reaches its
minimum at a larger level of output than the AVC curve.

4) MC passes through the lowest point of AVC and AC.

If MC < AVC (ATC), AVC (ATC) will decrease.
If MC > AVC (ATC), AVC (ATC) will increase.

5) TC is always increasing, because MC is positive.

If MC is positive, but decreasing, TC is increasing at a decreasing rate, the curve is bending

downwards.

If MC is positive and increasing, TC is increasing at an increasing rate, the curve is bending

upwards.
CAIE A2 Economics
Long-run production function - Notes

In the long run, all factors of production are variable inputs, fixed inputs do not exist.
To simplify, assume there are only 2 factors of production: labour and capital.

Iso-cost Lines
An iso-cost line represents the different combinations of two inputs or factors of production
that can be purchased with a given sum of money.

Assume the firm’s budget is equal to E, price of labour is PL and price of capital is PK.

The amount they spend on labour is the quantity of labour multiplied by its price: PLL.

The amount they spend on capital is the quantity of capital multiplied by its price: PKK.

If a producer uses all its money, PKK + PLL = E

Rearrange, k = E/PK – PL /PK * L

Isoquant
An isoquant is a curve showing all the various combinations of two factors that can produce a
given level of output. An isoquant map shows a set of iso-product curves. Each isoquant
represents a different level of output. A higher isoquant shows a higher level of output and a
lower isoquant represents a lower level of output.

The higher the isoquant output, the further right will be the isoquant. TP3 > TP2 > TP1.

Note that we could not conclude the exact level of output from the above diagram, unless it
is given.
Marginal rate of technical substitution (MRTS)
The slope of isoquant is marginal rate of technical substitution. This is the amount by which
the quantity of one input has to be reduced when one extra unit of another input is used so
that output remains constant.

Formula: MRTS = - MPlabour / MPcapital

The intuition behind it is as follows:

When the producer uses 1 more unit of labour, the output increases by MPlabour.
When the producer uses 1 less unit of capital, the output decreases by MPcapital.
Therefore, when producer uses 1 more unit of labour, they must reduce their use of capital
by MPlabour / MPcapital to keep total product constant and stay on the same isoquant.

Least-cost rule
Given a fixed budget, firms must try to produce the maximum amount of output. This is the
point of tangency between the iso-cost line and isoquant.

As TP2 is tangent to the iso-cost line, two curves have the same gradient at point A.
Gradient of iso-cost curve: – PL /PK
Gradient of isoquant: - MPlabour / MPcapital
Thus, at point A, MPlabour/Plabour = MPcapital/Pcapital.

This is the least-cost rule. It states that a firm wishing to produce a given amount of output at
minimum cost should employ factors of production so that the MPP per dollar spent on each
factor is the same.

Return to scale
Returns to scale is a long run concept about the relationship between a percentage increase
in all inputs and the resulting percentage change in output.

Assume that if a firm changes all inputs by 𝝀% then output changes by 𝝁%.
- If 𝝀>𝝁, then the firm experiences decreasing returns to scale (DRS).
- If 𝝀=𝝁, then the firm experiences constant returns to scale (CRS).
- If 𝝀<𝝁, then the firm experiences increasing returns to scale (IRS).
CAIE A2 Economics
Long-run cost function - Notes

As we noted earlier, all inputs are variable in the long run: this means that in the long run fixed
cost may also be varied. In the long run, in other words, a firm’s fixed cost becomes a variable
it can choose.

Long-run cost curve

The Long-run average cost (LRAC) curve shows the lowest possible average cost (AC) for any
given level of output when all the factors of production are variable. In other words, the LRAC
curve shows the relationship between output and AC when the quantity of factors that are
fixed in the SR has been chosen optimally for each level of output.

At any given point in time, a firm will find itself on one of its short-run cost curves, the one
corresponding to its current level of fixed cost; a change in output will cause it to move along
that curve. If the firm expects that change in output level to be long - standing, then it is likely
that the firm’s current level of fixed cost is no longer optimal. Given sufficient time, it will want
to adjust its fixed cost to a new level that minimizes average total cost for its new output level.

Important note: at any given level of output, LRAC is lower than SRAC. Thus, LRAC does not
pass through the lowest point of SRAC curves, unless at the lowest point of LRAC curve. The
lowest point of LRAC is called the minimum efficient of scale (MES).

Economies of scale
1) Internal economies of scale
This is a situation where LRAC decreases when output increases, it will lead to a downward
movement along LRAC curve.

- Financial economies
A bigger firm can get a better rate of interest than small firms. PLCS also have access to the
stock market and can raise finance through the issue of shares.

- Purchasing economies (bulk buying)

If you buy a large quantity, then the average costs will be lower. This is because of lower
transport costs and less packaging.
- Marketing economies
As the cost of advertising is fixed, when the firm grows in size, the average cost of advertising
decreases.

- Managerial economies
Large organisationsare likely to be able to afford to employ highly qualified specialist staff.
They may even be able to afford their own departments in areas such as exporting, marketing,
human resources, and administration.

- Risk-bearing economies
Some investments are very expensive and perhaps risky. Therefore only a large firm will be
able and willing to undertake the necessary investment.

2) Internal diseconomies of scale

This is a situation where the LRAC increases with output, it will lead to an upward movement
along LRAC curve.

Examples of internal diseconomies of scale include managerial diseconomies and alienation

of workers. As the firm increases in size, the complexity of the organisation may increase and
managers may find it more difficult to effectively co-ordinate production and monitor
performance. Communication may become more difficult, time-consuming and costly.

3) External economies of scale

This a situation where the LRAC of all the firms in an industry decreases as a direct
consequence of the growth of that industry. This will lead to an downward shift of the LRAC
curve.

If an industry becomes concentrated in a particular area it may benefit from improved

transport links and infrastructure. Ancillary industries may develop to provide supplies of
components. Specialist labour with specific skills may become available and colleges and
universities in the area may develop courses specifically linked to the industry. All of these
developments are likely to increase the productivity of all firms and reduce their average costs.

4) External diseconomies of scale

This is a situation where the LRAC of all the firms in an industry increases at every level of
output, this will lead to a upward shift of the LRAC curve.

This may be caused by traffic congestion and increase in cost of production.

CAIE A2 Economics
Revenue - Notes

Total revenue (TR) is defined as the total value of sales of a good or service, equal to the price
multiplied by the quantity sold.
TR = P * Q

Average revenue (AR) is defined as the revenue received by the firm per unit of output.
AR = TR / Q = P

Hence, the AR evaluated at a given level of output is equal to the demand price. The AR curve
is simply the demand curve. AR = D

Marginal revenue (MR) is defined as the change in TR generated by the sale of the last unit of
output. Graphically, MR is the slope of the TR curve at a given output. Mathematically, MR is
the derivative of TR.

Relationship between AR, MR and TR

1) If demand curve is downward sloping, to sell an additional unit of output, producers must
decrease price. This will have two effects on total revenue.

Price effect: after a price decrease, each unit sold sells at a lower price, which tends to
decrease revenue.

Quantity effect: after a price decrease, more units are sold, which tends to increase revenue.

For instance, as price decreases from $5 to $4, all 3 quantities originally sold at $5 are now
sold at $4, this causes a decrease in revenue equal to (5-4) * 3 = $3. On the other hand, an
additional unit of output is sold at $4, this causes an increase in revenue equal to (4-3) * 4 =
$4. Overall, the change in TR = MR = -3 + 4 = $1.

Note that MR is always less than AR, due to the negative price effect.

In the case of a linear demand curve: the AR and MR curves have the same vertical intercept.
The MR curve is twice steeper than the AR curve.
At low levels of output, the quantity effect is stronger than the price effect: as the monopolist
sells more, it has to lower the price on only very few units, so the price effect is small. Thus,
decrease in price (increase in quantity) will increase TR, MR is positive. In this case, PED > 1.

At high levels of output, the price effect is stronger than the quantity effect: as the monopolist
sells more, it has to lower the price on many units of output, making the price effect very
large. Thus, decrease in price (increase in quantity) will decrease TR, MR is negative. In this
case, PED < 1.

If decrease in price (increase in quantity) does not change TR, MR is zero. In this case, PED =
1.

2) If demand is perfectly price-elastic, it is a horizontal line. In that case, the firm does not
need to cut the price to sell more output. In other words, the price effect is zero. It follows
that the AR is equal to the MR, TR is linear and increasing. The higher the MR, the greater the
slope of TR curve.
Government intervention
Government may set a maximum price on a particular product. This will affect AR and MR.

If government introduces a maximum price, on the old AR curve, any price level above Pmax
is ineffective because firms are not allowed to sell goods at that price range.

As a result, AR becomes horizontal at price = Pmax, until quantity reaches Q1.

If AR is constant at Pmax, all goods are sold at Pmax. Thus, MR is also constant at Pmax, until
quantity reaches Q1.

After output Q1, when price is below Pmax, AR and MR curves are exactly the same as before.

Note that MR jumps at quantity Q1.

Numerical example: assume Pmax is 20, producers sell 3 units at this price.

When the producer sells the 3th unit, TR is 60, AR is 20, MR is 20.

After this quantity, producer has to lower price to sell more. Assume when the 4th quantity is
sold, price falls to 18. This means that all the previous 3 quantities need to be sold at 18.

Thus, TR is 72, AR is 18, MR is 12.

This shows that MR suddenly jumps after Q = 3.

CAIE A2 Economics
Profit - Notes

Profit is the difference between total revenue (TR) and total cost (TC). Total revenue is the
amount received by producers from the sale of products. Total cost is made up of all the
payments made to the factors of production: rent, wage, interest and profit. Clearly, profit
cannot be the difference between total revenue and total cost and an element of total costs,
unless we are referring to two different types of profit.

Explicit vs implicit costs

An explicit cost is a cost that requires an outlay of money. For example, the explicit cost of
the additional year of schooling includes tuition. Note that depreciation is considered as an
explicit cost.

An implicit cost does not involve an outlay of money. Instead, it is measured by the value, in
dollar terms, of the benefits that are forgone. For example, the implicit cost of the year spent
in school includes the income you would have earned if you had taken a job instead.

Note that the opportunity cost of any activity is equal to its explicit cost plus its implicit cost.

Accounting vs economic profit

Accounting profit is equal to revenue minus explicit cost.
Economic profit is equal to revenue minus the opportunity cost of resources used.

As opportunity cost is equal to the sum of implicit cost and explicit cost.

Thus, economic profit = account profit – implicit cost.

When economists use the term profit, they are referring to economic profit, not accounting
profit. Unless stated otherwise, the term profit will be used be refer to economic profit.

Normal profit
Normal profit refers to the minimum payment required to keep the factor of production in its
present use, this is known as the transfer earnings of the factor enterprise. If this amount is
not made, the entrepreneur will leave the industry for the next most profitable business
venture. Normal profit is the implicit cost of entrepreneurship.

If an entrepreneur makes normal profit, then the economic profit of the firm is zero. Thus,
total revenue is equal to total cost (TR = TC), average revenue is equal to average cost (AR =
AC).

Normal profit is not a specific sum of money, it will differ from entrepreneur to entrepreneur
and may vary over time as market conditions change.
Abnormal/supernormal profit
When an entrepreneur makes more than normal profit, the amount of economic profit above
normal profit is known as abnormal profit or supernormal profit.

If an entrepreneur makes abnormal profit, then the economic profit of the firm is strictly
positive: TR > TC, AR > AC.

An entrepreneur making abnormal profit earns more than enough to carry on with the
business. In other words, the entrepreneur would be worse off if he decided to run its next
best alternative business instead. It follows the present use of its entrepreneurial skills is
optimal.

Subnormal profit
When an entrepreneur makes less than normal profit, the amount of economic profit below
normal profit is known as subnormal profit.

If an entrepreneur makes subnormal profit, then the economic profit of the firm is strictly
negative: TR < TC, AR < AC.

An entrepreneur making abnormal profit earns less than enough to carry on with the business.
In that case, the entrepreneur would be better off running its next best alternative business
instead. It follows the present use of its entrepreneurial skills is not optimal.

Profit maximization: marginal analysis

For the operating firm, when MR > MC, it is advantageous for the firm to increase output as
each unit produced and sold brings in more revenue than it costs to produce and hence adds
to overall profit. However, if MR < MC, the last unit is making a marginal loss, firm should
decrease the output. Consequently, the firm will maximise profit at the output where MR=MC.
This condition is known as the optimum output rule. In that case, the difference between TR
and TC is the largest.

Note that even if firm is producing at the profit-maximisation level of output, it does not
guarantee that firm could earn abnormal profit. For instance, if AR is less than AC for the entire
range of output, the profit-maximisation level of outout is the level of loss minimization
output.

In practice, however, firms may not be able to do so in the theoretical manner. Evidence
suggests that firms rather adopt more simple strategies such as cost-plus pricing.

1) The firm may experience difficulty calculating and predicting its costs and revenue, and
therefore deriving its MR and MC schedules. It may have a particular problem predicting MR
for each level of output, since this requires the firm to have precise knowledge of the price
elasticity of demand for its product. If the firm is not able to obtain this information, then its
attempt to maximise profits will, at best, be an approximation to the theoretical ideal.
2) It should be noted that the theoretical model above is static, i.e. assumes a known,
unchanging cost and revenue structure. In reality, costs and revenues are dynamic; they
fluctuate over time, and do not all arise at the same time. This uncertainty means that a firm
cannot be sure if their current output and price is actually profit-maximising; it is a best-guess
given limited information at the current time.

Shut down Rule

A sunk cost is a cost that has already been incurred and is nonrecoverable. In the short run,
fixed cost is a sunk cost.

Consider the following two circumstances : If firm shuts down, it can eliminate all variable
costs, but it must still pay fixed cost; if firm stays in business, firm’s profit = TR – TVC – FC.
Thus, as long as TR > TVC (AR > AVC), it is better for firm to stay in business, in the short run.
If TR < TVC (AR < AVC), firm should immediately shut down.

At profit-maximisation level of output Q2, price is lower than AVC. Firm should shut down
immediately.

However, in the long run, all costs are variable costs, there are no sunk fixed costs. In this
case, a firm will stay in the market only if she can cover all costs and make at least normal
profit. This means TR > TC (AR > AC).
If TR < TC (AR < AC), firm should shut down, in the long run.

If market price is lower than P1, firm should shut down immediately; if market price is
between P1 and P2, firm could operate in the short run, but not in the long run. If market price
is higher than P2, there is no need for firm to leave the industry.
CAIE A2 Economics
Market structure - Notes

A market is a place where buyers and sellers meet, at a given point in time, to trade goods and
services. The market structure refers to the characteristics of a market.

According to CAIE syllabus, market structure should be explained by the following 4 factors:
1) The number of buyers and sellers
2) Product differentiation
3) Degree of freedom of entry
4) Availability of information

1) The number of buyers and sellers

If a market contains a large number of firms selling homogeneous products, then each firm’s
action cannot affect the market price of the good or service it sells. In this case, the firm is a
price-taker. The quantity of output sold by a price-taking firm has no influence on the market
price, firms face a perfectly price-elastic individual demand curve.

