The price system

7 and the micro

economy
Ideas for answers to Progress
Questions
1

Quantity 1 2 3 4 5 6 7 8
Total utility 100 190 250 300 340 350 357 360
Marginal utility 100 90    60    50    40    10     7     3
2

Output TC FC VC AFC AVC AC MC

0 110 110 – – – – –
1 170 110 60 110.00 60.00 85.00 60
2 220 110 110 55.00 55.00 110.00 50
3 260 110 150 36.70 50.00 86.70 40
4 320 110 210 27.50 52.50 80.00 60
5 420 110 310 22.00 62.00 84.00 100
6 560 110 450 18.30 75.00 93.30 140
7 780 110 670 15.70 95.70 111.40 220
8 1020 110 910 13.75 113.80 127.50 240
9 1320 110 1210 12.20 134.40 146.70 300
10 1680 110 1570 11.00 157.00 168.00 360
3 If an individual firm in a perfectly competitive market were to reduce its price,
because of the characteristic of perfect knowledge all consumers and other
firms would instantly be aware of this. Because the product is a homogeneous
good and consumers are indifferent as to whom they buy from, all consumers
would instantly switch to buying from the firm that had reduced its price
and away from other firms. As there is a perfectly elastic supply of factors
of production, the firm that has reduced its price would be able to meet the
increased demand and all other firms would either go out of business or (as is
more likely) reduce their price to the same level. The overall effect would be to
reduce profits for all firms. As the firm will know this there is no incentive to
reduce the price in the first place.

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Ideas for answers to Case Study
Questions
Increasing size of supertankers
1 Economies of scale available to shipping lines include: technical (economies of
increased dimensions; use of large capital equipment; R&D), marketing (bulk
buying of oil). Economies of scale for retailers mainly involve bulk buying
from low-cost suppliers.
2 As a result of their size both shippers and retailers will have access to a
wide range of economies of scale, e.g. financial (ability to raise finance from
a variety of sources at preferential rates), managerial (both shippers and
retailers can benefit from the ability to employ a range of experts/specialist
staff; as the ships can be run by very few crew members the size of the ship
can be increased with little increase in staffing costs). Shippers in particular
may benefit from external economies of scale such as the growth of
ancillary industries and suppliers particularly in relation to the building
of the supertankers.
3 Both shippers and retailers will be liable for all the main diseconomies of
scale: managerial, communication difficulties, alienation of workers and
labour disputes. These should be discussed in the context of shippers and
retailers in the case study.

Price discrimination and the internet

1 Price discrimination should be defined. Conditions for successful price
discrimination are:
uuSome degree of monopoly power
uuAbility to separate the market (examples should be given)
uuNo seepage (it must not be possible to buy in one market and re sell in another)
uuPrice elasticities of demand must be different in each market (the reason
for this should be illustrated diagrammatically).
The answer should make use of the data in the case study.
2 This can be developed in a number of ways. On the one hand the
development of the internet increases the amount of information available
to consumers which might make price discrimination by firms more
difficult. On the other hand the internet makes it easier for firms to identify
and target different segments of the market making price discrimination
more possible.
Again, the answer should make use of the information in the case study, as
well as research findings.

Product differentiation in the European low-cost

airline market
1 The process of creating real or perceived differences between products.
2 Possible advantages for Flybe might include:
uuIncreased revenue
uuIncreased market share
uuBrand loyalty
2

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 uuIncreased barriers to entry
uuDemand for flights might increase and/or demand might become more
inelastic.
Possible issues for Flybe and the market as a whole might include:
uuIncreased costs for Flybe which might impact on profits
uuIncreased price and non-price competition
uuRetaliation from other airlines (possible price wars)
uuFirms being forced out of the market.
3 Possible advantages for consumers might include:
uuLower prices if competition in the market increases (especially if a price
war ensues)
uuImprovement of service
uuGreater frequency of flights.
Possible disadvantages for consumers might include:
uuIncrease in prices if Flybe’s costs increase
uuIncreased market power/market domination by Flybe, which might
lead to some of the disadvantages of monopoly (e.g. higher prices, lower
output, less variety, less innovation, price discrimination).

