Economics A Level Year 2 – Chapter 2
CONTENT
Price System and the Microeconomy
Law of diminishing marginal utility
Indifference curves and budget lines
Types of cost, revenue and profit, short-run
and long-run production
Different market structures
Growth and survival of firms
Differing objectives of a firm
, Law of diminishing marginal utility
Law of diminishing marginal utility: states that as an extra unit of the good is
consumed, the marginal utility (additional benefit gained from consuming the
good) falls.
Relationship with the Individual Demand curve:
If marginal utility were measured in terms of money, then the marginal utility
curve would become a person’s demand curve. If price increases, less quantity
demanded will be consumed as the price exceeds the individual’s valuation. If
the price was set lower than P1 more consumers would purchase the good
(>Q1).
EQUI-MARGINAL PRINCIPLE:
P, MU
MUx = Px
MUy Py
Uses the LODMU to explain
P1 consumer behaviour when
distributing their income across
different goods/ services.
States that a consumer will maximise
total utility at the point where the
D=MU ratio of marginal utilities is equal to
the ratio of their prices.
So, consumers allocate their income
Q1 Quantity
to goods which derive greater MU.
RATIONAL BEHAVIOUR vs. BEHAVIOURAL ECONOMIC MODELS
RATIONAL BEHAVIOUR
This refers to the decision-making process of consumers and assumes that it
will result in the optimal level of benefit/ maximum utility.
Based on these key assumptions:
Uses all the information available
Consumers wish to maximise their satisfaction/ utility by correctly choosing how to
spend their limited income.
Independent (from anyone else’s) choices
Stable preferences
,However, consumers rarely act in a fully rational way, which is where
behavioural economics kicks in.
BEHAVIOURAL ECONOMICS
This mixes insight from psychology with Economics to explain why people
make irrational decisions. ‘Economists’ are said to be infinitely rational.
Reasons for questioning rational behaviour:
Limited ability to calculate
Importance of social networks
Emotion overtakes logic
Altruism (sacrifice for others) instead of self-interest
Desire for instant rewards
People stick to default choices
Most of us are not infinitely rational but rather face ‘bounded rationality’/
otherwise known as the ‘Administrative Man theory’. The assumption of
Herbert Simon’s model are:
First satisfactory alternative is selected
Decision maker recognises that they perceive the world as simple and
must be fine decision making without considering every alternative
Decisions can be made by heuristics [short cuts to avoid long time lags
making decisions whilst avoiding the issue of imperfect information or
limited time]
RATIONAL DECISION MAKING MODEL (Daniel Kahneman)
6. Carry out
1. Identify
decision
the
and
problem
evaluate
2. Find &
5. Choose
identify the
best
decision
alternative
criteria
4. Generate 3. Weigh
alternatives the criteria
, Indifference curves and budget lines
Indifference curve: Shows the combination of two goods that give equal utility to a
consumer. The consumer will be satisfied at any point along the curve if components are
constant.
Budget Line: Shows the boundary of an individual’s consumption set, given the amount
available to spend and the prices of the goods.
Indifference curves are downward-sloping as the consumer can swap the satisfaction of one
good by consuming the other.
INCOME, SUBSTITUTION & PRICE EFFECT
If a price of a good increases, there will be two different effects:
o INCOME EFFECT – How demand for a good is affected by a change in real disposable
income. An increase in price reduces real disposable income and therefore the
demand (the indifference curve) will fall.
o SUBSTITUTION EFFECT – How a change in price of a good affects the demand
compared to others. An increase in price means the good is relatively more
expensive than alternative goods and therefore people will switch to other relatively
cheaper goods.
INCOME AND SUBSTITUTION EFFECT on indifference curves – NORMAL GOODS
1.Assume the price of
oranges halves, so
consumer can buy more
Bananas
oranges within their budget
so BL1 shifts outwards to
BL2.
SUBSTITUTION EFFECT – As
Q1 oranges are cheaper
consumers can increase the
Q2 IC from IC1 to IC2 so
quantity of oranges
increases from Q1 to Q2.
The substitution effect is
marked by the change in
gradient, they switch to a
cheaper product.
