4.1 Individuals, firms, markets and market failure

This section of the specification is primarily about microeconomics.

Students will be required to acquire knowledge and understanding of a selection of microeconomic models and to apply these to current problems and issues. Microeconomic models such as demand and supply, perfect competition, monopoly, the operation of the price mechanism and the causes of market failure are central to this part of the specification. Students will need to demonstrate a realistic understanding of the decisions made by firms and how their behaviour can be affected by the structure and characteristics of the industry in which they operate. Other key models relate to the operation of labour markets, wage determination and causes of inequalities in the distribution of income and wealth.

Students will be expected to understand that traditional economic theory generally assumes that economic agents act rationally but they should also be introduced to models that recognise that consumer and firms’ behaviour is often governed by more complex influences.

During their course of study, students should be provided with opportunities to use economic models to explore current economic behaviour. They should be able to apply their knowledge and skills to a wide variety of situations and to different markets and examples of market failure, including environmental and labour market failures. They should appreciate and be able to assess the impact that developments in the European Union and in the global economy have upon microeconomic behaviour and performance.

4.1.1 Economic methodology and the economic problem

4.1.1.1 Economic methodology

Content

Additional information

  • Economics as a social science.
  • Similarities to and differences in methodology from natural and other sciences.
  • The difference between positive and normative statements.
  • How value judgements influence economic decision making and policy.
  • People’s views concerning the best option are influenced by the positive consequences of different decisions and by moral and political judgements.
Students should understand how thinking as an economist may differ from other forms of scientific enquiry.

4.1.1.2 The nature and purpose of economic activity

Content

Additional information

  • The central purpose of economic activity is the production of goods and services to satisfy needs and wants.
  • The key economic decisions are: what to produce, how to produce and who is to benefit from the goods and services produced.
 

4.1.1.3 Economic resources

Content

Additional information

  • The economists’ classification of economic resources into land, labour, capital and enterprise, which are the factors of production.
  • The environment is a scarce resource.
 

4.1.1.4 Scarcity, choice and the allocation of resources

Content

Additional information

  • The fundamental economic problem is scarcity and that it results from limited resources and unlimited wants.
  • Scarcity means that choices have to be made about how scarce resources are allocated between different uses.
  • Choices have an opportunity cost.
 

4.1.1.5 Production possibility diagrams

Content

Additional information

  • Production possibility diagrams illustrate different features of the fundamental economic problem, such as: resource allocation, opportunity cost and trade-offs, unemployment of economic resources, economic growth.
  • Why all points on the boundary are productively efficient but not all points on the boundary are allocatively efficient.

Students should be able to use production possibility diagrams to illustrate these features.

4.1.2 Individual economic decision making

4.1.2.1 Consumer behaviour

Content

Additional information

  • Rational economic decision making and economic incentives.
  • Utility theory: total and marginal utility, and the hypothesis of diminishing marginal utility.
  • Utility maximisation.
  • The importance of the margin when making choices.

Students should appreciate that the hypothesis of diminishing marginal utility supports a downward sloping demand curve but they are not expected to understand the principle of equi-marginal utility or to use this principle to explain why there is likely to be an inverse relationship between price and quantity demanded.

4.1.2.2 Imperfect information

Content

Additional information

  • The importance of information for decision making.
  • The significance of asymmetric information.

Students should recognise that imperfect information makes it difficult for economic agents to make rational decisions and is a potential source of market failure.

4.1.2.3 Aspects of behavioural economic theory

Content

Additional information

  • Bounded rationality and bounded self-control.
  • Biases in decision making: rules of thumb, anchoring, availability and social norms.
  • The importance of altruism and perceptions of fairness.

Students should appreciate that behavioural economists question the assumption of traditional economic theory that individuals are rational decision makers who endeavour to maximise their utility. They should understand some of the reasons why an individual’s economic decisions may be biased.

4.1.2.4 Behavioural economics and economic policy

Content

Additional information

  • Choice architecture and framing.
  • Nudges.
  • Default choices, restricted choice and mandated choice.

Students should appreciate that insights provided by behavioural economists can help governments and other agencies influence economic decision making.

4.1.3 Price determination in a competitive market

4.1.3.1 The determinants of the demand for goods and services

Content

Additional information

  • A demand curve shows the relationship between price and quantity demanded.
  • The causes of shifts in the demand curve.
 

4.1.3.2 Price, income and cross elasticities of demand

Content

Additional information

  • Be able to calculate price, income and cross elasticities of demand.
  • The relationship between income elasticity of demand and normal and inferior goods.
  • The relationship between cross elasticity of demand and substitute and complementary goods.
  • The relationships between price elasticity of demand and firms’ total revenue (total expenditure).
  • The factors that influence these elasticities of demand.