Supermarket price war

1 This question should be answered within the context of oligopoly theory.
There are a range of issues that could be discussed each of which should be
discussed within the context of the case study material provided. Issues that
could be discussed include:
uuRelative market share of the retailers indicated in the case study including
concentration ratios
uuThe characteristics of oligopolistic markets
uuMutual interdependence and the tension within oligopolistic markets
between collusion and competition
uuTypes of collusion and the likely impact
uuCompetition – the kinked demand curve and the likelihood/effect
of price wars
uuGame theory
uuNon-price competition.

Oligopoly – the UK petrol market

1 This question is essentially asking for an evaluation of the case for and against
the UK petrol market becoming more oligopolistic through the actions
being taken by the major retail food supermarkets who also supply fuel.
Throughout the answer, the theoretical arguments should be placed within
the context of the material in the case study.

Taxis – a contestable market

1 The answer should:
uuDefine and clearly identify the main characteristics of a contestable market
3

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 uuCompare the characteristics of a contestable market with the features of
the taxi markets in the case study
uuEvaluate the extent to which the taxi markets in the case study can be
regarded as contestable.

Answers to Activities
Budget lines
Apples

A
25

B
0 50 Pears

With an income of $100 an individual could purchase a maximum of

$100 ÷ $4 = 25 apples or a maximum of 50 pears ($100 ÷ $2). The budget
line is AB.
Apples

A
25

C B D
0 20 50 100 Pears

a If the price of pears rises to $5 an individual will still be able to buy
25 apples, but now only 20 pears. The budget line pivots inwards to
become AC.
b If the price of pears falls to $1 an individual will still be able to buy
25 apples, but will now be able to buy 100 pears. The budget line pivots
outwards to AD.

Income and substitution effects

a
Good A

L
R
Z
X
Y I1

I2

0 Q3 Q2 Q1 J M T Good B
4

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 The effect of a rise in the price of good B is that the demand for good B falls
from Q1 to Q3. The movement from Q1 to Q2 is the substitution effect and
the movement from Q2 to Q3 is the income effect. Both effects move in the
same direction to reduce the consumption of good B.
b
Good A

L
K

Z
X
I1
Y

I2

0 Q2 Q3 Q1 J M T Good B

The effect of a rise in the price of good B is that demand for good B falls
from Q1 to Q3. The movement from Q1 to Q2 is the substitution effect and
the movement from Q2 to Q3 is the income effect. The substitution effect acts
to reduce consumption but the income effect acts in the opposite direction.
However, the substitution effect is greater than the income effect and so the
overall effect is to reduce consumption of good B.
c
Good A

L
K

I1

Y
I2
0 Q2 Q1Q3 J M T Good B

The effect of a rise in the price of good B is that demand for good B rises from
Q1 to Q3. The movement from Q1 to Q2 is the substitution effect and the
movement from Q2 to Q3 is the income effect. The substitution effect acts to
reduce consumption, but the income effect acts in the opposite direction. It is
greater than the substitution effect and so the overall effect is to increase the
consumption of good B.

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Sales revenue maximisation
Cost and
revenue

X Y TC

TR

0 Q1 Q2 Quantity

profit maximumising output = Q1

Sales revenue maximising output = Q2
Q X
Profit maximising price = 1
O Q1
Q Y
Sales revenue maximising price = 2
O Q2
Cost and
revenue

MC
AC
P1
P2

AR

0 Q1 Q2 Q
MR
Profit maximising price and output = p1, Q1
Sales revenue maximising price and output = P2 Q2

Ideas for answers to Exam-Style

Questions
1 The answer should:
uuDefine utility
uuDefine total utility and marginal utility
uuExplain how the normal downward sloping demand curve for a product is
derived using marginal utility theory
uuEvaluate the extent to which marginal utility theory provides an explanation
of the downward sloping demand curve, in particular explaining the
limitations of the theory, e.g. difficulties in measuring utility, assumption
of all other things remaining equal, behavioural economists’ attack on the
notion of rational economic decision-making etc.
6

