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AQA A Level Economics Book 2 Sample

The document is a textbook that covers topics in microeconomics including consumer behavior, production costs, market structures, labor markets, and distribution of income and wealth. It contains several chapters with numerous sections that analyze these various microeconomic concepts in detail.

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0% found this document useful (0 votes)
1K views65 pages

AQA A Level Economics Book 2 Sample

The document is a textbook that covers topics in microeconomics including consumer behavior, production costs, market structures, labor markets, and distribution of income and wealth. It contains several chapters with numerous sections that analyze these various microeconomic concepts in detail.

Uploaded by

Tim
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd
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Contents

Introduction  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . vi
Breakdown of the examinations  . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ix

Part 1 Microeconomics
1 Individual economic decision making
  1.1   Consumer behaviour. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
  1.2   Imperfect information . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
  1.3   Aspects of behavioural economic theory. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
  1.4   Behavioural economics and economic policy. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23

2 Production, costs and revenue


  2.1  Developing short-run production theory: the law of

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diminishing returns. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
  2.2   Developing long-run production theory: returns to scale. . . . . . . . . . . . . 36
  2.3   Marginal cost and marginal revenue. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42
AF
  2.4   Profit. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49
  2.5   Technological change. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54

3 Perfect competition, imperfectly competitive markets


and monopoly
  3.1   Market structures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
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  3.2   The objectives of firms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
  3.3   Perfect competition. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
  3.4   Monopolistic competition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
D

  3.5   Oligopoly . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
  3.6   Monopoly and monopoly power . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
  3.7   Price discrimination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
  3.8  The dynamics of competition and the competitive
market processes. . . . . . . . . . . . . . . .
  3.9   Contestable and non-contestable markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
3.10  Market structure, static efficiency, dynamic efficiency 


and resource allocation . . . . . . .


iv
3.11  Consumer and producer surplus. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

4 The labour market


  4.1   The demand for labour, marginal productivity theory . . . . . . . . . . . . . . . . . . . . .
  4.2   Influences upon the supply of labour to different markets. . . . . . . . . . . . . .
  4.3  The determination of relative wage rates and levels of
employment in perfectly competitive labour markets. . . . . .
  4.4   The determination of relative wage rates and levels of
employment in imperfectly competitive labour markets. . . . . . . . . . . . . . . . . . .
4.5 The influence of trade unions in determining wages and levels of
employment. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .


4.6 The National Minimum Wage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
4.7 Discrimination in the labour market. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

5 The distribution of income and wealth: poverty and


inequality
5.1 The distribution of income and wealth. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
5.2 The problem of poverty. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
5.3 Government policies to alleviate poverty and to influence the
distribution of income and wealth . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

6 Revisiting market failure and government intervention


in markets
6.1 Marginal analysis and market failure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
6.2 Environmental market failures. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
6.3 Property rights. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

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6.4 Competition policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
6.5 Public ownership . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
6.6 Privatisation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
AF
6.7 Deregulation of markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Microeconomic key terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Microeconomic practice questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

Part 2 Macroeconomics
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7 Revisiting and developing macroeconomic theory
7.1 Developing the AD/AS macroeconomic model of the economy. . . . . . . . . .
7.2 Economic growth revisited . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
D

7.3 Employment and unemployment revisited. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .


7.4 Inflation, the Phillips curve and the quantity theory of
money revisited. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

8 Financial markets and monetary policy


8.1 The structure of financial markets and financial assets . . . . . . . . . . . . . . . . . . .
8.2 Commercial banks and investment banks. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
8.3 Central banks and monetary policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
8.4 The regulation of financial markets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . v

9 Revisiting fiscal policy and supply-side policies


9.1 Public expenditure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
9.2 Taxation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
9.3 Cyclical and structural budget deficits and surpluses . . . . . . . . . . . . . . . . . . . . . .
9.4 National debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
9.5 Micro impact of supply-side policies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
9.6 Free market and interventionist supply-side policies . . . . . . . . . . . . . . . . . . . . . . .
10 The international economy
10.1   Globalisation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
10.2   Trade. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
10.3   The balance of payments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
10.4   Exchange rate systems. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
10.5   Economic growth and development. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Macroeconomic key terms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Macroeconomic practice questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
Index

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AF
R
D


vi
1
Microeconomics
T
AF
R
D

1
1 Individual economic
decision making
This chapter develops from our explanation of demand theory in Book
1, section 2.1, ‘The determinants of demand for goods and services’, on
pages 21–30. We begin with a short recap of the parts of demand theory
that you must know in order to understand this introductory chapter
of Book 2. Following the recap, the chapter then introduces you to two
extremely significant aspects of individual economic decision making which
are not covered in Book 1. The first is utility theory, an old-established
body of theory which underlies the development of demand theory. Then,
following a brief discussion of how imperfect information affects individual
decision making, we introduce you to the second important part of this

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chapter, behavioural economics. Behavioural economics is a relatively new
part of the subject which provides significant insights into how individuals
make economic decisions.
AF
LEARNING OBJECTIvEs
This chapter will:
● remindyouofsomeofthemainelementsofdemandtheoryintroduced
inBook1,Chapter2
● discussthesignificanceofutilitymaximisationforindividualeconomic
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decisionmaking
● explaintheimportanceofthemarginwhenmakingchoices
● discusshowimperfectinformationandasymmetricinformationaffect
choicedecisions
D

● outlinetheemergenceofbehaviouraleconomicsasanimportantrecent
developmentineconomictheory
● investigateimportantelementsofbehaviouraleconomicssuchas
boundedrationality,biasesinindividualdecisionmakingandtheroleof
altruism
● relatebehaviouraleconomicstogovernmenteconomicpolicy

2
1.1 Consumer behaviour
●● Demand theory revisited
In this and the following paragraphs we are not going to repeat the whole of
the demand theory we explained in Book 1. Rather, we shall focus solely on
the elements of demand theory which are relevant to individual economic
decision making.
With this in mind, we focus on individual demand rather than market
demand. But to remind you, a market demand curve shows how much of
a good or service all the consumers in the market plan to demand at all
KEY TERMs the different possible prices of the good or service, whereas an individual’s

1.1 Consumer behaviour


individual demand curve
demand curve shows how much a single consumer in the market plans to
shows how much of a good or
service the consumer plans to demand at all the different possible prices of the good or service. (Remember
demand at different possible that the market demand curve is simply the sum of all the individual demand
prices. curves in the market.)
law of demand as a good’s We introduced you in Book 1 to the law of demand, which states that as
price falls, more is demanded. a good’s price falls, more is demanded. An individual’s demand curve thus
shows an inverse relationship between price and quantity demanded. This
relationship is shown in Figure 1.1, which is a repeat of Book 1, Figure 2.1,
except that in this case the demand curve shows how a single consumer
Price behaves in the market rather than all consumers taken together.
P1
Having explained the ‘law’ of demand in Book 1, we then went on to
distinguish between a shift of a demand curve to a new position (an increase
P2
in demand or a decrease in demand) and a movement or adjustment along
a demand curve, in response to a change in the good’s price. The latter we
Demand
called an extension of demand or a contraction of demand. A demand curve
O Q1 Q2 Quantity will shift if any of the factors influencing demand, other than the good’s own

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demanded per price, changes. These factors, which are sometimes called the conditions of
period of time
demand, include income, tastes and preferences, and the prices of substitute
Figure 1.1 An individual’s demand goods and complementary goods. An increase in income shifts demand
curve
curves rightward — but only for normal goods. A normal good is defined
AF
as a good for which demand increases when income increases. By contrast,
an inferior good is a good (such as poor-quality food) for which demand
STUDY TIP falls as income increases. If the good is inferior, an increase in income shifts
Make sure you understand the demand curve leftward. Figure 1.2 below shows a rightward shift of
the relationship between
demand from D1 to D2, caused perhaps by a fall in the price of a good in joint
market demand and individual
demand (a complementary good) or by a successful advertising campaign for
demand.
the product.
R

Price
KEY TERMS
shift of a demand curve the movement of a demand curve to a new position.
D

P1
increase in demand a rightward shift of the demand curve.
decrease in demand a leftward shift of the demand curve.
extension of demand an adjustment or movement down a demand curve
D1 D2 following a fall in the good’s price.
O Q1 Q2 Quantity contraction of demand an adjustment or movement up a demand curve
Figure 1.2 A rightward shift of demand following an increase in the good’s price.
condition of demand a determinant of demand, other than the good’s own
price, that fixes the position of the demand curve. A change in one or more
of the conditions of demand leads to a shift of demand. 3

STUDY TIP
Make sure you understand the difference between a shift of a demand (or
supply) curve and an adjustment in response to a price change along a
demand (or supply) curve.
●● Rational economic decision making and
economic incentives
At the heart of traditional or orthodox demand theory is the assumption that
the members of households or consumers always act rationally. Rational
KEY TERM behaviour means people try to make decisions in their self-interest or to
rational behaviour acting
maximise their private benefit. When a choice has to be made, people always
in pursuit of self-interest,
which for a consumer means choose what they think at the time is the best alternative, which means
attempting to maximise the that the second best or next best alternative is rejected. For households
welfare, satisfaction or utility and the individuals within them, rational behaviour is attempting to
gained from the goods and maximise the welfare, satisfaction or utility gained from the goods and
services consumed. services consumed.
Given the assumption of rational economic behaviour, a change in the price
of any good and a change in the conditions of demand (and/or supply), which
leads to a change in price, alters the economic incentives facing a consumer.
As we have seen, with a traditional downward-sloping demand curve, a fall in
the price of a good, relative to the prices of other goods, creates the incentive
to demand more of the good. Likewise, an increase in the good’s relative price
creates an incentive to demand less of the good.

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TEST YOURSELF 1.1
AF
Which of the following provides the best reason why consumers become
SYNOPTIC LINK early adopters of a new innovation such as a smart watch, even though
1 Individual economic decision making

At this point, go back to they know that they will be paying a high price for the good?
Book 1, pages 25–30, and Early adopters are people who:
remind yourself, first, of how
on occasion an individual’s A like technological gadgets
demand curve may slope B get up early to buy in a sale
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upward, and second, of how C base their consumption decisions on the reviews submitted online by
price elasticity of demand existing users
and cross elasticity of
demand affect the incentives
D want to be the first to get new types of product as they come onto the
market
consumers face when
D

prices change. Explain your answer.

●● Utility theory: total and marginal utility,


KEY TERMS and diminishing marginal utility
utility the satisfaction or
economic welfare an individual What is utility?
4 gains from consuming a good We mentioned in the previous section on rational economic decision
or service. making that consumers attempt to maximise the welfare or utility they
marginal utility the additional gain from the goods and services they decide to consume. We shall explore
welfare, satisfaction or this further in the next section, on utility maximisation. In economics,
pleasure gained from utility is usually defined as the pleasure or satisfaction obtained from
consuming one extra unit of consumption.
a good.
TEST YOURSELF 1.2

1.1 Consumer behaviour


A family’s typical weekly shopping basket might include ‘pleasure items’
such as packets of crisps and cans of Coca-Cola and other items which
fulfil a need and without which life would be more uncomfortable. Into
which category would you place:
● medicine
● chocolate
● daffodil bulbs
● electric light bulbs
● washing-up liquid?

The relationship between total utility and


marginal utility
Let us imagine a thirsty child who drinks six glasses of lemonade on a hot
sunny afternoon, deriving successively 8, 6, 4, 2, 0 and −2 ‘units of utility’
from each glass consumed. This information is shown in the total and
marginal utility schedules in Table 1.1, from which the total and marginal

T
utility curves drawn in Figure 1.3 are plotted.

Units of utility Table 1.1 Total and marginal utility schedules for lemonade
20 Glasses of Total utility Marginal utility
18
AF Total lemonade (units of utility) (units of utility)
16 utility
curve 0 0 —
14 1 8 8
12
2 14 6
10
3 18 4
8
4 20 2
6
5 20 0
R
4
6 18 –2
2
0 It is important to realise that the total and marginal utility
0 1 2 3 4 5 6
Glasses of schedules and, likewise, the total and marginal utility
D

lemonade
curves show exactly the same information, but they show
Units of utility
it in different ways. The total utility schedule and the total
8
utility curve show the data cumulatively — for example,
Diminishing
when drinking two glasses of lemonade, the thirsty child
6
marginal gains 14 ‘units of utility’ in total. After three glasses, total
utility
utility rises to 18 ‘units of utility’, and so on.
4
In contrast, the marginal utility schedule and the marginal
2
utility curve plot the same data as separate observations,
Point of satiation
rather than cumulatively. The last unit consumed is always
5
the marginal unit and the utility derived from it is the
0
1 2 3 4 5 6 marginal utility. So, after two drinks, the second glass
Marginal utility
curve of lemonade is the marginal unit consumed, yielding
−2
Glasses of a marginal utility of 6 ‘units of utility’. But when three
lemonade glasses of lemonade are consumed, the third glass becomes
Figure 1.3 An example of total utility and marginal the marginal unit, from which the still partially thirsty
utility curves child gains a marginal utility of just 4 ‘units of utility’.
In Figure 1.3, diminishing marginal utility is shown both by the diminishing
rate of increase of the slope of the total utility curve drawn in the upper panel
of the diagram and by the negative or downward slope of the marginal utility
curve in the lower panel. Notice that we have drawn a ‘point of satiation’ on
the diagram, which is reached as the fifth glass of lemonade is drunk. The fifth
glass of lemonade yields zero marginal utility. At this point, when marginal
utility is zero, total utility is maximised. In the context of food and drink,
satiation means being ‘full up’. Even if lemonade is free to the consumer, it
Economists refer to the utility of would be irrational for our ‘no-longer-thirsty’ child to drink a sixth glass of
a good: in this case, how much lemonade. He or she would experience negative marginal utility (or marginal
satisfaction can be received from disutility), which is shown by the downward slope of the total utility curve
consuming glasses of lemonade and by the negative position of the lower section of the marginal utility curve.

STUDY TIP
The relationships between marginal values and total values of an
economic variable must be understood when studying production theory,
cost theory and revenue theory, as well as when studying utility theory.
With production theory, cost theory and revenue theory, you must also
understand the relationships between marginal and average returns,

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marginal and average cost and marginal and average revenue.
AF
Quantitative skills 1.1
Worked example: calculating marginal utility
1 Individual economic decision making

An 8-year-old boy decides to enter a competition to see how many jam


doughnuts can be eaten in 15 minutes. Table 1.2 shows how many he ate
and his total utility schedule.
Table 1.2 Total utility for doughnuts
R
Total utility Marginal utility
Jam doughnuts (units of utility) (units of utility)
0 0
1 6
D

2 10
3 12
4 12
5 8
6 3

Complete the boy’s marginal utility schedule.


The boy’s marginal utility schedule is shown in Table 1.3.
Table 1.3 Total and marginal utility for doughnuts
6
Total utility Marginal utility
Jam doughnuts (units of utility) (units of utility)
0 0 —
1 6 6
2 10 4
3 12 2
4 12 0
5 8 –4
6 3 –5
The hypothesis (or ‘law’) of diminishing
marginal utility

1.1 Consumer behaviour


The numerical examples in Tables 1.1–1.3, and the graph in Figure 1.3,
illustrate a very famous economic hypothesis, which some would call an
economic law: the hypothesis of diminishing marginal utility. This simply
KEY TERM
states that as a person increases consumption of a good — while keeping
hypothesis of diminishing
marginal utility for a single consumption of other products constant — there is a decline in the marginal
consumer the marginal utility utility derived from consuming each additional unit of the good.
derived from a good or service
diminishes for each additional
unit consumed.
SYNOPTIC LINK
In the context of economic methodology, Book 1, Chapter 1 explained the
difference between a hypothesis and a theory. To remind you, whereas a
hypothesis is a proposed explanation for something, a theory is when a
hypothesis is tested and survives the test.

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CASE STUDY 1.1
Adam Smith’s diamonds and water paradox what people are demanding. Marginal utility is the
additional welfare a person gains from using or
In 1776 the great classical economist Adam Smith
AF purchasing an additional unit of the good. People
wrote about the diamonds and water paradox (or
are willing to pay a higher price for goods with
the paradox of value) in his famous book The Wealth
greater marginal utility.
of Nations. Smith wrote:
Relating this to water and diamonds, water is not
Nothing is more useful than water: but; scarce any
thing can be had in exchange for it. A diamond, on
scarce in most of the world, which means people
the contrary, has scarce any value in use; but a very
can consume water up to the point at which the
great quantity of other goods may frequently be had in
marginal utility they gain from the last drop
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exchange for it.
consumed is very low. They aren’t willing to pay a
lot of money for one more drink of water. Diamonds,
In most countries, water has a low price but a piece by contrast, are scarce. Because of their limited
of diamond jewellery has a high price. Why does supply, the marginal utility typically gained from
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an economy put a much lower value on something adding one more diamond to a person’s collection
vital to sustaining life compared to something that is much higher than for one extra drink of water.
simply looks good? Smith pointed out that practical However, if one is dying of thirst, then this paradox
things that we use every day have a value in use, breaks down. In this situation, the marginal utility
but often have little or no value in exchange. On the gained from another drink of water would be much
other hand, some of the things that often have the higher than the additional satisfaction of owning
greatest value in the market or in exchange, such an extra diamond — at least until the thirst was
as a drawing by Picasso, have little or no practical quenched.
use other than, in this case, as ornamentation.
Follow-up questions
Understanding the diamonds and water paradox
1 Define the terms ‘scarcity’ and ‘marginal utility’. 7
comes through first understanding the economic
terms ‘marginal utility’ and ‘scarcity’. Scarcity 2 Can you think of two other goods which generally
relates to how little of a good there is compared to illustrate the paradox of value?
EXTENSION MATERIAL

Marginal utility and an individual’s


demand curve
If lemonade were available completely free (at zero price), it would be
rational for our thirsty boy to drink exactly five glasses of lemonade in
the course of a hot, sunny afternoon. He would consumer up to the point
of satiation, beyond which no further utility can be gained. But because
lemonade is an economic good which is scarce in supply and which has an
opportunity cost, it is reasonable to assume that the child (or his parents)
must pay for his drinks. Suppose that the price of lemonade is equal to the
marginal utility gained from the fourth glass. At this price, P4 represents
the opportunity cost of the fourth glass of lemonade: that is, the utility that
could be gained if the price were spent on some other good, say a bar of
chocolate. To maximise utility at this price, the thirsty child should drink
four glasses of lemonade, but no more. It would be irrational to consume a
fifth glass at this price, since the extra utility gained would be less than the
opportunity cost represented by the price P4.
Figure 1.4 below shows the effect of the price rising from P4, successively

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to P 3, P2 and P1. These prices equal the marginal utility derived by the child
from the third, second and first glasses of lemonade. When the price rises
to P 3, our thirsty child reduces demand to three glasses, so as to maximise
SYNOPTIC LINK
This chapter focuses on the
AF
utility in the new situation. At price P2 demand is again reduced to two
drinks, and so on. The higher the price, the lower the quantity demanded,
individual choices made by which is exactly what a demand curve shows.
1 Individual economic decision making

consumers or members
of households when they
decide how much of a good Units of utility
or goods to consume in the 8 P1 = MU1
economy’s goods market or
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product market. In Chapter
4, by contrast, we explain the 6 P2 = MU2
choices made by members
of the same households
about how much labour to
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supply and how much leisure 4 P3 = MU3


time to enjoy when making
decisions in the economy’s
labour market. In both sets of 2 P4 = MU4
markets, utility maximisation
(explained below) is central to Glass 1 Glass 2 Glass 3 Glass 4 Glass 5
individual economic decision
0
making. In the labour market
we assume that workers Glass 6
8 attempt to maximise the utility
derived from the wage and −2
the utility gained from job Figure 1.4 Relating marginal utility to changes in price and to the shape
satisfaction. of a demand curve
●● Utility maximisation

1.1 Consumer behaviour


As we noted in Book 1, the assumption of maximising behaviour by economic
agents (consumers, workers, firms and even the government) is central
to orthodox or traditional economic theory. Economic agents decide their
market plans so as to maximise a target objective or goal which is believed
to be consistent with the pursuit of self-interest. In demand theory, the
objective which households are assumed to wish to maximise is the utility, or
satisfaction, obtained from the set of goods and services consumed.

