7. The price system and the microeconomy

For a thirsty person, successive cups might add 20, 12, 5, 0 and −3 utils. TU still rises through the third cup, peaks at the fourth, and falls only after the fifth.

Because later units usually give less MU, a consumer is willing to pay less for additional units. This supports the downward-sloping individual demand curve that is derived formally in 7.1.4.

For a discrete table: (1) calculate MU/P for every successive unit; (2) rank available units from highest MU/P; (3) buy the highest affordable next unit, respecting that earlier units of a good come first; (4) continue until the budget is exhausted; (5) check that no affordable reallocation raises total utility.

If MUx/Px is greater than MUy/Py, shift spending toward X. Diminishing MUx and reduced consumption of Y move the ratios toward equality. A rise in X's price lowers MUx/Px; a rise in the utility attached to Y raises MUy/Py, so the chosen bundle changes.

At the initial choice, MUx/Px equals the marginal utility of the last money unit elsewhere. If Px falls, MUx/Px becomes too high at the old quantity. The consumer buys more X; diminishing MUx lowers the ratio until equilibrium is restored. A price rise reverses the chain.

Plot price vertically and quantity horizontally, then join the points. The usual downward slope follows from diminishing MU: additional units are chosen only at a lower price. An own-price change is a movement along this curve.

The theory does not separate income and substitution effects, so it cannot adequately explain upward-sloping Giffen demand. It derives individual demand; a market curve also requires horizontal addition of many heterogeneous consumers' quantities.

Use the model as a conditional benchmark: it clearly links diminishing MU, price and ordinary quantity demanded, especially for repeated divisible purchases. Its adequacy is weaker for expensive infrequent goods, interdependent choices, imperfect information and systematically non-rational behaviour.

Points on or inside the budget line are affordable; points outside are unattainable. A point inside leaves income unspent. For a consumer who prefers more to less, the best affordable bundle lies on the budget line.

Convexity reflects diminishing MRS: as a consumer has more X and less Y, they normally surrender progressively less Y for another unit of X. Perfect substitutes can produce straight ICs and perfect complements right-angled ICs.

With $60, Px =$10 and Py = $5, intercepts are 6 X and 12 Y. If Px rises to$15, the X-intercept falls to 4 while the Y-intercept remains 12: the line rotates inward and becomes steeper in absolute value when X is horizontal.

Income tax or wages can change disposable income and shift the line. Product taxes change prices. Preferences, advertising or product quality can change the chosen point or IC map, but not the budget line itself.

For a fall in Px: (1) mark initial equilibrium A; (2) rotate the budget line outward on the X-axis and mark final equilibrium C; (3) draw a compensated line parallel to the new line but tangent to the original IC at B. A→B is substitution; B→C is income; A→C is the price effect.

For a price rise, reverse every direction. The substitution effect always moves away from the relatively dearer good. The income effect is positive for a normal good and negative for an inferior good; only when the opposing inferior income effect outweighs substitution is the good Giffen.

Repeat the final equilibrium for several prices to form a price-consumption path, then plot each own-price/quantity pair to derive individual demand. A price change cannot by itself reveal whether downward-demand X is normal or inferior because both can buy more after a fall.

A limited income is realistic, but that does not validate rationality or stable preferences. Loyalty-card evidence, for example, can reflect price discounts, targeted information, habit or emotional involvement, so observed choice may have several explanations.

The model is strongest as a benchmark for consistent trade-offs and for separating substitution from income effects. It is less reliable for discrete, infrequent, uncertain or behaviourally influenced purchases. Evaluate by linking a violated assumption to the direction or certainty of its prediction.

Economic efficiency seeks the greatest attainable benefit from scarce resources. A healthcare system, for example, cannot meet every possible demand; efficiency asks how to secure the maximum health gain from available resources.

The criteria are independent. A firm can produce at minimum AC yet restrict output so price exceeds MC; it is productively efficient but not allocatively efficient. An economy can be on its PPC at many output mixes, only one of which may match preferences.

If marginal benefit/price exceeds marginal cost, consumers value another unit more than the resources it uses, so output should rise. If marginal cost exceeds marginal benefit, output should fall. At equality, no extra unit creates a net marginal welfare gain.