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2 a The answer should:
uuExplain what is meant by the principal–agent problem
uuExplain what is meant by the divorce of ownership and control in the
modern corporation, i.e. ownership is in the hands of shareholders
who appoint managers to exercise control
uuExplain the nature of asymmetric information, i.e. the fact that owners
lack the skills and knowledge to run the company which is why they
appoint managers who do have the skills and knowledge
uuExplain that the divorce of ownership and control may mean that
managers may pursue goals other than profit maximisation.
b The answer should explain one of the theories of the firm that has
been developed as an alternative to the traditional theory based on the
assumption of profit maximisation. Alternative theories could include:
uuSales revenue maximisation
uuGrowth maximisation
uuManagerial utility maximisation
uuBehavioural theories.
In each case the implications for price, output and decision-making should
be explained. Where appropriate accurate diagrams should be provided.
3 a Accurate definitions for each cost concept should be provided.
FC
Average fixed costs are fixed costs per unit of output; AFC =
Q
VC
Average variable costs are variable costs per unit of output; AVC =
Q
TC
Average costs are costs per unit of output; AC = or AFC + AVC
Q
Marginal costs are the addition to total costs when output is increased by
one unit.
∆TC
MC =
∆Q
b The answer should:
uuDistinguish between the short run (at least one fixed factor) and the
long run (all factors of production variable)
uuExplain the fact that in the short run the shape of the average cost
curve is determined by the law of diminishing returns and in the long
run by economies and diseconomies of scale
uuExplain the law of diminishing returns and go on to explain how this
determines the shape of the short run average cost curve for a firm;
this should be illustrated with an accurate diagram
uuExplain economies and diseconomies of scale (with some examples of
each) and explain they determine the shape of the long run average cost
curve for a firm; this should be illustrated with an accurate diagram.
4 The answer should:
uuExplain the characteristics of a perfectly competitive market
uuExplain the characteristics of a monopolistically competitive market
uuContain diagrams to illustrate the long-run equilibrium position for forms
in perfect and monopolistic competition

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 uuWith the aid of the diagrams, compare the positions of perfectly and
monopolistically competitive firms in terms of price, output, allocative and
productive efficiency, non-price competition strategies.
5 The answer should should:
uuDefine monopoly and briefly explain how monopoly may arise.
uuExplain with the aid of a diagram the case against monopoly explaining
that monopolies may abuse their power in the market by charging high
prices and restricting output. They are also productively and allocatively
inefficient and may engage in practices such as predatory pricing and price
discrimination. Appropriate real-world examples should be given.
uuExplain with the aid of a diagram the case for monopoly, i.e. the fact that
a monopoly can reap economies of scale may mean that it is dynamically
efficient and can, therefore, produce a higher output at lower price than
a competitive firm. The fact that a monopoly can earn supernormal
profits may mean that it is in a position to be innovative, introducing new
technology. Appropriate real-world examples should be given.
uuExplain that in some cases a service is most efficiently produced if it is run
as a monopoly – natural monopolies.
uuExplain that in some cases a monopoly market may be contestable, in
which case the monopoly may not abuse its market power for fear of new
entrants in the future.
uuProvide a considered evaluation/judgement based on the arguments
put forward.
6 a The answer should explain that “rational consumers” as defined by
economists make decisions based on perfect information in such a way as
to maximise their total utility and that changes in behaviour are based on
evaluation of costs and benefits at the margin.
b The answer should:
uuExplain that consumer behaviour might not always appear “rational”
in the sense used by economists and give examples of apparently
irrational behaviour
uuExplain the nature of  “behavioural economics”
uuExplain with examples the insights that behavioural economics might
provide in explaining such apparently irrational behaviour.
7 The answer is D.
Marginal cost is the addition to total cost when output is increased by one
unit. It is, therefore, the change in total cost divided by the change in output,
∆TC
i.e. . The answer is therefore D.
∆Q
TC
A is incorrect as Average cost =
Q
FC
B is incorrect as Average fixed cost =
Q
VC
C is incorrect as Average variable cost =
Q
8 The answer is B.
B is the correct answer as firms in monopolistic competition have a monopoly
over the particular brand of the product they produce (the result of product
differentiation) and as such they are in a position to make supernormal profits
8

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 in the short run. However, these will be eroded in the long run as new firms
producing similar products enter the market.
A is incorrect as firms in monopolistic competition experience excess capacity
producing an output which is less than that at which minimum average costs
are experienced.
C is incorrect as an assumption of monopolistic competition is that there are
no barriers to entry to the industry.
D is incorrect as one of the characteristics of monopolistic competition is that
firms practice product differentiation and so the goods produced will not be
homogeneous.

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