EXTENSION MATERIAL

Maximising versus minimising behaviour


It is worth noting that any maximising objective can always be recast as a
minimising objective. Thus a household’s assumed objective of ‘maximising
the utility gained from the set of goods and services consumed’ can be
restated as ‘minimising the outlay, expenditure or cost of obtaining the same
combination or bundle of goods and services’. Whether we set up an assumed
objective in maximising or minimising terms depends on our convenience.

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It is more usual to investigate maximising objectives, but for some
purposes a consideration of the minimising principle can shed interesting
light on economic behaviour.
AF
Maximisation subject to constraints
If all goods were free, or if households had unlimited income and capacity
to consume all goods, a consumer would maximise utility by obtaining
all the goods which yield utility, up to the point of satiation. As we have
already indicated, satiation occurs when no more utility can be gained from
consuming extra units of a good. Any further consumption would yield only
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disutility at the margin (negative utility, dissatisfaction or displeasure).
However, because of the problem of scarcity, consumers face a number of
constraints which restrict the choices they make in the market place. The
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constraints are:
● Limited income. Consumers, even the very rich, do not possess an unlimited
income, or stock of wealth that can be converted into income, with which
to purchase all the goods and services that could possibly yield utility.
Income spent on one good cannot be spent on some other good or service.
● A given set of prices. Very often, consumers can’t by their own actions
influence the market prices they have to pay to obtain the goods and
services they buy. Given this assumption, consumers are ‘price takers’ rather
than ‘price makers’.
9
● The budget constraint. Taken together, limited income and the set of prices
faced impose a budget constraint on consumers’ freedom of action in the
market place. If we assume that all income is spent and not saved, that there
is no borrowing, and that stocks of wealth are not run down, a consumer can
only purchase more of one good by giving up consumption of some other
good or service, which represents the opportunity cost of consumption.
● Limited time available. Even when goods are free, consumer choices must
still be made because it is often impossible to consume more than one
good at a time or to store more than a limited number of goods for future
consumption.
●● Importance of margin when making
choices
Along with assumptions such as rational economic behaviour and opportunity
cost, the ‘margin’ is one of the key concepts in traditional or orthodox
economic theory. Given consistent tastes and preferences, rational consumers
choose between available goods and services in such a way as to try to
maximise total utility, welfare or satisfaction derived from consumption of the
goods. Along with the relative prices that must be paid for each of the goods,
the marginal utilities gained from the consumption of the last unit of each
good determine the combination of goods the consumer must choose in order
to maximise total utility.
As we shall see in later chapters in Part 1 of this book, in orthodox economic
theory, the margin is equally important in other areas of economic choice.
For example, we shall see how when firms choose how much of a good to
produce and sell, they take account of the marginal sales revenue received
from selling the last unit of the good, and the marginal cost of producing the
last unit. Generalising across all choice situations, we shall explain how in
order to maximise a desired objective, an economic agent must undertake the

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STUDY TIP activity involved up to the point at which the marginal private benefit received
The margin is one of the
equals the marginal private cost incurred. For example, a utility-maximising
key concepts in A Level
consumer must choose to consume or demand a good up to the point at
microeconomics. Make sure
AF
which MU = P. Marginal utility or MU is, of course, the marginal private
you understand and can apply
the concept. benefit derived from consuming the last unit of the good, while the good’s
1 Individual economic decision making

price, P, is its opportunity cost in consumption, at the margin.

EXTENSION MATERIAL

Can utility be measured?


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On several occasions we have referred to ‘degrees of utility’ as a


unit of measurement for the happiness, pleasure, satisfaction or
fulfilment of need which an individual derives from consuming a good or
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service. However, in real life there is no way in which an individual can


mathematically work out the utility to be gained from every unit of a good
consumed. Economists have found it impossible to measure directly units
of satisfaction, pleasure or fulfilment through which comparisons can be
made across individuals.
To get around this problem, the famous economist Paul Samuelson
introduced the concept of ‘revealed preference’. What revealed preference
theory does is work backward from observing how consumers actually
behave to observing their preferences. Consumers reveal their
10 preferences by choosing, at given prices and for given levels of income, the
bundles or combinations of goods they end up buying.
CASE STUDY 1.2

1.1 Consumer behaviour


The November 2012 edition of the Economic Review, nature of happiness. Since they are self-reported
a magazine published by Philip Allan for Hodder measures of wellbeing, how comparable are they
Education, included an article ‘The economics of across individuals?
happiness’ written by Corrado Giulietti and Juan
We might be inclined to think that happiness
David Robalino. This case study is an extract
decreases as an individual gets older. Strikingly,
from their article. If your school subscribes to the
this is not the case; in fact there is a U-shaped
Economic Review, you can gain access over the
relationship between happiness and age. The GHQ
internet to the complete article.
index reaches its lowest score when individuals
are about 45 years old. One possibility is that
The economics of happiness
individuals in their mid-40s are particularly
Happiness has been the subject of study of worried about achieving their career goals. More
philosophy, psychology, anthropology and many generally, this could be seen as the presence of a
other disciplines for a long time, but only recently ‘mid-life crisis’. On the other hand, after the age of
have economists become interested in happiness. 45, individuals’ wellbeing increases. One potential
The principal objective of public policy is to use explanation is that as they get older, individuals
limited resources to maximise the welfare of accept their life as it is and start enjoying it again.
individuals. But how do we measure welfare or Physical health produces a more straightforward
wellbeing? Economists have developed the concept result. As we might expect, people with excellent
of the utility function, which is a way to quantify

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self-reported health levels are happier than those
individuals’ welfare using mathematical tools. with poor health. In many studies, the relationship
However, a major practical drawback is that utility between health and happiness is stronger than with
cannot be observed directly, so how do we know any other determinants of happiness.
AF
whether one individual is better off than another?
Other major findings concern gender and marital
For many years, when evaluating policy status. Females report higher happiness than
interventions, governments relied on objective males (at least in the UK), married people are
measures such as the income or employment usually happier than those who are single, while
status of an individual. These indicators can divorced people are usually the least happy.
capture a significant share of individuals’ utility and
so it was thought that utility could be maximised
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through maximising these objective measures.
However, our welfare comprises of many aspects
that cannot be captured by economic indicators,
such as social and family relationships or pollution.
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Studies on the economics of happiness argue that


the happiness experienced by individuals can be
used to approximate utility. The most common
approach is to ask people how happy they are by
means of a detailed set of questions. Self-reported
measures are referred to as subjective wellbeing
measures.
Subjective wellbeing is usually measured using
indices derived from surveys such as the British
Household Panel Survey (BHPS). Respondents 11
are asked questions about their life satisfaction,
mental health and experienced happiness, from
which it is possible to derive alternative measures
of wellbeing. The General Health Questionnaire
(GHQ) of the BHPS consists of 12 questions about
mental health, ranging from the individual’s ability
to ‘concentrate’ and ‘face problems’ to whether Surveys of subjective wellbeing have revealed that
they feel ‘overall happy’ with their life. However, married people are usually happier than those who are
some economists are sceptical about the subjective single and that divorced people are often the least happy
If we compare employed and unemployed that happiness has not increased very much over
individuals with the same income (say, because the time despite material wellbeing improving for
unemployed receive benefits from the government), many people? One explanation is that it is not just
the latter are less happy. This suggests that a our income that makes us happy but also how our
job itself is associated with higher wellbeing. By income compares with that of people similar to
working, individuals feel socially included and they us (our neighbours or classmates, say). In other
don’t perceive the social stigma of being jobless. words, it seems that people are relatively happy
People never adjust to unemployment. It doesn’t when they earn more than the people around them.
matter how frequently or for what period of time a Therefore, if everybody gets richer by the same
person is jobless: unemployed individuals remain amount, there is no substantial increase in the level
persistently unhappy. of happiness.
A puzzling result emerges from the relationship Follow-up questions
between income and happiness. Studies have
found a positive relationship between happiness 1 Do you think that governments should rely on
and income, but surprisingly this association is not subjective measures of wellbeing rather than
very strong. The level of happiness of individuals objective indicators such as the level of real GDP to
who earn over £2500 per month is less than one evaluate the effectiveness of public policy? Justify
point higher than those who earn less than £1000. your answer.
This is named the Easterlin paradox after economist 2 Research what the current UK government has
Richard Easterlin. So how do we explain the fact been saying about the economics of happiness.

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1.2 Imperfect information
AF
●● The importance of information for decision
1 Individual economic decision making

SYNOPTIC LINK making


In Chapter 6 we extend the So far in this chapter, we have assumed that consumers possess perfect
R
analysis of merit goods and information — for example, about the goods that are available to buy,
demerit goods begun in Book
their prices and quality, and about the utility which will be derived from
1, Chapter 5 by examining
their consumption.
the information problems
households experience
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However, when attempting to maximise total utility, more often than not
when deciding how much to consumers possess imperfect information. As a result, they make ‘wrong’
consume of a merit good such decisions. We saw in Book 1, Chapter 5, section 5.5 how consumers may
as education, or a demerit choose to under-consume a merit good such as education and over-consume
good such as tobacco.
a demerit good such as tobacco because they possess imperfect information
about the long-term consequences of their choices. We shall investigate this
further in Chapter 6, section 6.1 of this book, and we shall also touch on
ACTIVITY this issue in our coverage of behavioural economics in the next section of
Get together with a group this chapter.
12 of your fellow students and On a more mundane level, a student may spend £100 on a ticket for a
discuss the things which rock concert, believing in advance that she would thoroughly enjoy the
make you happy and the
entertainment. However, she may come out of the stadium in which the event
ways in which your behaviour
was held believing that she has wasted her hard-earned money and would
is affected by imperfect
information as you go about be far better off if she had spent the £100 on other goods, such as a meal
your daily activities. Summarise in a high-class restaurant. This is an example of a ‘wrong’ choice, but it was
the group’s results. also a rational choice because she believed in advance that the concert would
be good.
●● The significance of asymmetric

1.2 Imperfect information


information
Sometimes, one party to a market transaction, either the buyer or the seller,
suffers from imperfect information about the nature of the transaction.
Asymmetric information arises when either the buyer or the seller involved
KEY TERM in a potential transaction knows something that is not observable to the other
asymmetric information
party. One of the ways in which asymmetric information can manifest itself
when one party to a market
transaction possesses less is through the process known as adverse selection, which is a feature of many
information relevant to the market transactions. For example, in the sale and purchase of a second-hand
exchange than the other. computer, the seller of the good knows more about the computer’s defects
than a potential purchaser. However, to avoid paying too high a price for an
inferior product which contains lots of defects, potential purchasers often offer
low prices on all second-hand computers, regardless of the fact that some of
the computers are good.
The problem of asymmetric information possessed by buyers and sellers is
described in a classic article by George Akerlof on the market for ‘lemons’ — a
‘lemon’ being American slang for a poor-quality second-hand car.

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CASE STUDY 1.3
The market for lemons
AF in America are known as ‘lemons’). A new car may be
a good car or a lemon, and of course the same is true
In 2001 George Akerlof was awarded the Nobel
of used cars.
Prize in Economics, largely in response to a 13-
page academic paper he published in 1970 titled The individuals in this market buy a new automobile
‘The market for lemons’. Back in 1970, Akerlof without knowing whether the car they buy will be
found it difficult to get his paper published. Two good or a lemon. After owning a specific car, however,
leading academic journals rejected the paper on the for a length of time, the car owner can form a good
ground that asymmetric information in the market
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idea of the quality of this machine.
for second-hand cars was too trivial an economic
An asymmetry of information has developed: for the
issue. However, by 2001 things had changed.
sellers have more knowledge about the quality of a car
On receiving his Nobel Prize, Akerlof said: than the buyers. But good and bad used cars must still
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sell at the same price, since it is impossible for a buyer


‘Lemons’ deals with a problem as old as markets
to tell the difference between a good and a bad car.
themselves. It concerns how horse traders respond
to the natural question: ‘if he wants to sell that It is apparent that a used car cannot have the same
horse, do I really want to buy it?’ Such questioning valuation as a new car — if it did, it would clearly be
is fundamental to the market for horses and used advantageous to trade a lemon at the price of a new
cars, but it is also at least minimally present in every car, at a high probability of the new car being a good
market transaction. car. Most used cars traded will be ‘lemons’, and good
used cars may not be traded at all. The ‘bad cars tend
Here is an extract from what Akerlof wrote in his
to drive out the good (in much the same way that bad
1970 paper:
money drives out the good).’
13
From time to time one hears either mention of or
surprise at the large price difference between new Follow-up questions
cars and those which have just left the showroom. 1 Akerlof asked the question ‘if he wants to sell that
The usual lunch table justification for this horse, do I really want to buy it?’. Explain how this
phenomenon is the pure joy of owning a ‘new’ car. question relates to the market for second-hand cars.
We offer a different explanation. Suppose that there 2 Suggest two other markets, other than the
are just four kinds of cars. There are new cars and markets for second-hand cars, used computers
used cars. There are good cars and bad cars (which and horses, in which market outcomes are
affected by asymmetric information.
1.3 Aspects of behavioural
economic theory
●● Emergence of behavioural economics
Behavioural economics is a field of study that has attracted a great deal
KEY TERM of attention since the beginning of the 21st century. Most of the research
behavioural economics a in the field has come from universities in the USA, but in recent years
method of economic analysis UK university economics departments have been offering courses in the
that applies psychological subject.
insights into human behaviour
to explain how individuals Behavioural economics is built on the insights of psychologists seeking
make choices and decisions. to understand human behaviour and decision making. This research
field can be traced back to 1931 when L. L. Thurstone conducted
experiments to determine consumer preferences by asking participants to
choose repeatedly between alternative bundles of goods. Two of the most
influential psychologists are the Israeli academics Amos Tversky and Daniel
Kahneman, who spent decades studying how people think and provided a

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major contribution to decision research and psychological theory. In 2002
Kahneman was awarded the Nobel Memorial Prize in economics and in 2011
he published Thinking, Fast and Slow in which he credits Tversky (who died in
AF
1996) for helping with much of his work.
In 2008 the Chicago economist Richard Thaler and the legal scholar Cass
1 Individual economic decision making

Sunstein published Nudge: Improving Decisions about Health, Wealth and


Happiness, which is a highly accessible overview of behavioural economics.
Having read Nudge, immediately on becoming prime minister in 2010, David
Cameron set up the UK government’s Behavioural Insights Team (BIT), which
was initially based in the Cabinet Office in Downing Street. The creation
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of the BIT, and of a similar body advising the US president, marked the
growing influence that behavioural economics was having on government
policy-makers.
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On its website, the BIT writes:


We coined the term ‘behavioural insights’ in 2010 to help bring together ideas
from a range of inter-related academic disciplines (behavioural economics,
psychology, and social anthropology). These fields seek to understand how
individuals take decisions in practice and how they are likely to respond to
options. Their insights enable us to design policies or interventions that can
encourage, support and enable people to make better choices for themselves
and society.
STUDY TIP The BIT’s website is worth reading to find out about projects that the team
14 Try and read Thaler and
run in government. The web address is: http://www.behaviouralinsights.co.uk.
Sunstein’s Nudge: Improving
You might also access a BIT publication, Better Choices: Better Deals, otherwise
Decisions about Health, Wealth
and Happiness, and also some known as the Government’s consumer empowerment strategy, which
of the Behavioural Insight recommends how government policy can attempt to influence consumer
Team’s publications, which can behaviour. It can be found at https://www.gov.uk/government/publications/
be accessed on the internet. better-choices-better-deals-behavioural-insights-team-paper. The case study
below has been adapted from the policy document.
CASE STUDY 1.4

1.3 Aspects of behavioural economic theory


Better Choices: Better Deals We are setting up six new programmes to give
We are trying to shift power to citizens and consumers richer, more relevant information about
communities. Three changes that are helping to the goods and services that they use. We are:
make this possible are: ● Introducing Annual Credit Card Statements,
containing information about fees and how to
● The increasing role of new technologies, in
switch.
particular internet and mobile phone applications,
● Working with energy suppliers to provide clearer
that have opened up new channels for consumers
information about the lowest available energy
to find, compare, and purchase goods and services.
tariff.
● The use of data, drawn from customers’ own
● Reforming Energy Performance Certificates so
transaction histories, that have allowed businesses
they include clear information about the costs of
to understand their customers better, allowing
heating a home.
them to make more tailored recommendations.
● Working with the Food Standards Agency, trialling
● The development of new ways for different
new ways to help consumers understand food
consumers to collaborate across the economy —
hygiene ratings of restaurants.
for example whether by sharing cars or bicycles,
● Reforming car labelling by supporting work to give
or giving feedback about a GP practice, a local
consumers clearer information about the costs of
tradesman or a multinational corporation.
running different cars.

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Putting power in the hands of consumers so that ● Facilitating the launch of a new programme of
they are better able to choose between suppliers, work to examine product information in relation to
will both enable them to get the best deals for health and the environment.
themselves individually and collectively, while also
We will make use of the ‘Power of the Crowd’ by
AF
putting pressure on businesses to be more efficient
introducing a range of new initiatives that will
and innovative. We see two profound changes
support the development of collective purchasing
taking place:
and collaborative consumption. We will be:
● A shift away from a world in which certain
● encouraging collective purchasing deals.
businesses tightly control the information they
● pilotinga green collective purchasing scheme
hold about consumers, towards one in which
in which B&Q will help encourage the uptake of
individuals, acting alone or in groups, can use their
energy efficiency measures.
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data or feedback for their own or mutual benefit.
● A shift toward an environment in which individuals Follow-up questions
and groups feel more able to send the right signals 1 The passage states ‘new technologies,
to business, and hence secure the products and in particular internet and mobile phone
D

services they want. applications…have opened up new channels for


In short, we want to see confident, empowered consumers to find, compare, and purchase goods
consumers able to make the right choices for and services’. Give two examples of this happening
themselves — to get the best deals, demand for yourself, your friends or your family.
better products or services, and be able to resolve 2 An important element of Better Choices: Better
problems when things go wrong. This approach Deals is ‘the power of the crowd’. This means
makes it easier for honest, high-quality businesses that consumers acting collectively can counter to
to compete and will drive innovation, competition some extent the market power of the businesses
and growth. A better deal for consumers and the which sell them goods and services. Is there any
economy means a better deal all round. evidence of this happening since Better Choices:
Better Deals was published in 2011? 15
TEST YOURSELF 1.3
The use of the internet affects consumer behaviour in which of the
following ways?
A It facilitates the use of price comparison websites
B It stops consumers comparing prices in store
C It generally adds to consumer confusion
D It slows down consumer decision making
Explain your answer.