A profit-maximising firm chooses MR = MC, which is not generally allocatively efficient when demand slopes down because MR lies below price. Regulation or public ownership may set P = MC, but if that price is below AC the provider can make a loss and need financing.

Both criteria hold only when the chosen output is simultaneously at minimum AC and at the relevant marginal-benefit/marginal-cost equality. A lower AC at unchanged output improves productive efficiency but not allocative efficiency if P remains above MC.

Many unequal allocations can be Pareto efficient because changing them would hurt someone. Pareto efficiency also says nothing about who has power, basic needs or equal opportunities.

A redistribution from a wealthy person to a poor person may improve welfare but fail the strict Pareto test because the donor is worse off, even if society regards the change as fair.

A temporary loss of static allocative efficiency may be defended if retained profits finance innovation. The claim must be tested: market power can provide resources for R&D, but it can also weaken the pressure to innovate.

A patent-protected firm may charge above marginal cost today while investing in a lower-cost production method that becomes available later. Whether this is dynamically efficient depends on the size and persistence of the innovation.

At the socially efficient output, MSB = MSC. When private prices omit a cost or benefit, private equilibrium can create overproduction or underproduction and a deadweight welfare loss; failure may be partial rather than the market producing nothing.

If pollution costs imposed on neighbours are absent from a factory's private costs, market output can exceed the socially efficient quantity: the transaction's full costs are not reflected in price.

Diagnose in three links: identify the missing or distorted signal; show how it separates private from social marginal incentives; state the resulting over- or under-allocation. The same symptom, such as low vaccination, can arise from an external benefit, information gap or market power.

A guaranteed price that creates unsold stocks is government intervention failure, not evidence that an unregulated market caused the original distortion. Diagnosis must precede any remedy.

If a project has SC of $100m and PC of$40m, EC = $60m. If one extra flight has MPC of$5,000 and noise/congestion MEC of $2,000, MSC =$7,000. A reduction in fuel cost shifts MPC down; quieter design reduces MEC.

When a producer is required to repair or compensate for damage, the payment becomes a private cost and the remaining external cost falls: the cost is internalised rather than counted twice.

If a hospital has SB of $240m and EB of$150m, PB = $90m. If an additional vaccination gives MPB of$30 and MEB from reduced transmission of $20, MSB =$50.

A faster journey for the motorcyclist who switches mode is private benefit; reduced congestion for remaining drivers and cleaner air for pedestrians are external benefits. Identify who receives each effect before calculating.

The key test is whether the affected person is outside the buyer-seller decision and whether the spillover is omitted from the market price. Negative externalities usually cause overproduction or overconsumption; positive ones cause underproduction or underconsumption.

Noise from a nightclub is a negative consumption or production spillover depending on the source. A firm’s research that other firms learn from creates a positive production spillover.

Put price/cost/benefit on the vertical axis and quantity on the horizontal. Locate market output where MPB = MPC. Locate social output where MSB = MSC. Compare Qm with Q* and label the relevant curve gap as MEC or MEB.

Steel pollution separates MSC from MPC; discarded gum or smoking burdens separate MSB from MPB; training and vaccination can make MSB exceed MPB. The party outside the transaction determines the external component.

An activity can create more than one externality, such as production costs and consumption benefits. Compare the net positions of MSB and MSC; do not infer over- or underproduction from one spillover alone when another operates simultaneously.

On a marginal diagram, shade the area between MSB and MSC over the quantities separating Qm and Q*. With straight curves it is often a triangle. Label both quantities before choosing the area; the external-cost rectangle or a producer/consumer transfer is not automatically DWL.

DWL grows with the marginal social gap and with the output distortion. For a constant MEC, more elastic demand can produce a larger quantity difference and therefore a larger welfare triangle, other curves unchanged.

Before a transaction, hidden information can cause adverse selection; after it, hidden action can create moral hazard. Monitoring, contracts, deductibles and disclosure can reduce—but not always remove—the problem.

An insured driver may take less care because the insurer covers much of the loss. A larger excess or monitoring device makes the driver face more of the marginal cost.

Define the project and counterfactual; identify incremental private and external effects; value each without double counting; calculate SC, SB and net social benefit (NSB); compare feasible alternatives and choose the greatest reliable positive NSB, subject to the budget and other objectives.

