Government Economic Service (GES) Assessment Centre Microeconomics for Policy Analysis Syllabus

What does the marginal rate of substitution (MRS) measure and what equals it at the optimum?

The MRS is the rate at which a consumer will trade one good for another keeping utility constant: $MRS = \frac{MU_x}{MU_y}$. At the optimum it equals the price ratio: $MRS = \frac{P_x}{P_y}$.

What are the defining properties of standard indifference curves?

They are downward sloping, convex to the origin (diminishing MRS), never cross, and higher curves represent higher utility. Each maps a set of bundles giving equal satisfaction.

Distinguish the substitution effect from the income effect of a price change.

The substitution effect is the change in quantity from the change in relative prices holding utility constant; the income effect is the change from the change in real purchasing power. Together they give the total (Slutsky) effect.

Write the formulas linking total, average and marginal cost.

$$TC = FC + VC,\quad ATC = \frac{TC}{Q},\quad AVC = \frac{VC}{Q},\quad MC = \frac{\partial TC}{\partial Q}$$

Why are short-run average cost curves typically U-shaped?

At low output, spreading fixed costs lowers ATC; at high output, diminishing marginal returns to the variable factor raise marginal and average costs. The minimum of ATC is where $MC = ATC$.

Distinguish economies of scale, diseconomies of scale and minimum efficient scale.

Economies of scale: long-run average cost falls as output rises. Diseconomies: LRAC rises with output. Minimum efficient scale (MES) is the lowest output at which LRAC is minimised.

State the general profit-maximisation rule for any firm.

A firm maximises profit by producing where marginal revenue equals marginal cost, $MR = MC$, provided $MC$ is rising through that point and price covers average variable cost in the short run.

What is the marginal revenue for a price-taking (perfectly competitive) firm?

For a price taker, marginal revenue equals price: $MR = P$. So its profit-maximising rule simplifies to $P = MC$.

State the short-run shutdown rule and the long-run exit rule.

Shut down in the short run if price is below average variable cost ($P < AVC$). Exit in the long run if price is below average total cost ($P < ATC$).

How is the marginal revenue curve related to demand for a price maker, and what is the MR formula?

For a downward-sloping demand curve, $MR$ lies below price and falls twice as fast (for linear demand). In general $$MR = P\left(1 + \frac{1}{E_d}\right)$$

What is bounded rationality?

Bounded rationality (Herbert Simon) is the idea that decision-makers are limited by available information, cognitive capacity and time, so they 'satisfice' (seek a good-enough option) rather than optimise perfectly.

Name four key behavioural-economics concepts relevant to policy.

Loss aversion (losses loom larger than gains), present bias/hyperbolic discounting, anchoring, framing effects, default/status-quo bias, and bounded willpower. These motivate 'nudge' policies.

What is a 'nudge' in behavioural policy and give an example?

A nudge alters the choice architecture to steer behaviour predictably without forbidding options or changing economic incentives much. Example: automatic enrolment in pension schemes (changing the default).

State the four assumptions that define perfect competition.

Many small buyers and sellers (price takers), a homogeneous product, free entry and exit, and perfect information. Result: firms face a perfectly elastic (horizontal) demand curve.

Why does perfect competition achieve allocative efficiency in long-run equilibrium?

In long-run equilibrium $P = MC = \min ATC$, so price equals marginal cost (allocative efficiency) and output is at lowest average cost (productive efficiency), with firms earning zero economic profit.

State the condition for allocative efficiency and explain it.

Allocative efficiency occurs where price equals marginal cost, $P = MC$: the value to consumers of the last unit equals its marginal cost of production, so resources are allocated to their highest-valued use.

What is the source of deadweight loss under monopoly?

A monopoly sets $MR = MC$ with $P > MC$, restricting output below the competitive level. The lost mutually beneficial trades between the monopoly quantity and the efficient quantity create deadweight loss.