EXTENSION MATERIAL

Squaring the circle between traditional and behavioural


economic theory
In his excellent book Predictably Irrational, Dan Ariely assumptions such as utility maximisation and profit
stated that traditional economics is about creating maximisation are unrealistic. Friedman argued

T
a theory and using it to explain actual behaviour, that a theory should be tested and then accepted or
whereas behavioural economics is about observing rejected on the basis of the validity and fruitfulness
actual behaviour and then coming up with a theory. of its predictions. If unrealistic assumptions led
Traditional theories are often attacked by behavioural to wrong conclusions, he would have argued that
AF the theory should be rejected or modified. But if
economists on the ground that the simplifying
assumptions on which the theories are built are assumptions are unrealistic because of the need
1 Individual economic decision making

unrealistic. In particular, in the context of what to abstract from a complex reality, but still lead to
orthodox economists call the ‘theory of the firm’, sound predictions which survive scientific testing,
behavioural economists query the ‘profit-maximising they can be justified. In summary, if members of
assumption’. This is the assumption that entrepreneurs households act ‘as if’ they are utility maximisers and
make business decisions solely on the basis of whether likewise the entrepreneurs who run firms act ‘as if’
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the decisions will lead to larger profits. they are profit maximisers, the predictive power of
traditional theories can still be good.
However, in a very famous essay, The Methodology of
Positive Economics, published in 1953, the great pro- In the traditional theory of the firm, entrepreneurs
free market economist Milton Friedman defended are assumed to produce and sell output up to the
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the traditional approach. Friedman wrote: ‘Truly point at which marginal revenue equals marginal
important and significant hypotheses will be found cost, yet real-world business people seldom make
to have “assumptions” that are wildly inaccurate such decisions when running their businesses.
descriptive representations of reality, and, in Friedman argued that this does not matter. If
general, the more significant the theory, the more Friedman had lived to the present day (he died at
unrealistic the assumptions.’ the age of 94 in 2006), he might be using similar
reasoning to defend traditional economic theory
Friedman rejected testing a theory solely on
from the attacks of behavioural economists.
the realism of its assumptions. He agreed that

16
STUDY TIP SYNOPTIC LINK

1.3 Aspects of behavioural economic theory


Make sure you understand The traditional theory of the firm and profit maximisation are explained in
the key differences between depth in Chapter 2.
traditional economic theory
and behavioural economics.

CASE STUDY 1.5


In the April 2010 edition of the Economic Review, immediate temptation, whether it be a chocolate
published by Philip Allan for Hodder Education, bar at the supermarket checkout counter, an extra
David Gill presented an overview of interesting hour in bed, or one beer too many at the end of an
developments in behavioural economics. This case evening out. Finally, we dislike change. The so-
study summarises the introduction of David Gill’s called ‘status quo bias’ means that we generally
article. If your school subscribes to the Economic like to stick with what we have, unless the incentive
Review, you can gain access over the internet to the to change course is compelling.
complete article.
Second, research from the field of cognitive
psychology paints a picture at odds with that of
Beyond homo economicus
homo economicus. This research shows that
Economists like to simplify the world; in particular

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humans often make decisions using simple rules-
they like to simplify people. Most of twentieth- of-thumb — called heuristics — and suffer from
century economics makes a number of standard many biases when choosing what to do, such as
assumptions about how people behave, which over-confidence, confirmation bias (the tendency to
AF
comprise our view of homo economicus or search for, and put greater weight on, information
‘economic man’. Homo economicus is self- that confirms one’s preconceptions) and recency
interested: he only cares about himself. He knows bias (the tendency to weight recent information and
the consequences of everything he does. He is experience more heavily than older information and
rational: he knows what he wants and always acts earlier experiences). Also psychological findings
on these preferences. emphasise the fundamental role of emotions in
This simple model has proved to be exceptionally decision making, including, for example, anger,
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useful in gaining insights into economic behaviour, regret, guilt, shame and disappointment.
especially when consumers and firms interact in Third, humans clearly face quite substantial
large-scale anonymous markets. However, the limitations of computation and reasoning. These
new science of behavioural economics seeks to are particularly important when the environment
move beyond homo economicus to a more realistic
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is complex — e.g. when people are interacting


representation of how people choose and behave. It strategically, my best action will depend on what
does so in a number of ways: others choose to do. An oligopolistic firm deciding
First, data collected by economists show a number what price to set will have to start thinking about
of so-called ‘anomalies’ — i.e. behaviour which what their competitors are going to do.
deviates in a consistent manner from that predicted
by the model of homo economicus. For example, Follow-up questions
people appear to be altruistic: they tend to put 1 What is meant by altruism, and how does altruism
at least some weight on the wellbeing of others. affect the economics of charities?
Another point is that we are generally impatient and 2 What is a ‘rule-of-thumb’? Give an example of a
lack self-control. Most of us find it difficult to resist rule-of-thumb you often use. 17

KEY TERM SYNOPTIC LINK


rule-of-thumb a rough and Oligopolistic pricing behaviour is explained in Chapter 3, pages XX–XX.
practical method or procedure
that can be easily applied when
making decisions.
●● Rational economic behaviour revisited
KEY TERMs Bounded rationality
bounded rationality when
making decisions, an So far in this chapter, and also in Book 1, we have assumed that when
individual’s rationality is exercising choice, individuals are perfectly rational, in the sense that they
limited by the information they make decisions in a context of being fully informed, with perfect logic and
have, the imitations of their aiming to achieve the maximum possible economic gain. However, in real
minds, and the finite amount life, individuals are seldom if ever perfectly rational. In the world in which
of time available in which to we live, decisions are made in conditions of bounded rationality, which
make decisions. means that individuals, however high or low their intelligence, make decisions
bounded self-control subject to three unavoidable constraints: imperfect information about possible
limited self-control in which alternatives and their consequences; limited mental processing ability; and
individuals lack the self- a time constraint which limits the time available for making decisions. In
control to act in what they see complex choice situations, bounded rationality often results in satisficing rather
as their self-interest. than maximising choices.

SYNOPTIC LINK
The difference between satisficing and maximising is explained in

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Chapter 3, pages XX–XX.

Bounded self-control
AF
Bounded rationality is closely linked to the related concept of bounded self-
1 Individual economic decision making

control. Traditional or orthodox economic theory implicitly assumes that


when making choices, individuals have complete self-control. Behavioural
economists, by contrast, believe that individuals have bounded (or limited)
self-control. Making New Year resolutions in the period immediately after
Christmas provides many good examples. Having put on weight during the
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Christmas festivities, people may decide to go for a daily jog early in the
morning before going to work each day after 1 January. For many, this may
work well for a few days, but the first bout of bad weather often leads to the
resolution being broken.
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Thinking fast and thinking slow


The Nobel prize-winning psychologist Daniel Kahneman has been one of
the most influential figures in the development of behavioural economics.
Kahneman introduced economists to the idea that human beings think in two
different ways. The first, which Kahneman called System 1 or ‘thinking fast’, is
intuitive and instinctive. Decisions are made quickly and little effort is used to
analyse the situation. This is automatic thinking.

18 The second, which Kahneman called System 2, is ‘thinking slow’. In this


method of thinking, which is also known as reflective thinking, concentration
and mental effort are required to work through a problem before a decision
can be made.
For example, when learning to play a new game such as golf, an individual
will ‘think slow’ when deciding on the appropriate golf club to select for
a particular stroke, and on how to grip the club and to take a swing at
the ball. Because the decision making is relatively slow, involving careful,
logical thought about every decision, the process can be tiring. However,
the more often the game is played and the more practice is put in, the less
will golfers have to think about minor decisions. Automatic thinking takes
over. Professional golf players often play quickly and instinctively. Through

1.3 Aspects of behavioural economic theory


years of repetitive training, their automatic systems have learnt to respond to
situations promptly and effectively. In big-game situations they can, of course,
suffer if they stop to think. When this happens, they revert back to System 1
or the reflective system, which can mean that bad decisions lead to disastrous
consequences.
Many of our everyday economic decisions will be taken by our automatic
system. Buying a coffee at a train station, buying groceries in a supermarket
and ordering drinks in a bar will often be quick, intuitive decisions. Bigger
and more important decisions tend to be taken by our reflective system.
Deciding whether to buy a car or a house, and choosing an insurance policy,
will normally result from reflective decisions.

ACTIVITY
Make a list of all the things you bought the last time you went on a serious
shopping expedition. How many of your decisions to buy were undertaken
by your reflective system and how many by your automatic system?

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AF
CASE STUDY 1.6
Daniel Kahneman adopted, exactly 200 people will be saved. If program
B is adopted there is a 1/3 probability that 600 people
Daniel Kahneman pretty much created the field of
will be saved and a 2/3 probability that no people will
behavioural economics. His central message could
be saved.
not be more important, namely, that human reason
left to its own devices is apt to engage in a number Here, the risk is presented in terms of gains, and
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of fallacies and systematic errors, so if we want to 72% of people tend to choose option A. Here’s the
make better decisions in our personal lives and as same problem but this time presented in terms of
a society, we ought to be aware of these biases and losses:
seek workarounds. That’s a powerful and important
Imagine your country is preparing for the outbreak of
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discovery.
a disease expected to kill 600 people. If program A is
Steven Pinker, psychology professor at Harvard University adopted, exactly 400 people will die. If program B is
adopted there is a 1/3 probability that no one will die
Along with Amos Tversky, Daniel Kahneman is and a 2/3 probability that 600 people will die.
famous for researching the apparently strange
way in which people make decisions in risky Now 78% of people choose B because the problem
situations. Kahneman and Tversky realised that is presented in terms of losses. People suddenly
people behaved in different ways depending on prefer to take a risk. The two situations are in fact
how the risky situation was presented. If a risk is mathematically identical, yet people’s decisions are
presented in terms of losses, people will be more heavily influenced by the way the problem is framed.
This effect has been termed preference reversal. 19
risk seeking, but if it is expressed in terms of gains,
people will be more risk averse.
Follow-up questions
Their classic example involves this fictional 1 Explain the difference between ‘risk seeking’ and
situation: ‘risk aversion’.
Imagine your country is preparing for the outbreak of 2 The final paragraph states that ‘people’s decisions
a disease expected to kill 600 people. If program A is are heavily influenced by the way the problem is
framed’. Explain what this means.
●● Biases in decision making
Behavioural economics argues that the decisions people make when exercising
KEY TERM choice are often heavily biased. This is because decisions are made on the basis
cognitive bias a mistake in
of one’s own likes, dislikes and past experiences. Psychologists use the term
reasoning or in some other
cognitive bias to describe this situation.
mental thought process
occurring as a result of, for A cognitive bias is a mental error that is consistent and predictable. There are
example, using rules-of- many kinds of cognitive bias, one of which is confirmation bias. This is the
thumb or holding onto one’s tendency to seek only information that matches what one already believes.
preferences and beliefs, It stems from the often unconscious act of listening only to opinions which
regardless of contrary
back up our pre-existing views, while at the same time ignoring or dismissing
information.
opinions — no matter how valid — that threaten our views.

EXTENSION MATERIAL
The AQA specification advises that you understand suspicious of others. We value our immediate group
some of the reasons why an individual’s economic at the expense of people we don’t really know.
decisions may be biased. Here are ten examples of Positive expectation bias: The sense that luck will
cognitive bias additional to confirmation bias, which

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eventually change for the better — which often fuels
we have already described: gambling addictions. A run of bad luck has to change
eventually and better times lie ahead.
Ten cognitive biases Post-purchase rationalisation: Believing after
AF the purchase of an unnecessary, faulty or overly
Status-quo bias: This is where people generally
prefer that things remain the same, or change as expensive good that buying the product was a good
1 Individual economic decision making

little as possible. It is the belief that changing the idea, thus justifying a bad decision.
status quo is likely to be inferior or make things Neglecting probability: The inability to grasp a
worse. proper sense of peril and risk, which can lead to
Memory bias: People are likely to possess accurate overstating the risks of relatively harmless activities
memories associated with significant emotions or and understating the risks of more dangerous ones
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events (such as the memory of what one was doing — for example, air travel versus car travel or cycling
when a grandchild was born or when a catastrophe risks.
such as the assassination of a world leader Negativity bias: People tend to pay more attention to
occurred). Memory bias influences what and how bad news than to good news. We perceive negative
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easily one remembers. news as being more important or profound.


Observational selection bias: The effect of suddenly Bandwagon effect bias: People succumb to ‘group-
noticing things not noticed much before and wrongly think’ or herd behaviour.
assuming that the frequency of the observation has Current moment bias: Preferring pleasure or
increased. gratification at the current moment to pleasure in the
In-group bias: We forge tighter bonds with friends future. The pain can be left for later.
similar to ourselves (our in-group), while being

20
ACTIVITY
Make a list of all the significant decisions you have made in the last week.
To what extent, if any, do these decisions embody one or more of the ten
cognitive biases listed alongside?
The availability bias

1.3 Aspects of behavioural economic theory


The availability bias occurs when individuals place too much weight on the
KEY TERM probability of an event happening because they can recall vivid examples of
availability bias occurs when
similar events. For example, after reading several news reports about bicycle
individuals make judgements
about the likelihood of future thefts, an individual may judge that vehicle theft is much more common than
events according to how easy it really is in the local area.
it is to recall examples of Consider also the economic decision to buy a lottery ticket. The probability
similar events. of selecting the winning numbers in a draw is outrageously long at over 14
million/1. It is irrational to believe that buying a ticket is a sound economic
decision because the chance of winning the jackpot is so improbable.
However, in October 2014 UK National Lottery tickets sales totalled £649.4
million, an increase of £134.0 million on the same period in 2013. No doubt,
when buying a ticket most players do not think about the odds but instead
focus on the news stories of people winning the jackpot. The lucky winners
of large jackpots are publicised in the national media and their tales are
promoted by Camelot, the business that runs the National Lottery. Since its
launch in 1994 the National Lottery claims to have created 3,700 millionaires
in the UK.

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The availability bias often leads to decisions that are not based on logical
reasoning. The media will report stories that stick in our mind and affect
our reasoning process. Humans will often believe that the probability of an
AF
extreme weather event, such as a hurricane or severe flooding, is more likely
than empirical statistical analysis bears out. In October 2014 Ipsos MORI’s
published research highlighting how the general public in 14 countries held
preconceptions on the make-up of their societies that were significantly
detached from the reality. In the UK, for example, the average citizen believed
that 24% of the population were immigrants when the real figure is 13%; and
likewise that 24% of the working age population was unemployed when in
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fact it was less than 7%.
Quickly recalling examples that come to mind is an automatic system
response. It will often lead to an overly cautious decision that over-estimates
the probability of an outcome occurring.
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Anchoring
Anchoring is an example of a predictable bias in individual decision making.
KEY TERMs Most people have a tendency to compare and contrast only a limited set of
anchoring a cognitive bias
items. This is called the anchoring effect. A good example is provided by
describing the human
tendency when making restaurant menus, which sometimes feature very expensive main courses,
decisions to rely too heavily on while also including more (apparently) reasonably priced alternatives. We are
the first piece of information lured into choosing the cheaper items, even though their prices are still quite
offered (the so-called high. When given a choice, we often tend to pick the middle option, believing
21
‘anchor’). Individuals use an it’s not too expensive, but also not too cheap.
initial piece of information
when making subsequent Biases based on social norms
judgements. Human beings are social animals and as a result the behaviour of other people
social norms forms or influences our own behaviour. By unconsciously learning from the behaviour
patterns of behaviour of other people, social norms are established.
considered acceptable by
a society or group within Negative social norms include attitudes towards drinking alcohol. Many young
that society. adults often drink heavily because they think it is what people of their age
are expected to do. By presenting statistical data showing that the majority of
young adults do not engage in regular heavy drinking, behavioural economists
would seek to nudge young adults into different patterns of behaviour.
KEY TERMS
economic sanctions in this Positive social norms can be seen in the way in which social attitudes have
context, restrictions imposed altered toward smoking in the last 30 years. In the 1980s it was socially
by regulations and/or laws acceptable to smoke in all public places including libraries, trains and the
that restrict an individual’s London Underground. Concerted health campaigns which provided the
freedom to behave in certain
general public with better information about the risks of smoking have altered
ways. Breaking a sanction can
lead to punishment.
social attitudes toward smoking. As a result people became much more willing
to accept laws which restricted their right to smoke. The laws banning smoking
nudges factors which
in public places are economic sanctions (used by government policy-makers)
encourage people to think and
act in particular ways. Nudges
and not nudges. Critics of behavioural economics point out that sanctions,
try to shift group and individual such as the smoking ban, are more effective at changing behaviour and
behaviour in ways which improving public health than nudges, which only alter the behaviour of some
comply with desirable social people. Nevertheless, government reports in Ireland claim that since smoking
norms. in public places was banned people are also less likely to smoke in other
people’s houses because it is now considered to be socially unacceptable.

SYNOPTIC LINK

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The cases for and against economic sanctions and nudges are developed
in Chapter 6, pages XX–XX.
AF
ACTIVITY
1 Individual economic decision making

Give examples of some of the social norms that affect your behaviour
when at home and when attending school or college.
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TEST YOURSELF 1.4
Which of the following provides the best definition of a norm?
Norms are:
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A laws that attempt to discourage excessive consumption


B informal rules that govern human behaviour
C formal rules that govern human behaviour
D formal rules about how to buy goods and services
Explain your answer.