On the other hand, if a firm has some degree of market power, then its action can affect the
market price of the good or service it sells. In this case, the firm is a price-setter. A price-setting
firm is facing a downward demand curve. It can either sell a certain price and sell the quantity
as indicated by the demand curve or sell the desired quantity at the market price indicated by
the demand curve. However, note that the firm faces the market demand curve, which means
that they could not set the price and quantity at the same time: the price-setting decision
must lie on the market demand curve.

2) Product differentiation
A good is a standardized product when consumers regard the products of different producers
as the same good. Consumers regard the output of one producer as a perfect substitute for
another producer. Consequently, producer cannot increase the price for his product without
losing all sales to other producers, as all products are homogeneous.

By contrast, product differentiation refers to a situation where the firms operating in a

particular market produce goods or services that are similar but not identical. The goods or
services sold in the market are regarded as imperfect substitutes by the consumers, so price
is not the only selection criterion. Therefore, product differentiation creates market power
and reduces the intensity of competition by decreasing the PED. This all means that product
differentiation gives each individual firm some scope of market power to influence price.

There are 3 important forms of product differentiation: differentiation by style or type,

differentiation by location, and differentiation by quality.
3) Degree of freedom of entry
Barriers to entry are factors that prevent or make it difficult for new firms to enter a market.
The existence of barriers to entry make the market less contestable and less competitive.

• legal barriers
This is the barriers to entry that are due to the law. A legal patent can provide a high entry
barrier because other firms can’t use its patent. For instance, a pharmaceutical company can
get a drug patent for seven years, meaning no one else can sell that particular drug. A tight
government regulation of an industry also creates high entry barriers. For instance, if a
government requires firms to pass quality control before allowing them to sell their product,
potential entrants may be deterred.

• market barriers
Developing consumer loyalty through establishing a strong brand image can deter entry. With
a very strong brand image, a new firm would have to spend a lot of money on advertising,
which is a sunk cost and a deterrent to entry. For example, many firms have tried to enter the
cola market, but none have been able to dislodge Coca-Cola and to a lesser extent Pepsi.

• cost barriers
Potential entrants may have higher production costs than incumbent firms, based on two
possible reasons. Firstly, due to imperfect information, potential entrants are unaware of the
most efficient technology. Secondly, new firms will find it difficult to compete because their
average costs will be higher than the incumbent firms benefiting from economies of scale.
This usually occurs if the industry is a natural monopoly, because high fixed costs make up a
large proportion of total costs so there is a first mover advantage.

• physical barriers
These are barriers that arise due to pricing or output decisions made by the incumbent
specifically to deter potential competitors. Limit pricing occurs when a firm sets price
sufficiently low to deter entry. A monopoly may engage in limit pricing - even though it means
fewer profits, it prefers to keep prices lower to prevent competition. Predatory pricing occurs
when an incumbent firm responds to a new firm entering the market by starting a price war
and trying to push the rival firm out of business. It is illegal so it may be difficult to implement
in practice. Vertical integration occurs when a firm has control over the supply and distribution
of the good. For example, oil companies can keep the price of petrol very high to discourage
new petrol retailers. If a new firm wants to enter the retail petrol market, it will have to buy
petrol from one of the big oil companies, who can set a high price, thereby discouraging entry
into the petrol market.

Barriers to exit are obstacles which prevent a firm from leaving a market quickly and at little
cost. These includes costs of making employees redundant, high investment in non-
transferable fixed assets and contract contingencies with suppliers or buyers. An
entrepreneur making subnormal profit will be better off staying in the market rather than
leaving if the barriers to exit are high enough.
4) Availability of information
Perfect information occurs when all consumers and producers are assumed to have perfect
knowledge of price, utility, quality and production methods of products. If buyers have only
imperfect knowledge as to price, cost and product quality, they have imperfect information.

Concentration ratios
Concentration ratios are used to determine the market structure and competitiveness of the
market. The n-firm concentration ratio measures the combined market shares of the n largest
firms. It could be a 3 firm concentration ratio (market share of 3 biggest) or a 5 firm
concentration ratio.

A high concentration ratio indicates that a few firms produce most of the industry output.
Therefore, a high concentration ratio usually signals substantial market power and low
competition.

Note that concentration ratios fail to account for the distribution of market shares among the
top firms.

Types of market structure

In order to develop principles and make predictions about markets and how producers will
behave in them, economists have developed four principal models of market structure:
perfect competition, monopoly, oligopoly, and monopolistic competition. This system of
market structures is based on two dimensions:

• The number of producers in the market (one, few, or many)

• Whether the goods offered are identical or differentiated

In monopoly, a single producer sells a single, undifferentiated product, barriers to entry are
very high.

In oligopoly, a few producers - more than one but not a large number - sell products that may
be either identical or differentiated. There is some level of entry barriers, which depend on
the industry.

In monopolistic competition, many producers each sell a differentiated product, there is no

entry barrier.

In perfect competition, many producers each sell an identical product, there is no entry barrier.
CAIE A2 Economics
Perfect competition - Notes

A market is perfectly competitive if there are many buyers and many firms selling
homogeneous goods. These agents operate under perfect knowledge, perfect labour mobility,
zero barriers to entry and exit, and no externalities.

All agents in a perfectly competitive market are price-takers. They buy and sell for the price
determined by the equilibrium between market supply and demand, which they cannot
individually affect.

In the real world, it is hard to find examples of industries which fit all the criteria of ‘perfect
knowledge’ and ‘perfect information’. However, some industries are close.

1) Foreign exchange markets.

Currency is all homogeneous. Also, traders will have access to many different buyers and
sellers. There will be good information about relative prices; when buying currency it is easy
to compare prices

2) Agricultural markets.
In some cases, there are several farmers selling identical products to the market, and many
buyers. At the market, it is easy to compare prices. Therefore, agricultural markets often get
close to perfect competition.

Equilibrium in perfect competition

The diagram on the right below shows a perfectly competitive market in equilibrium, market
price is determined by industry demand and supply, which is Pe. The invididual firm must take
this price Pe. Therefore, it faces a perfectly elastic demand curve, which is equivalent to its AR
and MR curve.

Profit-maximisation firm will produce at Qe, where MC = MR. At this point, AR > AC, the firm
is making supernormal profit, as indicated by the shaded area.
However, as there is no barrier of entry, this will attract new firms entering the industry and
shifting the industry supply curve to the right and reducing the market price.

This process continues until there are no longer any supernormal profits. This will occur when
demand curve is tangential to the minimum point of the AC curve and firms making normal
profits.

Similarly, if AR < AC, the firm is making a loss. Firms in this position will ultimately leave the
industry and the industry supply curve will shirt to the left driving up the market price. In this
case, the horizontal demand curve for the individual firm shifts upwards. This process
continues until when demand curve is tangential to the minimum point of the AC curve and
firms making normal profits.

The long-run equilibrium for the firm and industry occurs at the point where all firms are
making normal profits.
Individual supply curves
If market price is Pe, the firm must take this price Pe. Therefore, it faces a perfectly elastic
demand curve, which is equivalent to its AR and MR curve.

Profit-maximisation firm will produce at Qe, where MC = MR. This is presented by point X.

If market price rises to P1, firm’s MR and AR curve also shifts up, firm will produce at Q1,
where MC = MR1. This is presented by point Y.

Similarly, if the price rises to P2 the firm will produce at point Z. Thus, all the points X,Y,Z lie
on the firm’s supply curve.

However, not all points on MC curve lie on firm’s supply curve.

In the short run, firm could operate only if price is greater than AVC. Thus, the individual supply
curve is given by the increasing section of the MC curve which lies above the minimum of the
AVC.

In the long run, firm should operate only if price is greater than AC. Thus, the individual supply
curve is given by the increasing section of the MC curve which lies above the minimum of the
AC.
Industry supply curves
The industry supply curve shows the relationship between the price of a good and the total
output of the industry as a whole. Industry’s supply curve is the horizontal summation of
individual supply curves.

The short-run industry supply curve shows how the quantity supplied by an industry depends
on the market price given a fixed number of producers. In the short run, the individual supply
curve is given by the increasing section of the MC curve which lies above the minimum of the
AVC. Thus, industry supply curve is also upward sloping.

The situation is different in the long run. A market is in long-run market equilibrium when the
quantity supplied equals the quantity demanded, given that sufficient time has elapsed for
entry into and exit from the industry to occur.

Assume market price is Pe and firm is making abnormal profit by producing at MC = MR = Pe.
This implies that the lowest point of AC is Pe. If there is an increase in market demand, price
increases, firm is making abnormal profit. However, this will attract new firms entering the
market and drives down the market price. This process will stop until all firms are making
normal profits again. Since the lowest point of AC is Pe, after adjustments, the market price
will return to P1. Thus, although there is an increase in output from new entrants, there is no
change in market price.

Assume there is constant cost, long-run industry supply curve is perfectly elastic at lowest
point of AC.
CAIE A2 Economics
Monopoly – Notes

A producer is a monopolist if it is the sole supplier of a good that has no close substitutes.
There is high barrier of entry so firms could make abnormal profits in the long run.

In the UK a firm is said to have monopoly power if it has more than 25% of the market share.
For example, Tesco has 30% market share or Google has 90% of search engine traffic.

Sources of monopoly
Internal Growth is achieved when firms retain some of the profit and plough it back in the
form of new investment to increase their productive capacity. For example, Google became a
monopoly through dominating the search engine market.

External growth is achieved when firms join under common ownership through mergers or
takeovers. A horizontal integration is a merger or takeover between firms operating in the
same industry and at the same stage of the production process. A vertical integration is a
merger or takeover between firms in the same industry, but at different stages of the
production process.

The most important legally created monopolies today arise from patents and copyrights. A
patent gives an inventor the sole right to make, use, or sell that invention for a period that in
most countries lasts between 16 and 20 years. Patents are given to the creators of new
products, such as drugs or devices.

Monopolies also need barriers to entry to protect them from new firms entering the market.
Barriers to entry can include – brand loyalty through advertising and economies of scale.

Equilibrium in monopoly
Compared to competitive market, a monopolist has some degree of market power: it could
raise price above the competitive level by reducing output. Note that even though the price
of product increases, it keeps many of its customers, because they have nowhere else to go.

Profit-maximisation monopolist would produce at Q1, where MC = MR. At this point, price is
P1, shaded area represents abnormal profit. On the other hand, firms in competitive market
would produce at Q2 with price equal to P2. Thus, output is likely to be lower in monopoly
while prices are likely to be higher, this leads to a fall in consumer surplus.
Natural monopoly
A monopoly created and sustained by increasing returns to scale is called a natural monopoly.
The defining characteristic of a natural monopoly is that it possesses increasing returns to
scale over the range of output that is relevant for the industry. The natural monopolist’s ATC
curve declines over the output levels at which price is greater than or equal to average total
cost. The source of this condition is large fixed costs: when large fixed costs are required to
operate, a given quantity of output is produced at lower average total cost by one large firm
than by two or more smaller firms.

An example of a natural monopoly is tap water. There are very high capital costs involved in
setting up a national network of pipes and sewage systems, so the most efficient way to
provide tap water is to have just one company.

Monopoly vs perfect competition

Usually, a monopolist produces less and charges higher, compared to competitive market.
However, if firm gained a significant enough reduction in its long-run costs as a result of the
economies of scale which sole producers often enjoy, it may cause the market price to fall and
quantity to rise. This is especially possible if the industry is one suited to a natural monopoly
due to falling average costs over a wide range of output.

If the firm’s cost curves fall sufficiently, AC and MC curves would shift to LRAC and LRMC
curves respectively. If the firm is producing at profit maximization output, the output is Q3.
Although the firm is still making abnormal profit, the output is higher than Q2, which is higher
than the perfectly competitive output of Q2 with the previous higher cost curves. Furthermore,
the firm sets its price at P3, this is also lower than the perfectly competitive price P2.

Disadvantages of monopoly
1) Inefficient use of resources
This includes allocative inefficiency, X-inefficiency and deadweight loss. We will discuss this in
next chapter.

2) Higher prices
Monopolies face inelastic demand, they charge higher prices, consumer surplus will reduce.
Advantages of monopoly
1) Dynamic efficiency
Monopolies can make supernormal profit, which can be used to fund high-cost capital
investment spending. Successful research can be used for improved products and lower costs
in the long term. Consider the industry of pharmaceuticals. As the development of medical
drugs has a high risk of failure, monopoly profits may give a firm greater confidence to take
risks. We will discuss this more in next chapter.

2) Economies of scale
Increased output will lead to a decrease in average costs of production. These can be passed
on to consumers in the form of lower prices.

3) International competitiveness
A domestic firm may have monopoly power in the domestic country but face effective
competition in global markets. With markets increasingly globalised, it may be necessary for
a firm to have a domestic monopoly to be competitive internationally.

4) Subsidise loss-making services

Another potential advantage of a monopoly is that they can use their supernormal profit to
subsidise socially useful but loss-making services. For example, a train company can use its
monopoly power to set high prices on peak services, but this allows the firm to subsidise
unprofitable late-running services on Saturday night, which is useful for people going out for
the night.

Price discrimination
Price discrimination occurs when different prices are charged to different customers and
when the different prices are not a reflection of differences in the costs of production. There
are three degrees of price discrimination.

1st price discrimination occurs when producer knows exactly how much each consumer is
willing to pay and sell it to each of them at this price. This enables a seller to capture all
consumer surplus. First degree price discrimination is usually practiced by lawyers and doctors.

Under 1st degree price discrimination, the shaded area represents all producer surplus:
consumer surplus is zero.
2nd degree price discrimination involves creating differentiated versions of a product and
selling them for different prices. This would get consumers to reveal their willingness to pay
and select the suitable version of the product for themselves, which is known as self-selection.
For instance, front seat and back seat cost the same to produce. However, since one is
perceived as more valuable, it allows the theatre to sell them at different prices. The firm gives
consumers the change to select the seat which best matches their willingness to pay and those
have higher willing to pay will buy the more expensive seat.

3rd degree price discrimination refers to the selling of the same product in different markets
to different consumers at different prices. For example, peak-time business travelers have a
more inelastic demand than off-peak leisure travelers, enabling them to be charged a higher
price.

Conditions for successful price discrimination

For price discrimination to be successful, it must be possible to separate the markets. Markets
could be separated in a number of ways according to age of customer, status or time of travel,
this could prevent the possibility of reselling.

Note that the 3rd degree price discrimination requires there to be clear, identifiable segments
of consumers in the market, and knowledge of the differing PEDs for each segment.

Evaluate price discrimination

Under price discrimination, some customers will lose out and pay a price higher than marginal
cost, this results to allocative inefficiency. However, often people with inelastic demand have
greater ability to pay than people with elastic demand. Thus, the higher prices paid by inelastic
customers can subsidise lower prices for other groups of consumers, this enables a fairer
distribution of resources in society.