Students should be able to interpret numerical values of these elasticities of demand.

4.1.3.3 The determinants of the supply of goods and services

Content

Additional information

  • A supply curve shows the relationship between price and quantity supplied.
  • Understand that higher prices imply higher profits and that this will provide the incentive to expand production.
  • The causes of shifts in the supply curve.

Students should also know that, under perfect competition, the supply curve is the marginal cost curve.

4.1.3.4 Price elasticity of supply

Content

Additional information

  • Be able to calculate price elasticity of supply.
  • The factors that influence price elasticity of supply.

Students should be able to interpret numerical values of price elasticity of supply.

4.1.3.5 The determination of equilibrium market prices

Content

Additional information

  • How the interaction of demand and supply determines equilibrium prices in a market economy.
  • The difference between equilibrium and disequilibrium.
  • Why excess demand and excess supply lead to changes in price.

Students should be able to use demand and supply diagrams to help them to analyse causes of changes in equilibrium market prices.

They should be able to apply their knowledge of the basic model of demand and supply to a variety of real-world markets.

They should be aware of the assumptions of the model of supply and demand.

4.1.3.6 The interrelationship between markets

Content

Additional information

  • Changes in a particular market are likely to affect other markets.
  • The implications of joint demand, competitive demand, composite demand, derived demand and joint supply.

Students should, for example, be able to explore the impact of changes in demand, supply and price in one market upon other related markets.

4.1.4 Production, costs and revenue

4.1.4.1 Production and productivity

Content

Additional information

  • Production converts inputs, or the services of factors of production such as capital and labour, into final output.
  • The meaning of productivity, including labour productivity.
 

4.1.4.2 Specialisation, division of labour and exchange

Content

Additional information

  • The benefits of specialisation and division of labour.
  • Why specialisation necessitates an efficient means of exchanging goods and services, such as the use of money as a medium of exchange.
 

4.1.4.3 The law of diminishing returns and returns to scale

Content

Additional information

  • The difference between the short run and the long run.
  • The difference between marginal, average and total returns.
  • The law of diminishing returns.
  • Returns to scale.
  • The difference between increasing, constant and decreasing returns to scale.

Students should appreciate that both the law of diminishing returns and returns to scale explain relationships between inputs and output.

They should also understand that these relationships have implications for costs of production.

4.1.4.4 Costs of production

Content

Additional information

  • The difference between fixed and variable costs.
  • The difference between marginal, average and total costs.
  • The difference between short-run and long-run costs.
  • The reasons for the shape of the marginal, average and total cost curves.
  • How factor prices and productivity affect firms’ costs of production and their choice of factor inputs.

Students should be able to calculate different costs from given data. They should also be able to draw and interpret cost curves.

4.1.4.5 Economies and diseconomies of scale

Content

Additional information

  • The difference between internal and external economies of scale.
  • Reasons for diseconomies of scale.
  • The relationship between returns to scale and economies or diseconomies of scale.
  • The relationship between economies of scale, diseconomies of scale and the shape of the long-run average cost curve.
  • The L-shaped long-run average cost curve.
  • The concept of the minimum efficient scale of production.

Students should be able to categorise and give examples of both internal and external economies of scale.

Students should understand the significance of the minimum efficient scale for the structure of an industry and barriers to entry.

4.1.4.6 Marginal, average and total revenue

Content

Additional information

  • The difference between marginal, average and total revenue.
  • Why the average revenue curve is the firm’s demand curve.
  • The relationship between average and marginal revenue.
  • The relationship between marginal revenue and total revenue.

Students should be able to calculate marginal, average and total revenue from given data. They should also be able to draw and interpret revenue curves.

4.1.4.7 Profit

Content

Additional information

  • Profit is the difference between total revenue and total costs.
  • The difference between normal and abnormal (supernormal) profit.
  • The role of profit in a market economy.
 

4.1.4.8 Technological change

Content

Additional information

  • The difference between invention and innovation.
  • Technological change can affect methods of production, productivity, efficiency and firms’ costs of production.
  • Technological change can lead to the development of new products, the development of new markets and may destroy existing markets.
  • Technological change can influence the structure of markets.

Students should understand how the process of creative destruction is linked to technological change.

4.1.5 Perfect competition, imperfectly competitive markets and monopoly

4.1.5.1 Market structures

Content

Additional information

  • The spectrum of competition ranging from perfect competition at one end of the spectrum to pure monopoly at the other end of the spectrum.
  • Factors such as the number of firms, the degree of product differentiation and ease of entry are used to distinguish between different market structures.
 

