Unit 7 – A Level Economics

Complete Notes with Diagrams

Part 1: Marginal Utility Theory

Part 2: Indifference Curve Analysis
Part 3: Basic Economic Ideas & Resource Allocation
PART 1: Marginal Utility Theory

Slide 1 – Unit 7 Title

What is Utility?
When a consumer consumes a commodity, they derive satisfaction. This is called utility — the power of a
commodity to satisfy human wants. Utility is subjective: it varies from person to person, place to place, and time to
time. For example, alcohol has no utility for a non-drinker; meat has no utility for a vegetarian.

Slide 3 – Utility Definition

Two Approaches to Consumer Behaviour

1. Cardinal Utility Approach (Gossen, Marshall)
• Utility is measurable in numbers (1, 2, 3…)
• Uses imaginary units called 'utils'
2. Ordinal Utility Approach (Hicks, Allen)
• Utility is immeasurable but can be ranked (1st, 2nd, 3rd…)
• Consumer is assumed rational in ranking preferences
 Slide 4 – Cardinal Utility

Slide 5 – Ordinal Utility

Types of Utility
Total Utility (TU): Sum of all utilities from all units consumed. TU = MU■ + MU■ + … + MU■
Marginal Utility (MU): Extra utility from one more unit. MU = ∆TU / ∆Q
Average Utility (AU): Utility per unit. AU = TU / Q
 Slide 6 – Total Utility

Slide 7 – Marginal Utility

 Slide 8 – Average Utility

Assumptions of Marginal Utility Theory

• MU of money is constant
• Consumer is rational and aims to maximise satisfaction
• MU diminishes with more consumption (Law of DMU)
• Utility is additive
• Perfect information exists — ideal world

Slide 9 – Assumptions

Law of Diminishing Marginal Utility (DMU)

As more units of a good are consumed, MU falls. The table and diagram below show Mr. A's utility from consuming
chocolates:
Slide 10 – DMU Table & Graph

Slide 11 – DMU Summary

 Slide 12 – TU, MU relationship

• When TU rises at a diminishing rate → MU is positive but falling

• When TU is maximum → MU = 0
• When TU falls → MU is negative

Exceptions to the Law of DMU

• Dissimilar units (small then large)
• Very small units (e.g., water by spoon)
• Time intervals
• Rare collections (stamps, coins)
• Durable goods (TV, fridge)
• Abnormal behaviour (addicts, gamblers)
• Fashion / irrational behaviour

Slide 13 – Exceptions

Law of Equi-Marginal Utility

To maximise satisfaction from a limited budget, a consumer allocates spending so that the weighted MU per unit
of money is equal across all goods:
MUx/Px = MUy/Py = … = MUn/Pn

Slide 14 – Equi-Marginal Utility Law

Slide 17 – Proportional Rule

 Slide 18 – MU Schedule

Slide 20 – Equi-Marginal Table

 Slide 21 – Maximum Utility Calculation

Slide 23 – Equi-Marginal Diagram

Consumer Surplus & Optimum Consumption

• MCS (Marginal Consumer Surplus) = MU – Price
• TCS (Total Consumer Surplus) = sum of all MCSs
• Equilibrium: P = MU → consumer is in equilibrium
• Rational consumer maximises TCS by buying more as long as MU > P
 Slide 25 – Consumer Surplus Table

Slide 28 – Consumer Surplus Diagram

MU and the Demand Curve

A consumer's demand curve is the same as their MU curve. Since equilibrium is at P = MU, as price falls the
consumer buys more units (MU falls as more is consumed). The slope/shape of the demand curve reflects the rate
at which MU diminishes (PED).
Slide 29 – Deriving Demand Curve (1)

Slide 30 – Deriving Demand Curve (2)

Slide 31 – Deriving Demand Curve (3)

Slide 32 – MU = Demand
 Slide 33 – MU's Influence on Demand

Slide 34 – MU & Demand Curve Shape

Significance of MU Analysis
• Basis of the Law of Demand
• Used in marginal decision-making: equate MB with MC (P = MU)
• Supports progressive taxation: rich have lower MU of money than poor
• Resolves the Diamond-Water Paradox (Adam Smith/Carl Menger): Water has higher TU but lower MU
(abundant) → lower price. Diamond has lower TU but higher MU (scarce) → higher price.
 Slide 35 – Significance

Slide 36 – Diamond-Water Paradox

 Slide 37 – Paradox Explained

Budget Line
A budget line shows all combinations of two goods that can be bought with a given income at given prices.
• Slope = –Px/Py
• Budget constraint: TE = Px·Qx + Py·Qy
• Pivots if price of one good changes
• Shifts parallel if income changes

Slide 49 – Budget Line Diagram

Slide 51 – Slope of Budget Line

Slide 53 – Change in Budget Line

Slide 54 – Price Change Pivot

Slide 55 – Both Prices Change

 Slide 56 – Income Change

Substitution Effect & Income Effect (intro)

• Substitution Effect: When price of X falls relative to Y, consumer substitutes X for Y.
• Income Effect: Fall in price of X increases real income → consumer can buy more X (and other goods).