Another potential benefit of profit is that it might enable a firm to stay in business, who
otherwise would go out of business. For example, without price discrimination a train firm
may not be able to survive. There might be no one individual price greater than average cost.
However, through price discrimination, it can cover its losses and stay in business. In this case
price discrimination is beneficial for consumers, it is better to have higher prices than to have
no service at all.
CAIE A2 Economics
Monopolistic competition - Notes

Monopolistic competition is a market structure in which there are many competing producers
in an industry, each producer sells a differentiated product, and there is free entry into and
exit from the industry in the long run.

Monopolistic competition is often considered a more realistic market structure than perfect
competition or monopoly.

Examples of monopolistic competition:

1) Restaurants compete on quality of food as much as price. Product differentiation is a key
element of the business. There are relatively low barriers to entry in setting up a new
restaurant.

2) Hairdresser is a service which will give firms a reputation for the quality of their hair-cutting.

Price-setting power
Since consumers face a wide choice of differentiated products, price is not the only selection
criterion so the demand facing a monopolistically competitive firm is not perfectly price-
elastic as was the case in perfect competition.

If an individual firm raises its price it will lose some market share, but not all.

If an individual firm reduces its price then it is likely to attract more customers, but not the
whole market demand.

Therefore, the demand facing each monopolistically competitive individual firm is downward
sloping: monopolistically competitive firms have a certain amount of market power and are
thus price maker.

However, the demand curve facing a monopolistically competitive individual firm is likely to
be relatively price-elastic because there are many other firms supplying close substitutes.

Therefore, the market power of each monopolistically competitive firm is likely to be relatively
weak. In order to increase its market power, a monopolistically competitive firm can use non-
price competition strategies such as investment in advertising that develop a strong brand
image and makes the individual demand it faces less price-elastic.
Short-run equilibrium
We assume that every firm has an upward - sloping marginal cost curve but that it also faces
some fixed costs, so that its average total cost curve is U-shaped. Since firms in monopolistic
competition have price-setting power, it looks like any monopolist.

For an individual firm, the profit maximising output is at Q1 where MC = MR. At this point,
price is P1, which is higher the AC. Firms earn abnormal profit, as represented by the shaded
area.

It is also possible for firms to make subnormal profit. This occurs if price is lower than AC at
the profit-maximisation level of output.

Long-run equilibrium
Because the differentiated products offered by firms in a monopolistically competitive
industry compete for the same set of customers, entry or exit by other firms will affect the
demand curve facing every existing producer. For instance, if new gas stations open along a
highway, each of the existing gas stations will no longer be able to sell as much gas as before
at any given price. Thus, entry of additional producers into a monopolistically competitive
industry will lead to a leftward shift of the demand curve and the marginal revenue curve
facing a typical existing producer.

The industry will be in long-run equilibrium when there is neither entry nor exit. This will occur
only when every firm earns zero profit. Equilibrium level of output is Q1 with market price P1.
At this point, AC = AR.
Monopolistic competition vs perfect competition
For both markets, they have large number of sellers. With no entry barrier, all firms earn
normal profit in the long run. The key difference between two markets is product
differentiation. If a firm faces a downward demand curve, MR < AR = P. Profit maximization
level of output is where MC = MR. At this point, price charged is higher than marginal cost.

Advertising
Since price is higher than marginal cost, if the firm gets a few more customers than he
expected at the posted price, an additional sale at this price increases his revenue more than
it increases his costs because the posted price exceeds marginal cost. Thus, monopolistic
competitor usually engages in activities like advertising to build brand loyalty and increase
sales. This does not happen under perfect competitive market.

Consumers are not as rational as economists typically assume; they could be influenced by
ads that do not really provide any information about the product. Firms spend billions on
advertising because repeated exposure to famous brands can make consumers more likely to
buy ‘trusted’ brands. For instance, the big advertisement probably means that it’s a relatively
large, successful company - otherwise, the company wouldn’t have found it worth spending
the money for the larger advertisement. The same principle may partly explain why
advertisements feature celebrities: an expensive advertisement serves to establish the quality
of a firm’s products in the eyes of consumers.

Brand name
A brand name is a name owned by a particular firm that distinguishes its products from those
of other firms. In many cases, a company’s brand name is the most important asset it
possesses: clearly, McDonald’s is worth far more than the sum of the deep - fat fryers and
hamburger grills the company owns. In fact, companies often go to considerable lengths to
defend their brand names, suing anyone else who uses them without permission.

Excess capacity
Another difference between two markets is the position of each firm on its average total cost
curve. Firms in perfectly competitive market produce at the lowest point of AC. Under
monopolistic competition, the firm produces on the downward-sloping part of the AC curve:
it produces less than the quantity that would minimize average total cost. This means firm has
excess capacity: it does not take maximum advantage of available cost savings.
CAIE A2 Economics
Oligopoly – Notes

An oligopoly is an industry dominated by a few large firms: they produce relatively

homogeneous products. There must be some barriers to entry to enable firms to gain a
significant market share. These barriers to entry may include brand loyalty or economies of
scale. However, barriers to entry are less than monopoly.

Under the conditions above, there emerges a competitive environment where firms are
mutually interdependent, in the sense that they cannot make their decisions on pricing and
output in isolation. They have to anticipate how their competitors will respond to their actions,
and factor that into their decision-making process. The reason for this interdependence is that
an oligopoly is comprised of a few large firms, where the word ‘large’ implies that the actions
of a single firm can affect market conditions. This is unlike monopolistic competition, where
firms are taken to be small; because no single firm can affect market conditions, every firm
can make their decisions independently.

Probably the most important source of oligopoly is the existence of increasing returns to scale,
which give bigger producers a cost advantage over smaller ones. When these effects are very
strong, they lead to monopoly; when they are not that strong, they lead to an industry with a
small number of firms.

An industry with a five-firm concentration ratio of greater than 50% is considered an oligopoly.

Examples of oligopolies:
1) PC microprocessor: Intel, AMD
2) Aircraft: Boeing, Airbus
3) Operating systems: Windows, MacOS, Linux
4) Smartphone O.S.: Android, Apple

To understand more fully how oligopolists behave, economists, along with mathematicians,
developed the area of game theory, which is the study of behavior in situations of
interdependence.

Game theory helps us understand oligopoly.

The Prisoners’ Dilemma

Prisoner’s dilemma is a competitive situation in game theory. Two prisoners are accused of a
crime. If one confesses and the other does not, the one who confesses will be released
immediately and the other will spend 10 years in prison. If neither confesses, each will be held
only 1 year. If both confess, they will each be jailed 8 years.
A payoff matrix shows how the payoff to each of the participants in this two-player game
depends on the actions of both.
B: Confess B: Deny
A: Confess A=8,B=8 A=0,B=10
A: Deny A=10,B=0 A=1,B=1

Let’s assume that the prisoners have no way to communicate and each act in her own self-
interest. From person A’s point of view: she is better off confessing, regardless of what Louise
does. If person B doesn’t confess, Person A’s confession reduces her own sentence from 1
year to 0. If person B does confess, person A’s confession reduces her sentence from 10 to 8
years. Either way, it’s clearly in person A’s interest to confess. And because she faces the same
incentives, it’s clearly in person B’s interest to confess, too. To confess in this situation is a
type of action that economists call a dominant strategy: an action is a dominant strategy when
it is the player’s best action regardless of the action taken by the other player.

When they both confess, they reach an equilibrium of the game: it is an outcome in which no
individual or firm has any incentive to change his or her action. This kind of equilibrium is
known as Nash equilibrium: which is the situation where the outcome in which neither player
can improve their payoff, given what the other player chooses. This is why (deny,deny) cannot
be an equilibrium; either player could improve their own payoff by choosing confess.

Application in oligopoly
The payoffs represent the expected profits for each firm given their pricing strategy.

High price (B) Low price (B)

High price (A) 15,15 5,20
Low price (A) 20,5 10,10
The Nash equilibrium is for both firms to set low prices; this earns them a profit of 10. If they
both set high prices, they could have earned a profit of 15 each, However, (high,high) could
not be an equilibrium: if one firm sets a high price, the rival will set a low price to gain possibly
every customer in the market. To avoid that happening, they both end up setting low prices.

Note that if two firms could collude to set high prices, profits for both firms would increase.

Thus, the outcome in Oligopolistic market is uncertain: it depends on whether firms collude
or not.
1) It is possible to have a high market price, if firms collude. There are two types of collusions:
formal collusion and tacit collusion.

2) It is possible to have price war, if firms engage in noncooperative behavior. The purpose of
price war is to drive the competitor out of the industry.

3) It is possible to have stable price, if firms concentrate on non-price competition. Firm will
use product differentiation to increase sales.
Collusion
1) Formal collusion
Formal collusion occurs when rival firms enter into a firmal agreement in order to limit
competition and maximize their joint profit. Most formal collusive agreements result in lower
output and higher price. A group of firms engaging in formal collusion is known as a cartel.

Formal collusion can either be overt (i.e. open for everyone to see) or covert (i.e. designed to
be hidden from legal authorities). Most formal collusion is covert rather than overt, a notable
exception being the Organization of the Petroleum Exporting Countries (OPEC).

The diagram shows the joint profit maximization under cartel, market price is P1 which is
higher than AC, firm could earn supernormal profit.

Conditions for successful collusion

1) High entry barriers
Collusion will bring abnormal profits for existing firms. This will attract new firms entering the
market, if there are low entry barriers.

2) Similar cost structure

If one firm has significant cost advantage over its rivals, it does not have an incentive to collude.
Instead, it is possible that this firm will use predatory pricing to force the competitors out and
earn higher market share in the future.

3) Accurate information about each other

Firms always have an incentive to cheat to make a higher profit. It is only when they can easily
monitor each other and be sure that the agreement is being honored that collusion will be
worth it and succeed.

4) Stable market
If demand keeps fluctuating, and market conditions are uncertain, then firms will want to be
flexible. This makes it difficult to collude, since collusion massively decreases the individual
firm's ability to respond to volatile market conditions.
Incentive to cheat
By colluding, firms maximize their joint-profit but they might fail to maximize their individual
profit. Therefore, firms within the collusive agreement have an incentive to break ranks and
increase their own output or sell at a lower price in order to increase their individual profit.

Example: There are 20 firms; the competitive quantity produced by each firm is 25 units so
the competitive industry quantity is 500 units at $12. After the cartel forms, each firm agree
to restrict output to 20 units, so the industry quantity reduces to 400 units at $15.

When the cartel successfully raises the price, firms in the industry have an incentive to cheat.
The incentive to cheat is illustrated by the area B.

If a single firm increases output to 30 units while the rest of the firms are producing 20 units,
the single firm will earn larger profits. Profit is maximized when the cheating firm produces 30
units at point C while receiving the cartel price.

However, if every firm in the cartel decides to cheat, then the quantity produced in the
industry will increase which will decrease the price. The price will fall below monopoly price
and profit will not be maximized.

Antitrust policies
Collusion is illegal in most countries including EU countries and the USA. Policies targeted at
preventing oligopolistic industries from becoming or behaving like monopolies and breaking
up existing ones are known as antitrust policies. However, in practice, competition authorities,
such as the UK’s Competition and Markets Authority, find it difficult and often inconclusive to
investigate into anti-competitive behaviour and to prove either tacit or formal agreements.
This is because price similarities can be simply due to similar cost structures rather than the
outcome of a collusive agreement.

In the 1990s, the U.S. instituted an amnesty program in which a cartel member received a
much reduced penalty if it provided information on its co-conspirators. In addition, the U.S.
Congress substantially increased maximum fines levied upon conviction.
2) Tacit collusion
Tacit collusion occurs when rival firms enter into an unwritten agreement aimed at restricting
competition. Tacit collusion is not illegal. It involves an unwritten agreement between two
firms to not compete with each other through a price war. A typical example might be where
two large bus companies in a town agree not to cut fares in order to compete. Th ere may also
be a tacit agreement to not develop new routes that duplicate each other’s services since each
company’s costs would rise and profits reduce accordingly.

Tacit collusion may be enforced through some form of price leadership. There are three
common models.

Under dominant price leadership, the leader firm will have a dominant position in the market
in terms of its output and market share. Other firms will be likely to keep to the agreement
for fear that if they do not their existence could be threatened by an aggressive pricing
strategy by the dominant firm.

Under collusive price leadership, the price leader will behave in the interests of all firms: the
price will set high enough so that the least cost-efficient firm in the market may earn some
return above the competitive level.

Under barometric price leadership, the leadership will not by a dominant firm, but by a firm
that has consistently been seen to judge market conditions accurately over time. This does
not require the price leader to have a high degree of dominance.

Firms that have a tacit agreement not to compete on price often engage in vigorous non-price
competition, including branding and advertising, and the following forms:

Some big businesses have invested considerably in loyalty cards which give ‘rewards’ or
money back to customers who build up points/spending. Airlines use Airmiles to try and
encourage repeat custom while supermarkets use loyalty cards.

Direct mailing is a key method of retaining customers is through gaining access to their email
address and then sending targetted promotions and news about new features/products.
Some firms may give loyal customers the chance to get special deals or products not available
to the mass market.

Amazon has been successful at pushing prime delivery accounts, this promises free next day
delivery. Although the cost of delivery is often higher than what a customer is actually paying,
in the long-term, the convenience of prime delivery is changing shopping habits. Buying
something on Amazon and having it arrive at your doorstep the next day, means customers
are not wanting to go into traditional stores. Amazon is steadily gaining more market share.

Other forms of non-price competition: After-sales service, cultivation of good reviews,

bundles of products, foreseeing trends in markets.
Non-collusive oligopoly – the kinked demand curve model
The kinked demand curve model suggests that prices will remain stable. It is assumed that if
a single firm attempts to raise prices, its rivals will not follow, since they have an opportunity
to capture a greater market share. Therefore, the demand curve above market price is
relatively price elastic. Conversely, if a single firm attempts to cut prices, its rivals will have to
do so as well, since they would not allow themselves to be undercut. However, since all firms
are cutting prices, there is limited change in market share, the demand curve below market
price is relatively price inelastic.

According to the diagram, there is a kink in the demand curve at market price P1 and a vertical
segment of the marginal revenue curve. As a result, there is some price rigidity in the market:
as long as the marginal cost intersects the marginal revenue curve at its vertical segment, the
firm’s equilibrium is to produce Q1 at P1. Even if costs are rising, MC shifts to MC1 or MC2,
the equilibrium remains the same. Firms try to avoid price competition for fear of a price war,
so they follow the policy of price rigidity, and use other methods like advertising, better
services to customers etc. to compete.

However, the kinked demand curve model makes a lot of assumptions which may not stand
up in the real world. Firstly, it does not explain how the initial equilibrium is established, we
only know the market is rigid at P1. Secondly, a firm cannot assume that others will respond
to a price cut by also cutting prices. There is a great uncertainty: perhaps the firm wants to
avoid a price war. Therefore, a firm may cut prices hoping that others won’t follow suit. This
will happen if the firm is pursuing profit maximisation.