If flood defences have PC $450m, EC$60m, PB $260m and EB$190m, SC = $510m, SB =$450m and NSB = -$60m, so they fail the basic social test on these estimates. For output choice, expand while MSB > MSC and stop where MSB = MSC.

MP is the slope of TP: TP rises faster while MP rises, rises more slowly when MP is positive but falling, reaches a maximum when MP=0, and falls only if MP is negative. AP rises when MP>AP, is maximised when MP=AP, and falls when MP<AP.

Diminishing marginal returns begin when additional units of the variable factor add less output because they must share a fixed factor. They can begin while TP is still rising.

TFC is paid even at zero output and does not change with Q in the short run; TVC changes with output. Therefore AFC falls continuously as output spreads TFC. A change in TFC shifts TC and ATC/AFC but does not change TVC, AVC or MC.

If TC at Q=0 is $40, TFC=$40. At Q=4, TC=$80, so TVC=$40, AFC=$10, AVC=$10 and ATC=$20. If TC rises from$80 to $95 when Q rises from 4 to 5, MC=$15.

With a constant wage, rising MP lowers MC and rising AP lowers AVC. Once diminishing marginal returns reduce MP, MC rises; MC reaches its minimum before AVC and ATC reach theirs. Short-run AVC, ATC and MC are therefore typically U-shaped, while AFC is not.

Returns to scale describe what happens when all inputs rise together: increasing returns produce a more-than-proportional output rise, constant returns a proportional rise, and decreasing returns a less-than-proportional rise.

Doubling all inputs from a small automated plant may more than double output because tasks specialise; doubling a very complex organisation may produce less than double because coordination becomes difficult.

Each short-run average-cost curve represents one plant size. LRAC is the lower envelope: at each Q, choose the plant that produces that output at the lowest average cost. It need not pass through every short-run minimum.

LRAC falls while economies of scale dominate, can be flat under constant returns, and rises when diseconomies dominate. Technological change can shift LRAC down and can change the efficient scale.

Larger scale permits indivisible machinery, specialisation, stronger purchasing terms or shared industry facilities. Total cost then rises less than proportionately to output, so LRTC/Q falls and LRAC slopes downward.

When input prices are unchanged, increasing returns to scale is a physical route to falling LRAC: output rises more than all inputs. Economies of scale are the cost result and may also reflect lower input prices.

The firm continues to gain economies until LRAC reaches its minimum. MES is the smallest output at that minimum; after it, no further scale economy lowers average cost.

Ask what caused the advantage. If the firm's own growth unlocks it, it is internal. If growth or concentration of the wider industry/location creates it for several firms, it is external.

A supermarket receiving bulk discounts is an internal purchasing economy. A technology cluster attracting trained programmers and specialist repair firms creates external economies for local technology firms.

Both types lower average cost. Internal economies explain movement down a firm's LRAC as it expands; an external economy can shift the firm's entire long-run cost position downward as the industry develops.

Ask whether the higher unit cost would arise because this firm became harder to manage, or because the surrounding industry made common resources dearer or less reliable. The first is internal; the second is external.

A large retailer adding layers of approval suffers an internal diseconomy. If rapid warehouse growth in a region bids up drivers' wages and creates road congestion for every distributor, that is an external diseconomy.

MR is the change or slope of TR, not necessarily the price of the extra unit: to sell more under downward demand, the firm may cut price on earlier units too. Equal proportionate growth of output and TR implies constant AR/price.

At Q=10,000 and price/AR=$10, TR=$100,000. If economic TC=$100,000, the firm earns normal profit. With TFC=$40,000, TVC=$60,000 and AVC=$6 at that output.

At unchanged output and revenue, an upward shift of AC can reduce supernormal profit to normal profit. The label depends on the AR-AC or TR-TC comparison at the chosen output, not on whether the firm maximises profit or revenue.

First identify the output Q. Read price/AR and AC at that same output. Subtract to obtain profit or loss per unit, then multiply by Q. On a cost-revenue diagram the total is a rectangle: vertical AR-AC gap multiplied by horizontal output.

If Q=3, AR=$85 and ATC=$75, profit per unit=$10 and total supernormal profit=$30. The $10 vertical gap alone is not total profit.