Define the Lerner index of monopoly power.

$$L = \frac{P - MC}{P} = -\frac{1}{E_d}$$ It ranges from 0 (perfect competition) toward 1; higher values indicate greater market power and more inelastic demand.

State the three conditions required for successful price discrimination.

The firm must have market power (price-setting ability), be able to separate consumers by willingness to pay (or elasticity), and be able to prevent arbitrage/resale between groups.

Distinguish first-, second- and third-degree price discrimination.

First-degree: charge each consumer their maximum willingness to pay (captures all surplus). Second-degree: price varies by quantity/version (e.g. block tariffs). Third-degree: different prices to identifiable groups (e.g. student discounts).

What characterises an oligopoly market structure?

A small number of interdependent firms, significant barriers to entry, and the possibility of differentiated or homogeneous products. Each firm's optimal action depends on rivals' actions (strategic interaction).

What is a Nash equilibrium in the context of oligopoly?

A Nash equilibrium is a set of strategies where no firm can gain by unilaterally changing its own strategy, given the strategies of the others. It is the standard solution concept for strategic interaction.

Why is the prisoner's dilemma used to model cartel behaviour?

Each firm has an incentive to cheat (cut price/raise output) regardless of the other's choice, so the dominant-strategy Nash equilibrium is mutual defection (competition) even though collusion would yield higher joint profits — explaining cartel instability.

What does the kinked demand curve model predict about oligopoly prices?

It assumes rivals match price cuts but ignore price rises, so each firm faces a demand curve kinked at the current price. This makes demand elastic above and inelastic below, producing a gap in the MR curve and sticky prices.

What defines monopolistic competition?

Many firms, differentiated products, and free entry/exit. Firms have some price-setting power (downward-sloping demand) in the short run but earn zero economic profit in the long run as entry erodes profits.

Why is monopolistic competition allocatively and productively inefficient in the long run?

In long-run equilibrium price equals average cost (zero profit) but $P > MC$ (allocative inefficiency) and output is below minimum ATC, leaving excess capacity (productive inefficiency).

What is a contestable market?

A market where entry and exit are costless/frictionless (no sunk costs), so the threat of 'hit-and-run' entry disciplines incumbents to set prices near average cost and earn normal profit even with few firms.

List the main types of barriers to entry.

Structural barriers (economies of scale, high sunk/capital costs, control of key inputs, network effects), legal barriers (patents, licences, regulation), and strategic barriers (limit pricing, predatory pricing, brand proliferation).

Define a negative externality and state its efficiency consequence.

A negative externality is a cost imposed on third parties not reflected in market prices (e.g. pollution). Because marginal social cost exceeds marginal private cost, the market over-produces relative to the efficient level, creating deadweight loss.

What is a Pigouvian tax and what is its optimal level?

A Pigouvian tax corrects a negative externality by taxing the activity. The optimal tax equals the marginal external cost at the efficient output, so $MSC = MSB$, internalising the externality.

State the Coase theorem and its key condition.

If property rights are well defined and transaction costs are negligible, private bargaining will achieve an efficient allocation regardless of who holds the rights. High transaction costs or many parties undermine this result.

Define the two defining characteristics of a pure public good.

Non-rivalry (one person's consumption does not reduce availability to others) and non-excludability (you cannot prevent non-payers from consuming). Examples include national defence and street lighting.

Explain the free-rider problem.

Because public goods are non-excludable, individuals can enjoy them without paying, so each understates their willingness to pay. This leads to under-provision or non-provision by private markets, justifying public provision.

Define adverse selection and give an example.

Adverse selection is a pre-contract information asymmetry where hidden characteristics distort the market — e.g. in Akerlof's 'market for lemons', sellers know car quality but buyers do not, driving good cars out of the market.

Define moral hazard and contrast it with adverse selection.

Moral hazard is a post-contract problem of hidden action: an insured or protected party changes behaviour because they no longer bear the full consequences. Adverse selection involves hidden information before the contract; moral hazard involves hidden action after it.