Price war
If firms are keen to increase market sales, they may be more confident to cut prices and see
how much market share they can gain. An oligopolist would only start a price war if its costs
of production were significantly lower than those of its rivals. A price war may be the natural
outcome of events, such as overcapacity in the industry or the entry of new firms. It could also
be a defensive tactic where an oligopoly is losing market share to its rivals.
CAIE A2 Economics
Objectives of firm – Notes

Dissatisfaction with the traditional assumption of profit maximizationhas led to a number

alternative objectives being put forward to explain how firms behave. These are invariably
based on empirical investigation and are referred to as behavioural or managerial objectives.

Principal-agent problem
Principal agent problem occurs when principals may have different objectives from the agents
and principals can’t guarantee that their agents will operate in the principals’ best interests.
The main reasons for the principal-agent problem are conflicts of interests between two
parties and the asymmetric information between them (agents tend to possess more
information than principals).

Within large public limited companies, it is often argued that there is a divorce of ownership
from control, which is the result of principal-agent problem. The owners of the company are
the shareholders (principal), they normally appoint managers (agents) to run the company.
Shareholders will wish to make the maximum income possible from the investments and so
they will wish the firm to maximise profits. However, managers have much less incentive to
maximise profits because they do not get the same rewards as the shareholders. Instead,
managers may concentrate on enjoying work and getting on with workers.

Consequences of principal-agent problem

The principal-agent problem can cause adverse selection - poor choices based on asymmetric
information. This is where the agent has private information before a contract is written. For
example, a lazy worker gets a job because the employer doesn’t know he is lazy.

The principal-agent problem can also lead to an individual taking an excessive risk because the
ultimate cost is borne by someone else. For example, an investment banker may gain a bonus
for making high profits. This encourages the banker to take risky investments. If he fails and
loses $700m, the losses are absorbed by the bank, but not by the individual banker.

Solutions to the Problem

1) Contract design
The main purpose of contract design is the creation of a contract framework between the
principal and the agent to address issues of information asymmetry, stimulate the agent’s
incentives to act in the best interests of the principal, and to determine procedures for
monitoring agents.

2) Performance evaluation and compensation

The agent’s compensation is the primary method of aligning the interests of both parties. In
order to address the principal-agent problem, the compensation must be linked to the
performance of the agent. For instance, firms may adopt share and profit sharing schemes for
managers, in order to increase their incentives to pursue profit as one of their objectives.
Modern managerial theories
Modern managerial theories acknowledge that managers are likely to pursue other objectives
than profit maximization, including
1) profit satisficing.
2) revenue maximization.
3) sales maximization.
4) altruistic goals (e.g. fair trade, corporate social and environmental responsibility, etc.).

Profit Satisficing
Satisficing is a decision-making strategy that aims for a satisfactory rather than the optimal
solution.

Profit satisficing is a behaviour under which the managers of firms aim to produce satisfactory
profits rather than maximum profits.

Managers do just enough to keep the shareholders off their backs so they are free to maximize
their own reward (e.g. salary, prestige, managerial perks, etc.).

Revenue & Sales Maximization

There is some evidence to suggest that managers’ pay, conditions and prestige are linked to
the size of the company, which is in turn linked to the value or volume of sales, rather than
profit.

TR is maximized when the MR is equal to zero: MR = 0.

Sales are maximized subject to normal profit: AR = ATC.
Note that revenue & sales maximization are subject to a profit satisficing constraint.

A firm maximizing total revenue or sales rather than profit sells a larger output at a lower price.
Total revenue or sales maximization fails to maximize profit in the short run but it might
maximize profit in the long run. Indeed, the lower price can deter the entry of new
competitors into the market (i.e. limit pricing) or drive competitors out of business (i.e.
predatory pricing).

Shareholders may also buy stock where they feel there is the potential for long-run growth.
In recent years, several big tech firms have prioritised market share and revenue growth -
rather than profit. The logic was that because the industry was new, there was a benefit to
gaining a strong market share at the start of the industry. For instance, Amazon prioritised
growth and reinvested any profit into growing the business in recent years, it was even willing
to run some services at a loss to gain market share. Thus, shareholders were happy to hold
Amazon stock, even though it wasn’t making profit.

Unit cost minimization

If firm wants to minimize its average cost of production, it will produce at the minimum point
of AC, where MC = AC.
Summary:

At Q1, MC=MR, this is profit maximization output.

At Q2, MC = AC, this is cost minimization output.

At Q3, AR>AC, this is profit satisficing output.

At Q4, MR=0, this is sales revenue maximization output.

At Q5, AC=AR, this is sales maximization output.

Altruistic goals
Increasingly firms have to consider the environment. Co-operatives may wish to help
consumers or producers as in the ‘fair trade’ movement. State run enterprises may be
concerned with proving a service for the public. Some business owners may feel the necessity
of making a contribution to the local community, be generous to their workers or look after
the environment. Therefore they make choices which don’t necessarily maximise profits but
make them feel better because they have done something of social value.

Loss minimisation
In some situations firms may have a short-term objective of minimising losses. This is most
likely to be where a fi rm is facing serious unexpected external threats such as the loss of its
best customer or a downturn in the economy due to some external shock. Survival in such
circumstances becomes a priority in order to allow the firm to develop a revised strategy to
stay in business.

Other objectives
Many small and medium-sized firms are not listed on the stock market but are privately owned.
If they are privately owned, they have greater freedom to choose whatever objective they
wish. This may be to continue family ownership and run the business in a traditional way.

For example, a bookseller may concentrate on physical bookshops rather than move into e-
books because it feels traditional books have more value than e-books, even if it is not as
profitable.
Contestable market
A contestable market is any market structure where there is a threat that potential entrants
are free and able to enter the market to compete for profit. The determinant of a market’s
contestability are its barriers to entry and exit.

A market is said to be perfectly contestable where there are no barriers to entry so there is a
threat of entry from potential competitors. If incumbent firms took advantage of their market
power by charging a price above their ATC, then the absence of barriers to entry would attract
new firms into the industry until any abnormal profit has been competed away. Thus, in the
long run, firms only earn normal profits.

However, since no market in the world is perfectly contestable, all markets are contestable to
varying degrees. There is potential for new firms to enter and offer a substitute or alternative
product to the one sold by the incumbent. As a result, it might set prices relatively close to
average costs to prevent this from happening. This is known as limit pricing. In order for it to
be successful, it is necessary for the incumbent firm to have an accurate knowledge of the
cost structure of potential entrants.

If the firm is currently enjoying supernormal profits but facing competition, it could even sell
a good or service at a price below cost to force rival firms out of the business. This is known
as predatory pricing. The incumbent monopoly may have significant savings to finance a price
war, whilst the new firm is more vulnerable due to financing cost of entering the market. Thus,
these low prices and operating at a loss may force the new firm out of business.

In perfectly contestable market, firm only earn normal profits, market price is P2.

If firms use limit pricing, they still earn abnormal profits, market price is P1.

If firms use predatory pricing, they earn subnormal profits, market price is P3.
CAIE A2 Economics
Growth of firms – Notes

Internal growth
Internal growth is achieved when a firm increases size through increasing production and sales.
The firm retains their profits and invests them in order to improve its productive capacity.
They do this in order to be more cost-efficient so that they can be more aggressive in the
market, or take advantage of opportunities that the market presents.

1) Investment
If the firm is in a profitable industry, then it gains the revenue and confidence to expand
production. Investment enables the firm to provide more of the good or service. For a coffee
chain, the quickest way to grow is to open more establishments in new cities and locations. If
a firm does not have surplus profit and savings, it can borrow from banks to fund investment
in increasing capacity.

2) Sales maximization
If a firm decides to cut price to increase sales, it can be aimed at increasing the size of the firm.
This may make the firm less profitable in the short-term but if rivals are out of the industry,
incumbent firm could gain higher market share and be more profitable in the future.

3) Non-price competition
A firm can grow through methods of non-price competition. This can involve advertising
campaigns, loyalty cards and better after sales service.

External growth
External growth is achieved when firms join together under common ownership through
mergers or takeovers (or acquisitions).

Horizontal integration
A horizontal integration is a merger or takeover between firms operating in the same industry
and at the same stage of the production process.

Example: Mergers or takeovers between chained-brands hotels.

Vertical integration
A vertical integration is a merger or takeover between firms in the same industry, but at
different stages of the production process.
Vertical backward integration involves a firm taking over one of its suppliers.
Example: A drinks manufacturer buying a bottling manufacturer.

Vertical forward integration involves a firm taking over one of its purchasers.
Example: A diamond wholesaler buying a retail jewelry.
Lateral integration
A lateral integration is a merger or takeover between firms who sell related goods or
services but who do not compete directly with each other.

Example: Mergers or takeovers between banks and insurance companies.

Conglomerate integration
A conglomerate integration is a merger or takeover between firms in completely unrelated
fields.

Example: Merger or takeover between tobacco company and an insurance company.

Diversification
This is the third way a firm can grow. The firm produces or sells a wider range of products,
either to reduce risk by spreading it over a bigger range, or to exploit an opportunity in the
market.

For IT firms, it is easy to reach the end of a product life-cycle. CDs, tape players are all no
longer in demand. Therefore, firms need to keep introducing new technology which enables
them to develop new product lines. Firms can also try and be innovative and develop new
types of products and services. For example, firms are finding that offering greater product
customisation is a good way to attract new demand. 3D printing and online purchase gives
firms the opportunity to develop a greater range of products, which can appeal to particular
preferences of consumers.

Reasons for growth of firms

1) Profit motive
It is the incentive of profit which encourages owners to take risks to set up the business in the
first place. When a firm has shareholders, there is a greater incentive to try and make profit
to be able to pay shareholders a dividend.

However, when a firm seeks to grow, there is no guarantee that it will be more profitable. To
increase market share may require lower prices, which reduce profitability. If a firm seeks to
grow in size by diversifying into related industries, it may lack the expertise to do well in these
different industries.

2) Motivations of managers and workers

Managers and workers may prefer to work for a bigger firm. This is maybe in the hope of
getting a better salary or it may just be the personal satisfaction of working for a large firm.

However, it depends on worker morale; it may be that many workers and managers have little
desire to see the firm grow – growth may just increase their stress and responsibility.
Therefore, rather than growing, firms may end up pursuing a type of ‘satisficing’, where they
do enough to keep their owners happy, but then pursue other objectives.
3) Risk diversification
Virgin started off as a record shop. If it had just stayed in that industry, it would have closed
down because record shops have been in terminal decline. However, the Virgin group has
diversified into a range of industries such as airlines, insurance, mobile phones, and even
space travel. This diversification enables a firm to grow by reaching into new industries. Virgin
can make use of its strong brand name and financial reserves to successfully enter new
industries

However, diversification does come at a risk. Not all firms may be as successful as Virgin in
moving from retail to running trains.

4) Economies of scale (See 2.4)

Small Firms
Benefits of small firms
1) Niche markets
Small niche markets may have less competition and therefore be 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; firms can charge a bigger markup on the
marginal cost of production. This enables the firm to be more profitable, despite lower volume.

2) Low MES
In the car industry, there are a small number of relatively big firms as economies of scale are
very significant. But, in some industries like coffee shops, economies of scale are relatively
insignificant. There may be dis-economies of scale in expanding production. Therefore, it is
not a competitive disadvantage to retain low output.

3) Different business objectives

Not all firms aim at profit 3aximization and increasing market share. Some owners may prefer
a business that is manageable and easy to retain control. Expansion may involve listing on the
stock exchange which makes you liable to shareholders. If people work in small firms, they
may get more joy because they feel in control and have a close connection with customers.
Owners may create a business that is also a hobby. Therefore, they would prefer to keep the
firm small and avoid spending their time on management and paperwork.

Disadvantages of small firms

1) Less efficient than big firms.
Big firms can benefit from economies of scale in production and sell at lower cost.

2) Lack of resources.
Small firms do not have resources to invest in research and development and bring to market.
They may lack access to supply chains and retail outlets as well. For example, big supermarkets
may not want to deal with small suppliers.
3) Lack brand awareness.
Consumers may prefer to use a well-known brand as they can be sure of the quality and not
worry about getting an unexpected experience.

Determinants of size of firms

Market size
If the commodity in which the firm deals or which it manufactures has a wide market, naturally
the business will assume a large scale. But, if the demand for the commodity is limited, the
size of the firm will continue to be small.

Minimum efficient of scale (MES)

If MES occurs at a low level of output, the firms will remain small to produce at a lower cost.
However, for those industries with very high fixed costs, MES will occur at a very large level of
output, small firms are unable to produce that amount so large firms exist in those industries.

Availability of finance
If ample funds are available, it will help the entrepreneur to make his business grow to a big
size. This requires the proper development of the banking system so that saving of the
community can be effectively mobilised and utilised in the development of trade and industry.

Entrepreneurial skill
An entrepreneur of moderate ability will run business on a moderate scale and a man of
limited entrepreneurial skill will be content with a small business. For running the routine part
of the business, managers are appointed. If a firm is lucky enough to have a manager of
exceptional ability, the size of the firm will grow to considerable dimen-sions. On the other
hand, a mediocre manager will have a small sized firm to manage.
CAIE A2 Economics
Cost-benefit analysis - Notes

Externalities
An externality is said to arise if a third party (someone not directly involved) is affected by the
decisions and actions of others.

A negative externality occurs when the side effects have a negative or detrimental impact
that
involves unexpected costs to third parties.

Negative production externalities are spillover effects that occur because of production
activity. A common case is that of most forms of environmental pollution. Suppose a firm
disposes of chemical waste into a river. A production externality occurs because there are
additional costs imposed on the community and the river authority who must clean up the
mess. There is little or no cost to the polluting firm.

Note that zero pollution is not socially desirable, because if you want to eliminate all negative
externalities and pollution it often means not producing anything.

Negative consumption externalities are created by consumers because of their use of

products that result in harm to others who are not involved in the consumption. A very
relevant and topical global example is that of passive smoking. This causes costs to non-
smokers in the form of discomfort and respiratory problems where there is extensive
exposure.

A positive externality is where the side effects provide benefits to third parties.

Positive production externalities are benefits to third parties and are created by producers of
goods and services. Businesses that develop new technologies generate external benefits,
because their ideas often contribute to innovation by other firms.

Positive consumption externalities are the spillover effects of consumption of a good or

service
on others. For instance, when people in a community are vaccinated against Covid-19, there
is much less likelihood of people in the neighborhood catching the disease. Everybody
therefore will be able to live a healthier life.

Social cost
A private cost is the cost faced by the producer or consumer directly involved in a transaction.
An external cost occurs when producing or consuming a good or service imposes a cost upon
a third party. Social cost = private cost + external cost.

