Updated: Aug 19, 2019
Microeconomics in one of common topics to be seen in ACCA Accountant in Business (AB) / FAB, was F1, exam.
However, I see examiner often says the students’ performance on this topics are not very good.
For example, examiner told us the Microeconomics questions about Theory of firm in Section A is not well answered.
In this short article, I briefly talk what are important in microeconomics in ACCA AB/FAB syllabus.
In addition, selected past paper questions will be shared to illustrate how to apply the knowledge in answering exam questions.
Key topics include:
What is microeconomics?
Factors of production
Law of diminishing returns
Price mechanism – Demand and supply
Theory of firm
What is microeconomics?
Microeconomics is the branch of economics that considers the behaviour of decision takers within the economy, such as individuals, households and firms. In addition, microeconomics:
shows how and why different goods have different values, how individuals make more efficient or more productive decisions, and how individuals best coordinate and cooperate with one another;
is the study of economic tendencies, or what is likely to happen when individuals make certain choices or when the factors of production change.
looks after how different subgroups interact with supply and demand for resources as the price mechanism.
Factors of production
What are the resources of producing goods and services in an economy? Economists give the answer is “factor or production”.
There are four factors of production, namely, land, labour, capital and entrepreneurship.
Land is the first factor of production. It includes any natural resources to produce goods and services.
In addition to land, water, oil, iron ore and forest are examples of this factor.
Factor income is called rent which means the owner of resources earn in providing the factor in production.
The second factor of production is labour. It is the effort people contributed in the production of goods and services.
A waiter providing services in restaurant, or an artist create a painting are examples of labour.
Labour provided in return of factor income is called wages.
The third factor of production is capital. Some examples of capital are machinery, tools, buildings and computers.
Human used capital to produce goods and services.
Factor income of people providing capital is interest.
The fourth factor of production is entrepreneurship.
Entrepreneur is the person combining or coordinating 3 factors production, land, labour and capital, to make profit.
Profit is the factor income of entrepreneurship.
Law of diminishing (marginal) returns
In economics, law of diminishing (marginal) returns means a decrease in incremental (marginal) output of a production process as a single factor of production is increased, while all other factors of production remain the same.
It does not mean the incremental of a factor will decrease total production. Once any increase of a factor causes a decrease in total production, it is negative return.
The law of diminishing returns is not only a fundamental principle of economics, but it also plays a starring role in production theory.
Production theory is the study of the economic process of converting inputs into outputs.
Supply and Demand
Before going details of price mechanism, I would like to introduce supply and demand concept in microeconomics.
Supply and demand is an economic model of price determination in the market.
Holding all else equal, it postulates that a unit price of a particular good will change until it is at a point where the quantity demanded is equal to the quantity supplied in a competitive market.
The price point that quantity demanded and quantity supplied matched is called economic equilibrium.
A lot of students learning supply and demand in study text only focus on the supply curve and demand curve.
However, these curves are only the schedule of supply or demand with different price against different quantities supplied or demanded.
The focuses should be on the factors shifting the curves and the price mechanics.
Factors shift supply curve:
Firm’s expectation about future prices;
Number of suppliers.
Factors shift demand curve:
Tastes and preferences;
Price of substitution (goods and services);
Consumers’ expectation about future prices and incomes;
Number of potential consumers.
Under a price mechanism, if there is an increase in demand, then prices will go higher causing a movement along the supply curve.
Price mechanism is a mechanism where price plays a key role in directing the activities of producers, consumers, resource suppliers.
An example of a price mechanism uses announced bid and ask prices.
Generally speaking, when two parties wish to engage in trade, the purchaser will announce a price he is willing to pay (the bid price) and seller will announce a price he is willing to accept (the ask price).
Price mechanism is a mechanism where price plays a key role in directing the activities of consumers, producers and resource suppliers.
The concept of elasticity is concerned with the responsiveness of quantity demanded or quantity supplied to a change in price.
An elastic variable (>1) is one which responds more than proportionally to changes in another variable.
