AQA A Level Economics Book 2 Sample
AQA A Level Economics Book 2 Sample
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
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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
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2.4 Profit. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49
2.5 Technological change. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54
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
4.6 The National Minimum Wage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
4.7 Discrimination in the labour market. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
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6.4 Competition policy . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
6.5 Public ownership . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
6.6 Privatisation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
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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 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
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Microeconomics
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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.
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LEARNING OBJECTIvEs
This chapter will:
● remindyouofsomeofthemainelementsofdemandtheoryintroduced
inBook1,Chapter2
● discussthesignificanceofutilitymaximisationforindividualeconomic
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decisionmaking
● explaintheimportanceofthemarginwhenmakingchoices
● discusshowimperfectinformationandasymmetricinformationaffect
choicedecisions
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● outlinetheemergenceofbehaviouraleconomicsasanimportantrecent
developmentineconomictheory
● investigateimportantelementsofbehaviouraleconomicssuchas
boundedrationality,biasesinindividualdecisionmakingandtheroleof
altruism
● relatebehaviouraleconomicstogovernmenteconomicpolicy
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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
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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
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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.
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Price
KEY TERMS
shift of a demand curve the movement of a demand curve to a new position.
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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
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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
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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
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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
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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
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lemonade
curves show exactly the same information, but they show
Units of utility
it in different ways. The total utility schedule and the total
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utility curve show the data cumulatively — for example,
Diminishing
when drinking two glasses of lemonade, the thirsty child
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marginal gains 14 ‘units of utility’ in total. After three glasses, total
utility
utility rises to 18 ‘units of utility’, and so on.
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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
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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.
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Quantitative skills 1.1
Worked example: calculating marginal utility
1 Individual economic decision making
2 10
3 12
4 12
5 8
6 3
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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?
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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
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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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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.
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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’.
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● 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
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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
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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.
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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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1.2 Imperfect information
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●● The importance of information for decision
1 Individual economic decision making
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
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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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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
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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
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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
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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
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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
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STUDY TIP SYNOPTIC LINK
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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
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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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SYNOPTIC LINK
The difference between satisficing and maximising is explained in
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Chapter 3, pages XX–XX.
Bounded self-control
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Bounded rationality is closely linked to the related concept of bounded self-
1 Individual economic decision making
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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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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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
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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
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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.
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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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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
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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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T
AF
1 Individual economic decision making
Team. One of these is automatic pension enrolment (see case study 1.7).
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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
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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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.
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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
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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
AF
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.
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.
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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
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
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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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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
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The law of
AF diminishing returns Returns to scale
Revenue theory
Imperfect competition
Perfect Pure
competition monopoly
Oligopoly
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diminishing returns
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●● 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
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or services commercially. many charities, firms are commercial, earning revenue to cover the production
costs they incur.
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
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* 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.
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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
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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.)
EXTENSION MATERIAL
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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
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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.
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.
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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
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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
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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
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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
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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
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EXTENSION MATERIAL
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
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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
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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
Plant
size
KEY TERMS X 3 C
increasing returns to scale Figure 2.3 Contrasting short-run and long-run production
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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.
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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
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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.
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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
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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.
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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
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scale, including different types of economy and diseconomy of scale, re-
read Book 1, Chapter 3, pages 65–69.
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O Q1 Output
Figure 2.4 A U-shaped LRAC curve and its related SRATC curves
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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
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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
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of scale of scale
C1
O Q1 Q2 Output
Costs
SRATC1
SRATC2
Economies
of scale SRATC3
LRAC
C1
Minimum efficient scale (MES)
O Q1 Output
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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
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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
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Costs
SRATC4 LRAC
SRATC1
40 SRATC3
SRATC2
C1
O Q1 Output
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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
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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
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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
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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
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
T
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.
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
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.
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
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.
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
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
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.
T
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.
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.)
T
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
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
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?
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
T
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
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
T
●● 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
T
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
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
T
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
T
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
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
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
T
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
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.
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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.
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● 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 .
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●Aperfectlycompetitivefirmisaprice-taker,butamonopolyisaprice-
makerorquantity-setter .
●Economistsusuallyassumethatmaximisingprofitisafirm’smain
businessobjective .
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●Profitistotalsalesrevenueminustotalcostsofproduction .
●Normalprofitisjustsufficienttokeepincumbentfirmsinthemarketbut
isinsufficienttoattractnewfirmsintothemarket .
●Normalprofitistreatedasacostofproductionandisincludedinafirm’s
2 PRODuCTION,COsTsANDREvENuE
costcurves .
●Abnormal,orsupernormal,profitisanyprofitoverandabovenormal
profit .
●Thewaysinwhichfirmsoperateareaffectedbytechnologicalchange,
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whichencompassestheprocessesofinvention,innovationanddiffusion
oftechnologyintheeconomy .
●Inthelongrun,capitalismdevelopsthroughaprocessknownascreative
destruction,throughnewtechnologiesandinnovationsreplacingolder
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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?
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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.