If shirts sell for $10, variable cost is$5 each and fixed cost is $100, normal profit occurs where TR=TC: 10Q=100+5Q, so Q=20. If at Q=40 AR=$8 and AC=$11, the subnormal loss is ($11-$8)×40=$120.

The total and per-unit routes must agree because TR=AR×Q and TC=AC×Q. Use supplied total values directly when available; use the rectangle method when a diagram or average values are supplied.

Natural monopoly commonly combines very high fixed infrastructure costs with low marginal cost and continuous economies of scale. It creates a cost-based barrier and may justify one network, but ownership can be private or public and regulation remains a separate choice.

These are analytical benchmarks. Define the product and geographic market first, then use observed features: a dominant firm plus a competitive fringe can behave effectively as monopoly even when small sellers remain.

Use all four syllabus dimensions: number of buyers and sellers, differentiation, freedom of entry and information. Then infer conduct. Many wheat farms with identical output and a market price approach perfect competition; a few branded networks with high start-up cost and an 85% five-firm share indicate oligopoly.

Free entry tends to remove supernormal profit in long-run perfect and monopolistic competition. Product differentiation remains in monopolistic competition, so its firm faces a downward-sloping demand curve even in long-run normal profit.

Specialised machinery with little resale value, long contracts and redundancy liabilities can trap resources in a market. High sunk entry cost therefore also weakens hit-and-run entry and reduces contestability.

A large cost is a strong barrier when entrants cannot recover it, cannot finance it on comparable terms or must enter near MES while total demand is limited. Low capital-asset commitment and recoverable assets reduce the barrier.

For a profit-maximising firm, locate output where MR=MC and MC is rising, then read price from AR/demand and profit from (AR-AC)×Q. Structure changes AR/MR, entry and strategic response—not this core method.

A perfectly contestable market has free, rapid entry and exit with no sunk-cost disadvantage, so credible hit-and-run entry constrains even a monopoly or oligopoly. Potential competition can force lower/limit prices, normal profit and cost discipline. Few incumbent firms does not imply low contestability; high sunk costs do.

Price competition includes price cuts and limit pricing. Non-price competition includes quality, advertising, branding, service and innovation; it may increase demand/differentiation but adds cost and can become a market barrier. In a non-collusive oligopoly, rivals may match price cuts but not price rises, producing a kinked demand curve and price rigidity—not a proof that price never changes.

Collusion coordinates price/output to raise joint profit and is easier with few firms, similar costs/products, stable demand, high entry barriers and observable conduct. Differentiation, unstable demand, secret discounts, many firms and legal penalties make it harder. Collusion can raise price, restrict output and reduce allocative/X-efficiency, though scale or investment claims require evidence.

For a two-player pay-off matrix, read each firm's best response for every rival action. A dominant strategy gives the higher payoff regardless of the rival. The Nash equilibrium is the cell where both are best responding; it can give each less than mutual cooperation because each has an incentive to undercut or defect. Repetition, monitoring and punishment may sustain collusion, but cheating remains attractive.

Define the same product, geographic area, period and sales measure; rank firms from largest to smallest; add the largest n shares. If raw sales are supplied, divide their sum by total market sales before multiplying by 100.

Shares of 32%, 26%, 22%, 10% and 5% give CR4=32+26+22+10=90%, suggesting a highly concentrated, likely oligopolistic market. If the largest four later sum to 71.1%, CR4 has fallen by 18.9 percentage points—even if individual membership changes.

A higher ratio means a larger share is held by the leading firms and may signal greater market power or interdependence. A falling CR3 or CR4 indicates reduced concentration on that measure, not necessarily falling total sales or profits.

Small firms survive by differentiating, serving a niche, responding quickly, locating close to customers or providing personal service. Large firms survive through scale, brand, finance, diversification and bargaining power. Both can coexist when they perform different functions, such as small designers and large retailers.

Small-firm survival weakens when consumers switch to cheap standardised products, scale economies are strong, borrowing becomes difficult or entry is easy and rivalry intense. Growth can also stop when management/coordination diseconomies emerge.

A semiconductor producer using continuous internal R&D and investment to develop televisions and phones has achieved internal growth and diversification.