Driving a car imposes a private cost on the driver (cost of petrol, tax and buying car). However,
driving a car creates costs to other people in society.
Social cost of driving a car = costs of paying for petrol (personal cost) + costs of increased
congestion (external cost) + pollution and worse air quality (external cost)
Social benefit
A Private benefit is the benefit derived by an individual or firm directly involved in a
transaction as either buyer or seller. The private benefit to a consumer can be expressed at
utility. An external benefit occurs when producing or consuming a good cause a benefit to a
third party. Social benefit = private benefit + external benefit.

If we cycle to work, the private benefits include lower cost of cycling rather than driving. But,
the social benefit of cycling may also include external benefits, such as lower congestion for
other road users; lower pollution levels from a decision to cycle rather than drive; better
health may lead to lower health care costs.

Concept of ‘net’
If there is a net private benefit, then private benefit is greater than private cost.

If there is a net external benefit, then external benefit is greater than external cost.

If there is a net social benefit, then social benefit is greater than social cost.

Cost-benefit analysis
Cost-benefit analysis is a way to evaluate potential projects and decide whether they are in
the interest of the public. Cost-benefit analysis studies involve calculating the social costs and
social benefits to a particular project. If the social benefits exceed the social costs, it is
indicative that the project is desirable.

Procedure of Cost Benefit Analysis

1) Project/policy identification
2) Identify impacts
3) Valuing impacts
4) Discounting cost and benefit flows

The first problem encountered in using cost-benefit analysis is that it can be difficult to put a
value on certain costs and benefits. For example, building a new airport may cause noise
pollution, but it is hard to put an economic value on this.

A second problem is that it is hard to identify all potential costs and benefits. For example,
building a nuclear power station it might be hard to know potential future problems. For
example, the Chernobyl nuclear accident would be something not included in a cost benefit
analysis. In any planning there is an element of unpredictability and so it is hard to come to
meaningful conclusions.
CAIE A2 Economics
Efficiency – Notes

Economic efficiency is achieved when all scarce resources are used in the best possible way
so the greatest possible level of infinite wants is being met.

Productive efficiency
Productive efficiency is achieved when a given output is produced at the lowest possible cost.

For firm
A firm is productively efficient in the long run when it produces on its LRAC. To achieve this,
there are two conditions to meet. Firstly, the firm must choose the best possible combination
of inputs. This ensures a firm to produce a given output at the lowest possible AC
curve.Secondly, for the inputs chosen, the firm should produce the greatest possible level of
output. This ensures a firm to produce on the lowest possible AC curve.

When a firm is not producing at the lowest possible LRAC curve, X-inefficiency occurs.
1) Poor management
State-owned firms may employ workers who are not necessary for the productive process.
They may be more concerned about the political implications of making people redundant
than getting rid of surplus workers. Some big firms also have poor management control,
because they could not supervise their workers very carefully.

2) Monopoly power
A firm may not have an incentive to find the cheapest raw materials suppliers because they
don’t have competitors. State-owned monopolist may not aim profit maximization as well.

The lowest possible average cost to produce Q1 is equal to AC1. If the firm is producing on
LRAC curve, it is productively efficient. However, if the firm is producing on AC’, it is not
producing at the lowest possible AC curve, it is X-inefficient.

For economy
The economy is productively efficient when it is producing on its PPC. Any combination of
goods or services which lies below the PPC is productively inefficient.
Allocative efficiency
The marginal benefit (MB) of consumption is equal to the maximum marginal willingness to
pay of a consumer. Thus, at any given level of output, the MB of consumption is equal to the
demand price, so MB curve is represented by the demand curve.

If MB > MC, the value put on the resources by the producer is smaller than the value put on
the product by the consumer. In that case, more resources should be allocated to the
production of the good or service.

If MB < MC, the value put on the resources by the producer is larger than the value put on the
product by the consumer. In that case, fewer resources should be allocated to the production
of the good or service.

If MB = MC then a marginal change in output would leave welfare unchanged because the
value put on the resources by the producer is equal to the value put on the product by the
consumer. In that case, the amount of resources allocated to the production of the good or
service should remain unchanged. The resources allocation is allocative efficient.

Allocative efficiency is a situation when the quantity of output produced with scarce resources
would lead to the best satisfaction for consumers. This is achieved when the price is equal to
the marginal cost.

According to the diagram, at equilibrium, price equals marginal social cost, allocative
efficiency is achieved, and social welfare is maximized.

PPC and allocative efficiency

Unlike productive efficiency, it is not possible to illustrate allocative efficiency on a PPC.

Indeed, even if the PPC enables us to compute the MC of production, it does not provide any
information about the consumer preferences.

Therefore, any combination of goods and services that lies on the PPC is productive efficient
but it can be allocatively inefficient.
Pareto optimality
Pareto optimality is achieved when it is not possible to reallocate scarce resources in such a
way someone is made better off without making anyone else worse off.

A pareto improvement is a reallocation of scarce resources that makes at least someone

better off without making anyone else worse off.

Therefore, a resources allocation is said to be pareto optimal if no further pareto

improvement can be made.

Pareto optimality requires both productive efficiency and allocative efficiency.

1) If PE is not achieved, then it is possible to produce more of one good without reducing the
output of another and so there are further pareto improvements.

2) If AE is not achieved, then it is possible to produce more of the good whose MB exceeds
MC and so there are further pareto improvements.

Dynamic efficiency
In economics, static means at a given point in time and dynamic means over a given period of
time. Static efficiency is achieved when resources are allocated efficiently at a given point in
time. Productive efficiency and allocative efficiency are both static concepts of efficiency.

On the other hand, dynamic efficiency is achieved when resources are allocated efficiently
over a given period of time.

Dynamic efficiency acknowledges that the state of knowledge and technology changes over
time, it takes into account the rate of investment in Research & Development (R&D) projects
aimed at introducing process or product innovations.

According to the diagram, if technology improves, LRAC shifts downwards. Firm could produce
the given output at lower cost, dynamic efficiency is achieved.
Perfectly competitive market

Profit-maximisation firm is producing at point A where MC=MR. At this point, P=MC, allocative
efficiency is achieved if externalities do not exist in the market. Since perfect competitive
markets don’t have entry barriers, firms could only earn normal profit in the long run. In this
case, firms must produce at the LRAC curve to stay in business. Hence, productive efficiency
is achieved as well. Finally, firms are producing at the lowest point of AC curve, which is the
minimum efficient scale of output: economies of scale have been exhausted.

Monopolistic competition

In the long run equilibrium, all firms are earning normal profit, equilibrium level of output is
Q1 with market price P1. This is allocative inefficient, because P1 is higher than MC: there are
some people who value the goods higher than marginal cost but don’t consume it. The shaded
area represents deadweight loss. In addition, since firms only earn normal profits, they must
produce at the lowest possible AC curve: otherwise, they will earn subnormal profits and leave
the market. Thus, firms in monopolistic competitive market are also productive efficient.
Under monopolistic competition, the firm produces on the downward-sloping part of the AC
curve: it produces less than the quantity that would minimize average total cost. This means
firm has excess capacity, which implies wasteful duplication because monopolistically
competitive industries offer too many varieties. According to this argument, it would be better
if there were only two or three vendors in the food court, not six or seven. If there were fewer
vendors, they would each have lower average total costs and so could offer food more cheaply.
However, there is a drawback: consumers would be inconvenienced because vendors would
be farther apart. The point is that the diversity of products offered in a monopolistically
competitive industry is beneficial to consumers. So, the higher price consumers pay because
of excess capacity is offset to some extent by the value they receive from greater diversity.
There is a trade-off: more producers mean higher average total costs but also greater product
diversity.

Monopoly

Firms in perfect competitive market will produce Q2, while the monopolist produces at Q1.
This is allocative inefficient, because P1 is higher than MC: there are some people who value
the goods higher than marginal cost but don’t consume it. Compared to outcome is perfect
competitive market, less goods are produced, the shaded area represents deadweight loss.

However, whether a monopolist is productive efficient or not is debatable. Some nationalized

monopolies do not have competitors, because government imposes barriers to entry by
prohibiting. For instance, no organization but the U.S. postal service is legally allowed to
deliver first-class mail. In this case, the monopolist has less incentive to cut costs. As they do
not produce at the lowest possible AC curve, there is X-inefficiency. On the other hand, for
those privately owned firms, if they gain monopoly power because of the innovative products,
they are likely to be productive efficient. Apple is a good example of this. In addition, as Apple
is a listed firm, it aims profit-maximistion to satisfy the shareholders. Thus, they always have
the incentive to reduce the cost of production, that’s why most of the products are built in
China, due to low labour costs.

In addition, dynamic efficiency is achieved if the average cost is reduced in the long run. Since
the monopolist earns supernormal profits, if they reinvest to improve their production
process, they will be more dynamic efficient. Note that firms in competitive market only earn
normal profits, so it is not possible to achieve dynamic efficiency.
CAIE A2 Economics
Market failure – Notes

Market failure exists whenever a free market, left to its own devices and totally free from
any form of government intervention, fails to make the optimum use of scarce resources.

Welfare
The area under the demand curve up to a given quantity qm represents the total willingness
to pay for that quantity. The area under the supply curve up to a given quantity qm represents
the total variable cost of producing that quantity. This area represents the cost of producing
quantity qm. The total surplus in the market is the total benefit from consuming qm minus
the cost of producing qm. In absence of externalities, welfare is the sum of consumer surplus
and producer surplus.

Deadweight loss
Deadweight loss is something that occurs in the economy when total society welfare is not
maximized.

The conditions that must hold for societal welfare to be maximized (and thus have no
deadweight loss) are:

1) Perfectly competitive markets.

This means there are lots of buyers and sellers for a product, and no single buyer or seller has
influence over the price. In this case we prefer perfect competition to monopolies,
monopolistic competition, and oligopolies.

2) No externalities in the market.

This assumes that no externalities from production or consumption occur, such as pollution.
This ensures that the market price reacts to the true marginal benefits and marginal costs to
society.

3) No government intervention.
Government policies such as quotas, taxes, and price ceilings or floors will create a deadweight
loss if conditions 1 and 2 hold.
1) Monopoly
The welfare losses of monopoly (or any form of market power) can be illustrated by the
consumer and producer surplus on a graph.

In the competitive case, market price is Pc and quantity is Qc, this is determined by the
intersection of demand and supply.

Consumer surplus = a + b + c
Producer surplus = d + e
Welfare = a + b + c + d + e

In the monopoly case, market price is Pm and quantity is Qm. Output is determined by MR
and MR, while market price is determined by AR.

Consumer surplus = a
Producer surplus = b + d
Welfare = a + b + d.

Thus, deadweight loss = c + e

The effect of going from perfect competition to monopoly is bad for consumers. Consumer
surplus has been reduced by (b + c). Area b has gone from consumers to producers, so this is
not an overall welfare loss, just a distributional change from consumers to producers.
However the monopoly is good for producers. Producer surplus has increased by (b – e) and
as b is a larger area than e this is a net gain.

Areas c and e are deadweight loss. Consumers have lost c and producers have lost e, this is
because there is now less output being produced due to the quantity decreasing from Qc to
Qm. So overall society loses out – there is a net welfare loss when the aggregate welfare of
consumers and producers is taken into account, although producers are likely to be happy as
they have gained at the expense of consumers. From an economic point of view, here there
is an efficiency loss caused by going from perfect competition to monopoly.
2) Externalities
When there is a negative externality, a competitive market will produce an inefficiently large
amount of output. Conversely, when there is a positive externality, a competitive market
would produce an inefficiently small amount of output.

We can look at the welfare effects of the externality by breaking it down into consumer and
producer surplus.

At the competitive price-quantity combination (P1,Q1):

Consumer surplus = A + B + C + D
Private producer surplus = F + G + H
Externality cost = C + D + E + G + H
Welfare = consumer surplus + private producer surplus – externality cost = A + B + F – E

At the socially optimal price-quantity combination (P2,Q2):

Consumer surplus = A
Private producer surplus = B + C + F + G
Externality cost = C + G
Welfare = consumer surplus + private producer surplus – externality cost = A + B + F

The difference in welfare between the competitive output and the socially optimal output is
E, this is the deadweight loss of the externality in a competitive market.

The trick to remember when calculating deadweight loss, is that deadweight loss occurs
whenever marginal benefit is not equal to marginal cost. In order to get the total deadweight
loss for the economy you must consider every unit that is produced where marginal cost is
greater than marginal benefit (a net loss to the economy if MC > MB).

Also, it is possible that more should be produced if marginal benefit is greater than marginal
cost, this results in foregone welfare because we are not producing enough in the economy
even though MB > MC.
3) Public goods
As public goods are non-excludable and non-rival, free-rider problem exists: the individual’s
cheapest option is to wait for someone else to pay for the good. As a result, although public
goods do bring benefit for consumers (represented by MPB), the demand does not exist. Since
no single person would be willing to pay for the good themselves, producers cannot charge
anyone a price of it, and therefore cannot profit from supplying it.

The social optimum quantity of public goods is Qm, where the market equilibrium quantity is
0. As a result, the deadweight loss is equal to the sum of producer surplus and consumer
surplus, which is represented by the shaded area.

Market failure
Market failure occurs when there is an inefficient allocation of resources in a free market.
Market failure can occur due to a variety of reasons, such as monopoly (higher prices and less
output), negative externalities (over-consumed and costs to third party) and public goods
(usually not provided in a free market), as illustrated above.

Other types of market failure may involve information failure, moral hazard and lack of
awareness.

Information failure
Information failure is a type of market failure where individuals or firms have a lack of
information about economic decisions. For example, the seller of a car may know it has some
problem, but the buyer may not be aware. This is known as information asymmetries, where
one party has access to information that another party doesn’t.

Moral hazard
Moral hazard occurs when individuals alter their behaviour because of certain guarantees. For
example, an insurance firm may be willing to offer insurance against a bike being stolen.
However, the firm may not realise that through offering insurance, the consumer takes less
care to lock it up. Therefore, the insurance company loses out because it is more likely to pay
out than previously expected.

Lack of awareness (merit/demerit goods)

People do not realise the true personal benefit. For example, people underestimate the
benefit of education or getting a vaccination. Education is a merit good and is under-
consumed.
CAIE A2 Economics
Policies to correct market failure – Notes

Section A: Policies to correct externalities

Indirect tax
Taxes on negative externalities are intended to make consumers/producers pay the full social
cost of the good. This reduces consumption and creates a more socially efficient outcome.

According to the diagram, an indirect tax, which is ideally equal to the marginal external cost,
is added to the cost of producing the product. Supply curve is now equal to the MPC plus this
tax. The price increases from P1 to P2 while quantity produced decreases from Q1 to Q2. This
is socially efficient because MSC is equal to MSB at this output, the effect of the negative
externality is now internalized within the market.

Problems of indirect tax

It is very difficult to measure the true external cost of economic activity. For example,
government could ask people who live near the factory to assign a monetary value on the
external cost of pollution, but it is difficult for people to give unbiased opinions and they are
likely to put their own perspective onto the survey.