Name two market responses to information asymmetry.

Signalling (the informed party credibly reveals quality, e.g. education or warranties — Spence) and screening (the uninformed party designs choices to sort types, e.g. insurance deductibles — Rothschild-Stiglitz).

Distinguish merit goods from demerit goods.

Merit goods are under-consumed relative to the social optimum because consumers under-value private/external benefits (e.g. education, vaccination). Demerit goods are over-consumed because consumers under-value private/external harms (e.g. tobacco, alcohol).

What is government failure?

Government failure occurs when state intervention produces a net welfare loss, leaving outcomes worse than the unregulated market — through information gaps, distorted incentives, regulatory capture, administrative costs, or unintended consequences.

Give two common sources of unintended consequences from policy intervention.

Behavioural responses that offset the policy (e.g. moral hazard, the Peltzman effect), and distortion of incentives/prices (e.g. price controls causing shortages, subsidies encouraging over-production). Regulatory capture and rent-seeking are also key sources.

Define Pareto efficiency.

An allocation is Pareto efficient if no one can be made better off without making at least one other person worse off. It says nothing about fairness — many Pareto-efficient allocations exist.

State the First Fundamental Theorem of Welfare Economics.

Under competitive markets with complete markets and no externalities or market power, any competitive (Walrasian) equilibrium is Pareto efficient — the formal statement of Adam Smith's 'invisible hand'.

State the Second Fundamental Theorem of Welfare Economics.

Any Pareto-efficient allocation can be achieved as a competitive equilibrium given an appropriate lump-sum redistribution of initial endowments, with convex preferences. It separates efficiency from distribution.

What is the equity-efficiency trade-off?

Policies that redistribute toward greater equity (e.g. progressive taxes, transfers) can blunt incentives to work, save and invest, reducing efficiency. Okun's 'leaky bucket' captures the welfare lost in transferring resources.

Distinguish horizontal equity from vertical equity.

Horizontal equity: people in equal circumstances should be treated equally (equal pay equal tax). Vertical equity: people in different circumstances should be treated appropriately differently (those with greater ability to pay should pay more).

What is a social welfare function?

A social welfare function aggregates individual utilities into a single measure of society's wellbeing, $W = W(U_1, U_2, \dots, U_n)$, providing a basis for ranking allocations including their distribution.

Contrast the utilitarian and Rawlsian (maximin) social welfare functions.

Utilitarian sums utilities, $W = \sum_i U_i$, valuing total welfare regardless of distribution. Rawlsian maximin, $W = \min(U_1,\dots,U_n)$, ranks society by the welfare of its worst-off member, implying strong redistribution.

What are distributional weights in policy appraisal?

Distributional weights are multipliers applied to costs and benefits accruing to different income groups, giving extra weight to gains for poorer groups (reflecting diminishing marginal utility of income) so that appraisals account for equity, not just efficiency.

State the basic decision rule of cost-benefit analysis (CBA).

Approve a project if the present value of its social benefits exceeds the present value of its social costs, i.e. net present value $NPV = \sum_{t=0}^{T} \frac{B_t - C_t}{(1+r)^t} > 0$ (or benefit-cost ratio > 1).

Why is discounting used in CBA and how does the discount rate affect appraisal?

Discounting converts future costs and benefits to present values because resources have a time value (opportunity cost, time preference). A higher discount rate reduces the weight on distant future effects, disadvantaging long-term projects (e.g. climate).

What is the opportunity-cost principle and its role in CBA shadow pricing?

Opportunity cost is the value of the next best alternative forgone. In CBA, market prices are replaced by shadow prices reflecting true social opportunity cost where markets are distorted (taxes, unemployment, externalities).

How is the value of a marginal change in welfare measured for non-market goods in CBA?

By willingness to pay (WTP) for gains or willingness to accept (WTA) for losses, estimated via revealed-preference methods (e.g. hedonic pricing, travel cost) or stated-preference methods (e.g. contingent valuation).