Potential gains include technical, managerial and purchasing economies, lower contracting cost, access to technology/distribution, supply or sales security, faster growth and greater market power. Horizontal integration can make demand for the combined firm less elastic and reduce LRAC—but neither result is automatic.

Purchase finance, culture clashes, duplicated assets, communication layers and poor integration can raise LRAC and reduce profit. Greater concentration can restrict output and raise price, so competition authorities may block, unwind or regulate the deal. Cost savings reach consumers only if competitive pressure or policy passes them through.

Classify first: same/different industry and same/upstream/downstream stage. Then evaluate the stated mechanism against funding, integration, demand, market power and regulation; do not infer the consequence from size alone.

Treat the cartel as one producer: choose industry output where joint MR=joint MC, read price from market demand, then allocate enforceable quotas among members. Restricting industry output raises price; a member can increase its own short-run profit by secretly exceeding its quota while others restrict output.

A successful cartel usually raises price, restricts output, transfers surplus to producers and creates allocative deadweight loss. It may preserve scale or finance investment, but it can also reduce cost pressure and create X-inefficiency; net outcomes require evidence.

Cartels and price fixing are often investigated or prohibited. Legal penalties and detection risk destabilise the agreement; low entry barriers let outsiders expand and erode it.

Monitoring, performance pay, ownership stakes and clear contracts can align incentives, but they also have measurement costs and may encourage gaming. Information asymmetry is central.

A manager may favour an acquisition that increases the firm’s size and prestige even if its return is weak; a long-term return measure can make the incentive more consistent with owners’ objectives.

If MR exceeds MC, one more unit adds to profit; if MC exceeds MR, reducing output raises profit. The firm then reads price or average revenue from its demand conditions and compares total revenue with total cost.

At 100 units MR=$12 and MC=$9, expanding is profitable at the margin. At 105 units MR=$10 and MC=$10, the firm stops if MC is rising beyond the intersection.

On a standard downward demand/cost diagram, profit-maximising output is MR=MC; revenue-maximising output is further right at MR=0; sales maximisation subject to normal profit is further right again at the relevant AR=AC point. Read price from AR at each output.

Changing from profit to revenue or sales maximisation normally transfers some producer surplus to consumers through lower price and more output, but can reduce shareholder profit and may move output away from allocative efficiency. The exact result depends on costs and the constraint.

Separated ownership and control can make growth, sales or satisficing attractive to managers. Active owners, profit-related pay and takeover threats can pull decisions back toward profit.

Effective discrimination requires price-setting power; customers or purchases that can be identified/separated; different willingness to pay or PED; and little resale between low- and high-price markets. Third-degree profit allocation equates marginal revenue across segments to marginal cost, not the segment prices or PED values.

Non-transferable airline tickets sold cheaply months ahead and more expensively near departure can segment flexible travellers from urgent business demand. The result is discrimination only if cost differences do not explain the gap and resale is blocked.

Ask who is being influenced. Limit pricing deters a potential entrant before entry. Predatory pricing attacks a current rival and relies on later recoupment. Price leadership guides incumbent followers; it does not itself require below-cost price.

Consumers may gain temporarily from low limit or predatory prices, but long-run entry deterrence or rival exit can reduce choice and allow later higher prices. Price leadership can reduce uncertainty yet weaken independent price competition.

A low price is not enough to prove intent. Compare cost, duration, capacity, internal documents, rival entry/exit and whether later price increases can recoup losses. Aggressive efficient competition can also lower price.

A 10% price cut with a 20% quantity rise is elastic: new TR≈0.9P×1.2Q=1.08PQ, an 8% rise. With perfectly inelastic demand, quantity is unchanged, so a 5% price rise raises TR by 5%.

At an oligopoly's current kinked price, rivals are expected to ignore a price rise, so the firm's upper demand segment is relatively elastic and a rise cuts TR sharply. Rivals are expected to match a price cut, so the lower segment is relatively inelastic and a cut may reduce TR. This asymmetric response creates a discontinuous/vertical gap in MR; MC can move within the gap without changing the profit-maximising price and output.

The kinked-demand model explains price rigidity once a current price exists; it does not explain how that initial price was set and it does not mean price can never change. A large cost/demand shift or changed rival expectations can move the kink.