2013 A level H2 Economics Review: Microeconomics Qn 1

Economics assumes rationality decision making by consumers, firms, and government.

a) Explain what is involved in rational decision making both by consumers and firms. [10]
b) Discuss whether rational decision making by consumers, firms and government always lead to an efficient allocation of resources. [15]

The question is about the fundamental principles of economics in (a) and market failure in (b). Explain the thinking processes of consumers and producers and subsequently discuss how said rationality might create efficiency.

a) Explain what is involved in rational decision making both by consumers and firms. [10]

Economists assume many things. Rationality is one of them. A consumer is said to be “making a rational decision” when she chooses to eat chicken rice instead of nasi lemak for dinner because, all things considered, chicken rice makes her happier and better off.

There are two parts to a rational decision. First we have the objective or some measure that we want to maximise. For consumers this is usually utility and for producers it is profits. In the chicken rice example, this is the welfare and level of happiness of the consumer. Second there is the constraint or set of feasible outcomes we can choose from. Again, in the chicken rice example, the consumer only has two feasible options – chicken rice and nasi lemak – to choose from. She cannot eat peanut butter jelly because social convention dictates that to be an unlikely choice for dinner and she cannot eat a seafood buffet because she cannot afford it.

Consumers try to maximise the satisfaction obtained from consuming goods and services. The choice they have to make is the amount to consume of each good. This will lead to the demand curve. The higher the prices the less they will consume. For example, when price of a good increases, the consumer is likely to reevaluate his choice because he is poorer in terms of purchasing power (income effect) and he might have better alternatives to spend his money on (substitution effect). In this case, he is likely to consume less of the good.

Producers are profit maximising. The choice they have to make is the amount to produce for each good. This will give us an upward sloping supply curve. As prices increase, it will be more profitable for producers to supply more units of goods, all things constant. For instance, in a perfect competition market, when demand increases, driving up the prices of goods and services, it will attract more firms to enter the market and existing firms to increase their production of goods and services.

For both consumers and producers, rational decision making involves “thinking at the margin“. A simple example will be profit maximisation. We all know it is when MC=MR, and when MC > MR, producers should lower output and when MC < MR, producers should step up production. That is in a nutshell, thinking at the margin, which guarantees maximisation given certain assumptions (which will not be covered in A level economics, even though they are covered in A level Math).

For a 82 seconds explanation of the concept of rationality, check out this video.

b) Discuss whether rational decision making by consumers, firms and government always leads to an efficient allocation of resources. [15]

You want to answer exam questions directly. Avoid starting from the negative of the statement, which I imagine would be the most common mistake here. So start out by illustrating how rational decision making leads to efficient allocation of resources. An allocation is termed efficient when it is a social optimum. We know from H2 economics that with a few restrictive assumptions, the equilibrium arising from a competitive market with consumers and firms will be efficient. (Draw a demand and supply diagram and a corresponding diagram for a PC firm to show P=MC and explain why P = MC is socially optimum. Also explain how the equilibrium is stable.)

The assumptions needed are:

  1. Large number of producers and consumers, each having no control over the market price (price taking behaviour).
  2. No externalities and misinformation.
  3. No uncertainty.

If any of the above is not met, then efficiency is not guaranteed. But there’s a catch: the question did include governments in the mix. Governments can regulate markets and may be able to resolve the inefficiency. So with the help of rational governments, perhaps we may come down to only one assumption:

  1. Perfect information (and negligible cost in gathering it).

But I would argue that this is an unreasonable assumption that cannot ever be met. This should be rather unsurprising because the main advantage of the market system is that it allows decentralised decision making. To achieve efficiency, each consumer only has to know his own preferences and the market price and nothing more! In order for governments to achieve the same outcome in markets, they have to first know the aggregated preferences of all consumers for all goods.

However, governments are not entirely hopeless. In many cases they can still improve outcomes even with partial information. Examples include provision of public goods like defence and subsidies for merit goods like education and healthcare. The outcomes may not be efficient but they are better than not intervening at all.

What do you think? Please do leave your responses and questions in the comments below.

Till then, dream economics.

The above was jointly written by Kenneth and Hanfei.