Slide 57 – Income Effect

PART 2: Indifference Curve Analysis

Slide 1 – Unit 7 ICA Title

What is Indifference Curve Analysis?

An ordinal approach — ranks combinations of goods rather than measuring utility. An Indifference Curve (IC) is
the locus (set) of combinations of two goods giving a consumer equal satisfaction. Also called: iso-utility curve /
equal satisfaction curve.
Used to show the effect of: (a) a change in price of goods, (b) a change in income.

Slide 2 – ICA Introduction

 Slide 3 – Uses of ICA

Indifference Schedule
A list of combinations of two goods that give equal satisfaction to the consumer:

Slide 4 – Indifference Schedule Table

Assumptions of ICA
• Non-satiety: More is always preferred to less (e.g., Bundle B with 3X+2Y is preferred to Bundle A with
2X+2Y)
• Consistency: Preferences are stable — if B is preferred to A today, it will always be so
• Transitivity: If A > B and B > C, then A > C
• Diminishing MRS: As more of one good is consumed, the consumer is willing to give up less of the other
 Slide 5 – Assumptions (Non-satiety, Consistency)

Slide 6 – Assumptions (Transitivity, DMRS)

Marginal Rate of Substitution (MRS)

MRSxy = –∆Y/∆X (units of Y given up to get one more X)
MRSyx = –∆X/∆Y
MRS diminishes because goods are imperfect substitutes. When you have lots of Y and little X, you're willing to
give up more Y for one extra X. As you get more X, you give up less Y.
MRS = MUx/MUy = slope of the IC
 Slide 7 – MRS Table

Slide 8 – MRS of X for Y and Y for X

Constructing an Indifference Curve (Example)

Triral is indifferent among the following combinations of pears and oranges — each gives equal satisfaction:
 Slide 9 – Pears & Oranges Indifference Schedule

Slide 10 – Pears & Oranges IC Graph

Properties of Indifference Curves

Property 1 – Downward sloping (negative slope):
To keep satisfaction constant, gaining more of one good requires giving up some of the other. Hence IC slopes
downward to the right.
 Slide 11 – Property 1: Downward Slope

Property 2 – Convex to the origin:

Reflects diminishing MRS. As you substitute X for Y, each additional X is worth less Y. Only a convex IC shows
diminishing MRS.

Slide 12 – Property 2: Convex to Origin

Property 3 – Cannot touch the axes; not parallel:

Touching an axis means consuming only one good — but ICA assumes two goods in combination. ICs are not
parallel because MRS varies on each curve.
 Slide 13 – Property 3: No Axis Touch

Special Case – Perfect Complements (L-shaped IC):

e.g., Left shoe + Right shoe. One without the other is useless. IC is L-shaped.

Slide 14 – Perfect Complements

 Slide 15 – L-shaped IC Diagram

Special Case – Perfect Substitutes (Linear IC):

If two goods are perfect substitutes, MRS is constant = 1, so IC is a straight line with slope –1.

Slide 16 – Perfect Substitutes: Linear IC

Property 4 – Higher IC = higher satisfaction:

Combinations on a higher IC are preferred to those on a lower IC.
 Slide 17 – Property 4: Higher IC = More Utility

Property 5 – ICs cannot intersect:

If two ICs crossed, a point would appear on both — implying the same combination gives two different levels of
satisfaction. This is a contradiction.

Slide 18 – Property 5: No Intersection

Deriving MRS from the Diagram

 Slide 19 – Deriving MRS Graphically

Slide 20 – MRS = MUx/MUy = Slope of IC

At point (a), MRS = 6 (willing to give up 6Y for 1X). At point (b), MRS = 1.
MRS = MUx/MUy = –∆y/∆x = slope of IC

Indifference Map
An infinite number of ICs can be drawn. A finite set of ICs drawn together = Indifference Map. It shows the
consumer's scale of preferences.
• Further curves represent higher utility levels
• The map shows WILLINGNESS of the consumer
• Whether they reach higher ICs depends on their ABILITY (budget)
Slide 21 – Indifference Map Definition

Slide 22 – Willingness vs Ability

 Slide 23 – Indifference Map Diagram

Consumer Equilibrium (Optimum Consumption Point)