4.1.5.2 The objectives of firms

Content

Additional information

  • The models that comprise the traditional theory of the firm are based upon the assumption that firms aim to maximise profits.
  • The profit-maximising rule (MC=MR).
  • The reasons for and the consequences of a divorce of ownership from control.
  • Firms have a variety of other possible objectives.
  • The satisficing principle.

Students should recognise that firms have a range of possible objectives including survival, growth, quality, maximising their sales revenue and increasing their market share.

Students should be able to discuss how the divorce of ownership from control may affect the objectives of firms, their conduct and performance.

4.1.5.3 Perfect competition

Content

Additional information

  • The formal diagrammatic analysis of the perfectly competitive model in the short and long run.
  • The implications of the following for the behaviour of firms and the industry: large numbers of producers, identical products, freedom of entry and exit, and perfect knowledge.
  • Firms operating in perfectly competitive markets are price takers.
  • The proposition that, given certain assumptions, relating for example to a lack of externalities, perfect competition will result in an efficient allocation of resources.

Students should be aware that perfect competition, in both product and labour markets, provides a yardstick for judging the extent to which real world markets perform efficiently or inefficiently, and the extent to which a misallocation of resources occurs.

Students should also be able to assess critically the proposition that perfectly competitive markets lead to an efficient allocation of resources.

4.1.5.4 Monopolistic competition

Content

Additional information

  • The formal diagrammatic analysis of the monopolistically competitive model in the short and long run.
  • The main characteristics of monopolistically competitive markets.
  • Monopolistically competitive markets will be subject to non-price competition.
 

4.1.5.5 Oligopoly

Content

Additional information

  • The main characteristics of oligopolistic markets.
  • Oligopolistic markets can be very different in relation to, for example, the number of firms, the degree of product differentiation and ease of entry.
  • Oligopoly can be defined in terms of market structure or in terms of market conduct (behaviour).
  • Concentration ratios and how to calculate a concentration ratio.
  • The difference between collusive and non-collusive oligopoly.
  • The difference between cooperation and collusion.
  • The kinked demand curve model.
  • The reasons for non-price competition, the operation of cartels, price leadership, price agreements, price wars and barriers to entry.
  • The factors which influence prices, output, investment, expenditure on research and advertising in oligopolistic industries.
  • The significance of interdependence and uncertainty in oligopoly.
  • The advantages and disadvantages of oligopoly.

Students should be aware of the various factors which affect the behaviour and performance of firms in a variety of real world markets. The factors include different barriers to entry and the degree of concentration and product differentiation.

The kinked demand curve model should be used as an illustration of the interdependence between firms and not taught as if it is the only model of oligopoly.

Students should recognise that collusion may allow oligopolists to act as a monopolist and maximise their joint profits.

4.1.5.6 Monopoly and monopoly power

Content

Additional information

  • The formal diagrammatic analysis of the monopoly model.
  • That monopoly power is influenced by factors such as barriers to entry, the number of competitors, advertising and the degree of product differentiation.
  • The advantages and disadvantages of monopoly.

Students should appreciate that firms operating in monopolistically competitive and oligopolistic markets are price makers and have varying degrees of monopoly power.

4.1.5.7 Price discrimination

Content

Additional information

  • The conditions necessary for price discrimination.
  • The advantages and disadvantages of price discrimination.

Students should be aware of real-world examples of price discrimination and be able to assess its impact on producers and consumers.

A diagrammatic analysis of price discrimination is expected.

4.1.5.8 The dynamics of competition and competitive market processes

Content

Additional information

  • Both the short-run and long-run benefits which are likely to result from competition.
  • That firms do not just compete on the basis of price but that competition will, for example, also lead firms to strive to improve products, reduce costs, improve the quality of the service provided.
  • The process of creative destruction.

Students should understand that if firms have monopoly power and are making large profits, over time there will be an incentive for new firms to enter the market and to innovate to overcome the existing barriers to entry. Students should understand that this process of creative destruction is a fundamental feature of the way in which competition operates in a market economy.

4.1.5.9 Contestable and non-contestable markets

Content

Additional information

  • The significance of market contestability for the performance of an industry.
  • Concepts such as sunk costs and hit-and-run competition.
 

4.1.5.10 Market structure, static efficiency, dynamic efficiency and resource allocation

Content

Additional information

  • The difference between static efficiency and dynamic efficiency.
  • The conditions required for productive efficiency (minimising average total costs) and allocative efficiency (price = marginal cost).
  • Dynamic efficiency is influenced by, for example, research and development, investment in human and non-human capital and technological change.