CONTENT
Price System and the Microeconomy
Law of diminishing marginal utility
Indifference curves and budget lines
Types of cost, revenue and profit, short-run
and long-run production
Different market structures
Growth and survival of firms
Differing objectives of a firm
, Law of diminishing marginal utility
Law of diminishing marginal utility: states that as an extra unit of the good is
consumed, the marginal utility (additional benefit gained from consuming the
good) falls.
Relationship with the Individual Demand curve:
If marginal utility were measured in terms of money, then the marginal utility
curve would become a person’s demand curve. If price increases, less quantity
demanded will be consumed as the price exceeds the individual’s valuation. If
the price was set lower than P1 more consumers would purchase the good
(>Q1).
EQUI-MARGINAL PRINCIPLE:
P, MU
MUx = Px
MUy Py
Uses the LODMU to explain
P1 consumer behaviour when
distributing their income across
different goods/ services.
States that a consumer will maximise
total utility at the point where the
D=MU ratio of marginal utilities is equal to
the ratio of their prices.
So, consumers allocate their income
Q1 Quantity
to goods which derive greater MU.
RATIONAL BEHAVIOUR vs. BEHAVIOURAL ECONOMIC MODELS
RATIONAL BEHAVIOUR
This refers to the decision-making process of consumers and assumes that it
will result in the optimal level of benefit/ maximum utility.
Based on these key assumptions:
Uses all the information available
Consumers wish to maximise their satisfaction/ utility by correctly choosing how to
spend their limited income.
Independent (from anyone else’s) choices
Stable preferences
,However, consumers rarely act in a fully rational way, which is where
behavioural economics kicks in.
BEHAVIOURAL ECONOMICS
This mixes insight from psychology with Economics to explain why people
make irrational decisions. ‘Economists’ are said to be infinitely rational.
Reasons for questioning rational behaviour:
Limited ability to calculate
Importance of social networks
Emotion overtakes logic
Altruism (sacrifice for others) instead of self-interest
Desire for instant rewards
People stick to default choices
Most of us are not infinitely rational but rather face ‘bounded rationality’/
otherwise known as the ‘Administrative Man theory’. The assumption of
Herbert Simon’s model are:
First satisfactory alternative is selected
Decision maker recognises that they perceive the world as simple and
must be fine decision making without considering every alternative
Decisions can be made by heuristics [short cuts to avoid long time lags
making decisions whilst avoiding the issue of imperfect information or
limited time]
RATIONAL DECISION MAKING MODEL (Daniel Kahneman)
6. Carry out
1. Identify
decision
the
and
problem
evaluate
2. Find &
5. Choose
identify the
best
decision
alternative
criteria
4. Generate 3. Weigh
alternatives the criteria
, Indifference curves and budget lines
Indifference curve: Shows the combination of two goods that give equal utility to a
consumer. The consumer will be satisfied at any point along the curve if components are
constant.
Budget Line: Shows the boundary of an individual’s consumption set, given the amount
available to spend and the prices of the goods.
Indifference curves are downward-sloping as the consumer can swap the satisfaction of one
good by consuming the other.
INCOME, SUBSTITUTION & PRICE EFFECT
If a price of a good increases, there will be two different effects:
o INCOME EFFECT – How demand for a good is affected by a change in real disposable
income. An increase in price reduces real disposable income and therefore the
demand (the indifference curve) will fall.
o SUBSTITUTION EFFECT – How a change in price of a good affects the demand
compared to others. An increase in price means the good is relatively more
expensive than alternative goods and therefore people will switch to other relatively
cheaper goods.
INCOME AND SUBSTITUTION EFFECT on indifference curves – NORMAL GOODS
1.Assume the price of
oranges halves, so
consumer can buy more
Bananas
oranges within their budget
so BL1 shifts outwards to
BL2.
SUBSTITUTION EFFECT – As
Q1 oranges are cheaper
consumers can increase the
Q2 IC from IC1 to IC2 so
quantity of oranges
increases from Q1 to Q2.
The substitution effect is
marked by the change in
gradient, they switch to a
cheaper product.