The consumer maximises utility where the budget line is tangent to the highest possible IC. At this point:
• Slope of IC = Slope of budget line
• MRS = –MUx/MUy = –Px/Py
• Therefore: MUx/MUy = Px/Py
• No reallocation of the budget can increase utility further

Slide 24 – Equilibrium Position

 Slide 25 – Optimum Point Derivation

Slide 26 – Optimum Consumption Diagram

Effect of Change in Income (Income-Consumption Curve)

An increase in income → new, higher budget line → new optimum on higher IC. Joining all such optimum points =
Income-Consumption Curve (ICC).
• Upward-sloping ICC = both goods are normal goods (positive income effect)
• The ICC traces the income effect
Slide 29 – Income Change Step 1

Slide 30 – Income Change Step 2

 Slide 31 – Income Change Step 3

Slide 32 – ICC Diagram

Effect of Change in Price (Price-Consumption Curve)

A fall in price of X → budget line pivots outward → new optimum on higher IC. Joining these optimum points =
Price-Consumption Curve (PCC).
 Slide 33 – Price Change Effect

Slide 34 – PCC Diagram

Price Effect = Income Effect + Substitution Effect

Price Effect: Change in purchases due to a change in price, keeping money income and other prices constant.
Income Effect: Change in purchases due to change in income, keeping relative prices constant. Varies with type
of good.
Substitution Effect: Change in purchases due to change in relative prices, keeping real income constant.
Consumer substitutes the cheaper good for the dearer one.
 Slide 35 – Definitions

Slide 36 – Substitution Effect Definition

 Slide 37 – Price Effect Formula

Income & Substitution Effects by Good Type

Normal Goods: SE and IE work in the same direction (both reduce Qd when price rises). Large decrease in Qd.
Demand curve is normal and relatively elastic.

Slide 40 – Normal Good: Step 1

 Slide 41 – Normal Good: Price Rise

Slide 42 – Normal Good: Substitution Effect

 Slide 43 – Normal Good: Both Effects

Inferior (Non-Giffen) Goods: SE and IE work in opposite directions. SE > IE (SE wins). Small decrease in Qd.
Demand curve normal but relatively inelastic.

Slide 45 – Inferior Good: Step 1

Slide 46 – Inferior Good: Price Rise

Slide 47 – Inferior Good: SE

 Slide 48 – Inferior Good: Both Effects

Giffen Goods: IE completely overpowers SE. A price rise causes Qd to increase. Upward-sloping demand curve
(paradox). Total effect = Increase in Qd.

Slide 50 – Giffen Good: Step 1

 Slide 51 – Giffen Good: Price Rise

Slide 52 – Giffen Good: SE

Deriving the Consumer's Demand Curve from IC Analysis

PART 3: Basic Economic Ideas & Resource Allocation

Slide 1 – A2 Economics Title

Economic Efficiency
Efficiency is about how well scarce resources (time, talent, materials, technology) are used. Economic efficiency
exists when all scarce resources are used in the best possible way to satisfy the greatest possible level of wants.

Slide 2 – Economic Efficiency Definition

Productive Efficiency
Achieved when output is produced at the lowest possible cost using the fewest resources. Requires technical
efficiency (minimum inputs for a given output).
On a cost curve: productive efficiency exists at the lowest point of the lowest AC curve.
On a PPC: productive efficiency only exists on the boundary. Points inside the PPC are productively inefficient.
Slide 3 – Productive Efficiency Definition

Slide 4 – Example
Slide 5 – Productive Efficiency Diagram (AC Curve)

Slide 6 – Productive Efficiency on AC

 Slide 7 – PPC Diagram

Slide 8 – Productive Efficiency on PPC

Allocative Efficiency
Producing the goods most wanted by consumers. Exists when Price (AR) = Marginal Cost (MC). At this point,
the price paid by consumers equals the true economic cost of producing the last unit.
 Slide 9 – Allocative Efficiency

Slide 10 – Allocative Efficiency Explained

 Slide 11 – P = MC Condition

Slide 12 – Allocative Efficiency Diagram

Economic Efficiency in a Competitive Market

In perfect competition, at equilibrium: MC = MR = AC = AR. Both productive and allocative efficiency are achieved
simultaneously.
 Slide 13 – Competitive Market Efficiency

Slide 14 – Perfect Competition Efficiency Diagram

Static vs Dynamic Efficiency

Static Efficiency: Efficiency at a specific point in time (productive and allocative efficiency are static concepts).
E.g., can a firm produce 10,000 cars more cheaply using more labour and less capital?
Dynamic Efficiency: Efficiency over time — achieved through investment, innovation, and improving product
quality and consumer choice. A monopoly earning supernormal profit can reinvest in R&D.
 Slide 15 – Static Efficiency

Slide 16 – Static Efficiency Diagram

 Slide 17 – Dynamic Efficiency

Slide 18 – Dynamic Efficiency Example

 Slide 19 – Dynamic Efficiency Diagram

Pareto Optimality
A situation where the welfare of the community is at its maximum. It is impossible to make one person better off
without making another worse off. Resources are optimally allocated.