22 ●● Altruism and fairness


Altruism is when we act to promote someone else’s wellbeing, even though
we may suffer as a consequence, either in terms of a financial or time loss, or
KEY TERM by incurring personal risk. Before the development of behavioural economics,
altruism concern for the economists generally assumed that individuals were not altruistic and acted
welfare of others. only in their self-interest. Nevertheless, altruism could still be accommodated
within maximising theory — for example, by assuming that individuals derive
pleasure as a result of giving to others. More recently, behavioural economists
have drawn attention to the fact that for many if not most people, their first
impulse is to cooperate with each other rather than to compete. Very young
KEY TERM
children are frequently observed helping other children around them, out

1.4 Behavioural economics and economic policy


fairness the quality of being
impartial, just, or free of of a genuine concern for their welfare. Animals have also been observed
favouritism. It can mean displaying altruism.
treating everyone the same. Altruistic behaviour often results from people’s perceptions of fairness. This
Fairness involves treating
being a normative term incorporating value judgements, different people have
people equally, sharing with
a range of different views on the meaning of fairness. A popular view is that
others, giving others respect
and time, and not taking fairness involves treating people equally or in a way that is right or reasonable.
advantage of them.
1.4 Behavioural economics and
economic policy
SYNOPTIC LINK
Go back to Book 1, Chapter As we mentioned in our introduction to aspects of behavioural economics,
1 to remind yourself of UK and US governments have recently been introducing the insights of
the meaning of normative behavioural economics into practical policy making. In the context of the
statements. impact of behavioural economics on government economic policy making,
you need to consider how behavioural economics might influence the design

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of a variety of government policies which aim to reduce or eliminate particular
economic problems.
At times in this chapter, we have tended to portray traditional or orthodox
AF
economics and behavioural economics as if they are completely opposed
to each other, implying that if one is correct, the other is inevitably wrong.
However, this is a somewhat misguided way of viewing the two very important
branches of economic theory. It is better to think of behavioural economics
as complementing and improving traditional economic theory by allowing
governments and decision-makers to design policy interventions, such as
healthcare interventions, to enable them to achieve policy goals more effectively.
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Behavioural economics argues that individuals are not fully rational in the way
traditional economic theory assumes. As a result, individuals regularly suffer
from behavioural biases that make it difficult for them to achieve the behaviour
they actually prefer. In this situation, government intervention should aim at
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helping individuals to achieve an outcome that is in their own best interest.

●● Choice architecture and framing


KEY TERMS
Choice architecture
choice architecture a Choice architecture is the term used by behavioural economists to describe
framework setting out how government policy-makers can lead people into making particular
different ways in which choices. Government can use behavioural insights to design choice
choices can be presented to architectures so that citizens are nudged to opt for choices that are deemed 23
consumers, and the impact of to be in their best interest, so as to achieve a socially desirable outcome. For
that presentation on consumer example, countries that require people to opt out of organ donations generally
decision making. have a much higher proportion of the population willing to donate than
default choice an option that is countries that ask people to opt in.
selected automatically unless
an alternative is specified. This introduces us to a key behavioural concept known as default choice.
When framing policy on issues such as organ donation, individuals who, in
the event of their death, might donate body organs such as hearts or livers,
can be asked whether to opt in or opt out of organ donation. In this context,
an ‘opt-in’ default choice is illustrated by the use of a tick box which, if filled
in by member of the general public, indicates positively that they would like
to donate their body organs after their death. Unless the user ticks the box,
healthcare organisations such as the NHS cannot make use of their organs.
This is in contrast with an ‘opt-out’, where the default position is that the
organs can be used to help others survive unless the box has been ticked to
indicate that the body parts should not be used. For a behavioural economist,
the benefits of opt-out over opt-in are clear: the supply of donated organs rises
to be closer to the demand for them and the nation’s public health improves.

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AF
1 Individual economic decision making

Signing up to the NHS Organ Donor Register is an opt-in default choice


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Policy-makers can improve social welfare by designing government
programmes that select as a default an option that can be considered in an
individual’s best long-term interest. A number of examples of this approach
have been trailed and introduced by the UK government’s Behavioural Insights
D

Team. One of these is automatic pension enrolment (see case study 1.7).

CASE STUDY 1.7


Automatic pension enrolment 2018. After the first 6 months the BIT reported that
overall participation in pension schemes increased
There is a broad consensus among economists
from 61% to 83%. This saw 400,000 extra workers
in the UK that too many workers are saving too
saving income for retirement. By December 2014
little for their retirement in old age. In an effort to
the DWP reported that 5 million workers were
solve this problem the BIT and the Department for
included in automatic enrolment and that 9 out of 10
Work and Pensions (DWP) introduced a policy of
24 workers had not exercised their right to opt out of
automatic enrolment in October 2012. Previously
the system.
the default position for workers was that they
would not pay into a pension fund unless they made
Follow-up questions
the choice to opt into a scheme. Under automatic
enrolment the default position is that workers pay 1 Why is it desirable for social and economic policy
into a pension system unless they choose to opt out. for governments to base pension policy on an
opting-out rather than an opting-in default choice?
Initially the scheme started with the UK’s biggest 2 Research the BIT website to find other examples of
employers (firms that have over 250 workers) but policy being changed to incorporate the opting-out
it is being rolled out to include all employers by default choice.
Framing

1.4 Behavioural economics and economic policy


People are influenced by how information is presented. Framing is the
KEY TERM tendency for people to be influenced by the context in which the choice is
framing how something
presented when making a decision. Advertisers have for many years presented
is presented (the ‘frame’)
consumers with choices in a manner that frames their products in a favourable
influences the choices
people make. light. Consider the label on food products that read: ‘90% fat-free’. Would they
sell as well if the label read: ‘10% fat’?
Politicians will often frame (or spin) economic statements in a manner
that is favourable to the argument they are trying to make. For example, in
December 2014 the chancellor of the exchequer George Osborne said that
the government had more than halved the UK’s budget deficit since taking
office in May 2010. This message was printed on Conservative Party campaign
posters in January 2015. Osborne was trying to frame his government in
the voters’ mind as one of economic competence. This statement is true if
you measure the size of the budget deficit as a ratio of GDP. However, if you
measure the budget deficit in money terms, it has only been reduced by
around 40%.
Table 1.4 UK budget deficit, 2009/10 and 2014/15

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Year UK budget deficit (£bn) UK budget deficit as a % of GDP
2009/10 153.0 10.2
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2014/15 91.3 5.0

Source: OBR, A Brief Guide to the UK Public Finances, 3 December 2014

Mandated choices
A variation of default choice is mandated choice; this is where people are
KEY TERM required by law to make a decision. A mandated or required choice is when
mandated choice people are a choice architect designs a system that forces individuals to make an explicit
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required by law to make a decision and not merely go ahead with a default position. This system is
decision.
favoured by libertarians who philosophically oppose the notion that well-
meaning government officials should guide citizens into making the ‘correct’
choice favoured by the government, especially if this is the default option.
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An everyday example of a mandated choice outside of government policy is


the Microsoft software installation boxes that appear on our computer screens.
The Microsoft choice architects force computer users to make choices and
select various options before they can move onto the next step and complete
the installation process. Most people will choose the recommended settings
but they have to make an active decision to do so. Mandated choices work
well with simple yes/no decisions but less well with complex decisions.

Restricted choice 25
KEY TERM Restricted choice means offering people a limited number of options, on the
restricted choice offering basis that offering too many choices is unhelpful and leads to poor decisions.
people a limited number of Most people can’t, or can’t be bothered to, evaluate a large number of choices.
options by removing tempting The policy of requiring the energy companies to simplify their pricing
options deemed bad for them. structures and restrict the number of options offered to consumers is an
example of ‘restricted choice’ in action.
Government policy-makers should consider behavioural insights when
designing systems. A well-designed system should make it easier for citizens
to pay for government services by setting up direct debits, using accessible
language and sending text messages or e-mails to remind people to complete
requests. Evidence from the BIT shows that personalised letters increase
response rates, whilst asking respondents to sign forms at the top of the page
and not the bottom results in more honest answers.

Choice architecture: some further implications for


government policy
When making a choice, individuals need to understand the decision that
they are making. Simple decisions such as ordering a meal in a restaurant are
easy to understand. More complex decisions, such as taking out a mortgage
or insurance policy, can be difficult to understand due to complex clauses,
intricate pricing tariffs, and baffling legal terminology. Government regulation
of business behaviour should try to ensure that companies make their
products as straightforward and transparent as possible for consumers to
exercise choice. Individuals need to have as great an understanding as possible
of the consequences of any decisions and choices they make.
Well-designed choice architecture helps people to make good intuitive
decisions. For example, pedestrians are told by the writing painted on the
roads to look right or look left when crossing a road. This choice architecture

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helps reduce accidents, especially in tourist areas where a large number of
pedestrians are not initially familiar with the ‘rules of the road’.
However, as choices become more complex, people have greater difficulty
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in understanding the information presented to them. By providing an
individual with information about the choices made by similar people in
1 Individual economic decision making

similar situations, it is possible for an individual to benefit from ‘collaborative


filtering’. Accessing the preferences of like-minded people reduces the chance
that individual decisions are made on the basis of imperfect knowledge,
though to some extent this advantage may be offset by people’s tendency to
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‘join the herd’ without considering the disadvantages of doing so.
The best way to help an individual’s decision-making process is to provide
feedback that enables them to learn from their past performance. In a school
environment, good teachers do this all the time. Constructive feedback helps
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people to make better decisions and choices. However, negative feedback is


typically misperceived or rejected. Constructive feedback enhances people’s
feelings of competence and self-control. Feedback is most useful when
individuals actively participate in the feedback session. By contrast, destructive
feedback tends to cause conflict and reduce personal motivation.
Choice architects need to build incentives — sometimes based on monetary
rewards — into the choice architecture they design. People often respond to
such incentives. According to traditional economic theory, individuals value
26 money and other tangible rewards and try hard to gain them. People go to
work to earn money, so we expect them to work harder when there is more
money at stake. Reward incentives — particularly monetary incentives — can
motivate individuals to behave in ways they would otherwise avoid.
However, behavioural economics has made two important advances with
regard to reward incentives and how they affect economic behaviour. First,
it has suggested that not all incentives are equally important. As we saw
earlier, individuals feel losses more severely than equivalent gains. Second,
behavioural economics has shown that in certain situations, individuals

1.4 Behavioural economics and economic policy


respond in perverse ways to reward incentives. Monetary incentives, for
example, may cause individuals to respond in the workplace with less effort
rather than more. Behavioural economics recognises that people are not only
motivated by financial gain; social norms and perceptions of fairness, for
example, exert a powerful influence on people’s behaviour.

Revisiting nudge theory


As explained earlier, a nudge tries to alter people’s behaviour in a predictable
way without forbidding any options or significantly changing economic
incentives. A nudge is not a legal requirement. Neither is it an economic
sanction. Fines, taxes and subsidies are not nudges.
When used as a part of government policy, nudges must be open and
transparent to the general public. Governments should be honest with the
public and ensure that they explain why they have introduced a nudge, but
still allow individuals to make a choice.

Nudges versus shoves

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‘Nudge’ policies seek to lead people by providing them with helpful
information and language that then allows them to make an informed choice.
By contrast, ‘shove’ policies instruct people to behave in certain ways, often
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by their responding to financial incentives and disincentives that reward or
punish different decisions.
Government policies based on traditional economic theories have generally
sought to shove people into altering their behaviour rather than to nudge
them into the desired direction.

Table 1.5 Nudges versus shoves


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Nudge Shove
• Provides information for people to • Uses taxation and subsidies to alter
respond to. incentives and on occasion, in the case
• Opt-out schemes rather than opt-in of taxes to punish people.
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schemes and default choices. • Uses fines, laws banning activities and
• Active choosing by individuals. regulations.

ACTIVITY
School rules, which may not have changed significantly for many years,
are often based on the ‘shove’ principle. These include punishments for
lateness and bad behaviour. Get together with a group of fellow students
and discuss how, and the extent to which, the school might move away 27
from ‘shove’ to ‘nudge’. Then see what happens, both immediately and in
the future, when you submit your proposals to the school authorities —
for example, at a School Council meeting.
CASE STUDY 1.8
This case study has been extracted from a paper published by the UK
cabinet’s Behaviour Insights Team (BIT), published in 2013.

Applying behavioural insights to charitable giving


This paper explores new and innovative ways of increasing charitable
giving. It recognises the important indirect benefits of charitable giving
that recent behavioural research has begun to explore. This research
shows that giving both time and money has large benefits for the
wellbeing of the giver as well as the receiver.
Experiments have shown, for example, that individuals are happier when
given the opportunity to spend money on others. Similarly, volunteering is
associated with increased life satisfaction — not only among volunteers,
but also in the wider community. Charitable giving is good for donors, for
beneficiaries, and for society at large.

Four behavioural insights


Insight 1 is to ‘make it easy’. One of the best ways of encouraging people
to give is to make it easy for people to do so. Making it easy can include:

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● Giving people the option to increase their future payments to prevent
donations being eroded by inflation
● Setting defaults that automatically enrol new senior staff into giving
AFschemes (with a clear option to decline)
● Using prompted choice to encourage people to become charitable donors
1 Individual economic decision making

Insight 2 is to ‘attract attention’. Making charitable giving more


attractive to an individual can be a powerful way of increasing donations.
This can include:
● Attracting individuals’ attention, for example by using personalised messages
● Rewarding the behaviour you seek to encourage, for example through
R
matched funding schemes
● Encouraging reciprocity with small gifts

Insight 3 is to ‘focus on the social’. We are all influenced by the actions of


those around us, which means we are more likely to give to charity if we
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see it as the ‘social norm’. Focusing on the social involves thinking about:
● Using prominent individuals to send out strong social signals
● Drawing on peer effects, by making acts of giving more visible to others
within one’s social group
● Establishing group norms around which subsequent donors ‘anchor’
their own gifts
Insight 4 is that ‘timing matters’. If you get your timing right, it can really
help to increase charitable donations. This might include:
28 ● Ensuring that charitable appeals are made at the moments when they
are likely to be most effective — for example, people are more likely to
make a donation in December than January
● Understanding that people may be more willing to commit to future
(increases in) donations than equivalent sums today
Follow-up questions
1 The BIT paper recommends ‘establishing group norms around which
subsequent donors “anchor” their own gifts’. Explain the two terms
‘group norms’ and ‘anchor’.
2 Identify from within the extract, two examples of nudge theory being applied.
sUMMARY

1.4 Behavioural economics and economic policy


●Thestartingpointforunderstandingindividualeconomicdecision
makingisunderstandingthenatureofdemand,rationalityand
maximisingbehaviour .
●Economistshavetraditionallyassumedthatindividualswishto
maximiseutility .
●utilitycanbethoughtofassatisfaction,pleasureorfulfilmentofneed .
●Itisimportanttodistinguishbetweentotalutilityandmarginalutility .
●Thehypothesis(or‘law’)ofdiminishingmarginalutilityliesbehindthe
derivationofanindividual’sdemandcurve .
●Maximisationofutilitytakesplace,subjecttoanumberofconstraints
whichincludeabudgetconstraint .
●utilitycannotbemeasureddirectlybutcanbeindicatedbyrevealed
preference .
●Individualeconomicdecisionmakingisaffectedbyimperfectand
asymmetricinformation .
●Inrecentyears,behaviouraleconomicshasemergedtoquestionmany
oftheassumptionsoftraditionaleconomictheory .
●keyconceptsinbehaviouraleconomicsincludeboundedrationality,
boundedself-control,biasesindecision-makingprocessesand

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anchoring .
●Biasesareoftenbasedonsocialnorms .
●Nudgetheory,choicearchitectureandframinglieattheheartofthe
waysinwhichbehaviouralarchitecturecaninfluenceeconomic
AF policymaking .

Questions
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1 Describe the main features of an individual’s demand curve for a good.
2 What is meant by maximisation subject to constraints?
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3 Explain the difference between maximising and satisficing behaviour.


4 Discuss the similarities of, and the differences separating, the orthodox and the behavioural theories of
individual economic decision making.
5 What is a ‘nudge’? Explain how a food business might use nudges to promote healthy eating.
6 Outline two ways in which the insights of behavioural economics can be incorporated into government
economic policy.

29
2 Production, costs and
revenue

To understand production, costs and revenue in greater depth than was the
case in Book 1, it is necessary to understand how the ‘building blocks’ of
the theory of the firm, which are shown in Figure 2.1, link together. This and
the next chapter explain these linkages.
Production theory

Short-run production theory Long-run production theory

T
The law of
AF diminishing returns Returns to scale

Short-run cost theory Long-run cost theory

Revenue theory

Imperfect competition
Perfect Pure
competition monopoly
Oligopoly

Applying efficiency and welfare criteria


to evaluate market structures
R
Figure 2.1 The ‘building blocks’ of the theory of the firm

A theme running through Chapters 2 and 3 is that it is difficult and


sometimes impossible to understand properly market structures such
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as perfect competition and monopoly (shown in the final part of Figure


2.1) without first understanding the nature of production, costs and
revenue. More narrowly, cost theory cannot be fully understood without
understanding the first ‘building block’ in the flow chart, production theory.
In this chapter, we explain in more detail the concept, first used in
Chapter 1, of ‘the margin’, which we use to explain production, cost and
revenue curves in a more rigorous way than was the case in Book 1. The
margin is one of the most important economic concepts in the A-Level
economics specification, especially in microeconomics.
30 Figure 2.1 reminds us of the distinction explained in Book 1 between short-run
and long-run production and cost theory. However, in this chapter we explain
how the law of diminishing returns determines the shape of the marginal
returns curve (in short-run production theory) and the marginal cost curve
(in short-run cost theory). Likewise, we explain how the long-run concept of
returns to scale is a major determinant of the shape of long-run cost curves.
In contrast to production and cost curves, a firm’s revenue curves are
determined by the competitiveness and structure of the market in which
the firm sells its output. The main forms of market structure, shown in the
lower part of Figure 2.1, are explained and analysed in Chapter 3.
LEARNING OBJECTIVES

2.1 Developing short-run production theory: the law of diminishing returns


This chapter will:
● remind you of the difference between the short run and the long run
● explain the law diminishing marginal returns in the context of short-run
production theory
● describe how a firm’s short-run marginal cost curve is derived from
short-run production theory
● describe how a firm’s long-run cost curves are affected by the
production theory concept of returns to scale
● explain how a firm’s revenue curves are dependent on the type of
market structure in which the firm sells its output
● discuss the role of profit in the economy
● examine how technological change can affect production and costs, and
also competitiveness and market structure

2.1 Developing short-run


production theory: the law of

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diminishing returns
AF
●● What is a firm?
Before we delve further into the nature of production theory, first in the short
KEY TERM run and then in the long run, we shall first remind you of the nature of a firm.
firm a productive organisation A firm is a business enterprise that either produces or deals in and exchanges
which sells its output of goods goods or services. Unlike non-business productive organisations, such as
R
or services commercially. many charities, firms are commercial, earning revenue to cover the production
costs they incur.