In the opposite, an inelastic variable (<1) is one which changes less than proportionally in response to changes in other variable.
There are two price elasticity theories you need to know, price elasticity of supply and price elasticity of demand.
Price elasticity of supply measures how the quantity of a good that a supplier wishes to supply changes in response to a change in price.
It captures the extent of horizontal movement along the supply curve relative to the extent of vertical movement.
Price elasticity of demand is a measure used to show the responsiveness, or elasticity, of the quantity demanded of a good or service to a change in its price.
Elasticity can be quantified as the ratio of the percentage change in one variable to the percentage change in another variable.
Theory of the firm
Traditionally, theory of the firm is the microeconomic concept stating that firms exist and make decisions to maximize profits. Firms interact with the market to determine pricing and demand and then allocate resources according to models that look to maximize net profits.
In ACCA Accountant in Business syllabus, it expands the scope into examining different market structure in which firms exist, and firm’s price decision in maximizing profits, while marginal cost is equal to marginal revenue is the point of profit maximization.
Four market structures are considered, they are:
A set of market conditions must exist in order to have a perfect competition:
A large number of buyers and sellers;
No transaction costs (including well defined property rights, no barriers to entry or exit)
Rational buyers and sellers
In perfect competition, every participant is a price taker, that is, no participant with market power to set prices.
The sellers in a perfect competition market operate at zero economic surplus, which means sellers make a level of return on investment known as normal profits.
Since every participant is price taker, demand is equal to average revenue and marginal revenue.
Demand curve is a horizontal line if you read the chart.
A monopoly exists when a specific person or enterprise is the only supplier of a particular good or service, no product differentiation to consumer.
In other words, monopoly is characterized by a lack of economic competition to product the good or service, a lack of viable substitute goods.
A monopolist sets a price in excess of costs, making an economic profit. It will sell a lesser quantity of goods at a higher price than would companies by perfect competition.
In a monopoly market, demand is equal to the average revenue which is a downward sloping curve. Monopoly will produce at marginal costs (MC) equivalent to marginal revenue (MR) to maximize it’s marginal profit.
An oligopoly arises when there are few producers that exert considerable influence in a market. As there are few producers, they are likely to have a high level of knowledge about the actions of their competitors, and should be able to predict responses to changes in their strategies.
The minimum number of firms in an oligopoly market is two.
The firm in a oligopoly market facing a similar demand curve as a firm in monopoly market, however, the demand curve is flatter showing a competition among different players.
Monopolistic competition is a type of imperfect competition while many producers sell products that are differentiated from one another and hence not perfect substitutes.
In monopolistic competition, the prices taken by a firm is referred to its rivals, which is given, and ignores the impact of its own prices on other prices.
As product differentiation exists, the demand curve to a firm in monopolistic competition is downward sloping and it produces when marginal costs (MC) is equal to marginal revenue (MR).
Which of the following differentiates a monopoly from an oligopoly market structure? A Positive long-run economic profit
B No product differentiation
C Downward sloping inelastic demand curve
D High barriers to entry
The correct answer is B.
A monopoly market structure would contain no product differentiation as there is zero competition, whereas an oligopoly market structure would include slightly differentiated products.
The two market structures are similar in that each generates a positive economic profit over the long-term, have inelastic downward sloping demand curves, and have high barriers to enter the industry (with a monopoly having insurmountable barriers).
According to the theory of the firm, how does the average revenue curve for a monopoly appear when price is measured against output?
Downward sloping from left to right
Correct answer is D.
It is actually the demand curve while it is downward sloping from left to right.
A is incorrect because a horizontal average revenue curve exists in perfect competition.
Microeconomics is a popular topic in ACCA Accountant in Business exam while the pass rate of certain parts within are not high.
However, it does not mean the question is very challenging and what you have to know other than the knowledge is how to apply it.
The subjects mentioned here are frequently seen in exam which are found a bit difficult to students.
I hope you could understand them well now and just leave any comments below if you have questions, I will revert to you.
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