Some costs may also be unpredictable: the Chernobyl disaster was not predicted and after the
event, government intervention is too late.

A tax on production may be ineffective in reducing demand if demand is very inelastic: the
indirect tax may only marginally reduce the amount of pollution.

Taxes will cause inequality. A tax on cigarettes takes a higher percentage of income from those
on low-income, it is a regressive tax.

Tax evasion is also likely to happen. For example, with a new tax on disposing of rubbish, there
has been an increase in fly-tipping (illegal dumping of rubbish). Therefore, taxes can create
unintended consequences.
Subsidy
Subsidies involve the government paying part of the cost.

For instance, the consumption of vaccinations has positive externalities, so MSB is higher than
MPB. Without government intervention, market equilibrium quantity is Q1, this is under
optimal quantity Q2. To achieve an equilibrium at Q2, the government could subsidise
vaccinations by the amount of the external benefit EB.

Government could also subsidy the substitutes for those goods with negative externalities, so
the consumption of goods with negative externalities will decrease. For example, solar power
is an alternative to burning coal. A government subsidy can make solar power competitive and
encourage its development.

The problem of subsidies is that there is always a danger government subsidies could be
misused. Firms may take the subsidy but keep the money for extra profit rather than for
developing the alternative energy source. The government may lack the proper information
on what types of energy or firms to subsidise. This may lead to public money being wasted,
with little reduction in pollution.

Regulation
In economics, we define government regulation as any government intervention that is
carried out via legal channels. For instance, drinking alcohol is prohibited in certain city centers.
Government could also limit the amount of pollution engines can create.

Note that taxation would not be classified as regulation, because it is not operated via the law.

Nudge
Nudge theory deals with the use of persuasion to alter behaviour, without involving direct
intervention in the market (such as taxation, subsidies, regulation, etc).

If something is legally required (e.g. wearing a seatbelt), then the law can be used to enforce
it. Nudge theory deals with things that are not legally required (such as exercising, eating
healthy, reducing smoking and drinking, etc.) via persuasion.
Tradeable pollution permits
Pollution permits involve giving firms a legal right to pollute a certain amount e.g. 100 units of
carbon dioxide per year. Pollution permits are a free-market solution because permits can be
bought and sold.

If the firm produces less pollution, it can sell its pollution permits to other firms. However, if
it produces more pollution it has to buy permits from other firms or the government. This
creates a market for pollution permits with the price set by demand and supply. Pollution
permits can be a way for the government to raise revenue, by selling firms these permits to
allow pollution.

Over time, the existence of pollution permits should reduce demand for pollution. Firms wish
to avoid paying the cost and find a way to reduce pollution. As demand for permits falls, the
price of permits will fall. In this case of falling price of permits, it may be necessary for the
government to respond by steadily reducing the supply of permits. By steadily reducing the
amount of permits, the government can steadily reduce the quantity of pollution.

Property rights
Individuals, firms, governments, and others have the right to own resources such as housing,
factories, mines, farms, rivers and so on. This right gives the owner the legal right to use the
property as set down and to enforce property rights accordingly.

For instance, when a piece of property (for instance, a private lake) is owned by a specific
person, he has an incentive to keep it clean. When there is difficulty in allocating property
rights, then there is a lack of an incentive to maintain it, leading to externalities like pollution.

Necessary and sufficient?

To overcome externalities, government intervention is not necessary, because it is not the
only way to overcome this inefficiency.

According to the Coase theorem, even in the presence of externalities an economy can always
reach an efficient solution provided that the costs of making a deal are sufficiently low. The
costs of making a deal are known as transaction costs.

For an illustration of how the Coase theorem might work, consider the case of groundwater
contamination caused by drilling. There are two ways a private transaction can address this
problem. First, landowners whose groundwater is at risk of contamination can pay drillers to
use more-expensive, less-polluting technology. Second, the drilling companies can pay
landowners the value of damage to their groundwater sources—say, by buying their
properties outright so that the landowners move. If drillers legally have the right to pollute,
then the first outcome is more likely. If drillers don’t legally have the right to pollute, then the
second is more likely.
What Coase argued is that, either way, if transaction costs are sufficiently low, then drillers
and landowners can make a mutually beneficial deal. Regardless of how the transaction is
structured, the social cost of the pollution is taken into account in decision making. When
individuals take externalities into account when making decisions, economists say that they
internalize the externality. In that case the outcome is efficient without government
intervention.

On the other hand, in the case of positive externalities such as education, private educational
institutions have a profit motive to increase demand for education. They will launch massive
advertising campaigns to convince people of the value of education. If successful, market
demand will increase, quantity will reach social optimum as well.

Government intervention is also not sufficient, it is possible that government intervention

ends up costing more than it gains in social welfare, so efficiency will decrease. See limitations
of indirect tax as discussed above for an example.

Section B: Policies to deal with public goods

To overcome the missing market caused by the public goods, government intervention is
usually necessary, since a free market does not provide public goods. Most of public goods
are produced by the government, which is funded by the tax revenue.

While this intervention is highly likely to succeed, it is possible that a cost-benefit analysis
indicates the provision of the public good is not worthwhile. In this case, if a government
intervenes to provide it, efficiency will have been reduced.

Note that recently, there are cases when groups of individuals can come together to
voluntarily provide public goods.

Behavioural economics suggests that individuals can have motivations other than just money.
People may volunteer to contribute to local flood defences out of a sense of civic pride, peer
pressure or genuine altruism.

Examples of market provision of public goods include local communities providing private
policing, or raising money to pay for a local school, new garden or new statue.
Section C: policies to deal with monopoly

Policies to limit the exercise of the monopoly power

For firms like Google, Apple and Microsoft, they do have high degree of monopoly power, but
people wouldn’t consider it to be inefficient. In this case, government would limit the
monopoly power by profit capping.

Government could impose limit on the price charged by the product, which is known as price
capping. Since price charged is closer to marginal cost, there is an improve in allocative
efficiency. In the case of drugs, it could be argued they should not be too expensive: otherwise,
people cannot afford them.

Rate of return regulation is another form of price setting regulation where governments
determine the fair price which is allowed to be charged by a monopoly. It is meant to protect
customers from being charged higher prices due to the monopoly's power while still allowing
the monopoly to cover its costs and earn a fair return for its owners.

However, there is the possibility of government failure. For example, monopolist often
reinvest their supernormal profits to improve their production process over time, this makes
them dynamic efficient. If governments limit price, firms may not have sufficient profit to
encourage more research and development. Even if they do, the firm will be discouraged to
do so, because developing new drugs is quite risky with no guarantee of success. Therefore,
lower prices and lower profits could decrease dynamic efficiency.

Policies to prevent the existence of monopolies

Deregulation
Deregulation involves removing legal barriers to entry. For example, there used to be a legal
monopoly for the delivery of letters. Removing this legal barrier enables new firms to enter
the market providing choice and competition.

Investigation
The government could make sure the Office of Fair Trading investigates any potential anti-
competitive practices. For example, if firms engage in predatory pricing, they will prevent new
competitors from entering. If the government increased the penalties for predatory pricing
then new firms would have more confidence to enter.

Merger policy
The government has a policy to investigate mergers which could create monopoly power. If a
new merger creates a firm with more than 25% of market share, it is automatically referred
to the Competition and Markets Authority (CMA). The CMA can decide to allow or block the
merger depending on whether it believes it is in the public interest.
Natural monopoly
Breaking up a monopoly that isn’t natural is clearly a good idea: the gains to consumers
outweigh the loss to the producer. But it’s not so clear in the case of natural monopoly: if an
industry has high fixed costs, then the economies of scale may mean the most efficient
number of firms in an industry is one. There are two common policies to deal with natural
monopoly.

Nationalisation
Instead of allowing a private monopolist to control an industry, the government establishes a
public agency to provide the good and protect consumers’ interests. In Britain, for example,
telephone service was provided by the state - owned British Telecom before 1984, and airline
travel was provided by the state - owned British Airways before 1987.

The advantage of public ownership, in principle, is that a publicly owned natural monopoly
can set prices based on the criterion of efficiency rather than profit maximization.

The disadvantage is that publicly owned firms are often less eager than private companies to
keep costs down or offer high - quality products. Publicly owned companies may often end up
serving political interests - providing contracts or jobs to people with the right connections.

Price regulation
Government could ask a monopolist to set price at marginal cost to improve allocative
efficiency. However, in the case of natural monopoly, the situation is different.

According to the diagram, if the firm were unregulated, it would produce Qm and sell at the
price Pm, where MC = MR. Ideally, the regulatory agency would like to push the firm’s price
down to the competitive level Pc, so the firm is allocative efficient. However, at that level of
output, price would not cover average cost and the firm would go out of business. Since no
firm can operate indefinitely at a loss, government usually sets a price limit to ensure a firm
could earn at least normal profit.

The main problem is that regulators don’t have the information required to set the price
exactly at the level at which the demand curve crosses the average total cost curve.
Sometimes they set it too low, creating shortages; at other times they set it too high. Also,
regulated monopolies, like publicly owned firms, tend to exaggerate their costs to regulators
and to provide inferior quality to consumers.
Government failure
Government failure is a situation where a Pareto improvement is possible with a different
intervention. There are two types of government failure. Firstly, government intervention may
create further inefficiencies. Secondly, government may not employ the most efficiency-
improving intervention. We will focus on the first type of government failure in this section.

Imperfect information
Imperfect information makes it difficult for governments to correctly assess the magnitude of
welfare losses, this complicates the process of deciding what intervention is needed.

For instance, theoretically, government could impose a per-unit tax equals to external cost to
ensure production at the social optimum level of output. However, the government would
first have to gather data to estimate and model the MPC,MSC, and MPB curves, as well as the
elasticities of demand and supply. However, the theoretical models of the market are only
estimations, this may have changed by the time the government implements their policy.
Therefore, government operates under imperfect information, which may cause the
intervention to fail.

Unintended effects
The government may implement a policy intended to solve the problem of concern. However,
the policy may change people’s incentives in such a way that they do something different,
which makes the problem worse. For instance, if the government tries to solve the problem
of inequality via higher income taxation, they may reduce the incentives for people to work,
which will create new inefficiencies.

Public sector inefficiency

The government does have the incentive at the highest level because minimizing wastage will
enable them to do more with government revenue. However, the departments and agencies
which carry out government policy may not necessarily have this incentive, especially if they
provide free services to the public and are paid fixed salaries regardless of how well they do
their jobs.

Policy conflicts
The government may have multiple policy goals, some of which directly clash with each other.
As a result, intervention in pursuit of one goal may cause inefficiency with respect to another.
CAIE A2 Economics
Equity – Notes

Income and wealth

Income refers to the flow of wages, interest payments, dividends, and other things of value
accruing during a period of time (usually a year).

Personal income equals market income plus transfer payments. Most market income comes
from wages and salaries, while the major component of government transfers is social security
payments to the elderly.

Wealth consists of the net dollar value of assets owned at a given point in time.

A household’s wealth includes its tangible items (houses, cars and other consumer durable
goods, and land) and its financial holdings (such as cash, savings accounts, bonds, and stocks).
All items that are of value are called assets, while those that are owed are called liabilities.
The difference between total assets and total liabilities is called wealth or net worth.

Note that wealth is a stock (like the volume of a lake) while income is a flow per unit of time
(like the flow of a stream).

Poverty
Absolute poverty is defined by the World Bank as having an income below $1.90 per day.

Absolute poverty differs from relative poverty in the fact that those in absolute poverty are
unable to meet their daily needs of food and water. Those in relative poverty are poor in
comparison to the rest of the country.

Equity and equality

Equality means each individual or group of people is given the same resources or
opportunities.

Equity refers to a distribution that is fair or just. This distribution could be of income, poverty,
government benefits, wealth and so on.

Equity has two sides to it. These are:

1. Vertical equity is concerned with the relative income and welfare of the whole population,
it is concerned with how equitably resources are distributed and may imply higher tax rates
for high-income earners.

2. Horizontal equity is treating everyone in the same situation the same. For instance,
everyone earning £15,000 should pay the same tax rates.
Measuring income inequality
Lorenz curve
The Lorenz curve is a way of showing the distribution of income (or wealth) within an economy.
The Lorenz curve shows the cumulative share of income from different sections of the
population.

If there was a completely equal distribution of income, then this would be represented by the
45° line on the diagram: the poorest 20% of the population would gain 20% of the total
income, the poorest 60% of the population would get 60% of the income.

If income is not equally distributed, Lorenz curve is no longer a straight line, the extent of
inequality is shown by area A. As inequality rises, this area increases, moving towards the
bottom right of the diagram. In this Lorenz curve, the poorest 30% of households have 5% of
the total income.

In market economies, wealth is much more unequally distributed than is income. In the United
States, the top 10 percent of households in 2004 owned 70 percent of wealth, and the top 1
percent of the households owned around 35 percent of all wealth.

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.

The lower the figure of Gini coefficient, the more equal the distribution of income.

The Lorenz Curve can be used to calculate the Gini coefficient, the Gini coefficient is calculated
as area A/A+B.
Equality and efficiency
Equality does not imply efficiency. For instance, under planned economy, everyone receives
same amount of income, which is equally distributed by the government. Without the
incentive to work, the economy may not be productive efficient.

Similarly, efficiency does not imply equality as well. Assume two people producing
homogeneous product efficiently with same productivity, the market price of the product is
equal to marginal social cost, so the resources allocation is efficient. However, if one person
receives $499 in income and another person receives $1 in income, there is income inequality.
Ideally, we’d prefer each person to receive $250. Note that this situation is also pareto
efficient: if the second person wants $1, first person would lose $1.

Policies that are used to promote efficiency may have the effect of increasing inequality. To
promote efficiency, government usually encourages a more competitive market. If there is an
increase in demand for necessities, without any government interventions, price will rise.
Those most able to pay will continue to consume but the increased price will hurt those on
lower incomes much more. This will increase inequality.

Policies that are used to reduce income inequality will usually hurt economy efficiency as well.
For instance, if there is an increase in progressive tax, high income earners may have less
incentive to work, this will decrease productivity.
CAIE A2 Economics
Policies to redistribute income – Notes

There are three main types of policies that are available to reduce inequality in the distribution
of income and wealth.

Tax system
Progressive tax
The average tax rate is total taxes paid divided by total income. The marginal tax rate is the
extra taxes paid on an additional dollar of income. A progressive tax takes a higher percentage
of tax from people with higher incomes. It means that the more a person earns, the higher his
average rate of tax will be.

Mathematically, if marginal tax rate > average tax rate, then the tax is progressive.

Almost everywhere, higher incomes mean a higher rate of income tax. Income tax is
progressive.

Corporate profit tax is another example of progressive tax. A corporate tax is a tax on the
profits of a corporation. The taxes are paid on a company's taxable income, which includes
revenue minus cost of goods sold (COGS), general and administrative (G&A) expenses, selling
and marketing, research and development, depreciation, and other operating costs.

Taxes can also be imposed to reduce wealth inequalities.