CASE STUDY 2.1


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Ronald Coase and the nature of the firm function, that is, the costs of organising additional
transactions within the firm may rise…Secondly…
Way back in 1937, Professor Richard Coase, who
as the transactions which are organised increase,
much later in 1991 received the Nobel Prize in
the entrepreneur…fails to make the best use of the
Economics for his insights, set out to explain
factors of production.’ At a certain point, the gains
why firms exist. Coase’s starting point was that
from economies of scale are defeated by the costs
‘production could be carried on without any
of bureaucracy.
organisation at all’, and could be determined solely
by the price mechanism. Coase then asked ‘why do For further information on Coase and the nature
firms exist?’ His answer was that firms exist because of the firm, and on the different views of later 31
they reduce transaction costs, such as search and economists, access on the internet the article by Steve
information costs, bargaining costs, costs of keeping Denning, ‘Did Ronald Coase get economics wrong?’,
trade secrets, and policing and enforcement costs. published in Forbes Magazine on 25 September 2013.
Coase then asked ‘why then don’t firms become
Follow-up question
bigger and bigger? Why isn’t all world production
carried on by a single big firm?’ Coase gave two 1 Explain the meaning of the following terms
main reasons. ‘First, as a firm gets larger, there mentioned in the passage: the entrepreneurial
may be decreasing returns to the entrepreneurial function; transaction costs; bargaining costs; and
enforcement costs.
●● The short run and the long run
As we explained in Book 1, Chapter 3, the short run is defined as the time period
in which, in the course of production, at least one of the factors of production
is fixed and cannot be varied. (By contrast, in the long run, the scale of all the
factors of production can be changed.) As a simplification, we shall assume that
only two inputs or factors of production are needed for production to take place
— capital and labour. We shall also assume that in the short run, capital is fixed.
It follows that the only way the firm can increase output in the short run is by
adding more of the variable factor of production, labour, to the fixed capital.
Table 2.1 Short-run production with fixed capital

Fixed Variable labour


capital 0 1 2 3 4 5 6 7 8 9 10
Total 0 1 8 18 32 50 64 70 72 68 60
returns
Average – 1 4 6 8 10 10.7** 10 9 7.6 6
returns
Marginal 1 7 10 14 18* 14 6 2 −2 −8
returns

T
* The point of diminishing marginal returns
** The point of diminishing average returns
Note: Total, average and marginal returns are often called total, average and marginal product.
AF
For example, in Table 2.1 the ‘marginal returns of labour’ can be called the ‘marginal product of labour’.

Table 2.1 shows what might happen in a small musical instrument workshop
assembling guitars when the number of workers employed increases from 0 to
10. The first worker employed assembles 1 guitar a day, and the second and third
2 Production, costs and revenue

workers respectively add 7 and 10 guitars to the workshop’s total daily output.
KEY TERMS These figures measure the marginal returns (or marginal product) of each of the
marginal returns of labour first three workers employed. The marginal returns of labour are the addition to
R
the change in the quantity of total output brought about by adding one more worker to the labour force.
total output resulting from
the employment of one more In Table 2.1, the first five workers benefit from increasing marginal returns
worker, holding all the other (or increasing marginal productivity). An additional worker increases total
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factors of production fixed. output by more than the amount added by the previous worker. Increasing
law of diminishing returns a marginal returns are very likely when the labour force is small. In this
short-term law which states situation, employing an extra worker allows the workforce to be organised
that as a variable factor of more efficiently. By dividing the various tasks of production among a greater
production is added to a number of workers, the firm benefits from specialisation and the division of
fixed factor of production, labour. Workers become better and more efficient in performing the particular
eventually both the marginal tasks in which they specialise, and time is saved that otherwise would be lost
and average returns to the as a result of workers switching between tasks.
variable factor will begin to
fall. It is also known as the law But as the firm adds labour to fixed capital, eventually the law of diminishing
32
of diminishing marginal (and marginal returns (or law of diminishing marginal productivity) sets in. In this
average) productivity. example, the law sets in when the sixth worker is employed. The marginal
return of the fifth worker is 18 cars, but the sixth worker adds only 14 cars
to total output. Diminishing marginal returns set in because labour is being
added to fixed capital. When more and more labour is added to fixed plant and
machinery, eventually workers begin to get in each other’s way and the marginal
returns of labour fall, though not often at a labour force as small as six workers.
Note that the impact of diminishing marginal returns does not mean that an extra
worker joining the labour force is any less hardworking or motivated than his or
her predecessors. (In microeconomic theory we often assume that workers and
other factors of production are completely interchangeable and homogeneous.)

2.1 Developing short-run production theory: the law of diminishing returns


Any further specialisation and division of labour eventually become exhausted as
more labour is added to a fixed amount of capital or machinery.

EXTENSION MATERIAL

Understanding the law of diminishing


returns
Increasing marginal returns reflect the fact that initially there are not
enough workers to make efficient use of the available capital. However, as
the labour input increases, eventually there is not enough capital to allow
the labour force to work to maximum efficiency. When this happens, the
law of diminishing returns has set in. It is the balance between capital and
labour that determines when the law sets in.

Whereas marginal returns are the addition to total output attributable to

T
taking on the last worker added to the labour force, the average returns at
any level of employment are measured by dividing the total output of the
KEY TERMS
average returns of labour
labour force by the number of workers employed. The average returns of the
labour force employed in the guitar workshop are shown by the middle row of
total output divided by the total
AF
number of workers employed. data in Table 2.1. Note that in the table, the point of diminishing average
total returns of labour total
returns occurs after the sixth worker is taken on, whereas diminishing
output produced by all the marginal returns set in after the fifth worker is employed. The relationship
workers employed by a firm. between the marginal returns and the average returns of labour is illustrated in
the lower panel of Figure 2.2 in the next section.

The law of diminishing returns shown on a


R
Output
36
diagram
Y Total Figure 2.2 illustrates the law of diminishing marginal returns. In
product
27 the upper panel of the diagram, the law begins to operate at point
D

A A. Up to this point, the slope of the total product curve increases,


18 moving from point to point up the curve. This shows the labour
force benefiting from increasing marginal returns. When diminishing
9 marginal returns set in, the total returns curve continues to rise as
more workers are combined with capital, but the curve becomes less
0 steep from point to point up the curve. Point Y shows where total
Number of
workers employed returns begin to fall. Beyond this point, additional workers begin to
get in the way of other workers, so the marginal returns to labour
Output
become negative.
Marginal B
9 33
product It is important to understand that all three curves (and all three rows
C
in Table 2.1) contain the same information, but the information is
6
used differently in each curve (and row). The total returns curve
Average
plots the information cumulatively, adding the marginal returns of
3 product the last worker employed to the total returns before the worker
joined the labour force. By contrast, the marginal returns curve plots
W
0
Number of
the same information non-cumulatively, or as separate observations.
workers employed Finally, at each level of employment, the average returns curve
Figure 2.2 Total, marginal and average shows the total returns of the labour force divided by the number of
returns curves workers employed.
In the lower panel of Figure 2.2, the law of diminishing marginal productivity
sets in at point B, at the highest point on the marginal returns curve. Before
this point, increasing marginal returns are shown by the rising (or positively
sloped) marginal returns curve, while beyond this point, diminishing marginal
returns are depicted by the falling (or negatively sloped) marginal returns
curve. Likewise, the point of diminishing average returns is located at the
highest point of the average returns curve at point C. Finally, marginal returns
become negative beyond point W.

STUDY TIP
Negative marginal returns are not a result of workers’ obstinacy or
tendency to throw a spanner in the works. Neither are they because the
first workers employed are more efficient than those who are employed
later. As we said earlier, in the abstract world of microeconomic theory,
workers are treated as equally able, homogeneous units.

QUANTITATIVE SKILLS 2.1


Worked example: diminishing returns to one worker is employed from total output when

T
labour two workers are employed, are 22 units of output.
Via a similar calculation, the marginal returns of
A firm has a fixed amount of capital and land, and
the third worker are 26 units of output. However,
increases output by employing additional labour
AF
according to the schedule in Table 2.2.
diminishing marginal returns set in when a fourth
worker is added to the labour force. The marginal
Table 2.2 Diminishing returns to labour returns of the fourth worker are 25 units of output.
2 For each size of labour force, average returns are
Labour Output
calculated by dividing total output by the number of
2 Production, costs and revenue

1 20
workers employed. Average returns when the labour
2 42 force is 1, 2, 3 and 4 workers are respectively outputs
3 68 of 20, 21, 22.67 and 23.25, showing increasing
R
4 93 average returns. However, when the fifth worker is
5 100 added to the labour force, marginal returns fall to 7
6 90 units of output and average returns fall to 20 units of
output. Diminishing average returns (falling average
D

1 When do diminishing marginal returns set in? output per worker) have now set in.
2 When do diminishing average returns set in? 3 Diminishing total returns set in when the addition
3 When do diminishing total returns set in? of an extra worker causes total output to fall. This
1 Diminishing marginal returns set in when the happens when the sixth worker is added to the
marginal returns or marginal productivity falls for labour force. Note that marginal returns are now
an extra worker added to the labour force. The negative (−10 units of output). The workers are
marginal returns of the second worker, which are getting into each other’s way to such an extent that
calculated by subtracting total output when only total output falls.

34
STUDY TIP
In production theory, students often confuse the law of diminishing
returns, which is a short-run law applying when at least one factor of
production is fixed, with returns to scale, which relate to the long run
when firms can change the scale of all the factors of production. You must
avoid this mistake. As we explain shortly, the law of diminishing returns is
important for explaining the shape of short-run cost curves, and likewise,
returns to scale help to explain the shape of long-run cost curves and the
concepts of economies and diseconomies of scale.
EXTENSION MATERIAL

2.1 Developing short-run production theory: the law of diminishing returns


The relationship between marginal returns 
and average returns
The relationship between the marginal returns when a marginal falls. As we saw in Figure 2.2,
of labour and the average returns of labour is an marginal returns begin to fall as soon as the law of
example of a more general relationship that you need diminishing marginal returns sets in. Nevertheless,
to know. (Shortly, we shall provide a second example, as long as marginal returns are greater than the
namely the relationship between marginal costs and average returns of labour, the latter continue to rise.
average costs of production.) When marginal returns exceed average returns,
Marginal and average curves plotted from the same the average returns curve is ‘pulled up’, even when
set of data always display the following relationship: the marginal returns curve is falling. But when the
marginal returns curve cuts through the average
• When the marginal is greater than the average, the
returns curve (at point C in Figure 2.2), beyond that
average rises.
point the average returns of labour begin to fall. The
• When marginal is less than the average, the
marginal returns curve cuts through the average
average falls.
returns curve at the latter’s highest point. Beyond
• When the marginal equals the average, the
this point, the marginal returns curve continues
average is constant, neither rising nor falling.
to fall, and because marginal returns are less

T
It is vital to understand this relationship. It does than average returns, they ‘pull down’ the average
not state that an average will rise when a marginal returns curve.
is rising; nor does it state that an average will fall
AF
EXTENSION MATERIAL

The importance of productivity


Book 1, Chapter 3 introduced you to the very important economic concept
R
of productivity, focusing in the main on labour productivity, or output per
KEY TERMS worker. The chapter then looked at a big problem which has adversely
productivity output per unit of affected UK economic performance in recent years: the failure of labour
input. productivity to recover from a relatively low level, compared to other
D

labour productivity output countries such as Germany and the USA, in the years following the 2009
per worker. recession. This has been the called the ‘productivity puzzle’. Why has the
UK economy performed less well than competitor countries in increasing
labour productivity?
Among the explanations of the productivity puzzle that have been put
forward are: inadequate investment in new capital goods, relatively low
wages in the UK economy and employers ‘hoarding’ rather than laying off
workers in the recession, which, with depressed output, inevitably means
that labour productivity falls. With regard to the latter argument, the fall in
labour productivity has helped employment in the UK in the short run, but
the long-run consequences of low productivity growth may be much less 35
favourable. For further information on productivity, labour productivity
and related concepts such as the UK’s productivity gap, re-read Book 1,
pages 55–58.
CASE STUDY 2.2
Japanese manufacturing methods and
labour productivity
Until about 30 years ago, most car factories were
chaotic places. Modern car factories, by contrast,
are much calmer. The difference between the noisy,
confused old factory and the smooth-flowing world
of the modern ones is the Toyota Production System
(TPS), first developed in the 1950s by the Japanese
car company. Central to the Toyota Production
System, now adopted by all mass car producers, is
‘lean manufacturing’.
The aim of lean manufacturing is to combine the
best of both craftwork and mass production. It uses
less of each input: less labour, less machinery,
Car manufacturers use lean manufacturing to
less space, less time in designing products. Mass
eliminate waste
production concentrates on reducing defects to a
tolerable level. Lean production seeks to eliminate Now each stage of manufacturing performed in the
all defects; if something goes wrong, the whole factory is done on demand. The process eliminates

T
assembly line stops while the fault is identified and waste by making only as much as is wanted at any
put right. An old car factory would have produced given time; gone are the costly piles of work-in-
a complete afternoon’s worth of cars with the progress that used to litter the factory floor. The
AF
same defect. In a lean factory, the mistake is change has greatly affected labour productivity.
quickly nipped in the bud so that the production of
mechanically perfect cars can continue. Follow-up question
1 Explain how the changes in methods of
Lean manufacturing rejects the old idea of making
production mentioned in the passage are likely
2 Production, costs and revenue

things in huge batches, which requires holding


to have affected labour productivity and costs of
large buffer stocks of materials and components
production within manufacturing industries.
between each stage of the production process.
R

2.2 Developing long-run


D

production theory: returns to


scale
●● Returns to scale
Figure 2.3, which is an extended version of Figure 3.3 in Book 1, page 61,
illustrates the important distinction between returns to a variable factor
36 of production, which occur in the short run, and returns to scale, which
KEY TERMS operate only in the economic long run. Suppose that a firm’s fixed capital
returns to scale the rate
is represented by plant size 1 in the diagram. Initially, the firm can increase
by which output changes if
the scale of all the factors of production in the short run, by moving along the horizontal arrow A,
production is changed. employing more variable factors of production such as labour. To escape the
impact of short-run diminishing marginal returns which eventually set in, the
plant an establishment, such
as a factory, a workshop or firm may make the long-run decision to invest in a larger production plant,
a retail outlet, owned and such as plant size 2. The movement from plant size 1 to plant size 2 is shown
operated by a firm. by the movement along the vertical arrow X in the diagram. Once plant size 2
is in operation, the firm is in a new short-run situation, able to increase output
by moving along arrow B. But again, the impact of short-run diminishing
returns may eventually cause the firm to expand the scale of its operations to

2.2 Developing long-run production theory: returns to scale


plant size 3 in the long run.
Labour

Plant Diminishing returns to


size labour eventually set in
1 A

The long-run returns to scale


Plant The short-run returns
size to variable factors of
2 B production

Plant
size
KEY TERMS X 3 C
increasing returns to scale Figure 2.3 Contrasting short-run and long-run production

T
when the scale of all the
factors of production employed It is important to avoid confusing returns to scale, which occur in the long run
increases, output increases at when the scale of all the factors of production can be altered, with the short-
a faster rate.
AF
run returns that occur when at least one factor is fixed. With returns to scale
constant returns to scale there are three possibilities:
when the scale of all the
● Increasing returns to scale. If an increase in the scale of all the factors of
factors of production employed
increases, output increases at
production causes a more than proportionate increase in output, there are
the same rate. increasing returns to scale.
● Constant returns to scale. If an increase in the scale of all the factors of
decreasing returns to
production causes the same proportionate increase in output, there are
R
scale when the scale of all
the factors of production constant returns to scale.
employed increases, output ● Decreasing returns to scale. If an increase in the scale of all the factors of
increases at a slower rate. production causes a less than proportionate increase in output, there are
decreasing (or diminishing) returns to scale.
D

●● Economies and diseconomies of scale


Just as it is important to avoid confusing short-run returns to the variable
factors of production with long-run returns to scale, so returns to scale must
KEY TERMS
economy of scale as output
be distinguished from a closely related concept: economies and diseconomies
increases, long-run average of scale. Returns to scale refer to the technical relationship in production
cost falls. between inputs and outputs measured in physical units. For example,
diseconomy of scale as output
increasing returns to scale occur if a doubling of a car firm’s factory size and
37
increases, long-run average its labour force and other factors of production enables the firm to more than
cost rises. double its output of cars. There is no mention of money costs of production in
long-run average cost cost
this example of increasing returns to scale. Returns to scale are part of long-
per unit of output incurred run production theory, but economies and diseconomies of scale are part of
when all factors of production long-run cost theory. Economies of scale occur when long-run average cost
or inputs can be varied. (LRAC) falls as output increases. Diseconomies of scale occur when LRAC
rises as output increases.
STUDY TIP
Increasing returns to scale and economies of scale are often treated as
interchangeable terms, though strictly speaking, returns to scale are
part of long-run production theory whereas economies of scale are part
of long-term cost theory. You must understand the relationship between
returns to scale and economies or diseconomies of scale. The AQA A-Level
specification advises: ‘Students should appreciate that both the law of
diminishing returns and returns to scale explain relationships between
inputs and output. They should also understand that these relationships
have implications for costs of production.’

The link between returns to scale and economies and diseconomies of scale
is that increasing returns to scale lead to falling long-run average costs or
economies of scale, and likewise decreasing returns to scale bring about rising
long-run average costs or diseconomies of scale. The effect of increasing
returns to scale on long-run average costs can be explained in the following
way: output increases faster than inputs, so if wage rates and other factor
prices are the same at all levels of output, the money cost of producing a unit

T
of input must fall. Likewise, with decreasing returns to scale, output increases
at a slower rate than inputs, and the money cost of producing a unit of
output rises.
AF
There are other reasons for falling long-run average costs besides the impact
on costs of increasing returns to scale. These include the effect of ‘bulk buying’
reducing the cost of raw materials and components.
2 Production, costs and revenue

SYNOPTIC LINK
To remind yourself of further aspects of economies and diseconomies of
R
scale, including different types of economy and diseconomy of scale, re-
read Book 1, Chapter 3, pages 65–69.
D

TEST YOURSELF 2.1


Explain the difference between technical and managerial economies
of scale.

Bringing together long-run average cost and short-


run average cost
38
In Book 1 we described and explained various possible shapes of LRAC curve.
In this chapter, we go a stage further by explaining the relationship between a
firm’s LRAC curve and the associated SRATC curves.
Figure 2.4 shows a number of short-run average total cost (SRATC) curves,
each representing a particular firm size. In the long run, a firm can move from
one short-run cost curve to another, for example from SRATC1 to SRATC2,
with each curve associated with a different scale of capacity that is fixed in the
short run. The line drawn as a tangent to the family or set of SRATC curves is
the LRAC curve.
Costs

2.2 Developing long-run production theory: returns to scale


SRATC1 SRATC9 LRAC
SRATC2 SRATC8
SRATC3 SRATC7
SRATC4 SRATC5 SRATC6
Economies Diseconomies
of scale of scale
C1

O Q1 Output
Figure 2.4 A U-shaped LRAC curve and its related SRATC curves

Optimum firm size


The size of firm at the lowest point on the firm’s LRAC curve is known as the
optimum firm size. In Figure 2.4, we can identify a single optimum firm size,
occurring after economies of scale have been gained, but before diseconomies
of scale set in. In the graph, optimum firm size is shown by the short-run cost
curve SRATC5, with optimum output at Q1.

Other shapes of LRAC curve

T
The LRAC curve need not be symmetrically U-shaped, with a single
identifiable optimum size of firm, as illustrated in Figure 2.4. Four other
possibilities are depicted in Figures 2.5, 2.6, 2.7 and 2.8. Figure 2.5
AF
is a variant of Figure 2.4, but with a horizontal section to the LRATC
curve inserted between the sections of the curve showing economies and
diseconomies of scale.