Students should be able to apply efficiency concepts when comparing the performance of firms in markets with different structures. They should understand how conduct and performance indicators can be used to compare market structures.

4.1.5.11 Consumer and producer surplus

Content

Additional information

  • Be able to apply these concepts when discussing economic efficiency and welfare issues, such as price discrimination and the dead-weight losses associated with monopoly.

Diagrammatic analysis is expected.

4.1.6 The labour market

4.1.6.1 The demand for labour, marginal productivity theory

Content

Additional information

  • The demand for a factor is derived from the demand for the product.
  • The marginal productivity theory of the demand for labour.
  • The demand curve for labour shows the relationship between the wage rate and number of workers employed.
  • The causes of shifts in the demand curve for labour.
  • The determinants of the elasticity of demand for labour.
 

4.1.6.2 Influences upon the supply of labour to different markets

Content

Additional information

  • The supply of labour to a particular occupation is influenced by monetary and non-monetary considerations.
  • Non-monetary considerations include job satisfaction and dissatisfaction and working conditions.
  • The supply curve for labour shows the relationship between the wage rate and number of workers willing to work in an occupation.
  • The causes of shifts in the market supply curve for labour.

Students will not be required to understand the determinants of an individual’s supply of labour or the backward-bending supply curve.

4.1.6.3 The determination of relative wage rates and levels of employment in perfectly competitive labour markets

Content

Additional information

  • The economists’ model of wage determination in a perfectly competitive labour market.
  • Role of market forces in determining relative wage rates.

Students should appreciate that all real-world markets are imperfectly competitive to a greater or lesser extent.

4.1.6.4 The determination of relative wage rates and levels of employment in imperfectly competitive labour markets

Content

Additional information

  • How various factors such as monopsony power, trade unions and imperfect information contribute to imperfections in a labour market.
  • How, in a monopsony labour market, the employer can use market power to reduce both the relative wage rate and the level of employment below those that would exist in a perfectly competitive labour market.

The use of relevant diagrams is expected.

4.1.6.5 The Influence of trade unions in determining wages and levels of employment

Content

Additional information

  • The various factors that affect the ability of trade unions to influence wages and levels of employment in different labour markets.
  • How wages and employment are likely to be affected by the introduction of a trade union into a previously perfectly competitive labour market and into a monopsony labour market.

The use of relevant diagrams is expected.

4.1.6.6 The National Minimum Wage

Content

Additional information

  • The effects of a national minimum wage upon labour markets.
  • The advantages and disadvantages of a national minimum wage.
 

4.1.6.7 Discrimination in the labour market

Content

Additional information

  • The conditions necessary for wage discrimination.
  • The impact of gender, ethnicity and other forms of discrimination on wages, levels and types of employment.

Real-world examples should be used to illustrate wage discrimination.

Students should be able to assess the advantages and disadvantages of wage discrimination for workers, employers and the economy as a whole.

4.1.7 The distribution of income and wealth: poverty and inequality

4.1.7.1 The distribution of income and wealth

Content

Additional information

  • The difference between income and wealth.
  • The various factors which influence the distribution of income and wealth.
  • The difference between equality and equity in relation to the distribution of income and wealth.
  • The Lorenz curve and Gini coefficient.
  • The likely benefits and costs of more equal and more unequal distributions.

Some knowledge of the distribution of household income and wealth in the United Kingdom is expected.

Students should understand that the degree of inequality can be measured but that whether or not a given distribution of income is equitable (fair and just) involves a value judgement.

Students will be expected to interpret measures of inequality such as the Gini coefficient but they will not be expected to calculate the Gini coefficient.

Students should understand that excessive inequality is both a cause and consequence of market failure. They should also appreciate that value judgements will influence people’s views of what constitutes an equitable distribution of income and wealth and that these views will influence policy prescriptions.

4.1.7.2 The problem of poverty

Content

Additional information

  • The difference between relative and absolute poverty.
  • The causes and effects of poverty.
 

4.1.7.3 Government policies to alleviate poverty and to influence the distribution of income and wealth

Content

Additional information

  • The policies which are available to influence the distribution of income and wealth and to alleviate poverty.
  • The economic consequences of such policies.

Students should be able to evaluate the various approaches to redistributing income and wealth and alleviating poverty, recognising the moral and political perspectives.

4.1.8 The market mechanism, market failure and government intervention in markets

4.1.8.1 How markets and prices allocate resources

Content

Additional information

  • The rationing, incentive and signalling functions of prices in allocating resources and coordinating the decisions of buyers and sellers in a market economy.
  • The advantages and disadvantages of the price mechanism and of extending its use into new areas of activity.