1) Capital gains tax
A capital gains tax is a tax on the profit earned from the sale of an asset, such as stocks and
bonds. Capital gain = sales price - purchase price. As the tax rate depends on the investor's tax
bracket, capital gains tax is also progressive.

Note that if an investor sells an asset for less than he or she paid, this is called a capital loss,
and no tax is owed.

2) Property tax
Property tax is a tax paid on property owned by an individual. Property tax is based on the
value of the property, which can be real estate or—in many jurisdictions—also tangible
personal property.

The poor don't usually own property. It is usually individuals of high incomes who exchange
property, and therefore pay the tax. Thus, property tax is also progressive.

3) Inheritance tax
An inheritance tax is a tax paid by a person who inherits money or property of a person who
has died. We expect this to be progressive, because it is usually individuals of high incomes
who receive an inheritance, and therefore pay the tax.
Regressive tax
A regressive tax is a tax which takes a higher percentage of tax revenue from those on low
incomes. As income increases, the proportion of your income paid in tax falls.

Mathematically, if marginal tax rate < average tax rate, then the tax is regressive.

A sales tax is a consumption tax imposed by the government on the sale of goods and services.
This is a regressive tax, because poor and rich people pay the same absolute amount of tax,
those on low-income will pay a higher percentage of income in tax.

An ad valorem sales tax imposes a tax depending on its value. The tax is usually expressed as
a percentage. For example, in the UK, VAT is charged at 20% on most goods offered for sale.

A specific sales tax is a fixed amount of tax placed on a particular good. It is also referred to
as a per-unit tax, and the tax will depend on the quantity sold (not price).

Note that although both types of sales taxes are regressive, ad valorem tax is likely to be more
progressive than a specific tax. For instance, if your house is worth more, you will pay a higher
amount of stamp duty. Therefore, the wealthy tend to pay more stamp duty than those on a
low income.

Excise duty is a tax on the production of specific goods sold within the country. For instance,
an excise duty might be levied on alcohol or tobacco.

Benefits
A simple way to redistribute income is to pay benefits out of government spending to those
on low incomes. Money raised through the tax system is then paid to low-income persons and
families to increase their disposable income.

1) Universal benefits
Universal benefits are paid to every person who is entitled to such a benefit irrespective of
their income or wealth. Such benefits have the advantage of providing money to people
without having to ask them a lot of questions which could be seen as an invasion of privacy,
but they also have the disadvantage of providing money to people who might not really need
it. It could therefore be regarded as being somewhat wasteful of public expenditure.

2) Means-tested benefits
An alternative form of benefit is called a means-tested benefit. This literally means that certain
people are tested, by asking them questions, to see if they have sufficient means to pay for
certain things; if they can prove that they need additional funds, then they can receive the
benefit. Such benefits have the advantage of targeting those people who are most in need of
additional funds.
The most significant disadvantage of means-tested benefits is that they can give rise to what
has been called the poverty trap. If a person gains more income, perhaps by working longer
hours, the means-tested benefits may be reduced, or even possibly withdrawn, because the
person is less in need than was the case before. If this is the case, the person will be less
inclined to earn more money; the means-tested benefit therefore operates as a disincentive
to work longer hours and earn more money.

Transfer payments
A transfer payment is a payment of money for which there are no goods or services exchanged.
Such transfers today include aid for the elderly, blind, and disabled and for those with
dependent children, as well as unemployment insurance for the jobless.

Other policies
1) Price stabilisation
Price stabilisation refers to a situation where action needs to be taken by a government when
there are wide fluctuations in price, largely as a result of unplanned fluctuations in supply.
This is a particular feature of agricultural markets.

One way that a government could intervene in such a situation is through the establishment
of buffer stocks. A buffer stock is where a reserve of a commodity is kept to stabilise prices in
a market, so that the prices fluctuate within a given price range. When a surplus of a
commodity is produced, the product is bought, adding to the buffer stock. When there is a
shortage of the product, stocks can be run down.

2) National Minimum Wage

The government could increase the national minimum wage. This is an effective way of
increasing the incomes of the low paid and therefore reducing wage inequality.

However, the problem is that it may cause unemployment because firms may not be able to
afford the workers. If it does cause unemployment, poverty could worsen. However, if firms
have monopsony power, then they will be able to afford higher wages.

3) Negative income tax

Many economists have advocated supplementing the income of the poor using a negative
income tax. According to this policy, every family would report its income to the government.
High-income families would pay a tax based on their incomes. Low-income families would
receive a subsidy. In other words, they would “pay” a “negative tax.”

For example, suppose the government used the following formula to compute a family’s tax
liability: Taxes owed = (1/3 of income) - $10,000.
In this case, a family that earned $60,000 would pay $10,000 in taxes, and a family that earned
$90,000 would pay $20,000 in taxes. A family that earned $30,000 would owe nothing. And a
family that earned $15,000 would “owe” - $5,000. In other words, the government would send
CAIE A2 Economics
Labour supply - Notes

In the labor market, the roles of firms and households are the reverse of what they are in
markets for goods and services. A good such as wheat is supplied by firms and demanded by
households; labor, though, is demanded by firms and supplied by households. How do people
decide how much labor to supply?

Time allocation budget line

Assume a worker has a total of 80 hours per week that he could spend either working or
enjoying as leisure time. (The remaining hours in his week, we assume, are taken up with
necessary activities, mainly sleeping.) Also, let’s assume the hourly wage rate is $10.

If he worked all the time, he earned $800.

If he didn’t work, he earned $0.

A time allocation budget line shows an individual’s trade-off between consumption of leisure
and the income that allows consumption of marketed goods.

The optimal time allocation rule says that an individual should allocate time so that the
marginal utility gained from the income earned from an additional hour worked is equal to
the marginal utility of an additional hour of leisure. This is point A.

Note that to gain an additional hour of leisure, the worker must give up wage rate for one
hour. Thus, the price of leisure is the opportunity cost of it, which is the wage rate.

If there is an increase in wage rate, leisure becomes relatively more expensive. Other things
being equal, worker consume less leisure and work longer hours. This is known as substitution
effect.

However, leisure is also a normal good. If wage rate increases, worker will consume more
leisure and work less hours, ceteris paribus. This is known as income effect.
Individual labour supply curve
In general, the substitution effect is likely to dominate at low wages, since individuals on low
wages are likely to be concerned primarily with earning enough to support themselves.

While beyond a certain wage w*, the income effect is likely to dominate. This is because
individuals earning wages beyond this level can afford to be concerned about leisure, given
that they probably earn enough to meet their basic needs and wants.

If substitution effect is stronger than income effect, an increase in wage rate will causes the
worker to work longer hours. This is represented by point B on the new budget line.

If substitution effect is equal to income effect, an increase in wage rate will not change the
working hours. This is represented by point C on the new budget line.

If income effect is stronger than substitution effect, an increase in wage rate will causes the
worker to work fewer hours. This is represented by point D on the new budget line.

Thus, if wage rate increases, individual labor supply curves will change slope and to ‘bend
backward’ at high wage rates. An individual labor supply curve with this feature is called a
backward - bending individual labor supply curve.
Market supply for labour
By summing the labour supply of all workers in the market at all wage levels, we are able to
derive the market labour supply curve SL.

Although individual workers may display backward-bending supply curves, when workers in a
market are aggregated, higher wages will induce people to join the market, either from
outside the workforce altogether or from other industries where wages have not risen.

For simplicity, we assume that the overall effect of higher wages will always be to increase the
supply of labour. Therefore, SL is upward-sloping.

We assume the supply curve to be a straight line. Note that the curve does not pass through
the origin: workers demand some baseline wage W’ to supply any quantity of labour.

Elasticity of supply of labour

The slope of the labour supply curve will depend on the elasticity of supply of labour, i.e. the
degree of responsiveness of the supply of labour in response to a change in the wage rate. If
the supply of labour is inelastic, then a change in the wage rate will bring about a smaller
pencentage change in the quantity of labour supplied. There are 4 main reasons will cause
this:

1) If a job requires long period of study or training, workers cannot quickly enter the job
market. For instance, to lecture at university, worker must have a PhD degree, this requires at
least 4 years in graduate school. This is known as occupational immobility.

2) If the country is in full-employment, firms could not find enough workers to take up jobs.
The most employers can do is get existing workers to work more.

3) If there is a lack of skilled workers for a particular industry, then firms may find it very
difficult to hire workers, even though this job does not require a long education or training.
For instance, if no university in a country offers a course in Italian language, then firms looking
for people who are expert in this need to train new employers outside the country.

4) Workers may be reluctant to work at a place with high house prices, even though the salary
is higher. This is known as geographical immobility.
Factors affecting supply of labour
1) Non-pecuniary benefits
Pecuniary means relating to money. A job’s non-pecuniary benefits include good working
conditions, a sense of fulfilment, employer-provided health insurance, etc. Many individuals
often accept a lower salary in exchange for greater non-pecuniary benefits, especially in public
sector.

If the non-pecuniary rewards to a particular occupation increase then the supply curve will
shift to the right at each and every wage, and if the non-pecuniary rewards are reduced it will
shift to the left.

2) Wages in similar occupations

The argument here is similar to that for substitute goods; if wages in a similar occupation rise,
workers would prefer to work in that occupation rather than this one at the margin.

For instance, a rise in the wage offered to baristas by KFC might cause a fall in the number of
baristas willing to work at Burger King.

3) Size of the labour force

The greater the size of the labour force, the higher the supply of labour, ceteris paribus. The
size of the labour force is influenced by birth and death rates, immigration and emigration,
labour force participation rates government policy on minimum working age and mandatory
retirement age.

4) Fiscal policy
An increase in income tax rates might discourage people from working as it reduces the
amount of disposable income. This will decrease supply of labour.

On the other hand, if the government increases the level of unemployment benefits, it may
also cause the supply of labour to fall.

5) Education and training

Other things being equal, a country where individuals find it easier to acquire education and
training will have a higher supply of labour. Note that the availability of opportunities for
reskilling is an increasingly important determinant of supply of labour, because the skills
requirements of economies are fast changing: entire groups of workers are being made
redundant due to automation and the rise of artificial intelligence. If there is infrastructure in
place which allows structurally unemployed workers to acquire new skills, supply of labour
will increase.
Average and marginal cost of labour
The average cost of labour (ACL) equals total cost of labour divided by the total units of labour
employed.
ACL = TCL / QL

The marginal cost of labour (MCL) is the cost of hiring one extra unit of labour.

MCL = ΔTCL /ΔQL

Example: Assume a firm hires 9 workers and pays them $5 each. They hire an 10th worker, and
pay all workers a higher wage of $6.

When there are 9 workers, ACL = 9 * 5/9 = $5. Total cost is $45.

When there are 10 workers, ACL = 10 * $6/10 = $6. Total cost is $60.

The MCL for the 10th worker is $6 paid to the 10th worker, plus the extra $1 paid to each of the
previous 9, which is $6 + $9 * 1 = $15.

Formula 1: Marginal Cost of Labour = Wage of new worker + (Number of old workers X change
in wages)
Formula 2: Marginal cost of 10th worker = total cost of 10 workers – total cost of 9 workers.

Wage-taker
A wage-taker is a firm which takes the market wage as given; it can hire any quantity at the
market wage (Wm).

Since the firm hires every unit of labour for precisely Wm, both ACL and MCL are constant at
Wm. This is the cost of labour to the individual employer.
Wage-setter
A wage-setter is a firm which is free to set wages as it pleases, subject to the constraint of
labour supply. It can either pay a certain wage and allow hire the amount of labour willing to
work at that wage, or hire its desired quantity and pay the wage required to hire that quantity.

Since the labour supply curve indicates the wage that will be received by every unit of labour
hired, it represents the average cost of labour (ACL). This implicitly assumes that employers
cannot pay two workers a different wage for doing the same job; all workers hired to do the
same job will receive the same wage. If wages change for one of them, they must change
equally for all of them.

Assume the employer wants to hire 1 extra unit of labour, he must increase wages to hire this
extra unit – say, from w1 to w2. Thus, he moves up along the ACL curve from w1 to w2.
However, the marginal cost to the employer is not just w2: wages have to be increased from
w1 to w2 for all other units of labour. Thus, MCL is much higher than the ACL.
CAIE A2 Economics
Labour demand - Notes

Labour does not have value on its own, they are hired to produce goods and services, which
do have value because they can be sold for profit. Demand for labour is a derived demand.

Marginal revenue product

When an extra worker is hired, firms can sell the output produced by that extra worker. The
addition to output from hiring 1 extra worker, is the marginal physical product (MPP) of that
worker. Due to the law of diminishing returns, in the short run, there is usually a diminishing
marginal product when increasing the number of workers. The curve of MPP initially slopes
upwards but eventually slopes downwards.

The price at which the firm can sell the additional output produced by the worker is the
marginal revenue (MR). On the other hand, if a firm is a price-taker, all products are sold at
the market price, MR is a straight line. If a firm is a price-setter, in order to sell additional
quantity of product, firm needs to reduce price for all previous quantities, MR is downward
sloping.

The additional revenue an extra worker earned for the firm is called the worker’s marginal
revenue product (MRP), this is equal to the product of MPP and firm’s current MR.

MRP = MPP * MR

The demand for worker depends on MRP. we will use this to conduct all further analysis.
Non-wage determinants of labour demand
1) Changes in MR
AR curve is equivalent to the demand curve. Since MR and AR shift simultaneously by
definition, an increase in MR represents an increase in demand for the firm's product, and
vice versa. When demand for the firm’s product increases, the firm’s demand for labour
increases, and vice versa. This is why unemployment rises in a recession when consumer
demand is low, and falls in a boom when consumer demand is high.

2) Changes in MPP
Anything which increases the MPP will increase MRP and therefore labour demand. If labour
becomes more productive at their jobs, MPP increases. Note that technological improvements
do not always improve MPP, MPL could fall to zero if the assembly lines are fully automated.

Elasticity of demand for labour

The elasticity of demand for labour is a measure of the responsiveness of demand for labour
to a change in the wage rate. If demand for labour is wage-elastic then a given change in the
wage rate will bring about a greater percentage change in the quantity of labour demanded.
If the change in the wage rate leads to a smaller percentage change in the quantity of labour
demanded then the demand for labour is wage-inelastic.

1) Proportion of labour costs to total costs

The larger the share of labour costs relative to total costs, the more elastic the demand for
labour. For example, if a firm's total costs are $1 million, of which 90% or $900,000 are labour
costs, then a 10% increase in wages will raise costs substantially by $90,000. It may prove
difficult for the firm to absorb this cost increase by reducing profits or increasing prices, in this
case it will have to shed proportionately more labour.

2) Substitution of factors
If capital or other factors can be readily substituted for labour, then an increase in the wage
rate will induce the firm to reduce its demand for labour by relatively more than if there were
no substitute for labour. In particular, the demand for unskilled labour tends to be more
elastic than the demand for highly skilled labour.