Costs (£)

LRAC
SRATC1 SRATC11
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SRATC2 SRATC10
SRATC3 SRATC9
SRATC4 SRATC8
SRATC5 SRATC SRATC7
Economies 6 Diseconomies
D

of scale of scale
C1

O Q1 Q2 Output

Figure 2.5 A ‘three-section’ long-run average cost curve

In this diagram, the LRAC curve comprises three sections: a downward-sloping


section showing economies of scale; a horizontal mid-section; and finally, an
upward-sloping section which begins when diseconomies of scale set in. With
KEY TERMS this shape of the LRAC curve, it is not possible to identify a single optimum
39
optimum firm size the size firm size. Long-run average costs of production would be the same for any
of firm capable of producing size of firm producing at the lowest points on SRATC5, SRATC6 and SRATC7,
at the lowest average cost between and including the levels of output Q1 and Q2.
and thus being productively
efficient. Figure 2.6 illustrates an important concept in production and cost theory:
minimum efficient scale the minimum efficient scale (MES). MES is the lowest output at which long-run
lowest output at which the average costs have been reduced to the minimum level that can be achieved,
firm is able produce at the which means that the firm has benefited to the full from economies of scale. In
minimum achievable LRAC. Figure 2.6, all firm sizes to the left of the SRATC3 curve are below minimum
efficient scale, incurring higher average costs than can be achieved at the
lowest point on SRATC3. By contrast, there would be no further reductions
in long-run production costs for any firms producing levels of output
above Q1. In the diagram, the MES level of output is Q1, with average costs
minimised at C1.

Costs
SRATC1

SRATC2
Economies
of scale SRATC3
LRAC
C1
Minimum efficient scale (MES)
O Q1 Output

Figure 2.6 An ‘L’-shaped LRAC curve and minimum efficient


scale (MES)

Another possibility is illustrated by Figure 2.7: an LRAC curve which is


horizontal throughout its length. This curve depicts a market or industry
in which firms neither benefit from economies of scale nor suffer the

T
consequences of diseconomies of scale.

Costs
AF SRATC1 SRATC2 SRATC3 SRATC4
LRAC
C1
2 Production, costs and revenue

O Output
Figure 2.7 Constant long-run average costs
R
Figure 2.8 helps to explain why small firms are common in industries
supplying services, such as those provided by hairdressers and personal
trainers. The markets in which these services are provided typically possess
D

economies of small-scale production. Diseconomies of scale may set in early in


such industries, resulting in an LRAC curve in which the optimum-sized firm,
depicted by the short-run average cost curve SRATC2, is relatively small. The
MES, Q1, is at a low level of output.

Costs
SRATC4 LRAC

SRATC1

40 SRATC3
SRATC2

C1

O Q1 Output

Figure 2.8 The LRAC curve in an industry with economies of


small-scale production
EXTENSION MATERIAL

2.2 Developing long-run production theory: returns to scale


Plant-level economies of scale and firm-level economies
of scale
So far, we have discussed economies and occur at the level of a single plant or establishment
diseconomies of scale which occur when the whole of owned by a firm and those occurring at the level
a firm grows in size. Sometimes, however, firms grow of the whole firm. In recent years, continued
larger but without the plants they own and operate opportunities for further firm-level economies of
growing significantly in size. For this reason, it is scale have contributed to the growth of larger firms,
useful to distinguish between economies of scale that but expansion of plant size has been less significant.

External economies and diseconomies of scale


The scale economies and diseconomies referred to so far in this chapter have
been internal economies and diseconomies of scale. These occur when a
KEY TERMS firm, or a plant within the firm itself, increases its scale and size. By contrast,
internal economies and
external economies of scale occur when average or unit costs of production
diseconomies of scale
changes in long-run average fall, not because of the growth of the firm or plant itself, but because of
the growth of the industry or market of which the firm is a part. Likewise,

T
costs of production resulting
from changes in the size or external diseconomies of scale occur when average costs of production
scale of a firm or plant. increase because of the growth of the whole industry or market. To find out
external economy of scale a more about external economies and diseconomies of scale, and also about the
AF
various types of internal economy and diseconomy of scale, you should refer
fall in long-run average costs
of production resulting from back to Book 1, Chapter 3.
the growth of the market or
industry of which the firm is Scale and market structure
a part. In real life, some markets contain just a few firms — in the extreme case
external diseconomy of of pure monopoly, just one firm. At the other extreme there are markets
scale an increase in long-run containing a large number of similarly sized small firms. Between these
R
average costs of production extremes are markets containing firms of a variety of sizes — some large firms
resulting from the growth but also some small firms.
of the market or industry of
which the firm is a part. The existence or non-existence of increasing returns to scale and economies
D

of scale provide one explanation for variability in the size of firm in different
market or industry structures. This section brings together some conclusions
that can be drawn from Figures 2.6, 2.7 and 2.8.
● Figure 2.9, which is the same as Figure 2.6 but with a vertical line added
to show the maximum size of the market, can be used to explain natural
monopoly. Natural monopoly occurs when there is room in a market for
only one firm benefiting to the full from economies of scale. In Figure 2.9
this is shown by the firm producing on the short-run average cost curve,
SRATC3.
41
Costs
SRATC1 Maximum market size

SRATC2
Economies
of scale SRATC3
LRAC
C1
Minimum efficient scale (MES)
O Q1 Output

Figure 2.9 Circumstances in which natural monopoly arises


● The horizontal LRAC curve in Figure 2.7 illustrates a market in which
large, medium-sized and small firms or plants can coexist and compete
against each other. No firm or plant gains a cost advantage, or suffers a cost
disadvantage, compared to other firms or plants in the market. There are
likely to be firms and plants of varying size in such a market.
● As previously noted, Figure 2.8 helps to explain why small plants or
firms are common in markets or industries supplying personal services to
individuals and households. Economies of small-scale production mean
that the LRAC curve is ‘skewed’ to the left of the diagram. By contrast, in
Figure 2.10 (below) the LRAC curve is ‘skewed’ to the right of the diagram,
showing economies of large-scale production. Diseconomies of scale
eventually set in, but only after substantial economies of scale have been
achieved.

Costs (£)
SRATC1
LRAC
SRATC4

SRATC2
KEY TERMS

T
SRATC3
marginal cost addition to total
cost resulting from producing C1
one additional unit of output.
average fixed cost total cost
AF O Q1
Output
of employing the fixed factors Figure 2.10 The LRAC curve in an industry with economies of large-
of production to produce a scale production
particular level of output,
divided by the size of output: There are, of course, other factors, apart from the existence or non-existence
2 Production, costs and revenue

AFC = TFC ÷ Q. of scale economies and diseconomies, which contribute to markets containing
average variable cost total different sizes of firm. A factor that has been becoming increasingly important
R
cost of employing the variable in recent decades is firms ‘contracting out’ the provision of services, previously
factors of production to provided ‘in house’ by managers and workers employed by the firms
produce a particular level of themselves, to ‘outside’ suppliers of the same services. The outside suppliers
output, divided by the size of range from small independent firms such as a local sandwich shop to large-
output: AVC = TVC ÷ Q.
D

scale specialist firms providing services such as catering, accountancy and ICT
average total cost total cost maintenance.
of producing a particular level
of output, divided by the size
of output; often called average 2.3 Marginal cost and marginal
cost: ATC = AFC + AVC.
revenue
●● How a firm’s short-run marginal cost
42
curve is derived from short-run production
theory
Early in this chapter, we explained the shape of a firm’s marginal returns curve
in relation to the impact of the short-run law of diminishing returns. In this
section, we use the law of diminishing returns to explain, in the short run, the
shape of a firm’s marginal cost (MC) curve, before linking the MC curve to its
short-run average variable cost (AVC) and average fixed cost (AFC) curves,
which are explained in Book 1, Chapter 3, and finally its short-run average
total cost (ATC) curve.
Output Marginal cost is the extra cost a firm incurs when it produces one extra
unit of output. Short-run marginal costs are determined solely by changes

2.3 Marginal cost and marginal revenue


A
in variable costs of production since, by definition, in the short run,
B fixed costs don’t change when the level of output changes. For the sake
of simplicity, assuming labour is the only variable factor of production,
variable costs are simply wage costs. If all workers receive the same
hourly wage, total wage costs rise in exact proportion to the number of
MP AP
workers employed. However, if to start with the firm is benefiting from
O Workers increasing marginal returns to labour, the total variable cost of production
rises at a slower rate than output. This causes the marginal cost of
Costs producing an extra unit of output to fall. In Figure 2.11, the increasing
MC
marginal returns of labour (shown by the positive slope of the marginal
AVC revenue curve in the upper graph) cause marginal costs to fall (shown by
the negative slope of the MC curve in the lower of the two graphs).
However, once the law of diminishing marginal returns has set in,
short-run marginal costs rise as output increases. The wage cost of
O Q1 Q2
employing an extra worker is still the same, but each extra worker
Output
is now less productive than the previous worker. Total variable costs
Figure 2.11 Deriving the MC and AVC rise faster than output, so short-run marginal costs also rise. Again in

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curves from short-run production theory
Figure 2.11, the diminishing marginal returns of labour (shown by the
negative slope of the marginal revenue curve in the right-hand side of
the upper graph) cause marginal costs to rise (shown by the positive
STUDY TIP
AF slope of the MC curve in the right-hand side of the lower graph).
Make sure you understand
the relationship between the Relating marginal cost to average variable cost and
marginal returns curve and average total cost
the short-run marginal cost
curve. Just as a firm’s short-run MC curve is derived from the marginal returns of the
variable factors of production, so the firm’s average variable cost (AVC) curve
(illustrated in the lower panel of Figure 2.11 and also in panel (a) of Figure
R
2.12) is explained by the average returns curve (shown in the upper panel
of Figure 2.11). When increasing average returns are experienced, with the
labour force on average becoming more efficient and productive, the AVC per
unit of output must fall as output rises. But once diminishing average returns
D

set in at point B in Figure 2.11, the AVC curve begins to rise with output.
(a) Adding AFC to AVC to obtain the ATC curve (b) The U-shaped ATC curve

Costs Costs
MC MC ATC
ATC

AVC

43

AFC
O Output O Output
Figure 2.12 The relationships between marginal cost, average variable cost and
average total cost

To see a fuller explanation of the AVC curve (and also the average fixed cost and
short-run average total cost curves), you should re-read Book 1, pages 62–63.
However, at this point we should add that the marginal cost curve cuts through
from below both the AVC and SRATC curves at the lowest points of these curves.
This is a further example of the mathematical relationship between the marginal
and average values of a variable which we explained on page XX.

Quantitative skills 2.2


Worked example: calculating marginal and average variable
costs
Table 2.3 shows the total cost of producing different levels of output in the
short run.
Table 2.3 Total cost of different output levels
Output Total cost (£)
0 100
1 115
2 140
3 175
4 220

Calculate:

T
a the marginal cost of the first unit of output
b average variable cost when output is 4 units
a Total cost increases by £15 when the first unit of output is produced, so
this is the marginal cost of the first unit of output. Alternatively we can
AF use the equation TC1 − TC0 = MC1, which gives us the same answer, £15.
b The first row in the table indicates that total fixed costs are £100 even
though output is zero. This means that total fixed costs are £100
whatever the level of output. To calculate average variable cost when 4
2 Production, costs and revenue

units are produced, we divide total variable cost (£220 − £100, which is
£120) by total output, which is 4: £120/4 = £30. Thus AVC = £30.
R
Long-run marginal cost and long-run average cost
The mathematical relationship just described also holds in the long run, in
this case between long-run marginal cost and long-run average cost. If the
KEY TERMS
D

LRAC curve is U-shaped, as in Figure 2.13, the long-run marginal cost curve
long-run marginal cost
cuts through the lowest point of the LRAC curve. (Note that, for the sake of
addition to total cost resulting
from producing one additional simplicity, SRATC curves have not been included in Figure 2.13.)
unit of output when all the
Costs (£)
factors of production are Long-run Long-run
average costs
variable. marginal costs
(LRAC)
long-run average cost total
cost of producing a particular
Economies
level of output divided by the of scale
size of output when all the Diseconomies
44 of scale
factors of production are
variable.
C1

O Q1 Output

Figure 2.13 A long-run marginal cost curve cutting through a U-shaped


LRAC curve
TEST YOURSELF 2.2

2.3 Marginal cost and marginal revenue


Apply the mathematical rule of the relationship between the marginal
and average values of a variable (see page XX) to Figures 2.5, 2.6 and 2.7.
Copy the diagrams (but leave out the SRATC curves in each diagram) and
then draw on each diagram the long-run marginal cost curve that fits
the diagram.

●● Explaining the revenue curves facing firms


Book 1, page 70 introduced you to the total revenue a firm earns when selling
its output, and also to a firm’s average revenue. This chapter takes you deeper
into revenue theory, by introducing the key concept of marginal revenue,
and then by relating revenue curves to the two extreme market structures of
perfect competition and monopoly. First, however, we shall summarise what
you should already know about revenue from reading Book 1.

The meaning of revenue

T
Revenue is the money that a firm earns when selling its output. Total revenue
KEY TERMS (TR) is all the money a firm earns from selling the total output of a product.
total revenue all the money
By contrast, at any level of output, average revenue (AR) is calculated by
received by a firm from selling
its total output.
AF
dividing total revenue by the size of output. Stated as an equation:
average revenue total total revenue TR
average revenue = or AR =
revenue divided by output. output Q
marginal revenue addition to Marginal revenue (MR) is the addition to total revenue resulting from the sale
total revenue resulting from of one more unit of output. Stated as an equation:
the sale of one more unit of the
product. ∆ total revenue ∆ TR
R
marginal revenue = or MR =
∆ output ∆Q
where Δ is the symbol used to indicate the changes in total revenue and the
change in total output.
D

STUDY TIP
The Greek delta symbol ∆ is used by mathematicians as the symbol for a
change in the value of a variable over a range of observations. The word
‘marginal’ means the change in the value of a variable when there is one
more unit of the variable, so ∆ is the symbol that indicates this change. It
is used in the formulae for marginal product and marginal cost, as well as
for marginal revenue.

●● How the competitiveness of a market 45

structure affects a firm’s revenue curves


The nature of a firm’s revenue curves depends on the competitiveness of the
market structure in which the firm sells its output. The final row of Figure
2.1 at the start of this chapter sets out the four market structures that you
need to understand. These are perfect competition, monopolistic competition,
oligopoly and monopoly. However, we shall leave until Chapter 3 the
imperfectly competitive market structures of monopolistic competition and
oligopoly. This means that this chapter considers only the two extreme market
structures of perfect competition and monopoly.
In the latter part of Chapter 3, we shall also investigate the dynamics of
competition and the competitive market processes existent in real-world
markets. In this chapter, however, and in the early parts of Chapter 3, we
consider solely the type of competition known as price competition. This
focuses on the price or prices that firms charge, in pursuit of a single assumed
business objective: profit maximisation. (Other types of competition include
quality competition and after-sales service competition.) In this chapter we
look at revenue curves, first in perfect competition and then in monopoly.

Average revenue and marginal revenue in perfect


competition
A perfectly competitive market is defined by a number of conditions or
characteristics that the market must possess. These conditions, which we shall
revisit in Chapter 3, are:
● a very large number of buyers and sellers
● all buyers and sellers possess perfect information about what is going on in

T
the market
● consumers can buy as much as they wish to purchase and firms can sell as
much as they wish to supply at the ruling market price set in the market as
a whole
AF
● an individual consumer or supplier cannot affect the ruling market price
through its own actions
● an identical, uniform or homogeneous product
● no barriers to entry into, or exit from, the market in the long run
2 Production, costs and revenue

Taken together, the six listed conditions tell us that a perfectly competitive
firm, which is depicted in panel (a) of Figure 2.14, faces a perfectly elastic
R
demand curve for its product. (Figure 2.14 is the same as Figure 4.2 in Book
1, page 77.) The demand curve facing the firm is located at the ruling market
price, P1, which itself is determined through the interaction of market demand
and market supply in panel (b) of the diagram. Note that the horizontal axis in
D

the panel (b) diagram shows millions of units of output being produced. This
is because panel (b) depicts the whole market, comprising very large numbers
of both consumers and firms. In equilibrium, where market demand equals
market supply, the ruling market price is P1, and the equilibrium quantity is
Q1 millions of units. In panel (a), the horizontal axis is labelled ‘hundreds’, to
reflect the fact that in perfect competition a single firm is only a tiny part of
the total market,
The assumption that a perfectly competitive firm can sell whatever quantity
46 it wishes at the ruling market price P1, but that it cannot influence the ruling
market price by its own action, means that all firms in perfectly competitive
markets are passive price-takers.
KEY TERM
price-taker a firm which is The labels ‘No sales’ and ‘No sense’ placed on Figure 2.14(a), respectively
so small that it has to accept above and below the price line P1, help to explain why a perfectly competitive
the ruling market price. If the firm is a price-taker. ‘No sales’ indicates that if the firm raises its selling price
firm raises its price, it loses above the ruling market price, customers desert the firm to buy the identical
all its sales; if it cuts its price, products (perfect substitutes) available from other firms at the ruling market
it gains no advantage. price. ‘No sense’ refers to the fact that, although a perfectly competitive firm
could sell its output below the price P1, doing so is inconsistent with the
profit-maximising objective. No extra sales can result, so selling below the
ruling market price inevitably reduces both total sales revenue and therefore

2.3 Marginal cost and marginal revenue


profit, given the fact that the firm can sell any quantity it wants at the ruling
market price.
(a) One firm in the market (b) The whole market
Price Price
Market
supply
No sales
D = AR = MR Ruling
P1 P1
market price

No sense
Market
demand
O Output O Q' Output
(hundreds) (millions)
Figure 2.14 Deriving a perfectly competitive firm’s average and marginal
revenue curves

The horizontal price line facing a perfectly competitive firm is also the firm’s
average revenue (AR) curve and its marginal revenue (MR) curve. Suppose, for

T
example, that the firm sells 100 units of a good, with each unit of the good
priced at £1. The firm’s total sales revenue (TR) is obviously £100. The
horizontal price line is also the demand curve, depicted by the letter D on the
AF
graph, facing each firm in the market. You should note that the curve is
perfectly elastic. This results from the fact that the goods produced by all the
firms in the market, being uniform or homogeneous, are perfect substitutes for
each other.

STUDY TIP
Note that Figure 2.14 contains two demand curves. On the one hand,
R
the market demand curve, drawn in panel (b) of the diagram, slopes
downward, reflecting the fact that in the market as a whole a fall in price
will lead to an increase in the quantity sold; with a straight-line market
demand curve, the price elasticity of demand falls from point to point
D

moving down the demand curve. Goods produced in other markets are
partial, though not perfect, substitutes for goods produced in this market.
By contrast, the demand curve for the output of any one firm within the
market is perfectly elastic, and hence horizontal, because other firms
within the market produce identical goods which are perfect substitutes for
the goods produced by any one firm in this market.

