(2013) A Level H2 Econs Paper 2 Essay Q1

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1. Economics assumes rational decision-making by consumers, firms and government.

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

Introduction

We assume that rational consumers aim to maximise utility while rational firms aim to maximise profits. To explain what is involved in rational decision-making by consumers & firms - we will use the marginalist principle.

Rational decision-making by consumers

1. Consumers making a rational decision will consider their marginal private cost and their marginal private benefit

2. For instance, in considering whether to consume a sugar sweetened beverage, a rational consumer will consider his / her

• Marginal private costs = cost of beverage, health costs

• Marginal private benefits = satisfaction from the consumption of the beverage

3. The market equilibrium or Qe where MPC = MPB will allow a rational consumer to maximise his/her utility

4. A consumer will not consume at Q1 where MPB > MPC, as consuming more will result in an increase in utility

5. A consumer will not consume at Q2 where MPC > MPB, as consuming more will result in a decrease in utility

Rational decision-making by firms

1. Firms making a rational decision likewise, will consider their marginal private cost and their marginal private benefit

2. In the firm’s case, in considering whether to produce a good or service, a rational firm will consider his / her

• Marginal private costs = cost of production e.g. rental, wages, cost of raw materials

• Marginal private benefits = revenue derived from the sale of the good / service

3. The market equilibrium or Qe where MPC = MPB will allow a rational firm to maximise its profits

4. A firm will not produce at Q1 where MPB > MPC, as producing more will result in an increase in profits

5. A firm will not produce at Q2 where MPC > MPB, as producing more will result in a decrease in profits

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

Negative externalities in consumption

1. Consumers making a rational decision will consider their marginal private cost and their marginal private benefit

2. For instance, in considering whether to consume a sugar sweetened beverage, a rational consumer will consider his / her

• Marginal private costs = cost of beverage, health costs

• Marginal private benefits = satisfaction from the consumption of the beverage

3. This however, ignores the presence of negative externalities. A negative externality (MEC) is a cost imposed on a third party not involved in the production or consumption of the good.

4. In this case, there is a marginal external cost generated when individuals consume excessive quantities of sugar sweetened beverages, it increases the risk of developing diseases such as diabetes. Increased healthcare costs by the state are required to manage such health complications, treatments for such diseases which increases the burden of the average taxpayer.

5. Presence of the MEC leads to the Marginal Social Costs being higher than the Marginal Private Costs.

6. As such, the socially optimal level of consumption should be at Qs where MSC = MSB  while actual consumption occurs at Qm where MPC = MPB

7. Since Qm > Qs, overconsumption occurs and there is an efficient allocation of resources

Negative externalities in production

1. Producers making a rational decision will consider their marginal private cost and their marginal private benefit

2. In the fisherman (producer)’s case, in considering how much to fish, a rational producer will consider his / her

• Marginal private costs = cost of production e.g. rental, wages, cost of raw materials

• Marginal private benefits = revenue derived from the sale of the fish

3. This however, ignores the presence of negative externalities. A negative externality (MEC) is a cost imposed on a third party not involved in the production or consumption of the good.

4. For example in the case of fish producers, there is a marginal external cost generated when producers fish excessively in an area causing a depletion of fish stocks. The fishes may not be able to repopulate in a timely manner and this causes the fish stocks to dwindle, affecting all other future producers from being able to fish in the area.

5. Presence of the MEC leads to the Marginal Social Costs being higher than the Marginal Private Costs.

6. As such, the socially optimal level of production should be at Qs where MSC = MSB  while actual production occurs at Qm where MPC = MPB

7. Since Qm > Qs, overproduction occurs and there is an efficient allocation of resources

Information failure by the government

1. The government in the above instance, may try to correct market failure to bring about a more efficient allocation of resources, through for example, imposing a tax

2. A tax equivalent to MEC, if imposed, should theoretically shift MPC to the left to coincide with MSC, therefore forcing individuals to internalise the MEC, correcting the market failure

3. However, governments suffer from information failure and may not be able to accurately determine the correct value of MEC to impose a tax to correct the market failure.

4. If incorrectly imposed, the outcomes could be that

• An inadequate tax still causes an overconsumption of sugar sweetened beverages

• An excessive tax can now cause instead, underconsumption of sugar sweetened beverages

5. Government intervention may not always result in an efficient allocation of resources either.

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