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Evaluate whether consumers always actrationally (15 marks)
Introduction:
Rationality – The process where consumers attempt to maximise
their utility from a good or service
Bounded rationality - Consumers have limited info, time &
computational ability – decision making is bounded by these
limitations
Irrationality – Consumers make decisions which do not maximise
their utility
Objective of consumers – lowest price for highest utility can be
derived
Diagrams:
Consumption of a demerit good – neg ext of consumption
Analysis:
Para 1: Consumers attempt to maximise utility
Consumers have limited financial resources – will attempt to spend
the lowest price on a g/s to derive max utility
Will have to make choices on costs/benefits of g/s to calculate utility
Evaluation
Para 3: Past experience may cause irrationality
People often follow the status quo they’ve followed their whole life –
will continue to consume familiar goods – do not react to changes in
price/quality/competition
Brand loyalty may prevent people from switching to lower price
substitutes
Importance of recent events may cause overestimation of dangers
of consuming some goods – e.g. recent plane crash may cause
overestimation of risk of accidents
Para 4: May be addicted
Consumers may be addicted to the consumption of g/s – compelled
to consume them – do not care about costs/benefits
Demerit goods – consumption occurs even w/ full info
Diagram analysis
Conclusion
Depends on:
o Asymmetric info – could mislead consumers
o Level of experience
o Proportion of income spent on g/s
,Evaluate whether operating a market economy is
the best way to allocate resources (25 marks)
Intro
Market Economy
Basic Economic Problem
Diagrams
Dynamic Efficiency
Monopoly
Analysis:
Para 1: Dynamically Efficient
Likely to be Dynamically Efficient
Dynamic Efficiency = When the firm invests in capital to reduce CoP
and results in decrease of AC (AC1 to AC2)
Market based system – firms decide pricing – pass on lower costs to
consumers as there is presence of competition
Consumer pays lower price – consumers derive more utility from g/s
– purchasing power & living standards increase
Competition – produce lowest possible costs to make SNP – likely to
be X-efficient
Can use EOS – planned economies may have DOS
EOS = falling LRAC as output increases
Provides efficient allocation of resources
Para 2: Consumers Benefit
Market based system – incentives for firms to produce what
consumers want – consumers decide “what is produced?”
Consumer sovereignty – every unit bought/not bought signals to the
firm the level of demand – consumers benefit from getting what
they want – more utility
Creates innovation – firms need to produce at lowest price –
consumers get higher quality for lower price – max utility
Consumer sovereignty does not occur in planned economy – govt
dictates ‘what is produced?’ – leads to a misallocation of resources –
production of unwanted g/s
Society’s resources used for optimum purpose
Evaluation
Para 3: Consumer exploitation
Market efficiency could cause monopolies to form
Leads to misallocation of resources – no competition between firms
– price makers set high price for g/s
(Integrate monopoly diagram)
Not allocatively efficient – consumer does not pay D=MC
Firm likely chooses to Profit max – profit is at expense of consumer
paying a higher price than they have to
, Misallocation of resources – consumers cannot max utility – each
purchase takes up higher % of disposable Y
Decreases living standards
However, profits can be used as a source of investment – decreased
costs can be passed on to consumer
Para 4: Missing Market
In free market firms unlikely to invest/produce public goods
Public goods = non-excludable – consumer uses them for free
Creates free rider problem – firm is making a loss – decreases
incentive for production
Firm will not make NP – creates missing market
Public good is not provided = lower social welfare – deadweight loss
to society
Living standards decrease as access to socially important goods
(streetlighting) is not provided
Market failure arises due to lack of consumption of merit goods –
positive externalities in consumption not realised
Depends on whether firm has objective of CSR – might choose to
provide some merit goods for society from SNP from other markets
Conclusion
Depends on:
o Govt regulation
o Objectives of firms
, Evaluate the advantages and disadvantages of a
planned economy in allocating resources [25
Marks]
Intro:
Planned Economy – All FoP are allocated by the state – they decide
what, how and for whom goods are made
Diagrams:
DOS
X-inefficiency
Analysis
Para 1: Consumer Welfare is maximised
The price mechanism does not allocate resources.
The state decides the right amount of goods.
As a result, consumers aren't priced out through the forces of
demand and supply.
State less likely to be profit max – likely to be allocatively efficient –
consumers pay lowest price to max welfare
This lowers rent seeking behaviour where resources are only used to
gain profits, without providing benefits
Mitigating any negative externalities in production and maximising
social benefit.
Govt may directly provide public goods – free rider problem
eradicated – would occur in free market economy
Para 2:
Evaluation
Para 3: Suffer from DOS/X-Inefficiency
Planned economy = one firm for each market owned/run entirely by
the state
State monopoly = providing for entire country = higher level of
output
Output may be beyond MES – state monopoly suffers from DOS
DOS = increasing CoP = consumers worse off as g/s more expensive
1 firm = many managers required – do not contribute to production
Managers = increased CoP w/ limited output
Organisational slack could occur – X-inefficiency
Leads to wasted resources
Para 4: Consumers worse off
Govts do decide what, how & for whom g/s are made – no ‘consumer
sovereignty’
Could lead to inefficient allocation of resources – output not
purchased by consumers as do not want it
Market failure as supply exceeds demand – market disequilibrium
Consumers do not get g/s they want
State monopoly = no competition = no innovation
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