Average revenue and marginal revenue in monopoly


Price
£1
It is worth repeating that the demand curve facing a perfectly competitive 47
firm, besides being located at the ruling market price, is also the
firm’s AR curve and its MR curve. By contrast, the demand curve for
a monopolist’s output is the monopolist’s AR curve, but it is not the
£0.60
monopolist’s MR curve.
D = AR To understand why the market demand curve is the monopolist’s
O 1,000 2,500 Output average revenue (AR) curve, consider Figure 2.15, which shows two prices,
Figure 2.15 Price equalling average £1 and £0.60, which can be charged by a monopolist for the good it
revenue (AR) in monopoly produces.
At a price of £1, 1,000 units are demanded. At this price, the monopolist’s
KEY TERMS total revenue is £1000. Average revenue, or total revenue divided by output
price-maker when a firm
(TR ÷ Q), is £1, which is of course the same as price. This is the case at all
faces a downward-sloping
demand curve for its product, prices: the price charged for all units of the good and average revenue are
it possesses the market power always the same. For example, if the monopolist sets the price at £0.60, 2,500
to set the price at which it units of the good are demanded; total sales revenue is £1,500 and
sells the product. average revenue (TR ÷ Q) is £0.60. The demand-sloping market
quantity-setter when a firm demand curve facing the monopolist is therefore the firm’s average revenue
faces a downward-sloping (AR) curve.
demand curve for its product, The downward-sloping AR curve can affect the monopoly in two different
it possesses the market power
ways. If the monopolist is a price-maker, choosing to set the price at
to set the quantity of the good
it wishes to sell.
which the product is sold, the demand curve dictates the maximum
output that can be sold at this price. For example, if the price is set at P1 in
Figure 2.16, the maximum quantity that can be sold at this price is Q1.
Price But if the monopolist cuts the price it charges to P2, sales increase to Q2.
The choice between price
P2 making and quantity setting Alternatively, if the monopolist is a quantity-setter rather than a price-
facing a monopolist
maker, the demand curve dictates the maximum price at which a chosen
P1
quantity of the good can be sold. If the monopolist wants to sell Q2,
the market demand curve shows that the maximum price at which this

T
quantity can be sold is P2. To summarise, if the monopolist sets the price,
D = AR the market demand curve dictates the maximum quantity the firm can sell.
O Q2 Q1 Output Conversely, if the monopolist sets the quantity, the market demand curve
Figure 2.16 The choice between price
AF
determines the maximum price the firm can charge. However, for any one
making and quantity setting facing a good it produces, a firm cannot be a price-maker and a quantity-setter at
monopolist the same time.
However, to understand why marginal revenue and average revenue are
2 Production, costs and revenue

Price
not the same in monopoly, you must remember that when the marginal
value of a variable is less than the average value of the variable, the average
value falls.
R
Market
demand Because the market demand curve or average revenue curve falls as
= AR output increases, the monopolist’s marginal revenue curve must be below
its average revenue curve. Figure 2.17 shows the relationship between
D

O Output the AR and the MR curves. You should see, however, that the MR curve
is not only below the AR curve — it has also been drawn twice as steep.
MR
This is always the case whenever the AR curve is a downward-sloping
straight line.
Figure 2.17 Monopoly average revenue
(AR) and marginal revenue (MR) curves The relationship between AR and MR curves is illustrated in Figure 2.18.
The monopolist initially charges a price of P1 and sells the level of output
Price Q1. However, to increase sales by an extra unit to Q2, the downward-
Loss of revenue
X
sloping AR curve forces the monopolist to reduce the selling price to P2.
P1 Y
P2 h This reduces the price at which all units of output are sold. Total sales
48
revenue increases by the area k in Figure 2.18, but decreases by the area
AR h. Areas k and h respectively show the revenue gain (namely, the extra
Gain in k
revenue unit sold multiplied by price P2) and the revenue loss resulting from the
MR fact that, in order to sell more, the price has to be reduced for all units of
O Q1 Q2 Output output, not just the extra unit sold. Marginal revenue, which is the revenue
Figure 2.18 Explaining a monopolist’s gain minus the revenue loss (or k – h), must be less than price or average
marginal revenue (MR) curve revenue (area k).
EXTENSION MATERIAL

2.4 Profit
Elasticity and revenue curves
We mentioned earlier in the chapter that the Figure 2.19. Demand is elastic between A and B, unit
horizontal price line facing a perfectly competitive elastic at B, and inelastic between B and C.
firm is also the perfectly elastic demand curve for We shall revisit the significance of elasticity in the
the firm’s output. The explanation for this lies in next chapter, when comparing profit maximisation
the word ‘substitutability’. When studying elasticity, with revenue maximisation.
you learnt that the availability of substitutes is the
main determinant of price elasticity of demand. In Price
perfect competition, because of the assumptions A
of a uniform product and perfect information, the Unit elastic
Elastic
output of every other firm in the market is a perfect
substitute for the firm’s own product. If the firm tries
to raise its price above the ruling market price, it Elasticity falls B
loses all its customers. moving down Inelastic
the curve
In monopoly, by contrast, providing the demand
curve is a straight line as well as downward sloping, C
Demand
price elasticity of demand falls moving down the
O Quantity
demand curve. Demand for the monopolist’s output

T
is elastic in the top half of the curve, falling to be unit Figure 2.19 Price elasticity of demand
elastic exactly half way down the curve, and inelastic and a monopolist’s demand or average
in the bottom half of the curve. This is shown in revenue (AR) curve
AF
SYNOPTIC LINK
To understand fully the elasticity of the revenue curves explained in this
chapter, you should refer back to the explanation of price elasticity of
demand in Book 1, Chapter 2.
R

2.4 Profit
D

●● Defining profit
We mentioned in Book 1, Chapter 3 that students often confuse profit and
revenue, mistakenly believing that the two terms have the same meaning. In
fact, profit and revenue are different. Revenue has already been explained in
some depth in the previous sections of this chapter, and profit has been briefly
KEY TERM mentioned on a number of occasions. Profit is the difference between the sales
profit the difference between revenue the firm receives when selling the goods or services it produces and
total sales revenue and total the costs of producing the goods. 49
cost of production.
total profit = total revenue – total costs

●● The difference between normal and


KEY TERM
profit maximisation occurs
abnormal (supernormal) profit
at the level of output at which We have mentioned on several occasions in this chapter, and also in Book
total profit is greatest. 1, page 30, that economists often assume that firms have a single business
objective: profit maximisation. This means producing the level of output
at which profit (revenue minus costs) is greatest. (Firms may also have other
objectives, such as survival, growth and increasing their market share.)
In the next chapter, we shall explain how profit maximisation is achieved in
the different market structures of perfect competition, monopoly, monopolistic
competition and oligopoly. When explaining profit maximisation, we shall
apply two profit concepts, used frequently by economists undertaking
microeconomic analysis, but rarely used outside the field of microeconomic
theory. These are normal profit and abnormal profit. (Abnormal profit is also
called supernormal profit and above-normal profit.)

Normal profit
Normal profit is the minimum level of profit necessary to keep incumbent
KEY TERMS firms in the market, rewarding the time, decision making and entrepreneurial
normal profit the minimum
profit a firm must make to stay
risk taking ‘invested’ into production. However, the normal profit made by
in business, which is, however, incumbent firms, or firms already established in the market, is insufficient
insufficient to attract new to attract new firms into the market. Economists treat normal profit as an
firms into the market. opportunity cost, which they include in firms’ average cost curves. In the long
abnormal profit profit over run, firms unable to make normal profit leave the market. Normal profit varies
and above normal profit. Also from one industry to another, depending on the risks facing firms.

T
known as supernormal profit
and above-normal profit. Abnormal profit
Abnormal profit, or supernormal profit, is extra profit over and above normal
AF
profit. In the long run, and in the absence of entry barriers, abnormal profit
performs the important economic function of attracting new firms into
the market.
2 Production, costs and revenue

STUDY TIP
Avoid confusing normal profit with another abstract microeconomic term:
R
normal good. You came across normal goods when studying demand
theory in Book 1. A normal good is a good for which demand increases as
income increases.
D

QUANTITATIVE SKILLS 2.3


Worked example: calculating revenue and From the information in the table, calculate:
profit a marginal revenue when output per week
Table 2.4 provides information about the short-run increases from 4 to 5 units
output, costs and revenue of a firm. b the level of output at which the firm would make
normal profit but not abnormal profit
Table 2.4 Short-run output, costs and revenue
c the profit-maximising level of output per week
Output per Total revenue Total cost a The marginal revenue, which is the change in the
50 week (£000s) (£000s) total revenue, is £80,000 − £68,000, which is £12,000.
0 0 10 b Assuming that normal profit is being treated as a
1 20 14 cost of production, the firm makes normal profit, but
2 38 19 not abnormal profit, when total revenue equals total
3 54 28 cost. This is at a level of output of 5 units per week.
4 68 44
c Profits are maximised at the level of output at
which (TR – TC) is greatest. This is at a level of
5 80 80
output of 3 units per week, when total profit equals
6 90 93
£54,000 − £28,000, which is £26,000.
TEST YOURSELF 2.3

2.4 Profit
Using the information in Table 2.4, draw on a piece of graph paper the
firm’s average revenue and marginal revenue curves.

●● The role of profit in a market economy


Profit performs a number of roles in a market economy. These include the
creation of business, worker and shareholder incentives. Profit also influences
the allocation of resources, it is an efficiency indicator, and it is a reward
for innovation and for risk taking. Finally, profits also provide an important
source of business finance.

The creation of business incentives


As we have noted on several occasions both in this book and in Book 1,
traditional or orthodox microeconomic theory assumes that profit maximisation
is the most important business objective. Not only do rising profits, and the
hope of higher profits in the future, provide the incentive for managers within

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a firm to work harder to make the business even more profitable, but also they
create incentives for other firms to enter the market. Abnormal profit acts as
a ‘magnet’ attracting new entrants into a market or industry. If market entry is
easy and/or relatively costless, new firms joining the market should lead to an
AF
increase in market supply. We shall explain in the next chapter how the entry
of new firms triggers a process which actually reduces both abnormal profit and
prices, with the latter benefiting consumers. We shall also explain how economic
efficiency and economic welfare may be promoted through this process.
However, when entry barriers are high and monopoly or highly imperfect
competition exists in a market, profit may simply reward inefficient producers.
R
This is a form of market failure in which the ‘producer is king’ rather than
the consumer, and in which ‘producer sovereignty’ rather than ‘consumer
sovereignty’ exists.

The creation of worker incentives


D

Some companies use profit-related pay and performance-related pay to increase


worker motivation, in the hope that workers will work harder and share
the objectives of the business’s managers and owners. This can, however, be
counter-productive, if ordinary workers see higher management and company
directors enjoying huge profit-related bonuses, while they receive a pittance.

The creation of shareholder incentives


High profit generally leads to high dividends or distributed profit being paid
out to shareholders who own companies. This creates an incentive for more 51
people to want to buy the company’s shares. As a result, the company’s share
price rises, which makes it cheaper and easier for a business to raise finance.

Profits and resource allocation


High profits made by incumbent firms in a market create incentives for new
producers to enter the market and for existing firms to supply more of a
good or service. Likewise, loss making, or perhaps a failure to make above-
normal profits, create incentives for firms to leave markets and to deploy their
resources in more profitable markets.
SYNOPTIC LINK
The functions of profit in a market economy are closely linked to the
functions of prices. Very often, but not always, high prices signal to firms
that high profits can be made, and low prices signal the reverse. Book 1,
Chapter 5 explains the functions that prices perform in a market economy.

Profit and economic efficiency


Except when monopolies make large profits by exploiting their consumers,
profit can be an indicator of economic efficiency. Large profits might mean that
firms have succeeded in eliminating unnecessary costs of production and are
also using the most efficient production processes.

SYNOPTIC LINK
Later in this chapter, in section 5.2, we introduce the concepts of
productive efficiency and dynamic efficiency, which we explain in more
detail in Chapter 3. (Productive efficiency was also mentioned briefly in
Book 1.)

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Profit as a reward for innovation and risk taking
AF
As we explain later in this chapter, innovation is an improvement on
something that has already been invented, which thus turns the results of
invention into a useful product. If entrepreneurs believe that innovation can
result in high profits in the future, the incentive to innovate increases. As we
2 Production, costs and revenue

can never be sure of future profits, risks are involved. However, successful risk
taking leads to high profits.
R
Profit as a source of business finance
Instead of being distributed to the business’s owners as a form of income,
profit can be retained within the business. Retained profits are perhaps the
D

most important source of finance for firms undertaking investment projects.


High profits also make it easier and cheaper for firms to use borrowed funds as
an important source of business finance.

SYNOPTIC LINK
Chapter 8, ‘Financial markets and monetary policy’, explains how
capital markets, including the stock exchange, provide a mechanism
through which companies raise finance by selling new share issues and
corporate bonds.
52

Profit sends out a signal about the health of the


economy
The profit made by businesses throughout the economy can send out an
important signal about the health of the macroeconomy. Rising profit may
reflect improvements in supply-side performance — for example, higher
productivity or lower costs resulting from innovation.
ACTIVITY

2.4 Profit
Public limited companies (PLCs) publish information about their
profits twice a year: in an interim company report midway through
the company’s financial year, often in October, and in the full company
report published at the end of the company’s financial year, often in
March. Read the business sections of broadsheet newspapers such as
The Times, the Daily Telegraph and the Guardian in these months and
study the commentaries in which financial journalists analyse company
profitability. Occasionally, companies issue profit warnings. Why do they
do this, and what might be the effect on the company’s share price?

CASE STUDY 2.3


The John Lewis economy John Lewis bandwagon, extolling the virtues of the
British retailer and exhorting other companies to
John Lewis PLC is a highly successful retailing
introduce co-ownership and profit sharing. Here is
company in the UK which not only shares its profits
an extract from a speech made by Nick Clegg, the
with all its workers, but also makes them part-
then deputy prime minister, on 16 January 2012 at
owners of the John Lewis Partnership. From time
an event hosted by the City of London.
to time, leading British politicians climb aboard the

T
AF
R
D

We need more individuals to have a real stake in and higher wages. They weathered the economic
their firms. More of a John Lewis economy, if you downturn better than other companies.
like. What many people don’t realise about employee
Is employee ownership a panacea? No. Does it
ownership is that it is a hugely underused tool in 53
guarantee a company will thrive? Of course not. But the
unlocking growth. I don’t value employee ownership
evidence and success stories cannot be ignored, and
because I believe it is somehow ‘nicer’ — a more
we have to tap this well if we are serious about growth.
pleasant alternative to the rest of the corporate
The 1980s was the decade of share ownership. I want
world. Those are lazy stereotypes. Firms that have
this to be the decade of employee share ownership.
engaged employees, who own a chunk of their
company, are just as dynamic, just as savvy, as their
Follow-up question
competitors. In fact, they often perform better: lower
absenteeism, less staff turnover, lower production 1 Outline one advantage and one disadvantage of
costs. In general, they have higher productivity profit sharing and co-ownership for the United
Kingdom economy.
2.5 Technological change
Most people have a general idea of what technology means, but they
nevertheless find it difficult to give the term a precise definition. Internet
search engines, being prone to long-winded explanations rather than to
short, snappy definitions, often don’t help in this respect. Here, however,
is one snappy definition: whereas science is concerned with how and
why things happen, technology focuses on making things happen. Thus,
technology is knowledge put to practical use to solve problems facing
human societies.
Technological change, by contrast, involves improving existing technologies
KEY TERM and the development of completely new technologies, both to improve
technological change a term
existing products and the processes involved in making the products, and to
that is used to describe the
overall effect of invention, develop completely new products and processes. In the economic sphere, this
innovation and the diffusion leads to the development of completely new markets, to changes in market
or spread of technology in the structure, and also to the destruction of existing markets.
economy. As an aside, the word ‘technology’ is often associated with technical progress.
However, the term ‘technical progress’ has two rather different meanings. On

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the one hand, in a normative or value-judgement context, ‘technical progress’
implies that technological change is fundamentally about increasing economic
welfare and making people happier. For example, although the development
AF
and use of the motor car has several important drawbacks, such as the harm
resulting from road accidents and environmental pollution, for the most part,
through making it much easier for most people to travel, cars and buses have
significantly improved human welfare. But in a narrower sense, unrelated
2 Production, costs and revenue

to welfare considerations, ‘technical progress’ means applying scientific and


engineering knowledge, as it develops, to produce goods which are more
efficient and work better, regardless of whether these are good for society.
R
In this narrower meaning, technical progress includes the development of
distinctly harmful goods such as chemical weapons, which, when used, have a
devastating effect on human welfare.

●● The difference between invention and


D

innovation
Invention refers to advancements in pure science, whereas innovation is the
KEY TERMS application of the new knowledge created by invention to production. The
invention making something
American entrepreneur, Tom Grasty, distinguishes between the two concepts
entirely new; something that
did not exist before at all.
in the following way:
innovation improves on In its purest sense, invention can be defined as the creation of a product
54 or introduction of a process for the first time. Innovation, on the other
or makes a significant
contribution to something that hand, occurs if someone improves on or makes a significant contribution
has already been invented, to an existing product, process or service. Consider the microprocessor.
thereby turning the results of Someone invented the microprocessor. But by itself, the microprocessor
invention into a product. was nothing more than another piece on the circuit board. It’s what was
done with that piece — the hundreds of thousands of products, processes
and services that evolved from the invention of the microprocessor — that
required innovation.
If ever there were a poster child for innovation it would be former Apple
CEO Steve Jobs. And when people talk about innovation, Jobs’ iPod is
cited as an example of innovation at its best. But let’s take a step back for a
minute. The iPod wasn’t the first portable music device (Sony popularized

2.5 Technological change


the ‘music anywhere, anytime’ concept 22 years earlier with the Walkman);
the iPod wasn’t the first device that put hundreds of songs in your pocket
(dozens of manufacturers had MP3 devices on the market when the iPod was
released in 2001); and Apple was actually late to the party when it came to
providing an online music-sharing platform (Napster, Grokster and Kazaa all
preceded iTunes).
So, given those sobering facts, is the iPod’s distinction as a defining example
of innovation warranted? Absolutely. What made the iPod and the music
ecosystem it engendered innovative wasn’t that it was the first portable music
device. It wasn’t that it was the first MP3 player. And it wasn’t that it was the
first company to make thousands of songs immediately available to millions
of users. What made Apple innovative was that it combined all of these
elements — design, ergonomics and ease of use — in a single device, and
The original iPod, which was launched then tied it directly into a platform that effortlessly kept that device updated
in 2001 — invention or innovation? with music.
Apple invented nothing. Its innovation was creating an easy-to-use ecosystem
that unified music discovery, delivery and device. And, in the process, they
revolutionized the music industry.

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●● How technological change affects methods
of production, productivity, efficiency and
AF
firms’ costs of production
Through its diffusion into the economy, technological change affects methods
of production, productivity, efficiency and firms’ costs of production. We shall
now look at each of these in turn.