Students should understand how economic incentives influence what, how and for whom goods and services are produced.

Students should be able to assess the view that the price mechanism is an impersonal method of allocating resources.

They should also be able to assess the view that introducing the price mechanism and markets into some fields of human activity may be undesirable and is likely to affect the nature of the activity, eg introducing a market for blood changes the nature of the transaction and the incentives involved.

4.1.8.2 The meaning of market failure

Content

Additional information

  • Market failure occurs whenever a market leads to a misallocation of resources.
  • The difference between complete market failure (resulting in a missing market) and partial market failure (where a market exists but contributes to resource misallocation).
  • How public goods, positive and negative externalities, merit and demerit goods, monopoly and other market imperfections, and inequalities in the distribution of income and wealth can lead to market failure.

Students should be able to provide examples to inform their discussion of each of these causes of market failure.

4.1.8.3 Public goods, private goods and quasi-public goods

Content

Additional information

  • Pure public goods are non-rival and non-excludable and recognition of the significance of these characteristics.
  • The difference between a public good and a private good.
  • Circumstances when a public good may take on some of the characteristics of a private good and become a quasi-public good.
  • The significance of technological change, eg television broadcasting is now excludable.
  • The free-rider problem.
  • The tragedy of the commons.

Students should appreciate the relevance of the ‘tragedy of the commons’ for environmental market failures.

4.1.8.4 Positive and negative externalities in consumption and production

Content

Additional information

  • Externalities exist when there is a divergence between private and social costs and benefits.
  • Why negative externalities are likely to result in over-production and that positive externalities are likely to result in under-production.
  • Why the absence of property rights leads to externalities in both production and consumption and hence market failure.

Students should be able to illustrate the misallocation of resources resulting from externalities in both production and consumption, using diagrams showing marginal private and social cost and benefit curves.

4.1.8.5 Merit and demerit goods

Content

Additional information

  • The classification of merit and demerit goods depends upon a value judgement.
  • Such products may be subject to positive and negative externalities in consumption.
  • How under-provision of merit goods and over-provision of demerit goods may also result from imperfect information.

Students should be able to illustrate the misallocation of resources resulting from the consumption of merit and demerit goods using diagrams showing marginal private and social cost and benefit curves.

It should be understood that not all products that result in positive or negative externalities in consumption are either merit or demerit goods.

4.1.8.6 Market imperfections

Content

Additional information

  • Why imperfect and asymmetric information can lead to market failure.
  • Why the existence of monopoly and monopoly power can lead to market failure.
  • Why the immobility of factors of production can lead to market failure.
 

4.1.8.7 Competition policy

Content

Additional information

  • The general principles of UK competition policy and some awareness of EU competition policy.
  • The costs and benefits of such policies.

Examples of real-world applications of such policies should provide contexts in which students can evaluate the use of economic models to explore economic behaviour and further develop their appreciation of the behaviour of firms.

Detailed knowledge of UK and EU competition law is not required.

4.1.8.8 Public ownership, privatisation, regulation and deregulation of markets

Content

Additional information

  • The arguments for and against the public ownership of firms and industries.
  • The arguments for and against the privatisation of state-owned enterprises.
  • The arguments for and against the regulation of markets.
  • The arguments for and against the deregulation of markets.
  • The problem of regulatory capture.

Students should be able to assess the application of such policies in the United Kingdom and be able to evaluate their effects on economic performance.

4.1.8.9 Government intervention in markets

Content

Additional information

  • The existence of market failure, in its various forms, provides an argument for government intervention in markets.
  • Governments influence the allocation of resources in a variety of ways, including through public expenditure, taxation and regulation.
  • Governments have a range of objectives and these affect how they intervene in a mixed economy to influence the allocation of resources.
  • The use of indirect taxation, subsidies, price controls, state provision and regulation, the extension of property rights and pollution permits to correct market failure.

Students should be able to apply economic models to assess the role of markets and the government in a variety of situations.

Students should be able to explain, analyse and evaluate the strengths and weaknesses of the market economy and the role of government within it.

Students should be able to evaluate the case for and against government intervention in particular markets and to assess the relative merits of different methods of intervention.

4.1.8.10 Government failure

Content

Additional information

  • Government failure occurs when government intervention in the economy leads to a misallocation of resources.
  • Inadequate information, conflicting objectives and administrative costs are possible sources of government failure.
  • Governments may create, rather than remove, market distortions.
  • Government intervention can lead to unintended consequences.

Students should appreciate that the possibility of government failure means that, even when there is market failure, government intervention will not necessarily improve economic welfare.