NYJC H2 ECONS Q3

Question 3 a. Using examples, explain the basis by which rational decisions are being made by consumers and producers. [10] b. Assess the economic case for government intervention in the market when externalities are present. [15] Part a: Using examples, explain the basis by which rational decisions are being made by consumers and producers. Command – Explain Content – Basis for decision making for consumers and producers Context – Open The fundamental basis of economic decision making is individuals' or organizations' desire to maximize benefits while minimizing costs. This balancing act is referred to as maximizing value, and it is a sk ill that takes practice to master. For individuals, val ue maximization decisions may include choosing between name-brand products and generic products, and choosing between small or bulk sizes. For a company, value maximization involves finding the lo west-cost suppliers that meet the company's quality standards, then determining the economic order quantity for each purchase. Economic order quantity is the perfect amount of a product or material to order at a time, taking advantage of quantity discounts while also keeping holding and transportation costs under control. Explain what is involved in rational decision-making both by consumers and by firms. All economies face the problem of scarcity, a situa tion where there are unlimited wants but limited resources. Thus, choices have to be made for the best allocation of resources in an economy. Similarly, consumers and firms also face constraints and thus must also make choices. As opportunity cost is incurred when making choices, societies will choose the particular assortment of goods and services with the objective of gaining the highest level of satisfaction with the least possible cost. Both consumers and firms makes rational decision where t hey aim to maximise their self-interest. In the case of consumers, utility maximisation while in the case of firms, it is profit maximisation. This can be achieved by weighing up the opportunity cost arisin g from an activity against the benefits, by considering the marginal effects of change. Body 1: Marginalist principle applied to consumers in their decision making process A rational consumer seeks to maximise net total ben efits from consuming a good. Rational decision- making by consumers involves considering the marginal benefits and the marginal costs of consuming the good. Consumer will consume when MPB=MPC. The m arginal benefit is the satisfaction derived from consuming an additional unit of the good while the marginal cost is the price paid for the good. For example, if the plate of wanton mee costs $3 am d $1 is equivalent to 100 utils, the wanton mee should bring the consumer 300 utils of satisfaction . If a plate of wanton mee brings Tim 400 utils of satisfaction then Tim would deem that the plate of wanton mee is cheap as he pays only $3 for 400 utils of satisfaction. Tim would then buy that plat e of mee. If the 2 nd plate brings him 300 utils of satisfaction, then Tim would consume the second pla te and stop there as the price he pays is equivalent to the satisfaction he gets from consuming it! A rational consumer will buy an extra unit of a good as long as marginal benefit (MB) exceeds the price of the good because it increases the level of net t otal benefits from consumption i.e. consumers will consume up to the point where MB=P where the total net benefits are maximised. Consumers will not

consume the additional unit where MB is less than p rices as it lowers the net total benefits from consumption. (Explanation could also be given with reference to the MPB=MPC concepts) Since rational consumers will buy a product only if the MB exceeds or is at least equal to the price paid for it, it follows that the demand curve in a marke t represents the MB that consumers derive from consuming an extra unit of the good. Body 2: Marginalist principle applied to firms in their decision making process A rational firm seeks to maximise total profits fro m the production and sale of a good. Rational decision making by firms means that firms will base their output decision on the marginal revenue and marginal cost. In deciding how many units of a good to produce, a profit maximising firm will produce up to the point where the additional cost from prod ucing one additional unit of output equates the additional revenue from selling it. A rational firm will produce and sell an extra unit of a good as long as MR > MC. Because this means that by producing that unit, there will be bigger addition to revenue (MR) than to cost (MC) and total profits will increase given that marginal profit is positive. When production by the firm is at an output where MC exceeds MR, producing that add more to cos t than to revenue and hence reduce profit. Firms’ profits can be increased by cutting back on production since marginal profit is negative. Firms thus produce up to the point where MR=MC where the total profit is maximised. In perfect competition, MR=P. This means that the f irms produce up to the point where P=MC. This also means that the firm’s supply curve for the good, reflects the MC of the good. Body 3: Other basis for decision making by the consumer and the producer Rational consumer and producer decisions could also be made based on the following: • Gut instincts – some consumers or producers could base their decisions on an experiential or emotional background that may have no theoretical or analytical basis. Decisions made on gut instincts could come about due to refined and impro ved intuitive instincts drawn from repeated successes and sharpened discernment. • Alternative objectives – producers may have alterna tive objectives eg output maximization, revenue maximization, welfare maximization or others and these would govern their decision making maxim upon which they will decide as to how to price their product or decide upon which amount of output they would want to produce. • Statistical data – some consumers or producers may make decisions based on some statistical data that they may have gathered on their own or th rough some other means. These data may be random inputs that in and of themselves may hold little value. Validity of such decisions may be flawed depending on the nature of the data collected. • Information – information is obtained when data is derived from a more complete set of processed facts that would allow for a more thoroug h analysis and thus better informed decisions that are to be made. • Knowledge - Knowledge is information that has been refined by analysis. The knowledge has been assimilated, tested and/or validated. Most imp ortantly, it is actionable with a high degree of accuracy as there is proof that the conce pt exists. Decisions based on knowledge would prove to be more accurate than those based on data or information. These alternative sources of decision making proces ses for the consumer or the producer are valid and used by them. Conclusion The marginalist principle is adopted by both consum ers and firms when they attempt to maximise their self-interest. When resource allocation is left to the price mechanism, goods are produced up to

the point where demand matches supply. Since demand reflects MB and supply reflects MC, at the market equilibrium point, w