3) PED of the product

If wage rate increases, cost of production will increase, firms will raise the price of the product.
If demand for product is price-inelastic, an increase in price will raise the revenue for the firm.
Thus, the wage rise could be passed on to consumers, firms would not care too much about
the wage rise, demand for labour will be wage-inelastic. On the other hand, if the price
elasticity of demand for the final product is high then it will not be possible for wage rises to
be passed on to consumers through increases in price and so the demand for labour will also
be elastic.
CAIE A2 Economics
Wage rate determination - Notes

We have learned labour supply and labour demand in previous lessons. We could now analyse
how wages and employment are determined.

Profit-maximising quantity of labour

A profit maximizing firm should hire labour up to the point where the marginal cost of a unit
of labour is equal to the marginal revenue product of that unit of labour: MRP = MCL.

If MRP > MCL, then the firm can increase its profits by hiring more labour since the revenue it
would earn from hiring an extra unit of labour exceeds the cost of hiring that unit of labour.

If MRP < MCL, then the firm can increase its profits by hiring less labour since the revenue it
is earning from the last unit of labour it hired is less than the cost of hiring that unit of labour.

Wage determination in perfect market

In perfectly competitive labour market, there are many buyers and sellers. For both workers
and employers, there are perfect knowledge. Homogeneous workers are also perfectly mobile
within the industry. Under these circumstances, firms and workers in the industry are unable
to affect the prevailing wage rate by their own actions. They are effectively wage takers in a
labour market.

Wage rate will be determined by the demand for and supply of labour in the particular market
as a whole and then each individual firm will employ all the workers it requires at this wage.
Thus, the ACL and MCL curves for the firm are perfectly elastic and are constant at W1. The
employer would employ at the profit-maximisation point Q1, where MRP=MC.
Derive the demand curve
For firms under perfectly competitive labour market, they hire a quantity of labour given by
the intersection between MCL and MRP. This will be true for any given market wage.

When wage rate is W1, Q1 of worker is hired. When there is a decrease in market wage from
W1 to W2, firm will hire a quantity Q2 of worker given by the new intersection of MCL’ and
MRP. Thus, the MRP curve represents the firm’s labour demand curve, since it plots the
quantity of labour the firm will hire at any given wage.

However, the demand curve for labour curve is not the entire MRP curve. To hire workers,
employers also analyse whether this could bring profits to the firm.

Average revenue product of labour (ARPL) measures the revenue generated per unit of labour.
ARPL = TR / QL. Given that the firm is price taker in the product market, TR = P * TPP. Thus,
ARPL = P * APPL.

If wage rate is W1, the profit-maximisation level of employment is Q1, where MRP = MCL1 =
W1. However, at Q1, ACL1 is still greater than ARP, firm is making a loss when hiring labour.

If the wage rate is W2, the profit-maximisation level of employment is Q2. At Q2, ARP is
greater than ACL, the firm is making abnormal profit. Thus, it is willing to hire Q2 workers.

As we can see, the firm is making abnormal profit from hiring labour if and only if ARPL is
greater than ACL. Thus, the firm’s demand for labour is only given by the decreasing section
of the MRPL that lies below the ARPL.
Monopsony
A monopsony means there is one buyer and many sellers, this occurs when a firm has market
power in employing factors of production.

It often refers to a monopsony employer – who has market power in hiring workers.

If there is only one main employer of labour, then they have market power in setting wages
and choosing how many workers to employ.

Wage determination in imperfect market

A monopsony is a wage-setter, it faces the market supply curve for labour.

To maximise the level of profit, the firm employs Q1 of workers where the marginal cost of
labour equals the marginal revenue product MRP. However, although the firm values the
marginal worker at Wmrp, the wage paid is only W1, as indicated by the ACL curve. The market
is allocative inefficient.

In addition, as wage paid is not the same as MRP, labour demand curve is not MRP curve
because it no longer tells us the quantity of labour the firm will hire at any given wage. We
could not label DL = MRP as we did for a wage-taker. However, the MRP curve is still relevant
for analysing its optimal employment decision: a wage-setter’s demand for labour can be
meaningfully analysed using MRP theory.
Evaluation of the framework
1) Difficulties in evaluating MRP
To correctly estimate worker’s MRP, firms need to correctly estimate both the productivity
(MPP) of a worker as well as the marginal revenue (MR) gained from selling their output.

MRP is slightly easier to estimate if the firm is selling a good since it is straightforward to
observe a worker's production. However, for service industry, MRP is very difficult to estimate.
For instance, if a student pays $100 for an economics lesson, it’s hard to evaluate who
contributed more to the $100: the teachers, sales, or the brand of institution?

In addition, for public sector workers, they do not even produce goods and services. The only
way to get an idea of their MRP is to estimate what monetary value the public places on their
service. Furthermore, it is politically unpopular for public sector workers to be paid a high
wage relative to private sector workers because public sector wages are funded by taxpayer
dollars. Therefore, it is arguable that our models of the labour market are unsuitable to
analyse wage determination in the public sector.

2) Difficulties in evaluating labour cost

If the firm is a wage-taker, it’s easier to estimate the labour cost. However, if the employer is
a wage-setter, they need to estimate how much they would need to raise wages in order to
increase employment i.e., they have to correctly estimate their ACL and MCL. In reality, this is
difficult to do since it requires firms to know how workers will respond to a range of different
wages that they might offer.

3) Sticky wages
According to the model of labour market, wages will change with MRP. However, wages may
often be sticky for two reasons.

First, employers don't change wages on a regular basis: wages tend to be re-negotiated at the
end of each year. This means that there can be period of time when workers are being paid a
wage that is different from what we would predict. For instance, we would predict that if
demand for a product increases and its price goes up, workers producing that product would
be paid more. However, in reality, the workers producing that product may have their wages
contractually fixed for some period of time.

Second, workers tend to be very unwilling to accept wage cuts, even if the general price level
or demand has fallen. This is known as wages being 'sticky downwards'. For instance, our
theory predicts that wages should fall in a recession, when demand for goods and services is
low. Workers may not be willing to accept this, which can cause the market to fail to clear,
perhaps worsening unemployment.
CAIE A2 Economics
Economic rent and transfer earnings - Notes

Basic concepts
Transfer earnings: The minimum amount which must be paid to keep labour in its present
use.
Economic rent: Any payment to labour beyond its transfer earnings.

Wage earned = transfer earnings + economic rent.

Example: An individual has 2 job offers: the first pays $4000 per month while the second pays
$3500 per month. If he accepts the first one, transfer earnings is $3500: if the first employer
did not pay them at least $3,500, they would quit and work for the second employer instead.
The economic rent is $500, this is the amount they are paid above their transfer earnings.

Graphical analysis
Transfer earnings are represented by the area beneath the labour supply curve. Conversely,
economic rent is represented by the area above the labour supply curve, bounded by the wage
level.

The proportion of wages representing transfer earnings and economic rent depend directly
on the elasticity of labour supply. Inelastic supply curve corresponds to higher proportion of
economic rent.

When labour supply is perfectly inelastic, all wages paid represent economic rent. This is
because labour does not have to be 'transferred' out of any other use.
When labour supply is perfectly elastic, labour is unable to extract any economic rent. If there
is an unlimited amount of labour willing to work at the wage w, all units of labour will be hired
at precisely that wage.

Negative economic rent

Let’s imagine that a firm offers a worker a contract specifying that they have to work q2 hours
for a wage w.

Clearly, this worker would prefer to work only q1 hours rather than q2 hours at a wage of w.

However, if they are forced to work q2 hours and only paid at w for those extra hours, the
worker earns negative economic rent for the hours between q1 and q2, because economic
rent is defined as any wages earned above transfer earnings.

It follows that if a worker is paid a wage less than their transfer earnings, they are earning
negative economic rent.
CAIE A2 Economics
Government and TU negotiation - Notes

Minimum wage
Government imposes the minimum wage to guarantee the lowest wage that the workers
could receive. In this case, no worker will be willing to work for less than that amount.
Therefore, the labour supply curve becomes a horizontal line until it intersects the original
supply curve.

After this point, employment cannot be increased unless wages are increased beyond the
minimum wage, so the curve slopes upwards exactly as before.

If the minimum wage is non-binding, it does not have any effect on wage rate.

If the minimum wage is binding, ACL and MCL curves will shift upwards.

Wage rate determination under minimum wage

If government legally requires all workers to be paid at least the minimum wage, the labour
market is no longer competitive: there is only one monopoly seller of labour, which is the
government. If minimum wage is imposed higher than market wage, employment level will
fall.

At wage of Wmin, Qs workers want to work, but only Qd are hired. The level of unemployment
is equal to Qs – Qd. Profit-maximising firm will hire an amount of Qf, where MRP intersects
MCL.
Trade union
Trade union is an association of all the workers either in the same company, or the same
industry, or even in the same country.

The trade unions are formed for 2 broad reasons. First, to secure improvements in wages for
union members. Trade union typically do not concern themselves with the wages of non-
members. Second, to ensure proper working conditions and prevent the exploitation of its
members.

The strength of a trade union depends directly on the proportion of workers it represents. If
only a small proportion of workers are members of a trade union, the trade union is unlikely
to have significant bargaining power.

Increase MPP
Trade union could increase the MPP of the labour. Trade union may be able to increase the
level of productivity of labour by agreeing to more flexible working practices or the
introduction of new technology. This will increase marginal physical product (MPP) of labour
and hence increase MRP of labour. With higher MRP, workers could earn higher wages.

Closed shop
If the trade union can restrict the entry to a particular occupation, the supply curve for labour
in the industry will shift to the left, this is called a closed shop. Professional associations such
as law and accounting can achieve this by requiring a certain minimum level of qualifications.

According to the diagram, supply of labour will shift from SL to SL1, wage rate will increase
from W1 to W2 and employment will decrease from Q1 to Q2. The members in employment
will be able to enjoy higher wage while others may lose their jobs.
Collective bargaining
If trade union negotiates a higher wage rate, ACL and MCL both changes.

Up to Qmin, MCL will be a horizontal line exactly equal to ACL, because all units of labour up
to Qmin are simply hired at the negotiated wage.

Beyond Qmin, the supply curve slopes upwards exactly as before, since the negotiated wage
is no longer sufficient beyond Qmin. Therefore, the MCL curve also reverts to the original MCL
curve.

Connecting the two discontinuous segments of the MCL curve, we construct MCL and ACL
curves under negotiated wage.

Note that if an increase in the wage rate results in an increase in the number employed by the
firm, average costs of the firm will increase. If the demand for the product was price-elastic,
this will cause revenue to fall, so as firm’s profits. Thus, only if the demand for the product is
price-inelastic, there may be successful bargaining.

Similarly, if firm could replace labour with capital, the firm would just switch to using capital
instead, the bargaining will not be successful.
Wage rate determination under bilateral monopoly
Bilateral monopoly is a labour market in which there is a monopoly supplier, a trade union,
and a monopsonistic buyer of labour.

Trade union is able to bargain a higher wage in this market structure.

Without trade union negotiation, the monopsonist hires Q1 workers and pay wage rate of W3,
although MRP is W1.

However, with trade union negotiation, wages and employment could both increase: this is
because a monopsonist was not originally paying a wage equivalent to MRP, there is room to
reduce the monopsonist’s profits but also make it profitable for them to increase
unemployment.

The outcome depends on how high the trade union’s demanded wage is.

If negotiated wage is less than W1, employment will rise.

If negotiated wage W1, employment is unchanged.
If negotiated wage is greater than W1, employment will fall.

The greatest increase in employment is achieved when the union wage is equal to what the
wage would have been in a competitive market, which is the intersection of MRP and ACL.
The union would not be able to increase employment further than this.
CAIE A2 Economics
Wage differences - Notes

The difference in wage rate could be explained by our theoretical framework of wage
determination.

1) Demand and supply

Higher MRP with inelastic supply will lead to a higher wage rate.
Example: business manager earns higher wage rate than cleaner.

Based on MRP theory, employers are likely to be more willing to pay to hire a business
manager than a cleaner, since the business manager probably generates a higher revenue for
a business firm than a cleaner does for a cleaning firm. Demand for a business manager is also
likely to be relatively more inelastic than demand for a cleaner. This is because the cost of
manager is only a small proportion of firm’s total cost while it’s not easy to replace manager
by capital. On the other hand, the supply of cleaners is likely to be relatively more elastic than
the supply of business managers, since the job requires less skill and training.

Non-pecuniary benefits can account for wage differentials.

Example: for two identical firms in an industry, employers in the firm with more non-pecuniary
benefits may receive lower wage rate because of higher supply of labour.

Market demand for goods and services

If there is an increase in demand for product, demand for labour will also rise. Thus, we expect
wage rate to rise, during this period of time.
2) Market structure
The presence of a monopsonist can explain why workers in one industry are paid a lower wage
than workers in another. If an employer is a monopsonist, they have wage-setting power. This
results in a lower equilibrium wage than if the labour market was competitive.

Example: a public sector nurse earns less than a private sector nurse.

Government is one of the biggest employers of nurses, it may have a degree of monopsony
power. This would allow it to pay nurses at W3, which is less than they would earn in a
competitive labour market (W2).

3) Differences in minimum wage rate

This is useful for explaining differences in wages between workers in different countries, or
differences in the wages earned by the workers in a country at two different points in time.

Example: minimum wage in USA is $7.25 per hour while minimum wage in South Africa is
$2.66. Cleaners in USA earns higher wage than cleaners in South Africa even they are doing
the same jobs.

Example: A cleaner earns $1000 USD per month in 2000 while a housekeeper earns $2000
USD per month in 2020, this is because minimum wage rose in the last 20 years.

4) Differences in power of trade union

The presence of a trade union can generate wage differentials. This is particularly useful for
considering wages in unpleasant jobs, where workers are most likely to require the protection
afford to them by the presence of a strong trade union.
A powerful trade union might be able to get the employer to pay an even higher wage than
Wu, or hire more workers than Q1.

Comparatively, some trade unions may be a lot weaker than assumed, especially if they do
not have many members, or do not have funding. Some unions don’t even bother asking for
wage increases because they know that they have no bargaining power; they simply campaign
for better conditions instead.

Thus, if an industry has a powerful trade union, wage rate will be higher.

Wage differences up to here are explained purely by economic analysis. However, wage
determination in reality may diverge from the economic theory predicts, due to exploitation
and discrimination.

5) Exploitation
It may be the case that employers simply do not follow through on their promise to pay
required wages to workers, or decide to alter wages once the worker has already started
working. It can be very difficult for workers to retaliate against a monopsonist.

Another common form of exploitation is that of foreign workers, particularly those involved
in rough work and manual labour. They are frequently paid less than the minimum wage,
partly because labour laws are often very ambiguous in terms of the protection they grant to
non-citizens.

6) Discrimination
Discrimination is an unfortunate reality of labour markets, despite decades of social
movements and equal pay legislation. For instance, a sexist monopsonist might pay women
less because they believe that a woman will do a worse job than a man purely because they
are a woman, other things equal.