Methods of production
R
Throughout human history, technological change has affected methods of
production. As far back as the stone age, the bronze age and the iron age, as
the names themselves indicate, different materials were used to create early
D

forms of tool used by humankind. These eras covered scores of thousands


of years. Moving much closer to the present day, the eighteenth century saw
the onset of agricultural and industrial revolutions in which technological
change greatly affected methods of agricultural and industrial production.
Over the decades and centuries that followed, and right up to the present day,
agricultural output greatly increased with the development of new seeds and
the breeding of modern farm animals, the mechanisation of production — for
example, through the use of combine harvesters — and the application of
chemical fertilizers.
55
At the beginning of the industrial revolution in the eighteenth century,
manufacturing moved away from craft and cottage industry, to factory
production. Much more energy was now used in the course of production,
so manufacturing moved to parts of the country where first water power and
then steam power, fired by the burning of coal, was in plentiful supply. In
the nineteenth century, the ‘new’ iron age of the eighteenth century in which
cast iron had become perhaps the main industrial raw material, gave way to
a ‘steel age’, when improvements in smelting technology enabled steel, which
is strong yet malleable, to replace iron in much of modern manufacturing.
The steel age of the mid-nineteenth century was accompanied by a railway-
building age, in which railways replaced the rather cumbersome system of
eighteenth-century canals to enable the development of a modern transport
system necessary for the delivery of goods to markets.
The mid-twentieth century witnessed the growing use of automobiles. The
‘automobile age’ really got going in the USA in the 1920s, when modern
roads were built across the North American continent and mass production
allowed affordable cars to be bought by much of the US population. To
bring us right up to the present day, we are now living in the ‘computer age’.
Computers, which were first developed in the 1940s, are now widely used
in manufacturing (for example, when computer-controlled robots build
cars), in distribution (for example, in the online sale of books by Amazon),
and as consumer goods in themselves. And hidden within many goods
that are not themselves computers, such as washing machines and cars, are
microprocessors that control how the good functions.
Closely allied to the changes in production just described has been the
change in recent decades from mechanised to automated production. As
a simplification, mechanisation means that human beings operate the
KEY TERMS

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machines that are used to produce goods. Automation, by contrast, means
mechanisation workers
that machines operate other machines — for example, a computer-controlled
operating machines.
robot operating a welding tool to weld together the body panels of a car. Both
automation automatic control
mechanisation and automation have often been accompanied by assembly-line
where machines operate other
AF
production, allegedly first introduced by Henry Ford in 1908.
machines.
Productivity
Earlier in this chapter on page XX, we reminded you of the meaning of
2 Production, costs and revenue

productivity, a key concept which we explained in some detail in Book 1.


We defined productivity as output per unit of input, though it can also be
considered as output per unit of time. We also said that when economists
R
talk about productivity, they usually mean labour productivity, which is output
per worker.
Technological change generally increases labour productivity. This has
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usually been the case following the introduction of both mechanised and
automated production methods. However, in the case of automation and
the use of computers in production, there have been several well-publicised
examples in organisations such as the National Health Service of very
expensive computer systems that have failed to work properly and which, in
extreme cases, have had to be scrapped. In these cases, labour productivity
may fall rather than increase, at least until the system can be made to
work properly.

56
STUDY TIP
Make sure you don’t confuse production with productivity. The two concepts
are closely related, but production refers to total output, whereas
productivity is output per unit of input.
CASE STUDY 2.4

2.5 Technological change


The failure to produce paperless records of cost of the National Programme is still not certain.
patient care in the NHS The department’s most recent statement reported
a total forecast cost of £9.8 billion. However, this
On 18 September 2013, the Parliamentary Public figure did not include potential future costs.
Accounts Committee published a report on the
Dismantled National Programme for IT in the The benefits to date from the National Programme
NHS. Although officially ‘dismantled’, the National are extremely disappointing. The department’s
Programme continues in the form of separate benefits statement reported estimated benefits
component programmes which are still racking up to March 2012 of £3.7 billion, just half of the costs
big costs. incurred to this point. The benefits include financial
savings, efficiency gains and wider benefits to
Launched in 2002, the National Programme society (for example, where patients spend less
was designed to reform the way that the NHS in time chasing referrals). However, two-thirds of the
England uses information. While some parts of the £10.7 billion of total forecast benefits were still to
National Programme were delivered successfully, be realised in March 2012.
other important elements encountered significant
difficulties. In particular, there were delays After the sorry history of the National Programme,
in developing and deploying the detailed care the Public Accounts Committee was sceptical
records systems. Following three reports on the that the department could deliver its vision of a
National Programme by both the National Audit paperless NHS by 2018. Making the NHS paperless

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Office and the Public Accounts Committee, and will involve further significant investment in IT and
a review by the Major Projects Authority, the business transformation.
government announced in September 2011 that
Follow-up questions
AF
it would dismantle the National Programme but
keep the component parts in place with separate 1 Research on the internet to find out what has
management and accountability structures. happened to the NHS’s plan to introduce paperless
patient records in the period since September
The public purse is continuing to pay the price for
2013.
failures by the department and its contractors.
2 Find out about and investigate another example of
The department’s original contracts totalled £3.1
a ‘computer systems disaster’ in either the public
billion for the delivery of care records systems to
sector or the private sector.
R
220 trusts in the north, midlands and east. The full

Efficiency
D

As we explain in Chapter 3, economists recognise a number of types of


economic efficiency. Two of these are productive efficiency and dynamic
efficiency. Productive efficiency centres on minimising average costs of
KEY TERMS production. Dynamic efficiency measures the extent to which productive
productive efficiency involves
efficiency increases over time, in the economic long run. Dynamic efficiency
minimising the average costs
of production. also results from improvements in products and services, innovation and the
process of creative destruction.
dynamic efficiency measures
improvements in productive Technological change generally improves both productive efficiency and
efficiency that occur in the dynamic efficiency. As a general rule — though there are exceptions, one 57
long run over time. of which is illustrated by Case Study 2.4 — technological change leads to
improvements in both productive and dynamic efficiency. By increasing
productivity, over time technological changes shift downward both short-
run and long-run cost curves, thereby improving both productive and
dynamic efficiency.
Costs of production
It follows from what we have written about technological change generally
improving both productivity and efficiency that it also reduces costs of
production, in the short run but especially in the long run.

●● Technological change and the development


of new products and new markets, and the
destruction of existing markets
A theme running through this section on technological change is that,
particularly in recent years, technological change has been highly significant
in the development of new products and new markets, and the destruction of
existing markets. To explain this further, it is useful to introduce the concepts
of disruptive innovation and sustaining innovation.
A disruptive innovation is an innovation that helps create a new market, but
in so doing eventually disrupts an existing market over a few years or decades,
thereby displacing an earlier technology. Disruptive innovation often improves

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a product or service in ways that the market did not initially expect. It creates
new goods or services for a different set of consumers in a new market which
competes with the established market. By doing so, it eventually lowers
prices in the existing market. By contrast, a sustaining innovation does not
AF
create new markets but develops existing markets, enabling firms within
them to offer better value and often to compete against each other, sustaining
improvements.
2 Production, costs and revenue

According to Harvard University business professors Joseph L. Bower and


Clayton M. Christensen, one of the most consistent patterns in business is
the failure of leading companies to stay at the top of their industries when
R
technologies or markets change. Writing back in the 1990s, Bower and
Christensen gave the example of Xerox, the US company, which at the time
had dominated the photocopier market, losing market share to the Japanese
company, Canon, in the small photocopier market.
D

Bower and Christensen ask why it is that companies like Xerox invest
aggressively — and successfully — in the technologies necessary to retain
their current customers, but then fail to make certain other technological
investments that customers of the future will demand? The explanation
they offer is that companies that dominate an existing technology are in
danger, as disruptive innovation occurs, of remaining too close to their
existing body of customers. All too often existing customers reject the goods
produced by a new technology because it does not address their needs as
effectively as a company’s current products. The large photocopying centres
58
that represented the core of Xerox’s customer base at first had no use for
small, slow table-top copiers produced by Xerox’s new technology. Result:
Canon stepped in, quickened the speed of the copiers, and took over
the market.
CASE STUDY 2.5

2.5 Technological change


Kodak faces an uncertain future of the most lucrative business models of the last
century and threaten Kodak’s very existence. In
In September 2013, the American camera company
1999, only 5% of new cameras sold in the USA
Kodak emerged from the bankruptcy it had been
were digital. By the end of 2000, this had changed
in for nearly two years. Since 2000, demand for
dramatically. By 2003, now being accused of
Kodak’s most successful product, camera film,
ignoring the revolution until it was too late, Kodak
which once ranked among the most profitable
cut tens of thousands of jobs at its capital-intensive
consumer products ever invented, had been in
film factories and announced a new digital strategy.
rapid decline. To make matters worse, Kodak’s
management had grossly underestimated the Disruptive digital technology has caused the crash
speed of the collapse. of many business models since 1999 — but few
quite so rapid as the fate that befell Kodak. Within
This was all due to the development of digital
a matter of months, the once hugely profitable
cameras. Global sales of traditional photographic
camera film market had given way to the surge of
film and paper had dropped like a stone. Up to that
digital cameras.
point, the boxes of film that Kodak produced had
been highly profitable. New entrants were deterred
Follow-up questions
by the high costs of entry to this capital-intensive
market and Kodak enjoyed profit margins that 1 Research what has happened to Kodak since the
might have been as high as 50%. company emerged from bankruptcy in 2013.

T
2 In what way have smartphones, which were first
But in the first few months of this century, a marketed in 2007, affected the market for digital
technology change began that was to wreck one cameras?
AF
●● The influence of technological change on
the structure of markets
The Kodak case study you have just read provides a good example of the
influence of technological change on the structure of markets. The case study
R
describes how, when cameras transmitted the images they photographed onto
chemical film, very high entry barriers into the chemical film market led to
Kodak’s domination of the market. By contrast, entry into the digital camera
D

market is relatively easy. Hence the camera film market, dominated by Kodak,
was close to a monopoly, whereas the digital camera market is closer to a
much more competitive form of market, monopolistic competition, which
KEY TERMS we explain in the next chapter.
monopolistic competition a
market structure in which Technological change does not always, however, lead to more competitive
firms have many competitors, market structures. In some industries, technological change has led to
but each one sells a slightly outcomes in which very large firms dominate. Sometimes technological
different product. change leads to capital indivisibilities, which occur when very large quantities
duopoly two firms only in a of capital equipment are required for one unit of a good to be produced. A
market. good example is the jumbo jet industry. The technological change which 59
enabled very large jet airliners to be produced led to an outcome in which, in
the western world, the American Boeing Corporation and the European Airbus
consortium are the only two jumbo jet manufacturers. In the next chapter, we
shall call this situation a duopoly.
●● How the process of creative destruction is
linked to technological change
The term creative destruction was first coined in 1942 by the Austrian
KEY TERM economist Joseph Schumpeter to describe how capitalism, which dominates
creative destruction
the economic system in which we live, evolves and renews itself over time.
capitalism evolving and
renewing itself over time
(Capitalism is the name given to the parts of the economy in which the
through new technologies and means of production or capital are privately owned. In the UK, public limited
innovations replacing older companies or PLCs are the dominant form of capitalist business enterprise.)
technologies and innovations. In his famous book Capitalism, Socialism, and Democracy, Schumpeter
wrote: ‘The opening up of new markets, foreign or domestic…incessantly
revolutionises the economic structure from within, incessantly destroying

CASE STUDY 2.6


Apple and creative destruction the market power of a previously ‘dominant’
tech firm can disappear. However, following the
On 1 April 1976, Apple Computer Inc. was
introduction of Apple’s iPhone in 2007, the previous
incorporated by three ‘techno-geeks’, Steve Jobs,
market leaders Nokia and Blackberry began a

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Steve Wozniak and Ron Wayne. Twenty-one years
rapid decline.
later in 1997, Steve Jobs, having left Apple following
disputes about business strategy, rejoined the Under a headline ‘Once-cool Blackberry fails to keep
company and remained in charge until his death pace with rivals’, China’s Morning Post described how
AF
in 2011. (In 2007, Jobs had renamed the company Blackberry, an early mover in the high-end mobile
Apple Inc. to reflect the fact that Apple had phone market, lost market share mainly to Apple’s
diversified away from computers into the iPod, the iPhone and to smartphones powered by Google’s
iPhone, the iPad and iTunes.) Android operating system. While Blackberry was
2 Production, costs and revenue

considered perhaps the hippest if not the largest


Over this period, and particularly since 2001 when
mobile phone maker several years ago, the company
the iPod was first marketed, Apple had a crushing
quickly lost momentum as it failed to keep pace with
effect on specific competitors. According to Barry
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innovations from rivals. Gerry Purdy, an analyst at
Ritholtz, writing in the Washington Post shortly
Compass Intelligence, said that ‘The one gigantic
after Job’s death from pancreatic cancer, this was
issue facing Blackberry was the delay in getting
creative destruction writ large. Ritholtz argued
into the smartphone market. And that was three
that Jobs remade entire industries according to his
years after the iPhone was released. So that’s six
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unique vision. From music to film, mobile phones to


years. The market was moving too fast.’ Blackberry
media publishing and computing, Job’s impact has
was too complacent, having become ‘blinded’ to
been enormous.
competitive threats.
Today, the triple threat of iPod/iPhone/iPad has left
Even software giant Microsoft has suffered from
behind a wake of overwhelmed business models,
Apple’s innovation and marketing. Once Apple’s
confounded managements and bereft shareholders.
main competitor in computer manufacturing and
The businesses which have been destroyed, or
software, Microsoft has become vulnerable on
left as mere rumps of their former selves, include
multiple fronts. It has missed nearly every major
Hewett-Packard (HP), Nokia and Blackberry.
trend in technology in recent years. Microsoft
According to Ritholtz, HP’s printer business might
60 still has its cash cows Windows and its Office
still have some ink left in its cartridges, but its PC
suite of products, but the company could lose out
operations are hurting, gutted by sales of the iPad.
significantly to Apple in the next few years.
HP’s tablet entry, the TouchPad, was an unmitigated
disaster, unable to compete with the iPad.
Follow-up questions
In 2007, the Finnish company Nokia totally 1 What is meant by ‘creative destruction’?
dominated the mobile phone market. Many people 2 This case study was written at the time of Steve
thought that Nokia’s lead was more or less Job’s death in 2011. Find out what has happened to
insurmountable. But what has happened since Nokia’s and Blackberry’s smartphone business in
is a reminder of just how quickly and completely the years since then.
the old one, incessantly creating a new one. This process of Creative
Destruction is the essential fact about capitalism.’ Schumpeter also stated that

2.5 Technological change


‘The essential point to grasp is that in dealing with capitalism we are dealing
with an evolutionary process.’
Creative destruction is strongly related to the processes through which
technological change and innovation affect the ways in which businesses
behave. It describes a process in which economic growth occurs in the
economy as a result of new innovations creating more economic value than
that being destroyed by the decline of the technologies the new innovations
replace. Over time, societies that allow creative destruction to operate grow
more productive and richer; their citizens benefit from new and better
products and higher living standards. Creative destruction is central to the
ways in which free market economies and mixed economies develop and
change over time.

ACTIVITY
Cathode-ray television-tube manufacturers, video rental shops, high-
street travel agents and bookshops have all in recent years been victims

T
of creative destruction. Research how this has happened in one of these
industries (or in an industry of your choice) and explain why you think
consumers may or may not have benefited from the process.
AF
Summary
● The theory of the firm is the main part of business economics.
● A firm is a business enterprise which either produces or deals in and
exchanges goods or services.
R
● The building blocks of the theory of the firm include production theory,
cost theory and revenue theory.
● Production and cost theory divide into short-run and long-run theory.
● Production is a process or set of processes for converting inputs into
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outputs.
● The key concept in short-run production theory is the law of diminishing
returns, also known as the law of diminishing marginal productivity.
● t is vital to understand, and to distinguish between, marginal returns,
marginal costs and marginal revenue.
● The marginal return of labour is the extra output or the change in the
quantity of total output resulting from the employment of one more
worker, holding all the other factors of production fixed.
● Marginal cost is the extra cost a firm incurs when it produces one extra
unit of output.
● Marginal revenue is the extra sales revenue a firm receives when it sells 61
one extra unit of output.
● In the short run, the marginal cost curve and the average variable cost
curve are derived from the law of diminishing marginal (and average)
returns.
● Assuming that the variable factors of production experience diminishing
returns, the average variable cost (AVC) and the short-run average total
cost (SRATC) curves are U-shaped.
● The key concept in long-run production theory is returns to scale.
●Increasingreturnstoscale,constantreturnstoscaleanddecreasing
returnstoscaleareallpossible .
●Increasingreturnstoscalearelikelytoleadtoeconomiesofscale,
whicharedefinedasfallinglong-runaveragecosts .
●Decreasingreturnstoscalearelikelytoleadtodiseconomiesofscale,
whicharedefinedasrisinglong-runaveragecosts .
●Thelong-runaveragecost(LRAC)curvemaybeu-shaped,butother
shapesarepossible .
●Minimumefficientscale(MES)isthelowestoutputatwhichthefirmis
ableproduceattheminimumachievableLRAC .
●Profitistotalsalesrevenueminustotalcostsofproduction .
●Internaleconomiesanddiseconomiesofscaleshouldnotbeconfused
withexternaleconomiesanddiseconomiesofscale .
●Afirm’ssalesrevenue,whichmustnotbeconfusedwithreturnsto
factorsofproduction,isinfluencedbythemarketstructureinwhichthe
firmsellsitsoutput .Akeydifferenceisthatreturnsrelatetophysical
unitsofoutputwhereasrevenueismeasuredintermsofmoney .
●Perfectcompetition,monopoly,monopolisticcompetitionandoligopoly
arethefourmarketstructuresyouneedtoknow,andyoumustalsobe
awareofthemeaningofimperfectcompetition .

T
●Aperfectlycompetitivefirmisaprice-taker,butamonopolyisaprice-
makerorquantity-setter .
●Economistsusuallyassumethatmaximisingprofitisafirm’smain
businessobjective .
AF
●Profitistotalsalesrevenueminustotalcostsofproduction .
●Normalprofitisjustsufficienttokeepincumbentfirmsinthemarketbut
isinsufficienttoattractnewfirmsintothemarket .
●Normalprofitistreatedasacostofproductionandisincludedinafirm’s
 2 PRODuCTION,COsTsANDREvENuE

costcurves .
●Abnormal,orsupernormal,profitisanyprofitoverandabovenormal
profit .
●Thewaysinwhichfirmsoperateareaffectedbytechnologicalchange,
R
whichencompassestheprocessesofinvention,innovationanddiffusion
oftechnologyintheeconomy .
●Inthelongrun,capitalismdevelopsthroughaprocessknownascreative
destruction,throughnewtechnologiesandinnovationsreplacingolder
D

technologiesandinnovations .

Questions
1 Explain the difference between the law of diminishing returns and decreasing returns to scale.
How do these affect a firm’s cost curves in both the short run and the long run?
2 What is the relationship between returns to scale and economies and diseconomies of scale?
62
3 Explain why the average and marginal revenue curves of a monopoly slope downward, while
those of a perfectly competitive firm are horizontal.
4 Explain the mathematical relationships between the average and marginal values of an economic
variable.
5 Evaluate the view that a monopoly can simultaneously increase both the price of the good it
produces and the quantity of the good it sells.
6 With two examples of each concept, explain the difference between invention and innovation.

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