Slide 23 – Pareto Optimality Definition

 Slide 24 – Pareto Optimality Diagram

Market Failure
Occurs when the price mechanism fails to allocate resources efficiently. The self-regulating mechanism doesn't
lead to the best outcome.
Main causes of market failure:
• Externalities (spillover effects)
• Merit/Demerit goods — market under/overprovides them
• Public goods — market cannot provide them efficiently
• Information failure
• Adverse selection and moral hazard
• Abuse of monopoly power

Slide 25 – Market Failure

 Slide 26 – Causes of Market Failure

Externalities
Externalities are costs or benefits to third parties (those not directly involved in the production or consumption of
a good). Also called spillover effects.
Negative Externalities (External Costs): Costs imposed on third parties.
• e.g., Drunk person disturbing the public
• e.g., Car factory causing noise/air pollution, road congestion
Positive Externalities (External Benefits): Benefits received by third parties.
• e.g., Someone improving their front garden — neighbours enjoy it without paying
• e.g., Car factory creating local employment and infrastructure

Slide 27 – Externalities Definition

 Slide 28 – Negative Externalities

Slide 29 – Negative Externality Examples

 Slide 30 – Positive Externalities

Slide 31 – Positive Externality Examples

Types of Externalities
• Consumption → Consumption: A's consumption affects B (positive or negative)
• Production → Production: A's production creates spillovers on producer B (e.g., power plant harms fish
producer = negative; medical R&D; benefits other drug makers = positive)
• Mixed Externalities: Production affects consumer utility, or consumption affects production (e.g., electric
vehicles → cleaner air → better public health)
Slide 32 – Consumption Externalities

Slide 33 – Production Externalities

 Slide 34 – Positive Production Externality

Slide 35 – Mixed Externalities

Costs & Benefits Framework

Term Formula Meaning

MPC (Private Cost) Cost to the producing/consuming individual

MEC (External Cost) Cost imposed on third parties

MSC (Social Cost) MPC + MEC Total cost to society

MPB (Private Benefit) Benefit to the individual

MEB (External Benefit) Benefit received by third parties

MSB (Social Benefit) MPB + MEB Total benefit to society

Slide 36 – Private/External/Social Costs

Slide 38 – MPC, MEC Definitions

 Slide 39 – MSC = MPC + MEC

Slide 40 – Private/External/Social Benefits

 Slide 42 – MPB, MEB, MSB

Problems Created by Externalities

Negative externality → Overproduction:
Market produces at Qp (private optimum). Socially optimal output is Qs (lower). MSC > MPC → resources are
over-allocated. Deadweight Welfare Loss (DWL) is created.
Positive externality → Underproduction:
MSB > MPB → too little of the beneficial good is produced by the market.

Slide 43 – Problem of Negative Externality

 Slide 44 – Deadweight Loss from –ve Externality

Slide 45 – Problem of Positive Externality

Cost-Benefit Analysis (CBA)

A method of evaluating public/national projects by including ALL social costs and benefits — not just private
ones. Uses shadow prices for items without market values (e.g., scenic beauty, travel time).
Decision Criteria:
• B/C > 1 → project is worthwhile
• B/C = 1 → marginal project
• B/C < 1 → project should not proceed
• B – C > 0 → project is selected
Stages of CBA:
• 1. Identify all relevant costs and benefits (private + external)
• 2. Put monetary values on all costs and benefits (shadow pricing)
• 3. Forecast future costs and benefits (for long-term projects)
• 4. Decision: if NSB = SB – SC > 0, proceed
Difficulties:
• Hard to accurately value external costs/benefits
• Politically controversial
• CBA is an aid to decision-making, not a replacement

Slide 46 – Cost-Benefit Analysis

Slide 47 – CBA vs Private Methods

 Slide 48 – CBA Criteria

Slide 49 – Stages of CBA

 Slide 50 – Decision Making Stage

Slide 51 – Difficulties of CBA

Adverse Selection & Moral Hazard (Asymmetric Information)

Occurs when one party has more information than the other.
Hidden characteristics → Adverse Selection:
One party knows more before the transaction. e.g., Company management knows the true value of shares but
outside investors do not.
Hidden actions → Moral Hazard:
One party takes actions the other cannot observe. e.g., An employee on a fixed salary may slack off (play games,
browse social media) since the employer cannot monitor this.
Slide 52 – Adverse Selection & Moral Hazard