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Economic A Level Notes
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Class notes economics Cambridge International AS and A Level Economics Second Edition
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Class notes economics Cambridge International AS and A Level Economics Second Edition
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Unit 2.1: Demand Theory
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Economics A-Levels NotesBasic Economic Ideas and Resources allocation
Economic efficiency
Economic efficiency is when scarce resources are used in the most efficient way to
produce maximum output
● Productive efficiency: Firms are producing at the lowest cost possible and using
the least resources. If an economy is at the boundary of its PPC, then it is
producing optimally. Competition can lead to productive efficiency as firms
produce the lowest cost possible because of higher profits and survival.
● Allocative efficiency: Firms should produce the right amount of goods needed. It
occurs when the price of products is equal to its marginal cost as it represents the
true economic cost of producing that good. This cannot be shown on a PPC.
Competitive markets lead to allocative efficiency as firms produce those goods as
needed by the market.
Pareto optimality: where it is impossible to make someone better off without making
someone else worse off. If an economy is operating at the boundary of a PPC, it cannot
produce more of one good without sacrificing the other. If the allocation of resources is
not Pareto efficient then there is room for Pareto improvement.
Dynamic efficiency: Resources are allocated in such a way that output increases relative
to the increase in resources. Firms meet the changing needs of their market by allowing
new production methods to take place. It's how oligopolies and monopolies stay
competitive.
Market Failure
Market Failure is when markets fail at delivering economic efficiency, free markets fail
to make optimum use of scarce resources.
,Externalities are the actions of producers and consumers which gives rise to side
effects on third parties, AKA spillover effects. There are negative and positive
externalities
Social costs are the total costs of a particular action. External costs are paid for by
third parties and private costs are borne by the individual directly involved in an action
Social benefits are the total benefits of a particular action. External benefits are
received by third parties and private benefits are received by the individual directly
involved.
Goods with negative externality tend to be overproduced. The price of these goods will
be lower than if all costs are realised and demand will be more. Good with positive
externality tend to be under-produced. The benefits of these goods are not realised and
demand will be less than if all benefits were recognized.
Cost-benefit analysis
A method of assessing the desirability of a project takes into account all costs and all
benefits. It is used by the public sector in decision-making. It differs from the private
sector as it takes into account the social costs and benefits, too, and it puts a shadow
price (applied when there is no market price available) on costs and benefits.
The framework of cost-benefit analysis:
1. Identification of all relevant costs and benefits
2. Putting a monetary value on them
3. Forecasting future costs and benefits
4. Decision making
Price System and the Microeconomy
Utility
The utility is the satisfaction gained from consumption. Total utility is total satisfaction
gained and marginal utility is the satisfaction gained from consuming one extra unit.
Diminishing marginal utility is a concept where marginal utility decreases as consumption
,increases, this might result in disutility. Consumers try to maximise their utility in
theory. When utility is maximised, it is called Equi-marginal utility (when marginal
utility valuation is the same for all products).
Diminishing marginal utility suggests that consumers are rational; this, however, is not
the case. Special offers, deferred payment, emotional attachment, prejudice against a
brand causes consumers to act irrationally,
Budget line and indifference curves
Budget lines are combinations of two goods consumers can buy given an income. The
indifference curve shows the different combinations of two goods that give equal
satisfaction. The marginal rate of substitution is the rate at which consumers are
willing to sacrifice one good while keeping satisfaction the same as measured by the
slope.
The income effect is where following a price change, a consumer has higher real income
and will purchase more of that product. The substitution effect is following a price
change, consumers will go for the cheaper product relative to the expensive one. The
consumer's choice is optimal at the point where the budget line touches at the tangent
to the highest indifference curve.
IE and SE effects of a price change using indifference curves (see Fig 7.4). IE and SE
move in opposite directions in inferior goods and move in the same directions in normal
goods. For the diagram, first, we show SE by drawing a line parallel to the new budget
line touching the old indifference curve. For the IE, the new budget line touches the
new indifference curve.
Types of Cost/ Revenue and Profit/ Short-run and long-run production
Short-run production: Isoquant is a curve that shows a particular level of output that
can be produced using different production methods. In the short-run production
function, only labour is the variable production factor. All others are fixed. The
production function shows the maximum output from given resources. Marginal product
is the change in output when one unit of input is increased and diminishing marginal
return is when the marginal product falls when input is increased. A firm is any business
, that hires factors of production to produce goods and services with particular
objectives such as profit maximizations.
Short Run Costs
● Fixed costs - costs independent of output in the short run
● Variable costs - costs that vary with output in the short run. All costs are variable
in the long run. Marginal cost is also a variable cost. Rising marginal cost is a
reflection of diminishing marginal return.
MC crosses AVC and ATC at the lowest point because that's when production is at its
most efficient.
From short run to long run
Short is the period in economics when at least one FoP is fixed. The easiest factor to
change - is labour. Longest factor to change - Capital. All FoPs are variable in the long
run. Increasing returns to scale is where output increases at a faster rate than the
increases in factor inputs. Decreasing returns to scale is where factor input increases at
a faster rate than output. Isocosts are lines of constant relative costs for FoPs. The
points where isoquants are tangential to isocosts are joined to make the long-run
production function (expansion path). Limitations of this
● It is difficult to determine the isoquants because of no data or no experience
● The assumption that all FoPs are variable in the long run
● Some employers may be reluctant to switch labour because of social obligations
Long-run Costs
In the very long run, technology can change the entire production process, including the
nature of products. Firms can find ways of decreasing their cost structure over time.
Increasing the amount of capital used relative to labour in the production process, with
a consequent increase in factor productivity. LRAC shows the least costly combinations
of producing any particular good. Lowering LRAC suggests a firm can lower prices
without sacrificing profits. The LRAC curve is tangential to all of its SRAC. It is the
lowest possible average cost for each level of production.
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